We are in the midst of a war between the government, companies, and not-for-profit organizations against the sharp economic downturn caused by the coronavirus pandemic. As a result of the “fog of war,” and with so many news stories competing for headlines, it is hard to comprehend what is happening in many aspects of life, including housing finance. I have therefore compiled a list of seven “reports from the battlefield” that are important for understanding the current state, and possible future structure, of the country’s housing finance system.

1. Banks Are a Source of Strength

The 2008 financial crisis, at its core, occurred because the collapse of America’s sub-prime and then prime mortgage markets was transmitted to, and amplified by, the world’s banking system into a global financial and economic calamity. It revealed that the banks (and many other financial institutions) didn’t have enough capital or liquidity, and that no one had considered how the connection between banks, and between banks and other financial institutions, would worsen things in a stressed environment. It represented a failure of both the banking industry and its regulators to think deeply enough.

What a difference a decade makes. We are now in the midst of another financial and economic crisis, this time stemming from the coronavirus pandemic, and there are financial problems all around. But the market is not worried about liquidity runs on banks, it is not worried about the FDIC taking over and selling large banks that are failing, and it is not worried about the banks stopping almost all lending, all of which happened a decade ago. Instead, the banks are currently a source of strength (they are even being utilized by the government to channel economic recovery funds in several programs), and, at least so far, they are mostly just trimming their lending criteria in a conventional cyclical manner.

In other words, the reforms to the banking system – most exemplified by the Dodd-Frank Act – have taken hold and are working. That’s good news, both in general and for housing finance, where banks play many key roles – originators, servicers, investors (they own approximately 25 percent of all first single-family mortgages), lenders to non-bank mortgage companies, dealers in mortgage securities, and so on. Their stability is helpful at a time when other parts of housing finance are anything but.

Banks, of course, have already begun to take large earnings hits as credit losses mount and they are impacted by dislocations in the economy that are underway. They are supposed to take risk, so that’s natural. But that’s a very different outcome than having bank failures and near-failures being the cause of an economic downturn, and there is no sign of any market loss of confidence in the banking system. Again, this contributes to housing finance stability. Hopefully this will continue to be true through the worst of the downturn.

2. The PLS Market Shows No Resiliency

In February – only two months ago, before the pandemic became all-consuming – I wrote in GSEs and the Economic Cycle: Realistic Expectations that the Private Label Securitization (PLS) market, where the securitization of mortgages does not have the government support of Freddie Mac, Fannie Mae, or Ginnie Mae, was “viewed in the markets as the most volatile, procyclical source of mortgage capital” and that “in a downturn, whatever market share of originations it has at the time is expected to quickly decline.” Just weeks later this was proved true, to an extreme. The PLS market is now effectively fully shut.

By contrast, banks (again, so far just trimming their credit standards, as makes sense given their expected modest procyclicality), the GSEs, and the government departments that issue their securities through Ginnie Mae are still in business.

PLS proponents (a coalition of Wall Street firms that make money in the business and political think tanks devoted to free-market ideology) keep pushing for PLS to play a giant role in housing finance, many times its recent five percent market share. Its total disappearance is a reminder why this does not seem to be such a good idea.

3. How Will the Forbearance Honor System Perform?

One of the primary programs by which the government is attempting to help families through this tough economic time is allowing mortgage “forbearance,” meaning the ability to defer mortgage payments for six months (and renewable for a second six months). It applies to about 70 percent of America’s first mortgage loans, as those are financed with government support via Freddie Mac, Fannie Mae, and Ginnie Mae. This program, developed a few years ago, was enshrined into law by the CARES Act.

One of the unusual features of this program, however, is that, to qualify for forbearance, homeowners only have to attest that they are stressed in making payments due to a job loss or other event, with no documentation required. This is known in the industry as the honor system. Because the forbearance program was originally established when housing markets and the economy were performing so strongly, it has been little-used and there is no history of how credibly the honor system performs during a major stress event.

The mortgage industry is predicting that 25 percent of mortgage loans may go into this kind of forbearance. This means the country would have a large-scale government benefit program that is designed to not be universal, i.e. to be used only by those in need, but where one can sign up simply by asking, with no supporting evidence required. That is highly unusual, if not unprecedented.

If the vast majority of Americans believe that almost all of the homeowners who sign up for forbearance truly need the relief, it will work out fine, and will be considered a successful way to deliver benefits quickly in a crisis. But if the feeling develops broadly that paying your mortgage makes you a sucker, because others who could afford to do so are freeloading on the taxpayer via the forbearance program, then there will be nasty politics around the honor system. As a reminder, a similar feeling developed in the 2008 financial crisis, and was key in the founding of the Tea Party movement.

This is an issue to watch closely.

4. The Unintended Consequences of Forbearance on the Origination of New Mortgages

The GSE/Ginnie Mae forbearance program makes sense when considering existing mortgages, but with respect to the origination of new mortgages, there have been cascading problems, demonstrating unintended consequences and the incentive impact of government programs.

