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Unformatted text preview: The Devil’s in the Tail: Residential Mortgage Finance and the U.S. Treasury W. Scott Frame Federal Reserve Bank of Atlanta Larry Wall Federal Reserve Bank of Atlanta Lawrence J. White New York University Presented at the Federal Reserve Bank of Atlanta 2012 Financial Markets Conference Financial Reform: The Devil’s In the Details Atlanta, Georgia April 11, 2012 The Devil's in the Tail: Residential Mortgage Finance and the U.S. Treasury W. Scott Frame Federal Reserve Bank of Atlanta [email protected] Larry D. Wall Federal Reserve Bank of Atlanta [email protected] Lawrence J. White New York University [email protected] This Draft: March 23, 2012 Abstract This paper seeks to contribute to the U.S. housing finance reform conversation by providing a critical assessment of the various types of policy proposals that have been offered. There appears to be a broad consensus to maintain explicit government guarantees for certain narrowly defined borrower populations, such as FHA insurance guarantees for low‐ and moderate‐income and first‐time homebuyers. However, the expected role of the federal government in the broader housing finance system is in dispute: ranging from no role; to insuring against only extreme or tail events; to insuring against all losses. However, most proposals agree that the establishment and maintenance of residential mortgage underwriting standards and fees assessed for risks assumed are important for limiting taxpayer exposure. JEL Classification Numbers: G18; G28 Keywords: residential mortgages, securitization, government‐sponsored enterprises, housing subsidies. Acknowledgements: Pam Frisbee for research assistance. 2 The Devil's in the Tail: Residential Mortgage Finance and the U.S. Treasury 1.) Introduction The Dodd‐Frank Wall Street Reform and Consumer Protection Act of 2010 aimed at improving regulatory oversight of the U.S. financial sector in the wake of the recent financial crisis. Notably, however, that legislation did not address an important set of issues that were at the heart of the crisis: governmental involvement in the U.S. housing finance system. Central to this discussion is the future of two housing government‐sponsored enterprises (GSEs) ‐‐ Fannie Mae and Freddie Mac – which have been in federal conservatorship since 2008 and have thus far required $183 billion in taxpayer assistance.1 Fannie Mae and Freddie Mac together manage the credit risk that is associated with approximately $5.0 trillion of the $10.5 trillion U.S. residential mortgage market. This paper seeks to contribute to the U.S. housing finance reform conversation by providing a critical assessment of the various types of policy proposals that have been offered. We believe that there is a consensus to reduce the expected cost of federal government involvement in residential mortgage finance but also to maintain explicit government guarantees for certain narrowly defined borrower populations, such as low‐ and moderate‐income and/or first‐time homebuyers served by the Federal Housing Administration (FHA) insurance program and securitization of FHA loans by Ginnie Mae.2 Such targeted programs should be aimed at borrowers on the rent‐own margin and hence may allow society to capture any positive externalities that are associated with homeownership.3 However, most reform proposals also feature the U.S. Treasury’s absorbing the losses that are associated with 1 The Federal Housing Finance Agency projects that this amount will grow to somewhere between $220‐311 billion by the end of 2014. See < ;. 2 Similarly, the U.S. Department of Veterans Affairs (VA) provides mortgage guarantees for military veterans and the U.S. Department of Agriculture’s (USDA) Rural Housing Service guarantees residential mortgages located in rural areas. Both types of targeted loans are also securitized by Ginnie Mae. 3 For a review of the arguments and literature concerning the positive externalities from home ownership, see, for example, Coulson (2002) and Engelhardt, Eriksen, Gale, and Mills (2010) and the references in each article. 1 significantly adverse outcomes (“tail risk”) in residential mortgage markets more generally. It is less clear that such proposals are aimed at correcting an identifiable market failure.4 Before assessing several housing finance reform proposals below, we first provide some background on the evolution of the U.S. residential housing finance system over the past 50 years. 