How Do We Fix Our Housing Finance System? Part I: An Overview

First in a series.

There are signs that 2013 may finally be the year that meaningful progress toward reforming the housing finance system is made. 

For a variety of reasons neither Congress nor the Administration so far has provided any concrete plan for what comes after the mortgage crisis. And so our housing and mortgage markets remain in limbo, held hostage to various political forces, inertia from the GSE conservatorships and a general market malaise for the past several years. Political and fiscal distractions may be abating, and with the housing market showing signs of stabilizing, the opportunity to shape the future course of housing finance may have arrived. 

Tackling a comprehensive overhaul of our nation's housing finance system will be one of the most difficult undertakings policymakers have faced in the last 80 years due to the scope and complexity of mortgage finance activities and diversity of market participants.  Over the next eight weeks, I will explore the major issues and critical elements to accomplishing effective housing finance reform that opens the dialogue beyond the hallways of the Treasury Department. 

The housing finance system, much like home construction, is an integrated collection of key components, without which the system may not properly function.  If a house's foundation is cracked, it threatens the structural integrity of the entire home despite its other attributes.  And so for this series not only will the focus be on the critical components to achieving effective housing reform, but also on an integrated view required for its sustainability. 

Looking back on the mortgage crisis it is clear that no sector of the housing system escaped unscathed.  Spectacular failures of the private sector, the public sector and of the quasi-governmental organizations Fannie Mae, Freddie Mac and Federal Home Loan Banks suggest that any structural alternative to housing finance reform – purely private, purely government, or somewhere in between – has flaws.  Designing a housing system that avoids another financial abyss requires some deep introspection into the commonalities between sectors that drove banks like WaMu into insolvency, the Office of Thrift Supervision to merge with the Office of the Comptroller of the Currency, the FHA to experience unprecedented actuarial losses, and the GSEs to enter conservatorship, among other notable failures. 

Remarkably, in the decades leading up to the housing boom the housing finance system worked extremely well in many different credit and interest rate environments. While there were episodes of volatility, the system effectively provided liquidity and stability to markets and distributed credit risk among different participants. So how was it that a system that had operated rather well over a long period of time experienced a cataclysmic end?

A litany of root causes to the crisis have been researched and discussed since the crisis began.  But reflecting back on those that appear to have been major contributing factors are lapses in risk and oversight discipline, mission confusion, excessive credit risk concentration and product transmission deficiencies.  Each sector – public, private and quasi-governmental – was hurt by these factors. 

The proliferation of higher-risk mortgage products, and associated general lapses in risk management governance, processes and controls and in regulatory oversight were explosive catalysts for the abnormal trajectory taken by the industry and facilitated the overconcentration of credit risk in a few key players.  And more revealing is that this pattern was pervasive across the industry and regulatory agencies.  Reestablishing risk and oversight discipline is essential to stable housing finance. 

Compounding market and agency discipline issues was a lack of attention to essential critical infrastructure used to process loans and securities that devastated the integrity and credibility of the mortgage origination, security issuance, custodial services and servicing processes. Fixing the transmission issues in the mortgage manufacturing process and establishing an industry utility charged with overseeing the maintenance, enhancement and compliance with its requirements is a necessary ingredient to successful housing finance reform. 

Finally, each of these sectors suffered from mission confusion. Whether it was conflicts between affordable housing and shareholder interests in the case of the GSEs, short-term personal gain for senior management at mortgage originators, or regulatory capture by safety and soundness regulators, the missions of the key agents in the housing finance system became hopelessly blurred in the boom years.  Clarifying the expectations and requirements of each entity and participant must be part of any reform plan.

At the broadest level, restructuring the housing finance system to address these deficiencies must take into consideration the impact on market liquidity and stability, taxpayer exposure and any social welfare implications associated with making affordable and decent housing available to all citizens.  It is to this last criterion for an effective housing finance system that policymakers must first turn their attention. 

But thus far there is no clarity on what our national housing policy should be.  What is an appropriate homeownership rate in the U.S.? Should there be a federal guarantee on mortgages and if so what level should it be? What segments of the population should receive housing support? 

Looking at FHA's underwriting criteria today, it is unclear why there should be any federal guarantee on borrowers in high cost areas for loans of $729,750. That the FHA needed to adjust its loan limits to offset the retreat of private capital from mortgage markets during the crisis is not a satisfactory answer. 

In other words, the role of the federal government in housing is the first question that needs to be answered, putting political rhetoric and preconceived notions about the subject aside.

In the weeks to come I will review the merits and failures of the public, private and quasi government sectors with a focus on what their role could be and any required reforms in a reconstituted housing finance system.  Included in this discussion will be the FHA, the Federal Home Loan Bank System, Fannie and Freddie, private label securitization, and private mortgage insurance. 

Successful housing finance reform must not be made in piecemeal fashion but rather by conducting a holistic assessment across the system.

Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.