First, there appear to be some borrowers who signed up for forbearance just weeks after their mortgage loan closed, while the loan was still on the books of a primary lender and not yet securitized via one of the three government agencies. As the agencies don’t feel they should necessarily buy loans that are already impaired, this could leave the primary lender stuck with a loan on a long-term basis, which such companies are often not structured or capitalized to do. How to handle this is an open issue, with clear rules needed. In the interim, such lenders are reported to be defensively putting in “overlays” (i.e. tougher credit terms than the ones the agencies accept), to reduce the risk of this happening.

In fact, the impact on new loan origination of the offer of forbearance (being a new category of impairment in addition to traditional default) is impacting the complex flows by which mortgages are made, financed while in securitization pipelines, and eventually funded. It is anecdotally reported to be contributing to a tightening up of mortgage credit standards beyond what the economic downturn itself would generate.

In such situations, policymakers often focus on fairness. But fairness is hard to determine:

• Is it fair to the taxpayers supporting the GSEs and Ginnie Mae to guarantee a new mortgage when it comes to them already in a forbearance?
• Is it fair to mortgage lending companies to end up owning a just-made mortgage which goes into forbearance if the GSEs and Ginnie Mae won’t take it at the end of the securitization pipeline, when forbearance is a program the agencies themselves promulgated?
• If a new homeowning family is likely to suffer a major loss of income right as they close on a new house purchase, is it fair to them and the seller to up-end the transaction, in the works for months, and cancel it at the last minute when taking forbearance right after closing is acceptable according to the rules of the program?

One can come up with other similar scenarios. A loss of income and wealth in today’s downturn isn’t fair to anyone, and so everyone can argue it is fair that someone else take that loss rather than themselves.

The securitizers (the two GSEs and Ginnie Mae), who are now working on rules to address who is responsible for what, will presumably announce clear rules very soon, hopefully balancing the needs of all parties. This would eliminate as much uncertainty as possible, and minimize the impact on credit availability.

5. Helping Renters Is a Priority; How Is Unclear

The forbearance program allows the government to quickly focus help to homeowners with mortgages. The next biggest group to help when it comes to housing costs is renters; there are over 40 million rental units nationwide. And renters will surely need the help – on average they have lower income, lower net worth, and lower cash reserves (often none at all) than homeowners. On top of that, being a renter is positively correlated with being in the type of job that is more likely to be hurt in the economic downturn.

Some activists are calling for rent strikes in response. This is inefficient and wasteful as it makes no attempt to distinguish between those truly in need and those still able to pay their rent. It is also not very well thought through, as more than half of renters have “mom and pop” landlords, who in turn would quickly go into default on their mortgage if rents were to stop, creating massive downstream problems (including the landlord being unable to pay local property taxes). Then there are all the families who rent in public housing, where the landlord is the local government, or non-profit affordable housing projects where the landlord has limited resources to carry losses. Rent strikes by those tenants would, in turn, jeopardize their below-market-rent homes.

But there is a real and practical problem of determining who needs help with rent and how to deliver it. There is no master list of renters or landlords in the US. While the government does help finance just under 50 percent of the dollar value of all multifamily mortgages in the country through Freddie Mac, Fannie Mae, and the government departments that securitize their mortgages through Ginnie Mae, it must work through the owning landlords to reach the underlying renters. And, not well known, about half of all renters live in 1-to-4-unit properties, which are considered single-family when it comes to housing finance, and so the mortgages on those properties aren’t considered in the multifamily statistics.

Initial steps have been taken to help these renters. The CARES Act has some targeted initiatives tied to rental housing, and the government, for the mortgages backed by it, is giving multifamily landlords the ability to obtain forbearance, with eviction prevention requirements in turn. This is less comprehensive than the single-family forbearance program, and it is unclear how well it will work given the layers between landlords and tenants.

Interestingly, the most important program helping renters seems to be the $600 per week unemployment insurance supplement that currently is set to expire July 31 (with some likelihood of it being extended), but which doesn’t cover 100% of workers. It does, in aggregate, help bridge the considerable time required until a broad renter-specific program can be developed and implemented.

So, the challenge is how to help renters who need it, how to do it on a national scale, and how to do it quickly. Think tanks are organizing efforts and writing papers, industry associations are doing the same, Congressional staff are looking for ideas, and so on. In other words, the entire policy community that focuses on housing is trying to develop an answer to the renter challenge. Let’s hope they are quickly successful and that it doesn’t get caught up in partisan politics.

6. Rethinking the Role of Government in Housing Finance

I have recounted in my writings how big the role of government is in housing finance, which is most exemplified by it backing almost 70 percent of all single-family first mortgages in America.