2.) The Evolution of the U.S. Residential Mortgage Market5 Residential mortgages are seemingly simple debt instruments: A prospective borrower requests funds from a lender to cover some portion of the value of a home, which, in turn, will serve as the collateral for the loan. The borrower then makes monthly principal and interest payments according to the terms of the loan. As a result of this arrangement, a mortgage lender faces two kinds of risks: The first is credit risk: the risk that the lender will not be repaid the full principal amount and the contracted interest. This risk crucially depends on the borrowers’ credit history, prospective income, and equity position in the home.6 The second is market risk, or how changes in market interest rates affect the fair value of the mortgage. U.S. residential mortgages are particularly exposed to market risk, as the typical loan involves a long maturity, a fixed interest rate, and an embedded prepayment option that can be exercised at no cost.7 4 A market failure arises when market outcomes are not Pareto efficient (i.e., it is possible to increase the utility of at least one person without reducing the utility of any other persons). A change in credit markets that results in a reduction in the supply of loans (fewer loans at higher prices) to one sector is not necessarily indicative of a market failure as this funding may be diverted to another sector. For example, a reduction in the supply of residential mortgages may result in an increase in the supply of commercial loans. 5 This section draws extensively from Frame and White (2012). 6 This equity position is frequently summarized (in reverse fashion) as the loan‐to‐value ratio. The greater is the borrower’s equity position (and the lower is the loan‐to‐value ratio), the greater is the “cushion” that the lender has against bearing a loss in the event that the borrower defaults (i.e., fails to repay) and the lender has to foreclose on the property. 7 The term of almost all U.S. mortgages (fixed rate or variable rate) is 15, 20, or 30 years, and these loans typically include a “free” prepayment option – the price of which is instead captured in the interest rate. The market risk that is associated with fixed‐rate prepayable mortgages arises in the following manner: As with standard fixed‐ 2 These mortgages, which are unique from a global perspective, have comprised over 90 percent of residential mortgage originations since the onset of the financial crisis.8 Fixed‐rate mortgages were first introduced in the 1930’s by the Home Owners Loan Corporation as the federal government sought to refinance large numbers of delinquent borrowers that typically had short‐term, floating‐rate, interest‐only loans (e.g., Wheelock, 2008; Rose 2011). Table 1 documents the evolution of the U.S. residential mortgage market over the past 50 years. Prior to 1980, residential mortgages were largely made by local depository institutions ‐‐ often a savings and loan institution or savings bank ("thrift") that had a charter that restricted it largely to making mortgage loans. The localized nature of residential mortgage finance – and other forms of retail banking ‐‐ arose from both technological limitations as well as legal restrictions on interstate and intra‐state branching. Throughout the 1960s and 1970s, thrifts alone accounted for over half of all single‐family residential mortgages outstanding, and depository institutions together (thrifts, commercial banks, and credit unions) accounted for over two‐thirds of the total. There were several implications of a localized residential mortgage finance system: First, mortgage interest rates could vary across the country, with depository institutions that operated in concentrated markets and/or markets with scarce deposits relative to loan demand charging higher rates (other things being equal).9 Second, without the ability to diversify geographically, depository institutions were largely at rate debt, if interest rates rise (decline), the price of the mortgage declines (rises) – and the longer is the maturity of the instrument, the greater are the associated price swings. These price risks are further complicated by changes in the rate of prepayment: Lower interest rates induce borrowers to repay their existing mortgages, thereby depriving the lender of the potential capital gain on the mortgage. Conversely, a higher interest rate leads to less prepayment. Hence in the falling rate environment, the lender is not as well‐off as it would otherwise be, while in the rising rate environment it is even worse off. This nonlinear value structure for U.S. residential mortgages is often described as exhibiting "negative convexity." 8 Authors’ calculations based on data from Inside Mortgage Finance (2011, p.20) 9 The Federal Home Loan Bank System (FHLBS) was created by Congress in 1932 to provide an additional source of funding to thrift institutions by making loans (“advances”) that are collateralized primarily by mortgages. Since the FHLBS raised its funds (which were then re‐lent to local thrifts) in national credit markets, this somewhat ameliorated the problem of the balkanization of local mortgage lending markets. Moreover, because the FHLB 3 the mercy of local economic conditions. Third, because the standard U.S. long‐term fixed‐rate mortgage was being funded by deposits that frequently reprice, the institutions were exposed to substantial market risk.10 This risk manifested itself in the