I got an email from CBO this morning on this topic and thought I’d revisit the two main options under consideration from the administration’s Housing Finance report that I helped work on a bit more than two years ago. If you are interested in this, you should definitely read this paper by David Scharfstein and Adi Sunderam – it does a great job laying out the issues and ends up recommending something much closer to Option 2 than to Option 3.
Here are the two main housing finance reform options:
“Option 2: Privatized system of housing finance with assistance from FHA, USDA and Department of Veterans’ Affairs for narrowly targeted groups of borrowers and a guarantee mechanism to scale up during times of crisis
[…] FHA and other narrowly targeted programs would provide access to mortgage credit for low- and moderate-income borrowers, but the government’s overall role in the housing finance system would be dramatically reduced. In this option, however, the government would also develop a backstop mechanism to ensure access to credit during a housing crisis.
This backstop would maintain a minimal presence in the market during normal times, but would be ready to scale up to a larger share of the market as private capital withdraws in times of financial stress. One approach would be to price the guarantee fee at a sufficiently high level that it would only be competitive in the absence of private capital. It would thus only expand when needed, and that need would be dictated by the market. An alternative approach would restrict the amount of public insurance sold to the private market in normal times, but allow the amount of insurance offered to ramp up to stabilize the market in times of stress.
The strength of this proposal is that it would be designed to address one of the primary concerns associated with the prior model – the inability of the government to soften a contraction of credit during a crisis – without necessarily taking on all the costs associated with a broad government guarantee during normal times. During normal times it would avoid the distortions in the housing market associated with a broad-based guarantee and thus reduce both moral hazard and taxpayer risk. Again, private capital would be more likely to flow to the most productive assets in the economy, private actors would be on the hook for their own risky decisions and the government would not be putting taxpayers at direct risk in backing the nation’s mortgage market.
In addition to these benefits, the government would be in a better position than under Option One [ie option 2 without a a scaling mechanism in a crisis] to manage another downturn in the housing market. As private capital pulls back, the government could better step in to ensure the availability of credit and thus help to stabilize a declining market. Though this would likely be more effective than relying only on Congress, FHA, and the Federal Reserve, there remains a significant operational challenge in designing and managing an organization that can remain small during normal economic times, yet has the capacity to take on much more business quickly during these times of need.
There are other costs to this model as well. Aside from the uncertainty around how well it would be able to scale up in times of crisis, there is the same concern with the access issues that we face with the prior option. Access to credit, particularly the pre-payable, 30-year fixed-rate mortgage, would likely be more expensive under this option than under the following one.
Option 3: Privatized system of housing finance with FHA, USDA and Department of Veterans’ Affairs assistance for low- and moderate-income borrowers and catastrophic reinsurance behind significant private capital
Under this option, as in the previous options, the mortgage market outside of the FHA and other federal agency guarantee programs would be driven by private investment decisions with private capital taking the primary credit risk. However, to increase the liquidity in the mortgage market and access to mortgages for creditworthy Americans – as well as to ensure the government’s ability to respond to future crises – the government would offer reinsurance for the securities of a targeted range of mortgages.
In one approach to such a system, a group of private mortgage guarantor companies that meet stringent capital and oversight requirements would provide guarantees for securities backed by mortgages that meet strict underwriting standards. A government reinsurer would then provide reinsurance to the holders of these securities, which would be paid out only if shareholders of the private mortgage guarantors have been entirely wiped out. The government reinsurer would charge a premium for this reinsurance, which would be used to cover future claims and recoup losses to protect taxpayers.
The strength of this option is that it likely provides the lowest-cost access to mortgage credit of the three options. While mortgage rates would be increased by the cost of the premium and the first-loss position of private capital, this reinsurance will likely attract a larger pool of investors to the mortgage market, increasing liquidity. This, in turn, could help to lower the prices and pricing volatility of mortgages and increase the availability of the pre-payable, 30-year fixed-rate mortgage. It will also provide a more competitive playing field for smaller lenders and community banks, which, in turn, could improve access in communities where those institutions have a good record of service. And finally, the government reinsurer’s broad presence in the market could put it in a position to scale up to provide credit during a time of stress in the market more effectively.
However, this option, too, comes with costs. The increased flow of capital into the mortgage market could draw capital away from potentially more productive sectors of the economy and could artificially inflate the value of housing assets. And while the capital requirements, oversight of the private mortgage guarantors, and premiums collected to cover future losses will together help to reduce the risk to the taxpayer, the reinsurance of private-lending activity, by its nature, exposes the government to risk and moral hazard. If the oversight of the private mortgage guarantors is inadequate or the pricing of the reinsurance too low or recoupment of costs too politically difficult, then private actors in the market may take on excessive risk and the taxpayer could again bear the cost.”