The State of the Debate

Last week the Urban Institute hosted a three-day online “Housing Finance Reform Policy Debate,” in which I was one of the participants. The moderator, Ellen Seidman (non-resident fellow at the Urban Institute, and at one time a colleague of mine at Fannie Mae for a few years), set our topic as: “How the federal government should support housing—both homeownership and rental—for those the market will not.”

Providing adequate support for low- and moderate-income homebuyers has been one of the more difficult challenges for people seeking to replace the current system of secondary mortgage market finance based on Fannie and Freddie with a new set of institutions or some different mechanism. Accordingly, five of the nine debate participants had expertise in affordable housing, minority lending, or multifamily rental finance: Mike Calhoun of the Center for Responsible Lending, Barry Zigas of the Consumer Federation of America, Rob Randhava of The Leadership Conference on Human and Civil Rights, Lisa Rice of the National Fair Housing Alliance, and Shekar Narasimhan of Beekman Advisors. Also participating were three individuals I would label housing policy analysts—Laurie Goodman of the Urban Institute, Mark Zandi of, and myself—and one advocate of free-market housing policies, Ed Pinto of the American Enterprise Institute.

One of Ellen’s ground rules was that we try to keep our posts to around 200 words, and most of us were pretty good about that. By the end of the three days there really hadn’t been much “debate,” yet a good deal of valuable information was conveyed nonetheless. Also, I thought we reached something close to a consensus on each of the main issues we were asked to address: (a) there are clear roles for government in providing housing finance to underserved populations; (b) there is very little chance of reform legislation being passed in the foreseeable future, and (c) in the absence of legislation, the current game plan of Treasury, backed by what I call the Financial Establishment, of discretely hobbling Fannie and Freddie in an attempt to “crowd in” more private capital will continue, with the main doubt in people’s minds being whether these efforts will become more overt or extreme.

Those interested in reading all of the comments can find them here. In addition, the three questions Ellen posed to us (in italics), the responses I gave to each, and a brief summary of the other comments are offered below—along with a discussion of two recent attempts I made to get responses to my criticisms of credit risk transfers.

Question One: I’d like debaters to (i) define the federal government’s responsibility to support housing both in terms of the type of support and who should be supported; (ii) highlight the major flaws you see with the current system; and (iii) provide a succinct bottom line description of how you think the system (including if you wish FHA, VA, RHS and the Home Loan Banks) should be reformed to better meet the government’s responsibility as you’ve defined it.”

I responded by saying, “The federal government’s housing responsibilities should be to (a) devise and implement subsidy programs in support of underserved populations, and (b) foster the development of a housing finance system that will provide the lowest-cost mortgages to the widest range of borrower types, consistent with an agreed-upon standard of taxpayer protection.

The biggest flaws in the current system are that the centerpieces of the secondary mortgage market, Fannie and Freddie, have not yet been given updated, true risk-based capital standards, and that they remain in conservatorship without the ability to retain earnings or raise private capital. During and after the crisis these two companies had by far the lowest default rates of any source of mortgage credit. There is no policy reason to replace them with an untested alternative; they should be allowed to recapitalize to new risk-based standards, be given utility-like return limits and made subject to tighter regulation, and be released from conservatorship.

For subsidized housing programs, I propose a small (5-10 basis point) fee assessed on all new residential mortgages, not just those financed in the secondary market.”

With the exception of Ed Pinto—who believes that government efforts to support affordable housing do more harm than good—respondents generally agreed with my formulation of what the government’s responsibilities should be. Everyone also agreed that the current system was not doing a good job meeting the needs of the affordable housing community, particularly minorities and renters. Mike Calhoun best summed up the roles the government should play, noting, “Market participants that benefit from implicit federal government-backing must serve the public interest through enforceable obligations. Compliance with fair lending is required along with affirmative duties on regulators to further fair lending.”

Question Two: “For the second question, please discuss why and how you think the Senate draft does or does not align with the goals you’ve set out for access and affordability.  Please consider issues beyond dollars—both because we’re dealing with a system, not just a series of transactions, and because the Senate bill touches on these issues (whether by commission or omission).  What of housing goals, duty to serve, business judgment, fair lending, enforcement mechanisms?”

Here my response was, “My framework for government involvement in housing has two components: an effective direct subsidy program, and a mortgage credit guaranty system whose structure and operation facilitate cross-subsidies that hold down guaranty fees for affordable housing borrowers.

The Senate draft bill misses badly on both. Its proposed reform of the secondary market credit guaranty system is almost completely devoid of details, making it impossible to assess how guaranty fees would be affected under the bill. The draft is silent on credit guarantor capital requirements—the most important determinant of guaranty fees—and leaves nearly all of the difficult challenges of replacing the existing system based on Fannie and Freddie with a new multi-guarantor system to be figured out by the regulator after the bill has passed. That is extremely risky.

The Senate draft compounds this error by pretending that having an effective direct subsidy program is conditional upon secondary market reform. It is not. To the contrary, the “market access fee” proposed in the Senate bill would collect much more revenue, and provide support for many more affordable housing programs, if were levied on all newly originated mortgages, not just those financed by secondary market credit guarantors.”

Laurie Goodman and Mark Zandi had the most positive views of the Senate bill, with Goodman focusing on its proposed 10 basis point market access fund, which she said “makes the cross subsidization explicit” and “allows the subsidy to be much more clearly and effectively targeted to those who need it in ways they can use it.” Advocates for lower-income borrowers, on the other hand, criticized the facts that the new credit guarantors created by the bill would not be subject to any affordable housing mandates, and that their fees for guaranteeing such loans likely would be higher than they are currently. Lisa Rice noted, “the Senate bill eliminates important [fair housing] language” in existing legislation, and “also includes language regarding the right of newly formed entities to exercise their business judgment without threat of liability.” And Calhoun provided a useful link to a report published by the Center for Responsible Lending and the National Urban League that gives detailed arguments in support of his contention that the Senate bill “is not only a blow to affordable housing, it harms the overall housing market.”