early 1980s as Regulation Q limits on interest paid on savings deposits were lifted and long‐term interest rates climbed ‐‐ resulting in “negative carry” for thrifts’ portfolios of long‐term fixed‐rate mortgages (with low interest rates) that were funded by short‐term deposits (with high interest rates).11 During the last 30 years, we have witnessed rapid technological improvements in data processing, finance, and telecommunications, as well as important changes in government policies toward depository institutions and secondary mortgage market institutions. As a result, a vertically dis‐integrated industrial structure for residential mortgages, based on securitization, has emerged and flourished. As shown in Table 1, since 1975, the share of residential mortgage credit exposures that has been held by depository institutions has steadily declined – from 73 percent to 28 percent ‐‐ while secondary market institutions have gained prominence. Today, Fannie Mae, Freddie Mac, and Ginnie Mae together hold the credit risk on almost 55 percent of outstanding residential mortgages, while investors in “private‐label” securitizations (as indicated by the category “ABS Issuers”) make up another 10 percent. The FHA was created in 1934 to provide mortgage insurance that protects lenders against loss in the event of mortgage default. Since 1990, the FHA has been oriented toward first‐time and low‐ and moderate‐income homebuyers that tend to have very small down payments and hence are at a greater risk of default. In exchange for providing the mortgage insurance, the FHA collects upfront and monthly banks were willing to lend to their thrift institution members for longer terms than the typical terms of the thrifts’ deposit liabilities, the FHLBS also provided thrifts with some help in dealing with the maturity mismatch between their long‐lived mortgage assets and their shorter‐term deposit liabilities. See Flannery and Frame (2006) for further discussion of the FHLBS. 10 Until the early 1980s, all federally chartered and most state‐chartered thrifts were barred from offering adjustable‐rate mortgages. See, for example, White (1991, p. 65). 11 See, for example, White (1991, ch. 5). 4 premiums that are paid by the borrower based on outstanding principal. Expected credit losses are covered by the insurance premiums, while unexpected losses are intended to be absorbed by the FHA’s “mutual mortgage insurance fund” that, by law, is expected to maintain an economic value of at least two percent of unamortized insurance in‐force. However, should losses exceed the insurance fund, FHA’s promises are backed by the full faith and credit of the U.S. Government. The National Housing Act of 1934, which created the FHA, also provided for the chartering of national mortgage associations as entities within the federal government. The only association that was ever formed was the National Mortgage Association of Washington in 1938, which eventually became the Federal National Mortgage Association – or Fannie Mae. Initially, Fannie Mae’s role was limited to issuing debt and purchasing and holding FHA‐insured residential mortgages that were originated by nondepository “mortgage banks”. In 1968, Fannie Mae was converted into a private corporation, with publicly traded shares that were listed on the New York Stock Exchange, although it retained a unique federal charter. Fannie Mae was replaced within the federal government by the Government National Mortgage Association (“Ginnie Mae”), an agency that is within the Department of Housing and Urban Development (HUD) and that guarantees securities that are backed by mortgages that are insured by the FHA or the VA. Ginnie Mae issued the first "pass‐through" mortgage‐backed securities (MBS) in 1970.12 It is widely believed that the liquidity that is created by these federal guarantees ultimately results in lower primary mortgage rates for borrowers – on the order of 10‐20 basis points during normal times (Scharfstein and Sunderam, 2011). Freddie Mac was created by Congress in 1970 to support mortgage markets by securitizing mortgages that were originated by thrifts; Freddie Mac issued its first pass‐through MBS in 1981.13 Freddie 12 These MBS are described as “pass‐through” because the principal and interest payments from the underlying mortgage borrowers are passed through (less any fees) to the securities investors. 13 Fannie Mae issued its first pass‐through MBS in 1981. 