How Do We Fix Our Housing Finance System? Part II: Rethinking Government's Role, Starting with FHA's

Second in a series

As I noted in my first installment of this series on reforming the housing finance system, there are no perfect choices ahead as private, public and quasi-public entities all confronted failures of different forms in the aftermath of the crisis.  However, determining the role of the federal government in housing finance is the lynchpin to reform. 

A number of criteria come to mind that should be used as benchmarks for assessing the level and extent of government intervention and subsidy in housing finance.  The first is recognizing that the housing system is a critical sector of the general economy and that ensuring stability and liquidity is a desirable feature.  The Federal Housing Administration's resurgence, tripling its market share from historical levels as private capital retreated during the crisis, shows the importance of the government's countercyclical role during economic stress. This suggests the government would need to maintain some direct role in providing a lifeline to housing at critical times. 

From a social policy perspective, providing credit to low- and moderate-income and first-time home borrowers, veterans and other segments has been a major mission of the government since the Great Depression.  That role expanded over the years and remains an area ripe for policy reassessment. 

The FHA, due to its expansion during the crisis, is insuring loans to many borrowers who otherwise could access private markets, even today, for credit.  The mechanism, timing and process for how the government modulates its entry and retreat from housing finance are today an ad hoc process and one that requires a detailed plan. 

In an era requiring heightened fiscal discipline, minimizing taxpayer exposure to mortgage risks is essential.  Related to this is the criteria that changes to the housing finance system must mitigate potential moral hazard by lenders and borrowers.  Lastly, modernizing and strengthening underlying processes used to originate, securitize and service mortgages is essential. 

There is no question other important criteria could be added to this list, but the ones called out here stand out as foundational to any successful  plan. With these criteria in mind, what sort of role for government might be envisioned, realizing that multiple variations could deliver similar benefits?

Despite the many flaws in the existing housing finance system, there are a number of features that with some adaptation and integration with other segments could meet the above criteria.  Most market observers and participants would agree that the FHA's current market share of about 30% needs to shrink back somewhere around its historical level of 10% to 15%.  FHA's policy levers to achieve this include a combination of pricing, credit and lender policies, but standing in the way from the FHA achieving this objective are three factors.

First, no policy criteria have been established to identify what segment of the housing market is to be supported with a direct federal insurance subsidy going forward. Second, we have no clear idea of when to start any transition toward private capital. And lastly, the FHA is ill-equipped for the role of providing a countercyclical balance to housing and delivering and maintaining effective credit and pricing policies over varying economic cycles.  Despite its best efforts, the agency has struggled with a ponderous bureaucracy that not only has stifled innovation, but limited its access to personnel and technologies essential to its crucial role.

Fundamentally, the federal government and the FHA specifically need to outline the market segments to be served directly by the government and augment that policy with a set of protocols describing the combination of pricing and policies it will use during stress events to fill in voids in the market. In addition, the FHA also needs to formulate an escape plan for when its involvement should subside.  The lack of such a mechanism today is one of a number of factors preventing private capital to return. We could take a page from the Federal Reserve in its efforts to tie interest rate policies to target inflation and unemployment rates.  Likewise signals from the housing market could be used to guide incremental policy responses by FHA (and, for that matter, Fannie Mae and Freddie Mac, or whatever succeeds the two government-sponsored enterprises) in reducing their housing finance footprint. For example, shadow inventory levels, home price trends and other metrics of housing stabilization could be used to direct policy more explicitly.

Achieving a countercyclical role for government like Option 2 in the Treasury Department's plan requires a level of performance beyond that which exists currently.  The FHA in its current form would not be able to handle that role but it has a much better chance if it were moved out of the Department of Housing and Urban Development and combined with Ginnie Mae and the remnants of key operations of Fannie and Freddie after their wind-down.  This new government corporation would have a better chance of attracting talent and resources, making adjustments to federal pay scale commensurate at least with the safety and soundness regulators, and would have less potential to be held hostage by Congressional and Administration politics as it has since its inception.

There will need to be some federal support for certain borrower segments that need a helping hand.  That is an appropriate role for government, but in the last decades we expanded that mission well beyond reasonable bounds and with limited resources to understand the risks posed. That blind expansion has left the FHA's $1 trillion insurance fund underwater by billions of dollars.  To ensure that taxpayers are protected, potential for moral hazard is mitigated and that those charged with overseeing this fund can effectively monitor and manage risks and innovate over time, the FHA's role and place in government must evolve and adapt to the complexities of the greatest housing system in the world.

My next post will focus on the issues surrounding government guarantees for the non-FHA/VA market segment. I'm avoiding referring to it as "conventional conforming" as I'm not sure that terminology will apply in a post-GSE world.

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.