More than $5.8 trillion in home mortgage debt in the United States is now either owned or guaranteed by a federal entity—Federal Housing Administration (FHA), Ginnie Mae, the Veterans Housing Administration, or one of the two government-sponsored enterprises (GSEs) under “conservatorship” since 2008, Fannie Mae and Freddie Mac.
This guaranteed debt constitutes a large contingent liability facing American taxpayers. If a future economic crisis triggers widespread defaults within this mortgage pool, hundreds of billions of dollars could be added to the nation’s already unsustainable deficits.
The solution to this crisis in the making is the wholesale transfer of housing credit risk back to the private sector. The nation can work down these guarantees by reawakening the private mortgage finance market from its post-crisis slumber. The objective would be to replace government mortgages with private loans as owners move or refinance—on average, mortgages are refinanced every seven to eight years.
There are four large roadblocks that have to be removed before private capital can take on residential mortgage risk.
The first roadblock is the high conforming loan limits for Fannie Mae and Freddie Mac (266 percent of the current Case-Shiller median mortgage price) and an even higher conforming loan limit for FHA and Ginnie Mae (311 percent of median mortgage price), which are rapidly increasing in market share. These high caps on the mortgages eligible for their subsidized guarantees mean the private sector can’t compete on nearly all mortgages in the nation.
The answer is to lower conforming loan limits gradually, to give the private sector more room to compete.
The second roadblock is a combination of mortgage provisions in the Dodd-Frank Act, the most restrictive of which is the risk retention requirement. There are a host of unintended consequences in this requirement that residential mortgage-backed securities (RMBS) underwriters hold 5 percent of risk on all mortgages except those determined to be super-safe—the yet-to-be-finalized “qualified residential mortgage” (QRM). The worst is that exempting Fannie, Freddie, and FHA from these requirements gives them a cost advantage against the private sector.
The remedy to this and related problems is to repeal the QRM and risk retention provisions and instead have strict resolution and bankruptcy procedures for those that take on too much mortgage-backed security risk.
The third roadblock is the complex legal framework governing RMBS. The high level of defaults following the subprime meltdown exposed an industry that never prepared (legally or emotionally) for losses on this scale, resulting in years of “tranche warfare,” the fight among various classes of investors over who shoulders these losses.
The solution to this process is evolving, with a combination of legislative clarity, new regulatory frameworks, and judicial review.
Need for Confidence
But to move beyond small-scale RMBS issuance, the government must clear the fourth roadblock: lack of confidence in the models used by credit rating agencies to assess residential mortgage-backed securities, and in the rating agencies themselves.
Two tools to overcome this roadblock can be found in our newly published Reason Foundation study, “Restoring Trust in Mortgage Backed Securities,” which outlines a series of policy initiatives regarding ratings problems for mortgage assets.
We suggest Congress authorize underwriters to include property-level address data in RMBS disclosures so investors or independent analytic firms can perform more detailed and accurate risk assessments at lower cost. Currently, it is both illegal and taboo for mortgage investors to receive the addresses for the properties backing their bonds. Without address-level data, however, it is impossible to get a precise fix on a mortgage’s value in real time.
Prevailing wisdom suggests a ZIP code is enough to perform loan-level analysis, but ZIP codes can contain several thousand properties and embrace large, heterogeneous areas. For example, in northeast DC’s 20002 ZIP code, Zillow.com recently listed a price range of $250,000 to $2.8 million, depending on whether you want to live in Little Trinidad or in an upscale townhouse on Capitol Hill.
We also suggest the mortgage finance industry enforce common formatting of RMBS collateral data to make investor due diligence easier, more competitive, and less costly. This would enable more third-party analysts and research firms to more readily analyze the risk of an RMBS offering, providing more competition for the major rating agencies.
This, combined with the availability of address-level data, would enable investors to perform their own in-house risk assessments and track the value of their investments without relying on an outside ratings assessor.
We further propose the mortgage finance industry create a Mortgage Underwriting Standards Board based loosely on the Financial Accounting Standards Board (FASB) model. This organization would provide self-regulation against misrepresentation and could even replace the QRM standards with industry-established categories of mortgages that are transparently defined by risk.
We recognize our proposals are just the beginning of what’s needed to address the confidence problem that plagues the private sector. Our study includes more ideas, including standardizing the formatting of loan level data and authorizing third parties to challenge ratings provided by the ratings agencies when used for capital adequacy purposes.
We do not suppose this is the perfect solution, but our fear is that without a debate about the best ways to tear down this roadblock, the pace of private capital’s return to mortgage finance will be sluggish at best.
Anthony Randazzo ([email protected]) is director of economic research at Reason Foundation.
“Restoring Trust in Mortgage-Backed Securities,” Reason Foundation: http://reason.org/news/show/trust-in-mortgage-backed-securities