Government Sponsored Enterprise Reform: A Historical Perspective Part II


By: Mark Semotiuk

(Editor’s note: This is the second post in a three part series. The first post covers the history of the mortgage market and the advent of modern mortgage securitization practice. This post examines some of the roots of the financial crisis and discusses the impact of the financial crisis on the mortgage market.  Look forward to the third installment covering the future of the mortgage market and GSE reform on Saturday)

Part II: The Financial Crisis

Economic fundamentals supported  growth in the homeownership rate through the 1990s, the longest period of economic growth in American history. Around the turn of the century, however, housing prices detached from fundamentals. It was a perfect storm of macroeconomic and regulatory conditions.

With respect to macroeconomic conditions, the housing market had significant wind at its back. First, policy makers enacted aggressive policies to increase the homeownership rate and reforms, such as the repeal of Glass-Steagall, in the name of promoting economic growth. Second, small investors poured money from the dotcom crash into the housing market. Housing was seen as an attractive investment because affordability was still in line with long term fundamentals as a result of the aftermath of the savings and loan crisis and recession. Third, the Bush tax cuts and Greenspan’s interest rate cuts in response to the September 11th recession helped make mortgages even more affordable. Finally, financial innovation made mortgage backed securities the hottest investment on Wall Street.

The financial innovation taking place in the mortgage market was based on two critically flawed assumptions. First, ignoring empirical evidence from the Great Depression, most investors assumed that housing prices never fall. Second, relying on the first assumption, investors assumed that by re-securitizing BBB tranches (as described in the previous post) increased diversification would create an AAA worthy investment known as a Collateralized Debt Obligation (CDO).

The false sense of security created by this innovation caused a race to the bottom in the sub-prime mortgage industry. In 2004, the GSEs were rocked by an accounting scandal which required them to adopt a conservative strategy.  By contrast, private mortgage originators loosened their underwriting standards to gain market share. In 2003, the GSEs held 70% of the market; in 2008 it was 40%. By 2006, the GSE’s scandal blew over and the GSEs were again reducing loan quality to remain competitive.

The macroeconomic conditions were exacerbated by regulatory gaps. These gaps in oversight occurred for multiple reasons. Poor consumer protections resulted in bad mortgage products and predatory lending. Lack of disclosure requirements in the securitization process resulted in opaque securities which hampered regulator’s efforts. Inadequate capital requirements left financial institutions ill prepared for shocks, placed the broader financial system at risk, and required the taxpayer to foot the bill.

Furthermore, the housing finance system was fraught with improper incentives. Mortgage originators were not required to maintain any skin-in the-game and earned a fee for the mortgages they sold regardless of the credit quality. They therefore originated bad loans with impunity. Further, the GSEs profit maximizing structure was at odds with their government mandated mission of ensuring market stability. The implicit government guarantee allowed the GSEs to take irresponsible risks which resulted in short term profits for the shareholders and long term costs borne by the taxpayer.

The crisis began to affect the financial sector in 2007. Housing prices continued to increase, but foreclosures began to outpace projections, primarily in the sub-prime market. Banks, as a result, began to take losses on their sub-prime related mortgage holdings.

On July 30th 2008 President Bush signed the Housing and Economic Recovery Act of 2008 into effect creating the Federal Housing Finance Agency (FHFA). On September 7th, the FHFA placed Fannie Mae and Freddie Mac into conservatorship due to the loss of value on their sub-prime holdings. The implicit government guarantee had become fully explicit; the entities were being bailed out. This shocked investors’ confidence in mortgage backed securities (MBS). Within almost a week Lehman Brothers went bankrupt in large part due to their MBS holdings. Within another week, AIG was nationalized in part due to its CDS exposure to Lehman brothers. The financial crisis was in full effect (Michael Lewis’ The Big Short provides a lively explanation of CDS liability. Baseline Scenario provides a fuller discussion of the Financial Crisis).

The crisis had drastic impacts on the housing market. As investors began to lose money on their sub-prime investments the private mortgage backed securities market – over half of the mortgage market at the time – collapsed almost overnight. This put pressure on housing prices which in turn put further pressure on mortgage backed securities and created a vicious cycle.

As of 2012, the Federal Reserve reports that home prices have fallen by 33% resulting in a loss of about $7 trillion dollars in wealth. The current net cost of the GSEs conservatorship is about $151 billion dollars. This does not include the social costs of improper foreclosure practices such as the robo-signing scandal which came to light in 2011 (and covered on this blog here). Approximately six and a half million homes have been foreclosed on since 2005 and the shadow inventory of potential additional foreclosures is about seven million additional homes. This represents approximately fifteen percent of the entire stock of ownership housing.

The mortgage industry is still in a period of reform and the housing industry and the broader economy depend on its continued stability. Mortgage backed security issuance, which peaked at about $4 trillion per year in 2003, is now running at a rate of $1 trillion per year. The GSEs, under conservatorship, now have a near monopoly on the secondary mortgage market. Private mortgage backed security issuance is down about 99%. Significant mortgage industry reform will likely not take place until this market heals.

How this reform looks will fundamentally influence American society. Together the GSEs own or guarantee over 40% of all of the residential mortgages in the United States, over $5.2 trillion dollars in securities. For nearly sixty years, America, through the GSEs, has promoted a homeownership policy. GSE reform will influence the degree to which this policy will continue.


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Fordham Journal of Corporate & Financial Law