BNA INSIGHTS: Can the Private Market Return to Home Lending?

When a family buys a home in the United States, they typically finance the purchase by obtaining a loan at a local bank or mortgage broker, which will take that 30-year promise of monthly payments and sell it to Fannie Mae or Freddie Mac. They will combine that mortgage with other mortgages, guarantee the payments, tack on a little something for its assumption of risk and then sell the resulting security in the market.

The securitization of mortgages is a way for the banks that issue them to pest itself of much of the risk inherent from such a loan. For instance, Hometown Community Bank in the small town of Morton, Ill., is likely to only make home loans within the environs of the town of Morton and the surrounding area. Because it knows the town well, it can fairly price the risk premium for mortgages in the town, but it cannot easily avoid the risk it faces if the local economy takes a turn for the worse, an event that would no doubt bankrupt many of its clients and hurt the value of the mortgages it held. By selling the mortgages to a third party it insulates itself from the risk of a localized economic catastrophe. If it uses the money from the sales of its mortgages to buy a mortgage-backed security it will have merely traded one type of risk for another, of course.

A small proportion of home loans—typically the ones for non-conforming “jumbo” loans that exceed the allowable limits for purchase by the government-sponsored enterprises—will be kept by the bank. A similarly small proportion of loans will be securitized not by the GSEs but by other private entities.

If and when the private sector does begin competing in the market for mortgage-backed securities again, it’s going to do so in spite of the federal government and not because of any prodding or the costly construction of a Common Securities Platform.

It was never the government’s intention that Fannie and Freddie have a virtual monopoly on the issuance of mortgage-backed securities. When Congress passed legislation in 2008 to deal with the GSE’s financial distress, few members expected the resolution would eventually entail increasing their market share and squeezing out private capital.

However, that is precisely what has occurred since the Federal Housing Finance Agency (FHFA) put the two into conservatorship. This development is the logical consequence of a system that encourages the GSEs, aided and abetted by their regulator, to do what they can to expand their market shares.

In an attempt to reverse this trend, the FHFA has proposed building a Common Securities Platform (CSP) that can be used by private entities that want to get into the business of securitizing home loans. By reducing the cost of entry for issuers and improving the liquidity of the resulting private mortgage-backed securities, the theory goes, this ought to make it more appealing for investors to put private capital back to work in the mortgage space.

However, it’s not the securitization costs and illiquidity that have kept away private companies, which somehow managed to issue their own mortgage backed securities without this platform prior to the financial crisis. The real problem is that many investors who purchased private mortgage-backed securities prior to the financial crisis feel they got burned by the resolution of the 2008-2009 morass and have little appetite to buy these securities again, no matter how “standard” the platform may be.

The litigation that ensued after the financial crisis — and government action that redistributed money away from investors who had already suffered losses and into the hands of delinquent and defaulting borrowers after the fact — left a lot of investors unwilling to take further serious risks in the MBS market.

A Problem of Demand

Expanding the market for private mortgage-backed securities is a demand problem, not a supply problem at this point. Investors want to hold Fannie and Freddie’s paper because they believe they won’t suffer capital losses, and they will eschew private-label paper because that’s manifestly not true in that market.

Additionally, the lack of transparency on mortgage data, the lack of enforceability of representations and warranties, and the absence of protections against the many market problems that were exposed in the wake of the last crisis remain problems. As a result, it will take serious reform to keep the GSEs from continuing to have a virtual monopoly in this market.

Perhaps we can just let the next housing price decline do the job. Under the current structure of Fannie Mae and Freddie Mac it’s not clear how long the market will come to perceive even the mortgage-backed securities they issue as being nearly riskless. In the first quarter of 2016, Freddie reported a loss and narrowly avoided needing draws from the U.S. Treasury.

By itself, a small loss incurred by a GSE in one quarter should be unexceptional. In periods where few homeowners are refinancing or the mortgage market is otherwise sluggish, it’s only natural for the two entities to suffer an occasional loss. But the fundamental inability to build up a capital cushion under the current financing structure for the conservatorships means that the two will have to receive funds from Treasury in the very near future. When that occurs, it’s very difficult to predict what will happen politically.

