Government Sponsored Enterprise Reform: A Historical Perspective Part III


By: Mark Semotiuk


(Editor’s note. This is the third post in a three part series. The first post discussed the history of the GSEs. The second post discussed the roots of the financial crisis and its impact on the mortgage market.)


In February of 2011, the Treasury released a whitepaper outlining three possible GSE reform proposals. The first proposal calls for a fully privatized system of housing finance. The second proposal calls for a fully privatized system with an explicit guarantee mechanism that can scale up during times of crisis. Finally, the Treasury proposed a mixed public/private system: reinsurance on all conforming mortgages behind significant private capital.

The first blog post of this series identified the GSEs two primary business lines: purchasing mortgages to develop a secondary market, and providing insurance through a guarantee. It is notable that the whitepaper mainly discusses the future of the guarantee. The secondary mortgage market has matured and has developed a wide range of participants. Therefore, the government’s involvement in purchasing mortgage securities to facilitate the development of a secondary market appears somewhat antiquated. Some commentators have called for the GSEs portfolio to be completely wound down.

The treasury identified four main considerations with respect to reform proposals. First, government support (for example, guarantees) can expand access to mortgage credit by attracting additional capital into the system and keeping the cost of mortgages down. Second, government support can draw investment into the housing market, which may prevent capital from locating overseas and further lowering housing prices. Third, to protect taxpayers from directly or indirectly paying for loan losses, financial risk assumed through government support must be appropriately managed. Finally, government support can help promote financial stability by ensuring the flow of credit through periods of economic stress.

The report highlights the benefits of placing private capital back at the center of housing finance. Private coordination minimizes capital distortions, reduces the moral hazard in mortgage lending and reduces taxpayer exposure to private lenders’ losses. As a result, permanent and complete nationalization of housing finance is unlikely unless privatization efforts fail.

A fully privatized system, however, is also not without its disadvantages. A majority of commentators agree that even if housing finance is supposedly private, policy makers will intervene in the next crisis to ensure that mortgages are available and to stabilize financial markets. Since the government support is latent, it would be better to make the government backstop explicit and place a value on it than give it away for free.

Further, a fully privatized option would increase the borrowing cost for the majority of borrowers. Interest rates could rise by hundreds of basis points, and hundreds of thousands of homes would go undeveloped or unsold (comparing jumbo to conforming rates, a quick and dirty analysis, suggests rates would rise by about half a percent). Some commenters argue that the economic impact would be significant enough to render such reform socially and politically untenable.

The second reform proposal, a private model that scales up in times of crisis, poses operational questions. The current conservatorship is primary an example of operationalization difficulties. Such problems would also hamper the government’s ability to facilitate market stability during the next crisis. This lends further support for a structure with a broad based explicit guarantee.

The optimal solution maximizes the benefits from the private sector’s more efficient capital allocation and assumption of risk with the public sector’s increased affordability and market stability. Some commentators argue this can be accomplished by placing private capital in a first-loss position before a secondary government guarantee, as in the government’s third reform proposal. The private capital would provide a buffer for taxpayers, give investors appropriate incentives for risk taking and bring private capital back into housing finance. The secondary government guarantee would reduce housing and mortgage costs, although not as much as in a fully nationalized system, and minimize operational difficulties.

In one approach to such a system, a group of private mortgage guarantor companies that meet stringent capital and oversight requirements would provide guarantees for securities backed by mortgages that meet strict underwriting standards. A government reinsurer would then provide reinsurance to holders of these securities which would only be paid out if shareholders of the private mortgage guarantors have been entirely wiped out. The government reinsurer would charge a premium for this reinsurance, which would be used to cover future claims and recoup losses to protect taxpayers.

Allowing competition among various such firms would ensure than any subsidies are passed onto borrowers through lower borrowing costs – as opposed to shareholder profits, which the implicit guarantees padded under the old GSE model. Further, allowing for entry and competition would also help ensure that enough firms undertake securitization that one could fail without concerns of destabilizing the entire housing finance market – another problem under the old model.

Regardless of which model is selected, regulators will be playing a central role in the future of housing finance. Their role will include: properly aligning the incentives of market participants; deciding on the price of the federal guarantee; deciding on the amount of capital required in front of the federal guarantee; ensuring that firms maintain adequate amounts of capital on their balance sheets; promoting financial transparency; and enforcing consumer protections to prevent low-quality mortgage products and predatory lending from proliferating.

The Dodd-Frank Act has laid the groundwork for many of these reforms. For example, the Act established the Bureau of Consumer Financial Protection (CFPB) whose mission, not surprisingly, revolves around consumer protection. The CFPB is charged with preventing bad mortgage products and predatory lending, promoting choice and clarity by setting clear, consistent rules, and setting stronger underwriting standards. The CFPB is currently crafting rules that will directly impact the mortgage origination process by requiring that lenders make a good faith determination that borrowers have the ability to repay their mortgages.

Further, Dodd-Frank allows the SEC to implement stricter disclosure and reporting standards to make the risks of securities more transparent. The SEC will also establish an Office of Credit Ratings which will improve disclosure for ratings methodologies. Finally, Dodd-Frank also impacts mortgage securitization by requiring private label securitizers or originators to retain five percent of the credit risk sold to investors unless the mortgages underlying the pool meet certain underwriting standards. This is aimed at aligning the incentives of those who create and sell mortgage securities with those who ultimately bear the risk.

Dodd-Frank also created the Financial Stability Oversight Council (FSOC).  FSOC’s mandate is to monitor systemic risk. It has the authority to require consolidated supervision of any financial firm whose failure could pose a threat to financial stability.  FSOC would also play a critical role in any future crises in housing finance by determining the extent to which the government backstop would be implemented.

Finally, regulators have targeted capital requirements through the Basel III capital accords. The accords increase the overall amount of capital that banks are required to hold. This will insulate banks from future downturns and shocks. Ultimately, this helps ensure adequate private capital is placed before a government guarantee.

The secondary mortgage market is in clear need of reform. Private mortgage backed security issuance is approximately 99% below where it was before the financial crisis and the GSEs remain in conservatorship. This series provided a history of the secondary mortgage market and concluded with three categories of potential reform proposals. It further examined the regulators post-conservatorship role. Ultimately, higher mortgage rates and economic effects associated with privatization may determine the extent to which a particular form of reform is palatable. As some estimates provide that there are still seven million foreclosures in the pipeline, it will likely be quite some time before any major reform is completed.



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Fordham Journal of Corporate & Financial Law