DeMarco: Should Government Set Standards, Backstop the Market, or Continue to Issue Guarantees?

by devteam March 20th, 2013 | Share

Edward J. DeMarco, Acting Director of the Federal Housing Finance Agencyrn(FHFA) told lawmakers on Tuesday that the role of housing finance reform shouldrnbe to promote the efficientrnprovision of credit to finance mortgagesrnforrnsingle-family andrnmultifamily housing.  Speaking at a hearing of the House Committee on Financial Services DeMarco said that an efficient marketrnsystem for providingrnmortgage credit to homebuyers should have certain core characteristics: allowing innovation, providing consumer choice, providingrnconsumer protection, andrnfacilitatingrntransparency.  At the most fundamental level, thernkey question in housingrnfinance reform isrnwhat,rnand how large, should be the role of thernfederal government?</p

DeMarco said that as anrneconomist he would approach the issue in the context of a potential marketrnfailure which may lead thernprivate market to produce less of,rnorrnmore of, a particular good than wouldrnbe economically optimal. rn</p

There are atrnleast two potentialrnmarket failures</bin housing finance that may leadrnto an under-provision of mortgage credit. rnIf undue or unnecessary concerns about thernstability and liquidity of mortgage credit prevail in a purelyrnprivate market lessrncredit willrnbe provided than in thernabsence of this type ofrnuncertainty. The government response could range from establishing standardsrnandrngreater transparency;rnproviding liquidity or creditrnsupport, or providing a government guarantee to eliminate uncertainty.</p

A second failure occurs when the benefits of homeownership arernviewed as extending to the broader aspectsrnof society. In such cases the market will never providernthe optimal number of homeowners so government may seek to increase demand through subsidies or assistance to encouragernor facilitate consumption, i.e. the mortgage interest taxrndeduction.  </p

As of the fourth quarter ofrn2012, there was aboutrn$9.9 trillion in single familyrnmortgage debt outstanding, 13rnpercent of which was directly government guaranteed and 52 percent guaranteedrnby Fannie Mae and Freddie Mac (the GSEs). rn In the thirdrnquarter of 2012rnnewrnsingle family mortgage originations totaled approximately $510 billion;rn18 percent was guaranteedrnthrough directrngovernmentrnprogramsrnand, 66 percent through the GSEs. Measured by securities issuance, thernproportion supportedrnbyrnthe governmentrnis over 90 percent.  </p

DeMarco said that the longstandingrnroles of FHArnand VA suggest the government will continue a role in housingrnfinance, but the relevantrnquestion is how to move from thernmassive government support of today to a future marketrnwith a larger private presence; particularly the $5 trillionrnGSE portion of the market.</p

If policymakersrnbeginrnbyrndefining which borrowers wouldrnhave access to FHA and other government mortgage creditrnprograms thenrnit should be easier to consider therngovernment’srnrole,rnif any,rnin the remainder of the market. rn</p

Considering how to replace the government sponsored enterprise model, in particular developingrnan efficient secondary mortgage market thatrncanrnaccess capital markets to serve the single family marketrnthat is not covered by traditional government credit programs is central to congressionalrnconsideration of ending the conservatorships.</p

DeMarco sees three options: arnmarket-oriented approach thatrnwould ensure broad minimum standards; establishingrna Federalrnbackstoprnto provide liquidity when needed,rnor developing a government guarantee structure tornensure credit stability and limit market uncertainty. </p

A standard-setting approachrnwould replace some of thernGSEs’ standard-settingrnand government guarantees with arnregulatory regime or a market utility thatrnsets standards to provide a degree ofrncertainty to investors. The focus in such anrnapproachrncould be on settingrnstandards aroundrnkey featuresrnthat investors needrnto price creditrnrisk which include standards associatedrnwith underwriting, pooling and servicing, andrndisclosures. rnInvestors would also be responsible for enforcingrntheir rights under the standard contractsrndevelopedrnunder this framework. rn</p

To establish arnliquid non-government guaranteed market with such standards would seem tornrequire a greater homogeneity inrnborrower characteristicsrnwhich, while it would broadly cover the bulk ofrnthe GSEs’ business,rnmight not be availablernserve all of their borrowers. Where characteristics do not fit neatly intornthe secondary market, we need to findrna way to getrninsured depository institutionsrnback into the business of funding mortgages, a role DeMarco sees the Federal HomernLoan Banks suited to at least partially fill.</p

It would bernimportant to consider howrna standard-regulated marketrnwithout government guarantees wouldrnoperate in a time of stress.rnPreserving liquidity and the availability of credit are important functionsrnand a determination should be made whether a federal backstop such as FHA forrncredit or the Treasury Department for liquidity is needed.  Or alternatively,rnwith a more standardizedrnmarket andrninfrastructure,rnwould it be possible for an existing guarantor,rnlike Ginnie Mae, to playrnsuch a temporary guarantee function?</p

The third option would resemble a housing finance system withrnsome type of government guarantee asrnwe have today.  A guarantee wouldrnenable securities to be priced favorably andrnhave a high degree of liquidity to reflectrnthat guarantee but would not provide the benefitrnof pricing the credit riskrnof the underlying mortgages.  Private sector capital throughrnequity investmentrnwould stand in a firstrnloss position, with arngovernment guarantee thatrnwas funded through anrninsurance premium being available to cover other losses. </p

Replacing the GSEs’ implicit guarantee withrnanrnexplicit one does not resolve allrnthe shortcomings andrninherent conflicts in that model,rnand it may produce itsrnown problems. First,rnthe presumption behind the needrnforrnan explicit guarantee is thatrnthe market eitherrncannot evaluate and price the riskrnof mortgage default at a reasonable price or it cannot manage that amount ofrnmortgage credit riskrnon its own.  However, is there reason to believe thatrnthe governmentrnwill do better?  If therngovernmentrnbackstop is underpriced, taxpayers eventually may foot thernbill again.</p

Second, if it provides explicitrncredit support for the majority of mortgages it would likely want to determine the allocationrnor pricing of mortgage credit for particular groups orrngeographic areas, distorting risk pricing and risking further taxpayer involvement.rn</p

Third, explicit creditrnsupport for most mortgagesrnin addition to the mortgage interest deduction  would further direct ourrnnations investmentrndollars toward housing and possibly drive uprnthe price of housing, other things being equal. </p

DeMarco also told committeernmembers about FHFA’s 2013 goals under the 1212 Strategic Plan for the GSEs and aboutrnthe proposed reform of the securitization platform.  This was a reprise of information DeMarcornsent to the committee on February 21 and covered by MND.   </p

DeMarco concluded his testimony byrnsaying that few could have imagined in 2008 “That we wouldrnbe approaching the fifthrnanniversary of placingrnFannie Mae and Freddie Mac inrnconservatorshipsrnand have made littlernmeaningful progress to bring these governmentrnconservatorships to anrnend. rnHe urged Congress to make thernnecessary policy determinationsrnand then set aboutrnending these conservatorshipsrnand transitioning to a future housing finance system that canrnserve our children, grandchildren, andrnbeyond.

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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