What’s Government’s Role in Regulating Home Purchase Financing?

The Obama administration recently proposed housing finance reforms to wind down Fannie Mae and Freddie Mac and bring private capital back to the mortgage markets. HBS professor David Scharfstein and doctoral student Adi Sunderam put forth a proposal to replace Fannie and Freddie and ensure a more stable supply of housing finance. Key concepts include:
  • The two leading types of housing finance reform proposals are 1.) broad-based, explicit, properly priced government guarantees of mortgage-backed securities, and 2.) privatization.
  • Properly priced guarantees would have little effect on mortgage interest rates relative to unguaranteed mortgage credit during normal times, and would expose taxpayers to moral-hazard risk with little benefit.
  • Privatization reduces, but does not eliminate, the government's exposure to mortgage credit risk. It also leaves the economy and financial system exposed to destabilizing boom and bust cycles in mortgage credit.
  • The main goal of housing finance reform should be financial stability, not the reduction of mortgage interest rates.
  • The private market should be the main supplier of mortgage credit, but it should be carefully monitored using new approaches to regulating mortgage securitization. Moreover, the government should play a role of "guarantor of last resort" in periods of crisis.
by Sean Silverthorne

The collapse of the US housing finance system, the subprime mortgage crisis, was a key contributor to the international economic crisis ignited in 2008. What should government do to prevent such an economic short-circuit in the future?

On February 11, the Obama administration announced a number of proposals, which would include the wind down of two government sponsored enterprises—Fannie Mae and Freddie Mac. Between them they generated more than half of all US mortgage credit before failing in September 2008.

According to a new paper from Harvard researchers, reform also needs to address the changing nature of housing finance and its increasing reliance on less-regulated securitization markets. "As we move to greater reliance on private mortgage credit it will be important to combine such privatization with better regulation," says HBS finance professor David S. Scharfstein, coauthor of The Economics of Housing Finance Reform: Privatizing, Regulating and Backstopping Mortgage Markets.

In a presentation delivered recently at the Brookings Institution, Scharfstein and doctoral candidate Adi Sunderam also argued for government as a "guarantor of last resort" in a time of crisis when private mortgage credit dries up. "In that case, a government-owned corporation could guarantee newly issued, high-quality mortgage-backed securities to keep credit flowing," says Scharfstein. "This entity could have a small footprint in normal times to ensure that it could ramp up its activities in the crisis."

Scharfstein discussed the issue further in a recent Q&A with HBS Working Knowledge.

Sean Silverthorne: In general, why is reform needed? What problem will it solve?

David Scharfstein: There are two basic problems with our housing finance system. The first is that housing finance has evolved dramatically over the last 30 years with a greater reliance on markets rather than banks, and our regulatory regime has not kept up with those changes. That is one of the reasons we had a subprime crisis. The second is that housing finance became excessively dependent on Fannie Mae and Freddie Mac, with about 50 percent of all mortgage credit going through these firms. They were able to take extraordinary risks with their implicit government backing and failed spectacularly in September 2008 just before Lehman went down. We need a system without this level of government involvement.

Q: The Obama administration has just come out with a white paper that proposes the elimination of Fannie Mae and Freddie Mac and less government involvement in mortgage markets. What are the risks of taking this approach?

A: That's a really important first step in the right direction. Of course, in the short to medium run the government will still play an important role in supporting housing finance. But as we move to greater reliance on private mortgage credit it will be important to combine such privatization with better regulation.

As Carmen Reinhart and Ken Rogoff have shown in their great book This Time Is Different, credit markets…particularly mortgage markets…are prone to boom and bust cycles that can have long-lasting and devastating economic impacts. Regulation is going to have to be redesigned to recognize that most mortgage credit is done through securitization. That's not going to be easy, but it's critical to privatization.

As we increase our regulation of banks and require them to hold more capital, we'll be driving more activity into the less-regulated securitization markets. Our paper identifies a number of steps we can take to ensure the safety of these markets including regulating the leverage used in securitization.

Q: What are the options for replacing Fannie Mae and Freddie Mac, and which approach do you favor?

A: At one extreme, the government's role would be limited to supporting mortgages to lower income households through the existing programs at the Federal Housing Administration. To a first approximation, that's the right approach, but there are times…like the crisis period we just experienced…when markets benefit from government support. At the other extreme, the government would provide a backstop to private firms that would provide broad-based guarantees of mortgage-backed securities [MBS]. This approach would be most similar to the current system except that the new firms would not be government sponsored and would have to pay for the government backstop.

Our paper argues that this approach is problematic on a few fronts. First of all, if the government charges the right price for bearing the credit risk of its guarantee, the effect on mortgage rates is likely to be small. Second, the government guarantee proposals that involve private financial firms are likely to suffer from the same sorts of governance problems that plagued Fannie and Freddie, which will expose the taxpayer to considerable risk in housing downturns. Given that guarantees have small benefits during normal times, these costs are probably not worth bearing. And finally, when markets are stressed, private financial firms that guarantee mortgages are likely to be financially impaired. This will limit their ability to guarantee new MBS issues even if the government guarantee protects old MBS issues. So, in a crisis the government may have to inject capital into private guarantors to ensure that mortgage credit keeps flowing, just as it has done with Fannie and Freddie.

That's why we have advocated a middle-of-the-road approach where the government is just a "guarantor of last resort" in a time of crisis when private mortgage credit dries up. In that case, a government-owned corporation could guarantee newly issued, high-quality mortgage-backed securities to keep credit flowing. This entity could have a small footprint in normal times to ensure that it could ramp up its activities in the crisis.

In a way, this would return the government to its original role in housing finance, which was to facilitate mortgage credit during the Great Depression, a time when markets were functioning poorly. We were happy to see an approach like this included in the administration's white paper.

Q: What are the drawbacks of your proposal?

A: One concern is that if we are going to rely more heavily on private mortgage credit, we need to do a better job regulating it. We may fail in this regard, and that worries us. But it worries us about all the plans. If there are broad-based government guarantees for high-quality mortgages, there will still be many mortgages that will not be guaranteed. If regulators do a poor job overseeing that market, it could lead to a boom and bust in mortgage credit, like the recent crisis, resulting in large losses on government guarantees.

Another concern might be that the government-owned corporation could be pressured to expand its footprint even in normal times. However, we have in mind a legislative limit on its market share that could only be lifted in a crisis by agreement of top regulators. It's also important to keep in mind that the FHA, which already guarantees mortgages for low- and moderate-income households, operated for many years without such pressure. Because it was not seeking to earn profits, it did not actively lobby to expand, which is what Fannie Mae and Freddie Mac did. By making the guarantor of last resort a government entity, we hope to limit its incentive to expand.