Can America Finally Have a Stable Housing Finance System?
The Financial Stability Oversight Council (FSOC), a committee of federal financial regulators created by the Dodd-Frank Act of 2010 and chaired by the secretary of the Treasury, announced in mid-July it would do a review of the secondary mortgage market.
It’s about time.
For many decades, housing finance policy, going back to the early days of the Great Depression, has been focused on making mortgages available and affordable to support and expand homeownership. In the past decade, housing finance policy discussions have also been heavily focused on whether the two government-sponsored enterprises (GSEs), Freddie Mac and Fannie Mae, should continue in their current form or something different on their path to exiting conservatorship. Unfortunately, the stability of the housing finance system never quite seems to make it to the policymaker front burner, despite its having been at the heart of the two largest financial crises in the entire 75 years of the post-World War II era up until the pandemic hit. Even in the pandemic, the mortgage market has shown, once again but on a less dramatic scale, how prone it is to instability.
This disconnect – that the housing finance system has caused the two largest systemic risk financial crises since World War II (the S&L crisis of 1989 and the financial crisis of 2008), but policymakers have never prioritized comprehensively improving its stability – is explained by two things. First, financial stability (meaning the ability of major parts of the financial system to resist stresses and shocks enough to avoid falling into crisis, or to resist transmitting and amplifying stresses from other parts of the financial system) has been a priority focus of financial regulation only in the decade-plus since the 2008 financial crisis. Second, no single regulator has supervisory authority over the entire housing finance system; amazingly, some key parts of it aren’t even subject to any conventional safety-and-soundness regulation at all. So, no one has been or is really fully in charge.
FSOC is thus the perfect place for such a stability review. The review was announced as being limited to the secondary mortgage market, which I interpret to mean that it is focused on the activities and issues of mortgage-backed securities (MBS), and everyone and everything involved with them. That would include looking, in whole or in part, at the two GSEs, the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), Ginnie Mae, the hundreds of servicers of their MBS, all the participants in the private-label securitization (PLS) market, and the mortgage insurers (which are fundamentally only utilized for loans that go into GSE-issued MBS). It would also include the MBS markets in general, and might even include the originators of mortgages that end up in MBS and MBS-specialized institutional investors.
In essence, FSOC will be attempting to answer the question: what can regulators do better to reasonably reduce weaknesses in the financial stability of the secondary mortgage market? It is a narrow but extremely important issue, and high time it was tackled head on.
In my new paper, “Dear FSOC: Can We Finally Have a Housing Finance System That Is Stable as Well as Affordable?”, I first review the three major financial crises since World War II – how and why housing was at the heart of two of them, and showed significant instability in the third (i.e. today’s pandemic). This history reaffirms how urgent and important getting true stability to housing finance is.
I then give specific suggestions of what the FSOC review should have as its agenda, organized by risk-type: interest rate risk, credit risk, and operating risk, and no issue is sacrosanct or politically off-limits in this list. These suggestions include, among others:
- Interest rate risk-related: How has agency MBS performed in recent stress periods? Did the new single-security MBS (i.e. the uniform MBS now used by both Freddie Mac and Fannie Mae) hold up well?
- Credit risk-related: Are regulatory capital levels required by the concentrated credit risk in the various secondary market mortgage monoline institutions (e.g. the GSEs, the mortgage insurers) good enough to meet post-2008 stress-resistance criteria? Are credit risk transfer (CRT) transactions a positive to reduce systemic risk or not, and, if they are, are they designed to work as advertised even in periods of significant financial stress?
- Operating risk-related: Are there parts of the “plumbing” of housing finance known to be a source of instability and, if so, what can be done to reduce the risk? How adequate are the eligibility standards used by the GSEs and FHA in providing an indirect form of safety-and-soundness regulation of non-bank originators and servicers? Should the system of mortgage servicing rights, which creates significant profit instability for mortgage servicers, be revised?
If FSOC did address the full recommended agenda in a quality way, overcoming the politics that are so endemic in housing finance, and its recommendations implemented, then America would, indeed, have a stable housing finance system.
It’s long overdue.