House under construction

Housing Perspectives

Research, trends, and perspective from the Harvard Joint Center for Housing Studies

America’s Housing Finance System in the Pandemic, Part 2: Extraordinary Support and Necessary Consequences

As I wrote last week, in America’s Housing Finance System in the Pandemic: Ten Stress Points to Watch, several components of the country’s $10 trillion-plus mortgage system have already begun to (or may soon) buckle under the financial and economic stress caused by the pandemic. As a result, the government is engaged broadly in undertaking extraordinary support actions. This article will review those related to housing finance that are (1) underway right now, (2) being worked on for implementation shortly, and (3) some that it is easy to predict will be required in due course. The article will then focus on the necessary consequences, which fall into two categories: (1) what compensation to the taxpayer is appropriate for that extraordinary support, and (2) what long-term reforms of business models must the government impose so that housing finance does not once again become a source of systemic weakness. The simple principle, which has a long tradition, is that a rescue of private sector companies from the consequences of their own actions should not be done gratis or without forced business model reforms designed to avoid a repeat of such buckling.

Extraordinary support actions by the federal government, where specific institutions or categories of institutions are rescued, are almost always dubbed “bailouts” by the media, although many of them are more indirect and covert than a classic bailout. While industry lobbyists will always look for any extraordinary support to be given gratis and with no unwanted business model changes being imposed by the government, the history is very clear: it is good policy, and ultimately good politics, for there to be penalties and forced business model changes. And it can sometimes be quite painful: the two government-sponsored enterprises (GSEs) of Freddie Mac and Fannie Mae being placed into conservatorship in 2008, a state which continues to this day, is an excellent example of this.

I will focus on six of the ten stress points, all of which are likely to need extraordinary support.


The Problem: Various mREITs have had significant liquidity distress in terms of rolling over their funding, where they borrow short to invest in long-term assets. This has been well-reported in the media. Such mREITs can specialize in everything from investing in relatively illiquid commercial MBS (mortgage-backed securities) to the most traditional and highly-liquid agency MBS securities guaranteed by the two GSEs and Ginnie Mae.

Solutions Underway: Actions by the Federal Reserve to inject massive liquidity support into the markets, designed to relieve broad market stresses, will definitely relieve some of the pressures on mREITs – especially with respect to agency MBS, which is directly included in the Fed’s bond purchases. It is unclear how much current, or possible additional, Federal Reserve actions will materially help non-agency MBS investors.

The mREITs are reportedly asking their lenders for forbearance from full contractual margin calls, which is apparently being given at times by lenders with the support of their regulators. (Their policy objective is to maintain an orderly market in these stressed times, rather than adding fuel to the fire.) Of course, the most heavily leveraged and illiquid mREITs do not have to be rescued to preserve orderly markets – there just can’t be too many disorderly liquidations. Freddie Mac and Fannie Mae have even been utilized by the government to provide liquidity to mREITs, to a limited extent, as part of the solution.

Necessary Consequences: When such a rescue is done through general market support (e.g. the Federal Reserve buying securities to help balance the supply and demand by investors), it goes to the “anonymous” market rather than bilaterally benefitting a specific investment company. There is therefore no overt mechanism to “charge” an mREIT for that benefit. After the dust has settled a bit from the current stresses, then, the consequences of the rescue will be a regulatory (and potentially a Congressional) review of what happened and why, followed by recommendations for required business model changes. It is obvious the business model changes would focus on setting maximum leverage and minimum liquidity standards for mREITs, which could be implemented through one of several possible channels. The mREIT industry will not like it (as it will be harder to make high returns), but such changes will be necessary to avoid a repeat of their becoming a source of systemic weakness the next time there is severe financial distress.


The Problem: Agency MBS markets, normally second in liquidity only to Treasury securities, have gone to historically low levels of liquidity. As one analyst put it, this sets up a possible “accident” that could be profound in its impact. So far, this has mainly affected the ability of investors to finance their positions (both in terms of cost and availability) and greatly widened mortgage spreads versus comparable-maturity Treasuries (recently coming down from highs previously seen only in the depths of the 2008 financial crisis). It all stems from the massive flight to liquidity and quality underway.