Prior to 2008, the US housing finance system was generally well-regarded, and so the debate about whether the role of government was too large didn’t get much attention outside a few specialty circles. After the two GSEs were taken into conservatorship in 2008, the debate became much broader and very intense, and focused almost exclusively on the $5 trillion share of the $10 trillion market held by Freddie Mac and Fannie Mae. The result was a consensus between conservatives and the first Obama administration that the two GSEs should be fully “wound down” (that’s the exact phrase used), and replaced by something different, with a more limited government role.

More recently, given the inability of Congress to come up with such a replacement system after nearly a decade of trying, it has been looking more like the current GSE-centric system will continue, but continuing with the major reforms that were put in place during conservatorship (dramatically reduced investment portfolios, credit risk transfer, and so on). A practical consensus in the mortgage industry and among many members of Congress, which seemed close to emerging when the pandemic hit, was that this was the right way to go, possibly also with some sort of utility-style regulation of guarantee fees.

There is a saying that wars change lots of things, including how people think. The role of government in housing finance is likely one where that may happen after the war to fight the pandemic. It is now absolutely clear that our thinking about the structure of housing finance must address both normal markets and highly abnormal ones, which history now suggests we should expect every decade or two. Given what is happening right now, it is a major strength during crises for government to have a large say in housing finance, where aid to 70 percent of the owners of mortgage-financed homes can be quickly delivered through the forbearance program. In fact, such aid was one of the first large-scale programs to help Americans that was announced and begun by the government.

By comparison, however, do the thought experiment if the “wind down” consensus from a decade ago had been implemented, and the GSEs were gone: in the current crisis, the government would have only been able to deliver forbearance relief for about 20 percent of the market (the portion securitized through Ginnie Mae). That would not have been anywhere near enough. This difference, in human terms, represents over 25 million homeowning families.

So, the current plan being executed by the FHFA and Treasury – where the GSEs are not wound down but instead exit conservatorship via administrative means, while maintaining the reforms of the last decade – is looking pretty good. In fact, it’s very close to the consensus that was seeming to emerge. Given the reforms that have been implemented, the GSEs in this scenario should operate properly and safely in normal times, and in crises it will enable the government to be nimbler and more effective in quickly delivering large-scale relief.

Hopefully, then, moving forward via administrative means is what emerges as the clear consensus in both the industry and in Congress when we’re past today’s crisis.

7. Will GSE Capital-Raising Be Delayed?

A frequently asked question in housing finance is the timing by which Freddie Mac and Fannie Mae will exit conservatorship, especially as the Director of the FHFA, Mark Calabria, has made it a priority since he took the position a year ago. In reality, there are three related timing questions: 1) When would the legal status of conservatorship end, 2) When would the first equity raises be done, and 3) When would the two firms be fully capitalized and able to operate without special government controls?  I have found most people are particularly interested in the timing of the first equity raises; Director Calabria, who varies his predictions as he learns more, most recently estimated not until 2021.

Last December, I wrote in Treasury’s Long GSE Capital To-Do List that Treasury, which must do much of the work for conservatorship exit and capital raising, making politically-sensitive decisions along the way, has announced almost nothing about those topics since last September, and that its to-do list is long and will take considerable time to execute. Lawsuits over the conservatorship make it more likely to go slowly. As a result, I wrote that the dates of the initial equity raise and of the companies being fully capitalized were likely to be later than most assumed.

And then the pandemic struck, and the latest question is whether the crisis will significantly delay the conservatorship-ending and capital-raising process. Director Calabria has stated it will not do so by much, presumably trying to maintain momentum and enthusiasm.

Unfortunately, I believe the pandemic will materially delay the exit process, especially the first capital raises, for two primary reasons:

1. Both FHFA and Treasury will, and should, prioritize dealing with the deep economic disruption and downturn unleased by fighting the pandemic (which is far worse than thought just a month ago). The GSE exits are far less important, and with only so many hours in the day and people to work on priority issues, conservatorship exit-related decisions and actions will get pushed back. Of particular note, learnings from the current stress environment should inform the new capital rule that FHFA is in the midst of developing, which means its finalization should wait until the current crisis has mostly run its course.
2. Raising equity for the GSEs will require record-setting large new issues, which means investor appetite must be broad and strong. However, investors will not sign up to buy record-setting amounts of GSE shares at acceptable prices while the credit cycle, now beginning a severe and hard-to-predict downturn, has the GSEs seeing increasing delinquencies and large credit reserves. (This is known on Wall Street as “catching a falling knife”- i.e. to be avoided.) In fact, history shows that investors will largely wait to see that the credit cycle has credibly peaked before purchasing large amounts of new issue shares. As a guide, that peak happened three-plus years after the beginning of the last financial crisis in 2008. This time around, no one will get a clear picture of credit quality until at least the forbearance programs (which can last up to 12 months) have run their course, so investors can determine how much forbearance turns into re-started prompt monthly payments versus default.

So, there will be a delay, and likely by more than just a few months. It’s regrettable and unfortunate, but lots of well-laid plans are being delayed if not wholly changed by the current pandemic.