This paper proposes reforms of the U.S. housing finance system to increase the role of private capital in funding housing, reduce taxpayer exposure to housing risk, sell off the government stakes in the mortgage finance firms of Fannie Mae and Freddie Mac, and charge appropriate premiums for secondary insurance provided by the U.S. government on housing securities. These measures would generate revenues for the federal government, improve the allocation of capital within the U.S. economy, and focus governmental assistance for affordable housing on those most in need. With reform, private firms would securitize qualifying mortgages into mortgage-backed securities (MBS) and pay for a secondary government guarantee, while considerable private capital would take losses ahead of the government. The U.S. government would support homeownership and access to housing financing, but with transparent subsidies rather than implicit guarantees, better protection for taxpayers, and a clear delineation of the roles of the public and private sectors.
At the center of housing finance reform is an agenda to unwind the conservatorship of Fannie and Freddie that has stabilized these two government-sponsored enterprises (GSEs) since September 2008. Taxpayer support has ensured that mortgages have been available throughout the financial crisis even while other credit markets have been strained, but at a cost to taxpayers of roughly $132 billion so far, including $187.5 billion put into the two firms less $55.2 billion in dividends received (FHFA 2012e).
Moving forward with reform will return some or perhaps a good deal of the money put into Fannie and Freddie to the government, but not necessarily the full amount. Indeed, a key point of this proposal is that actions that maximize the financial return to taxpayers do not align with desirable housing policy. The U.S. Treasury now receives all of the profits of the two GSE firms and might well maximize revenue through an indefinite conservatorship in which private capital is effectively shut out of securitization for government-guaranteed MBS. A reform that brings in private sector competition would not necessarily maximize the value of the government stake in Fannie and Freddie, but it would mean better possibilities for the innovation and beneficial risk taking that go along with private sector incentives. The crisis gave financial innovation a deservedly bad name, but innovation is still valuable in the financial system. This can be seen today: borrowers with imperfect credit histories have trouble obtaining loans, even though low interest rates and the tight rental market mean that monthly mortgage payments for many might be no greater than rent. Housing finance reform that leads to a system with diverse sources of mortgage funding including both guaranteed and nonguaranteed mortgages would provide channels by which private investors can extend mortgage credit to borrowers who are now unable to obtain loans.
Similarly, Fannie and Freddie would be most valuable in a privatization sale if they are allowed to dominate the business of mortgage securitization as in the past rather than face new competition. It would be better policy, however, for reform to foster a system in which new firms can compete in the business of securitization of guaranteed MBS. The (inevitable) underpricing of government insurance gives rise to an implicit subsidy. Competition would help ensure that any such implicit subsidy flows through into lower mortgage rates for homeowners rather than being kept by shareholders and management as in the past when Fannie and Freddie had considerable market power as duopolists. The federal government will not assure any homeowner any particular interest rate. But entry by new firms into securitization and origination will place competitive pressure on banks and securitizing firms that reduces excessive interest rate spreads between yields on MBS and mortgage interest rates paid by homeowners. The importance of competition is illustrated by the present situation in mortgage origination, in which the absence of competition means that low yields on MBS do not fully flow through to reduced mortgage rates for borrowers.
Such a proposal could have a budgetary impact of roughly $134 billion. Any gap between the budgetary recovery and the amount of the bailout will represent the cost of the former housing finance system under which the government provided an implicit guarantee on Fannie and Freddie and thus took on housing risk without proper compensation, while allowing the private shareholders and management to capture part of the benefits of government support for homeownership.