Solutions Underway: The agency MBS market illiquidity is also being addressed by the Federal Reserve’s announced program to purchase such bonds; it is being indirectly addressed by programs to help those lenders which provide financing for agency MBS (e.g. securities firms) to be under less stress themselves.

Necessary Consequences: Again, as described above, it is not possible to directly charge agency MBS investors for the benefit they receive from the extraordinary actions undertaken by the Fed, because that benefit goes to the anonymous market. Instead, the regulatory and Congressional review that may occur, after current stresses have subsided, might lead to changes in how the market works or to the business model of certain key agency MBS investors. It is unclear at this time what such changes might be, but generally tightening up allowed leverage or minimum liquidity requirements for various types of agency MBS investors could follow.


Two Problems: Mortgage servicing, as a business, has two well-recognized business model weakness that came to the fore in today’s distressed markets: (1) The obligation to keep agency MBS investors whole by advancing funds to cover principal and interest payments (often along with property taxes and insurance) when borrowers stop paying is proving unsustainable. It will require tens of billions of dollars, given the announced forbearance programs by the government agencies of Freddie Mac, Fannie Mae, and Ginnie Mae. (2) The value of MSRs on the books of the servicers has plummeted with the major decline in interest rates, causing big accounting losses.

While this is probably sustainable (if uncomfortable) for servicers that are part of banks, which have other business lines and also access to bank-centric sources of liquidity (like the ability to borrow at the Federal Reserve), it is clearly unsustainable for non-bank mortgage servicers, which are usually monolines and which now account for fully half the $7 trillion market for agency mortgages.

Solutions Underway: The government is all over the problem related to the liquidity crunch caused by the obligation to advance principal and interest to MBS investors, at least with respect to GSE- and Ginnie Mae-related assets. Treasury Secretary Mnuchin announced a task force to come up with a solution quickly, and Ginnie Mae announced one of its own (although the details of how it will work are still to come). I note that the most talked-about solution is a special line from the Federal Reserve for the non-bank servicers to draw upon to make their required payments.

There is no reported program to address the business model weakness of the value of MSRs being so volatile; as the pain has already been incurred with the major decline in their value, it is not an immediate market stress issue but can be addressed longer-term.

I would suggest for consideration an alternative, although unconventional, approach to address the upcoming liquidity crunch: the two GSEs can buy the MSRs on their own loans from all the non-bank servicers, and then sub-service them right back to each selling servicer, on a fee-for-transaction basis, to match. This would have the impact of (1) transferring the obligation to make MBS investor advances from the non-bank servicers to the GSEs themselves (which would likely require an increase in their allowed investment portfolio size, possibly engendering some political controversy), and (2) putting the risk of MSR values being so unstable onto the GSEs as well, which are better positioned to absorb and hedge them than the usual servicer.

Necessary Consequences: If there is to be a Federal Reserve line to non-bank servicers (or maybe even bank-affiliated servicers as well) to fund their needed advances to MBS investors, the non-banks will need to pay for this extraordinary support. The regulatory history is such that the interest rate on the borrowings should be at a “penalty” rate – i.e. considerably higher than normal market terms. Additionally, the Federal Reserve, which is not designed to take credit risk on its lending, is going to need some credit protection from allowing possibly hundreds of small, non-public servicers borrowing from it. Such protection would likely be in the form of collateral or margin requirements on those loans; if the servicers cannot provide that support, then Treasury may need to provide it. If the latter happens, based upon precedent and statements by Secretary Mnuchin, there will need to be additional compensation demanded, up to and including something equity oriented.

After the crisis is over, only a quick post-mortem will be needed, because the issues of the risk exposure of the non-bank servicers to the cash drain from advances, and from the highly-volatile nature of MSRs, have long been recognized and understood in the industry. It was just that no specific organization, including among regulators, had the authority and responsibility to fix it.

