The Trump administration will soon release its much-anticipated report on reforming the housing finance system, and it finally has a reform-minded Federal Housing Finance Agency (FHFA) director who is willing to deal with Fannie Mae and Freddie Mac. It remains unclear exactly how the FHFA will pull this off, but fixing the U.S. housing finance system would be a legacy achievement for any administration.
Housing finance was at the center of the 2008 financial crisis, yet Congress has done virtually nothing to fix it. The basic structure is pretty much unchanged from the pre-crisis era, and the federal government is even more entangled – with the private sector even more sidelined – than it was prior to the crash.
The status quo is harmful because it unnecessarily exposes taxpayers to financial risks and fuels unsustainable growth in debt and home prices. Even without Congressional action, reforming the housing finance system will be a herculean task because it requires the cooperation of at least three federal agencies, and because any effort to shrink taxpayer-protected risky debt will stir up a massive backlash from the special interests making money from that debt.
Still, the administration can improve things enormously by dealing with just two problematic aspects of the system.
The first problem involves the Dodd-Frank mandated “ability to repay” standard and the qualified mortgage (QM). The standard turned common sense on its head by exposing lenders to legal liability if their borrowers prove unable to repay their debts. At the same time, the QM gave lenders a safe harbor from that legal liability. The general idea was that if a loan met the QM standard, a sort of a minimum quality mortgage, the lender was safe.
It was a terrible idea because it gave lenders every incentive to make only QM loans. It was easy to predict that lenders would avoid writing non-QM loans for everyone except those with pristine credit. It was even easier to predict that financial firms would want a specific list of regulator-sanctioned underwriting guidelines to ensure compliance.
The mortgage market was well on its way toward killing off consumer choice and putting the federal government effectively in charge of underwriting mortgages.
Making matters worse, Congress gave the Consumer Financial Protection Bureau the responsibility of developing “the” QM rule, but allowed the Federal Housing Administration (FHA), Rural Housing Service (RHS), and Veterans Affairs (VA) to develop their own QM rules. While a key feature of the CFPB’s final rule was that QM borrowers could have a maximum debt-to-income (DTI) ratio of 43 percent, the bureau also included a temporary QM category (known as the patch) that exempted all Fannie and Freddie loans from the 43 percent DTI requirement.
As a result, all Fannie, Freddie, and FHA loans – more than 75 percentof the mortgage market – were able to escape the 43 percent DTI requirement. Fannie and Freddie have been purchasing loans with up to 50 percent DTI, and the FHA has been insuring loans with DTIs as high as 57 percent. As long as taxpayers are standing behind these kinds of loans, and they are stamped with the QM safe harbor, the non-QM market will never develop. (Given the default history of these types of loans, taxpayers should not be standing behind them in any way.)
The CFPB can’t simply get rid of the “ability to repay” standard or the QM. The bureau can, however, make the QM rule very broad and make compliance very easy, all while adhering to the spirit of Congress’ original intent. The bureau can accomplish this task in two steps:
- Let the patch expire, as it was designed to, in January 2021.
- Adjust the QM rule so that any trouble-free loan that has been on a financial institution’s books for at least two years (or some slightly longer time frame) automatically converts to a QM loan.
In the case of a loan that defaults after two or three years, it strains all reason to argue that the loan defaulted because of faulty underwriting. To make the new rule more effective, the FHA should revise its own rule to match the CFPB’s rule.
(If Congress really wants to fix this problem for good—getting the federal government out of the underwriting business and incentivizing more consumer choice and lower prices in the mortgage market—it will eliminate the ability to repay standard and the QM altogether.)
The second major problem that the administration will have to tackle deals directly with Fannie Mae and Freddie Mac, the two GSEs that have remained in government conservatorship since they imploded in 2008. The FHFA can fix this problem in two steps:
- Apply new capital standards to Fannie and Freddie.
- Place Fannie and Freddie into receivership and liquidate their assets because they are critically undercapitalized.
These moves will cause a firestorm, but it doesn’t really matter: The FHFA director has legal authority to take these steps, and anything the administration does to shrink Fannie and Freddie’s footprint will cause a firestorm. (The shareholders can still have their day in court.) Liquidating the two companies was the right thing to do in 2008, and it is still the right thing to do. The fact that Fannie and Freddie still exist is a testimony to the power of special-interest lobbying.
Defenders of the status quo will insist that Fannie and Freddie would have enough capital to meet the requirements if only the Treasury hadn’t amended its deal with the two companies, forcing them to hand over all of their profits to the federal government. But this view ignores reality and pretends that Fannie and Freddie would have been able to survive without hundreds of billions in taxpayer support.
Here's a quick rundown of what actually happened.
In September 2008 Treasury bailed out Fannie and Freddie, promising to provide them each with up to $100 billion. In return, they forced the companies to give Treasury 1 million shares of preferred stock, worth a total of $1 billion. These shares required the companies to pay quarterly cash dividends to the Treasury, and they included a protection device called a liquidation preference. This device means that, among other things, the companies cannot raise new equity capital without first paying back a stipulated amount to the Treasury. [Fannie owes more than $120 billion as of December 2018 (see page 13); Freddie owes more than $75 billion (see page 2.)]
In May of 2009, the companies were still struggling, so Treasury promised to provide each with up to $200 billion and allowed them to own an additional $50 billion in mortgage assets. In December 2009 the companies were still struggling so Treasury changed its commitment formula, allowing it provide more than $200 billion depending on the severity of the companies insolvency in 2010, 2011, and 2012.
In simple terms, Treasury actually bailed out Fannie and Freddie three times between September 2008 and December 2009. Yet, the companies were still struggling in August 2012—so much, that they faced the prospect of drawing on Treasury’s commitment (i.e., borrowing from Treasury) in order to pay the dividends they owed Treasury. To paper over this problem, Treasury amended the agreement once again, this time taking any profit that Fannie and Freddie managed to earn in order to satisfy the dividend payments.
It is true that, between 2008 and 2018, Fannie and Freddie paid back about $100 billion more in dividends than they received from Treasury. But this fact is a gross oversimplification that ignores that Fannie and Freddie were able to pay these dividends only with the aid of four successive bailouts. It also ignores that, for the entire conservatorship, the FHFA has “suspended” the companies’ capital requirements.
Now, some people want to allow the companies to retain profits for “four or five years” and then issue new equity capital. But there’s another catch: combined, the companies would still have to pay back another $200 billion to Treasury (due to the liquidation preference) before being allowed to raise new equity capital.
Unless, of course, Treasury gives them another bailout.
It is long past the time for Washington to end, permanently, the government-protected duopoly of Fannie and Freddie.
This piece originally appeared in Forbes https://www.forbes.com/sites/norbertmichel/2019/07/15/the-best-housing-finance-reform-options-for-the-trump-administration/#6210b4d7d3fe