Chairman Tester, Ranking Member Johanns, and Members of the Committee, thank you for the opportunity to testify on the vital topic of returning private capital to mortgage markets. I am a professor at the University of Maryland's School of Public Policy and a faculty affiliate of the Center for Financial Policy at the Robert H. Smith School of Business at the University of Maryland. I am also a senior fellow with the Milken Institute's Center for Financial Markets and a visiting scholar at the American Enterprise Institute. I was previously Assistant Secretary for Economic Policy at the Treasury Department from December 2006 to January 2009.
Bringing private capital back to fund mortgages and take on credit risk is an essential element of housing finance reform, particularly with respect to reform of the government-sponsored enterprises (GSEs) of Fannie Mae and Freddie Mac. Housing finance reform should ensure that mortgages are available across economic conditions, while shielding taxpayers from taking on uncompensated risk and protecting the broader economy from the systemic risks that arose in the previous system. Bringing about increased private capital as part of housing finance reform will help protect taxpayers and improve incentives for prudent mortgage origination by lenders and investors with their own resources at risk.
The situation in housing finance today is that taxpayers fund or guarantee more than 90 percent of new mortgages through the GSEs and through government agencies such as the Federal Housing administration (FHA). Fannie Mae and Freddie Mac stand behind virtually all new conforming mortgages through the two firms' guarantees on the mortgage-backed securities (MBS) into which the two firms bundle the home loans they purchase from originators. There is loan-level capital to absorb losses in the form of homeowner down payments and private mortgage insurance (PMI), but no private capital at the level of the mortgage-backed security (MBS) ahead of the financial resources of Fannie and Freddie. With the U.S. Treasury committed to ensuring that Fannie and Freddie remain solvent, the U.S. government effectively backstops conforming loans, leaving taxpayers exposed to considerable losses in the event of another housing downturn—and this risk remains even while the two firms are now profitable. Taxpayers further take on credit risk in housing through the government backstop on the Federal Home Loan Bank (FHLB) system, and through guaranteed mortgages supported by the Federal Housing Administration (FHA) and other federal agencies. I have previously testified on reforms to the FHA that would better protect taxpayers while focusing the agency on its mission to expand access to mortgage financing for low- and moderate income families who have the financial wherewithal to become homeowners. I thus focus here on GSE reform.
Bringing back private capital into housing finance would mean that private investors would absorb losses as some mortgage loans inevitably are not repaid. In some instances, this could involve mortgage loans with no government guarantee, while in others there could be a secondary government guarantee that kicks in only after private capital absorbs losses (or the guarantee could be alongside private capital, with losses shared). Private investors would be compensated for taking on housing credit risk, so that it should be expected that mortgage interest rates will increase as housing finance reform proceeds. This interest rate impact reflects the facts that the previous system was undercapitalized and provided inadequate protection for taxpayers.
It would be useful for reform to allow for a diversity of sources of funding for housing, and for private capital to come in a number of forms and through a variety of mechanisms. This will help make the future housing finance system more resilient to economic and market events that affect particular parts of financial markets and thus impinge on the availability of funds for housing.
At the level of the individual loan, capital for conforming mortgages will continue to be present from a combination of homeowner down payments, private mortgage insurance, and the capital of originators that carry out balance sheet lending. The recent housing bubble and foreclosure crisis highlighted the importance of homeowner equity as a factor in avoiding foreclosures, as foreclosure rates were especially elevated for underwater borrowers—those who owed more on their mortgages than the value of their home. As reform proceeds, it is vital to ensure that meaningful down payments remain a central aspect of underwriting and a requirement for mortgages to qualify for inclusion in MBS that benefit from a government guarantee. Similarly, regulators must ensure that private mortgage insurers have adequate levels of their own high-quality capital to participate in mortgages that receive a government guarantee.
The larger changes involved with the return of private capital to mortgage origination will come at the level of the mortgage-backed security. With nearly all securitization of conforming mortgages going through the GSEs, there is essentially no capital at the MBS level. The so-called profit sweep agreement between the Treasury Department and the two GSEs prevents Fannie and Freddie from building up the capital that would be the norm for an insurer.
Fannie and Freddie are setting up risk-sharing mechanisms to allow private investors to invest in securities that will take losses ahead of the firms' guarantee (that is, ahead of the taxpayer guarantee). There is still little securitization of mortgages taking place without a guarantee (private label securitization of non-conforming loans), and firms other than Fannie and Freddie are not allowed to compete in the business of securitization of conforming mortgages with a government guarantee. Housing finance reform should involve changes on all of these dimensions so that private capital is present at the MBs-level. These changes are discussed next.