Simply put, the mortgage servicing business model needs to be changed. Servicer compensation needs to be shifted, going forward, to a fee-for-transaction basis rather than today’s fixed percentage of the balance of the mortgages beings serviced (usually 0.25 percent) as this eliminates the MSR accounting asset entirely. And the system of advances needs to be restructured, so that others shoulder all or part of the burden, as non-bank servicers clearly do not have the capacity to handle it alone. This might even mean MBS investors receive their cash late at times, even if they will be made whole eventually so as not to be fully exposed to mortgage credit risk. If no such restructuring of how advances are handled is possible, then at some point there is little choice but for the government to move servicing back to regulated banks and away from non-banks.


The Problem: The six PMI firms are not under immediate liquidity stress. However, as the next several quarters reveal how bad the economic damage of the pandemic is in terms of unemployment and reduced incomes, there most likely will be a material increase in single-family mortgage delinquencies. Given that the business of PMIs is to write credit insurance on the riskiest portions of the riskier GSE loans, this will disproportionately hurt their profits, probably causing significant losses. (This is classic “solvency” risk.) It is almost inevitable that credit rating downgrades will occur, likely taking one or two more into “junk” status (i.e. below investment grade, a status one of the six already has), making it improper for safety and soundness that the two GSEs incur new exposures to them. There could even be failures of one or more of the firms, as happened in 2008 when three of the then-seven firms were placed into run-off by their state-level insurance commissions (which is the equivalent of bankruptcy for insurance companies) with the GSEs incurring losses.

As a reminder, all high loan-to-value ratio (over 80 percent) mortgages must, by law, be supported by the PMI firms (or by one of two other now-obsolete methods) so that the GSEs do not take on too much risk. As a matter of public policy, then, letting more than a few of the six PMI firms become ineligible to sell loans to the GSEs means there will be real crimp in the normal flow of high-LTV lending, which would impede an economic recovery.

Solutions Underway: The PMI firms will need to be given, probably before year-end, some sort of relaxation of the criteria by which they remain eligible to write new credit insurance policies. In conservatorship, the criteria for being eligible to write insurance on new loans being sold to the GSEs is set by FHFA, largely based upon minimum capital and liquidity requirements. (And if a PMI firm is ruled ineligible, it is unlikely that it could ever recover from just running off its current book of business, as it would not be able to raise capital on commercial terms.) This relaxation does not have to permit all six to survive intact; the public policy should be for taxpayers to only rescue as many as needed to keep high LTV loan flow going, which probably only requires three or four of the existing six PMI firms to survive. There is little choice in doing such a distasteful rescue if another downdraft to the housing finance system is to be avoided. (Industry talk is that such a request for relaxation from the eligibility criteria is already quietly underway.)

Necessary Consequences: If the PMI firms are given a relaxation of the eligibility criteria, it will be an extraordinary support action, and should trigger the resulting “penalty” pricing so the taxpayer (who stands behind the GSEs while they are in conservatorship) is compensated for its support to the industry. I would recommend the penalty pricing take the following form, recognizing it is a bit unusual: (1) Immediately, with no delay, the PMIs should be required to give up the ability to independently and retroactively deny claims that the GSEs themselves determine to be valid. In other CRT products, the providers agree to align themselves fully with the GSEs, meaning that the protection provided has full “certainty of coverage.” (Without full certainty of coverage, the GSEs will find themselves with loans they thought were insured but turn out not to be, incurring losses as a result.) (2) The FHFA should publicly announce that when the market stresses clear up, there will be another revision (on top of the two already done) to increase PMI capital requirements in an orderly manner to match what the GSEs would need to carry for the very same risks, as per the final FHFA post-conservatorship capital requirements for the GSEs (expected to be finalized later this year). (3) Finally, the government should take an equity interest in the companies, at a minimum akin to the warrants associated with the TARP program a decade ago, so that the taxpayer gets some of the upside of the benefit of the rescue.