5 Mac was originally cooperatively owned by the 12 Federal Home Loan Banks and by thrifts that were members of the FHLBS. In 1989, Freddie Mac was converted into a publicly traded company with the same special features as apply to Fannie Mae. In its early history, Freddie Mac tended only to securitize mortgages, whereas Fannie Mae tended to buy and hold mortgages. By the 1990s, however, the two companies' structures and strategies looked quite similar: Both issued MBS that included their own guarantees to investors against credit risk on the securitized mortgage pools, and both held mortgages and MBS on their respective balance sheets. An important reason for the widespread acceptance of mortgage securitization was the presence of U.S. Government guarantees: Ginnie Mae MBS carry an explicit, “full‐faith and credit” guarantee of the timely payment of principal and interest on mortgages that are already insured by the FHA or VA. Similar securities that are issued by Fannie Mae and Freddie Mac carry these GSEs’ own guarantees against credit risk. Prior to their federal takeover in 2008, each GSE’s debt and MBS benefitted from a strong perception in the financial markets of an implicit federal backstop owing to provisions in their respective Congressional charters.14 These provisions included: (1) the authorization of the Secretary of the Treasury to purchase a limited amount of each housing GSEs securities; (2) an exemption from state and local taxation; (3) the treatment of GSE obligations as “government securities” for purposes of the Securities Exchange Act of 1934; (4) the use of the Federal Reserve as fiscal agent so that their securities are issued and transferred using the same system as U.S. Treasury borrowings; (5) the ability of the President of the United States to appoint five of the 18 members of each company’s board of directors; and (6) the lack of a bankruptcy procedure or any legal authority to appoint a receiver if one became insolvent.15 Other public policies further fueled investor perceptions of an implied federal guarantee prior to the financial crisis. For example, Congress had previously intervened to assist troubled GSEs (U.S. General Accounting Office 1990) and 14 The Charter Acts can be found at: < ; (Fannie Mae) and < ; (Freddie Mac). 15 See, for example, U.S. Congressional Budget Office (1996, 2001) and Wall, Eisenbeis, and Frame (2005). 6 established regulators to oversee each institution’s compliance with statutory mission and safety‐and‐ soundness provisions.16 The movement toward a vertically dis‐integrated mortgage market structure resulted from a combination of these explicit and implicit U.S. Treasury guarantees interacting with technological and regulatory changes. The presence of government guarantees allowed for a much wider array of domestic and foreign investors to hold U.S. residential mortgage assets. In terms of technology, markedly improved and lower‐cost data processing, financial modeling, and telecommunications allowed mortgage originators more efficiently to collect, analyze, and transmit borrower information to secondary market participants. Changes to regulatory capital requirements at depository institutions and GSEs were also extremely important for the depth of secondary market activity. The 1988 Basel risk‐based capital standards (Basel I) for depository institutions introduced risk‐based capital requirements of zero percent for those institutions’ holdings of Ginnie Mae MBS; a requirement of 1.6 percent equity capital for holding similar securities that were issued by Fannie Mae and Freddie Mac;17 and a 4.0 percent equity requirement for holding otherwise similar, but unsecuritized (whole), residential mortgage loans. These tiered capital requirements were intended to cover the credit risks that were inherent in the various categories of debt instruments; unhedged market risk was expected to be covered by additional capital. For institutions that were bound 16 The Federal Housing Finance Agency (FHFA) was created in 2008. The FHFA succeeds the Office of Federal Housing Enterprise Oversight (OFHEO, which was the former safety‐and‐soundness regulator of Fannie Mae and Freddie Mac), the Federal Housing Finance Board (former regulator of the Federal Home Loan Bank System), and the U.S. Department of Housing and Urban Development’s mission oversight of Fannie Mae and Freddie Mac. 17 In 2003, this 1.6 percent capital requirement was extended to any MBS that carried a credit rating of AA or better. 7 by risk‐based capital requirements, the lower capital requirements for MBS strongly encouraged the substitution of MBS for whole mortgage loans on their balance sheets.18 Also, in 1992, Fannie Mae and Freddie Mac became subject to a statutory 2.5 percent equity capital charge against mortgages or MBS that were funded on their balance sheets and a 0.45 percent equity capital charge against the MBS that they had issued to investors (all of which carried the GSEs’ credit‐risk guarantees).19 In both respects, the GSEs enjoyed a substantial advantage in reduced capital requirements relative to depository institutions that are bound by the 4.0 percent minimum Basel I requirement. Some parts of the residential mortgage market were historically beyond the reach of Ginnie Mae, Fannie Mae, and Freddie Mac. As noted previously, Ginnie Mae can guarantee only securities that are backed by FHA, VA, and USDA mortgages, while the two GSEs may only purchase or securitize loans that are at o...
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