It’s very easy to conceive of an outraged Congress, having been promised that the GSEs had been fixed and would never cost the government a dime again, demanding that Something Be Done and a new administration with no political capital at stake—and anxious for this to not upend the rest of their agenda— acquiescing to some sort of unsatisfactory compromise that solves the optics of the Treasury giving the GSEs money but does nothing to actually improve the mortgage market.

Restoring Investor Trust

Creating a new market for mortgage-backed securities that has robust private sector entities competing with Fannie and Freddie is a worthy goal to pursue, but this has nothing to do with building a new platform. Rather, it requires taking steps to ensure the continued trust of the investors needed to buy those securities.

To restore that trust, investors have to believe that mortgages are actually collateralized by the mortgaged property. That requires the ability to foreclose and to do so in a timely manner. A necessary step in that direction is the repeal of Dodd-Frank’s Qualified Mortgage (QM) and Qualified Residential Mortgage (QRM) rules, which significantly increase the legal risk associated with both originating and securitizing mortgages.

These giveaways to the trial bar ultimately come at the expense of higher mortgage costs and reduced availability. The GSE “patch” on QM and QRM has been one of the few things that has allowed any recovery in the mortgage market. That patch should extend to private actors who put their own money at risk, rather than the taxpayer.

Investors don’t buy Fannie and Freddie’s paper because it has a “superior infrastructure” that needs to be given away or lent out to private players for them to compete. Investors buy that paper because they believe they won’t suffer credit losses when they hold it. While Fannie and Freddie currently have a Treasury backstop, each should have their own real on-balance-sheet capital that regulators and the markets can take comfort in over the long term.

GSE obligations are not obligations of the federal government, and they shouldn’t be. Wasting money on the CSP is another classic Washington boondoggle, fundamentally misdiagnosing the problem and building a new organization to provide a solution no one in the market asked for.

Regardless of whether Fannie Mae and Freddie Mac caused the financial crisis, their actions clearly made it a lot worse. Their gradual evolution from semi-public corporations designed to help make mortgages more liquid to entities completely politically captured by Congress, operating with the goal first and foremost of satisfying political patrons, was an inevitable evolution once both sides embraced the false promises of the home ownership society.

The government allocates an enormous amount of money in the name of increasing homeownership, and the overwhelming evidence suggests these efforts do nothing to actually boost the number of people who own their own home. What’s more, the very argument that home ownership is an unalloyed good that’s worthy of government subsidies is based on some questionable evidence.

The sensible approach for the federal government when it comes to home ownership would be to eliminate the mortgage interest deduction, get the government out of mortgage financing altogether, and tackle the myriad regulatory impediments that push up home prices especially in urban areas.

Treasury’s Exit

Since none of this is likely to happen anytime soon, the second-best solution is to extricate the heavy hand of the U.S. Treasury from the mortgage market before it does any more damage, and that would entail repealing the Third Amendment and allowing Fannie and Freddie to accumulate adequate capital to function without Treasury’s help while foregoing what amounts to a $100 million investment in the false panacea of the CSP.

As part of that deal, a new “Fourth Amendment” could require considerably higher levels of capital than the GSEs held before the crisis, based on guidance from FHFA which has stronger regulatory powers than its predecessor OFHEO. Such a new amendment could also include appropriate activity restrictions and requirements, including the registration of GSE debt under the Securities Act of 1933.

More capital is badly needed by all participants our nation’s mortgage market, including borrowers, lenders and the GSEs. However, while more capital can mitigate credit and insolvency risk, it cannot insulate against political and legal risk.

How does an investor or lender price the risk a foreclosure could take as long as three years to resolve? How does a lender price the various fees and penalties that could materialize from nonmaterial and honest mistakes? These are far harder questions than pricing for the risk that a subprime borrower walks away. The difficulty in pricing these risks discourages private capital and forces greater reliance on the government.

If and when the private sector does begin competing in the market for mortgage-backed securities again, it’s going to do so in spite of the federal government and not because of any prodding or the costly construction of a Common Securities Platform.

Ike Brannon is a senior visiting fellow at the Cato Institute and president of Capital Policy Analytics, a consulting firm in Washington DC. Mark Calabria is director of financial regulation studies at the Cato Institute.