Longer term, the ongoing business model of the PMIs needs revision, period. They cannot have a virtual monopoly on enabling all high LTV lending via PMI insurance contracts with a business model that calls for their promises to pay being unsecured (i.e. with zero collateral) and not at the highest of credit ratings (along with incomplete certainty of coverage). In fact, their current credit ratings are not particularly strong (the average is in the BBB range, which is at the bottom of investment grade); prior to 2008, they were required to be AA. In addition, FHFA has to be supportive of the two GSEs reinvigorating the now-dormant alternatives allowed by their charters (the legislation establishing them) to eliminate the virtual monopoly which requires repeated bailouts of the PMI firms done in the interest of keeping the high LTV mortgage system fully active.


The Problem: Over upcoming quarters – and maybe not even until into 2021 – it will become clear how well the mortgages backed by (1) the GSEs (which own about 45 percent of the total outstanding), (2) the two government agencies of FHA and VA (which insure about 20 percent), and (3) commercial banks (which own about 25 percent) perform. They will all throw off increased credit losses for sure; after all, they are in the business of taking risk to support economic growth. The question is whether the losses will be revealed under today’s stress environment to have been consistent with each’s stated risk appetite (known colloquially in the industry as the “credit box”) or not.

Solutions Underway: This is not a short-term issue; it will only develop over quarters and perhaps even several years. It will be heavily tied to future house price movements and unemployment, the latter of which is already rising strongly. As to future house prices, it is a great unknown at this time, but in the 2008 financial crisis, house prices did not bottom out until 2011-12, three-plus years later.

If credit losses develop to be materially inconsistent with the credit box of each of these three categories of backers of credit risk, the appropriate regulators and government authorities will need to intervene to adjust that credit box or other credit policies to reflect what has been learned – in other words, a forced business model change. (How effective credit risk transfer has been at shedding risk might also be included in this process.) Industry participants worry most today about the FHA, which does not risk-adjust pricing (and so tends to attract the worst credits) and did not shrink back to its traditional small market share after growing countercyclically post-2008. If the FHA does indeed incur losses materially larger than its credit box implies, there would need to be not only a substantial revision to its business model, but possibly revisions to the legislation under which it works.

Necessary Consequences: The necessary consequences vary significantly: (1) If the GSEs have losses beyond what is implied by their credit box, there is no obvious “penalty” to impose as the two companies remain in conservatorship from the 2008 financial crisis; as the conservator, FHFA can directly revise their credit boxes and credit policies. (2) If specific banks end up with unexpectedly large losses, bank regulators may need to directly intervene in the construction of their credit box; individual institutions heavily concentrated in mortgages may even need rescues that would mimic the TARP program (with equity warrants going to Treasury). (3) If the FHA and/or VA show up as the problem, they will need a business model revision that, at a minimum, changes how they calculate and maintain its “reserves” (a unique calculation required of them, not to be confused with credit loss reserves under General Accepted Accounting Principles) or what level of such reserves are required (versus the 2 percent requirement today). A more broad-based change to its business model might also be warranted, very possibly requiring changes in the legislation governing them.


Things are moving fast right now in the markets and the economy, which is causing real stress in the mortgage system. While some stresses will take only weeks or months to develop (like the issue of advances required from mortgage servicers), others will take even longer – credit losses could take years to fully develop, depending on the nature of the economic recovery.

To date, in my view, the government has moved quickly and reasonably competently in addressing the financial market stresses of the pandemic, fortunately having a well-developed set of tools from the 2008 financial crisis to pull down from its shelves and implement very quickly. This is already allaying financial market stresses, but with considerably more improvement to go before things get anywhere near normal. For those mortgage stresses which have a somewhat longer timeframe to unfold, the government is prioritizing developing solutions right now on top of those already implemented in response to the 2008 financial crisis (an example would be the forbearance programs, which are likely to reduce eventual credit losses, but has the knock-on impact of causing more immediate servicer stresses with those large obligations to advance funds to MBS investors). I have written this article to help the reader appreciate the resulting plan of action for each, including the policy-political issue of whether the necessary consequences from the government’s extraordinary support (i.e. bailouts) is enough to be fair to the taxpayer and also prevent an instant replay the next time markets go into general distress.