Question Three: “For our final question, please consider what could and likely will happen over the next 3-5 years (go out to 10 if you dare), first, if there is no legislation and second, if legislation similar to the Senate draft bill is enacted.  In your responses, consider (i) what the Treasury and FHFA have the authority to do, alone or together; (ii) the likely impact of any decision and/or settlement of the shareholder litigation; and (iii) likely budgetary action by Congress relating to HUD and the FHA.”

I chose to respond to the question this way: “I don’t believe there is any way to predict what will happen if the Senate bill passes, since it’s virtually devoid of operational details. It is analogous to having a group of auto critics design a car as it’s being built on the assembly line; it’s anybody’s guess as to what it will look like when it rolls off, let alone whether it will run.

A non-legislative outcome is far more likely in any case, due to the complexity of the problem and the dysfunction in Congress. Even here, however, prediction is very difficult. It’s more a case of what’s most probable, and here is my assessment of that:

– Fannie and Freddie will remain in conservatorship until some triggering event—most likely an adverse ruling in one of the court cases challenging the net worth sweep—occurs to prod (or force) administrative action by Treasury.

– Treasury’s reform initiative will follow the model put forth by Moelis & Company last June. This is a “turnkey” solution, with support of the investment bankers who will need to raise the capital for it, and it also will yield upwards of $100 billion for Treasury through conversion of warrants for Fannie and Freddie common stock.

– Affordable housing groups will succeed in getting legislation, not tied to secondary mortgage market reform, that imposes a small fee on all new mortgage originations, with the proceeds used for targeted subsidy programs.”

No one who replied to this question said they thought there would be reform legislation this year—or indeed at any time during the 3- to 5-year horizon of the question. And in the absence of legislation, most commenters said they thought that Treasury and the FHFA would continue to manage Fannie and Freddie consistent with their ultimately being replaced by some other entities or financing mechanism. Several noted that Mel Watt’s term as FHFA director expires in January 2019, and Barry Zigas, Zandi and Goodman all thought a new director was likely to take steps that would be negative for affordable housing. As Zigas expressed it, “A new director probably would try to shrink the GSE footprint and ‘crowd in’ private investment by increasing guarantee fees and reducing loan limits, no matter how dubious that outcome is.” None of the participants representing affordable housing constituents took issue with this prediction (unfortunately).

In their comments about the likely futures of Fannie and Freddie, both Zandi and Goodman predicted continued expansion of the companies’ credit risk transfer programs. Zandi added, “The process will surely be tested by recession and financial market volatility, but it will successfully adapt to these challenges.” After reading this latter statement I decided to engage on it, and posted the following:

“I have been a critic of credit risk transfer (CRT) securities as a substitute for equity capital in a reformed secondary market credit guaranty system, because I strongly believe that programmatic CRT issuance will make guarantors less able to absorb the credit losses they retain.

My argument is a simple one. Investors price CRT securities with the objective of earning a competitive risk-adjusted return (that is, so that the interest income and principal repayments they receive will comfortably exceed expected credit loss transfers). If they believe there is a significant chance of losing money on a CRT investment, they either will raise their yield requirement or (more likely) decline to purchase new CRT issues. The inevitable result of this entirely predictable behavior by CRT buyers is that the issuer will end up paying more (and likely far more) in interest on the CRTs it issues than it receives in credit loss transfers, weakening its ability to bear losses itself during times of stress.

In the spirit of debate, I would like to ask supporters of programmatic CRT issuance: ‘Am I getting anything wrong in my analysis, and if not, what is the counter-argument for supporting a ‘reform’ element that is bad both for the stability of the housing finance system and for homebuyers, who will have to bear the cost of this program?’”

This was a very clear question, to which I hoped to get a very clear answer. I did not. I posed my question at around 11:30 on Friday morning, but not until five minutes before the 5:00 pm cut-off time did any response appear. Then Zandi posted, saying, “This paper presents the case for the capital market CRTs in the current and future housing finance system.” The linked paper was from last August; it was not remotely responsive to my question, and I had no time left to make that or any other point.

I might have been surprised by this, except something very similar had happened barely two weeks earlier, when I sent a detailed criticism to the authors of a paper titled “Credit Risk Transfer and De Facto GSE Reform,” published by the New York Federal Reserve. Rather than respond to my criticism, one of the authors (who I discovered was an executive at a real estate investment trust, Annaly Capital Management) instead sent back a note stating he “would choose not to further discuss this given our different points of view, which seem somewhat ideological, and hence we likely won’t bridge the gap.” (I discuss this episode in more detail in a comment here, in my blog.)

Both Zandi’s and the Annaly Capital executive’s (non-) responses to my criticisms encapsulate where we now are in the mortgage reform process—and, according to the participants in the Urban Institute’s on-line debate, where we’re likely to remain for the foreseeable future. Led by Treasury, the Financial Establishment is able to have its way with Fannie and Freddie, sweeping all of their profits, dictating what policies they adopt, and persistently diverting their business, and revenues, to well-connected competitors. Valid criticisms of what Treasury and FHFA are doing, or fact-based refutations of their stated reasons for doing it, pose no real threat to them. Until some individual or group in this or a future administration steps up and shows leadership on reform issues, there will be little change for the good to the status quo, which has been created by and favors the Financial Establishment. We will continue to debate how best to serve low- and moderate-income homeowners and renters, and they will continue to be served poorly.