Over the past 80 years, Congress has assembled a system of federal housing finance enterprises (FHFEs), which have led to the long-term deterioration of credit underwriting standards, created moral hazard, and encouraged imprudent risk-taking in the housing finance system. Indeed, beginning with the New Deal–era housing policies of the 1930s, Congress has created an ever-growing apparatus of FHFEs that provides various forms of insurance and guarantees of residential home loans. The list of the FHFEs encompasses federal government agencies, the Federal Housing Administration (FHA), and the Rural Housing Service (RHS) authorized to provide mortgage insurance and guarantee coverage, as well as the Government National Mortgage Association (Ginnie Mae), which is authorized to guarantee the timely payment of pass-through income to investors of qualified mortgage-backed securities (MBS). In addition, the FHFEs include three government-sponsored enterprises (GSEs)—the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Home Loan Banks (FHLBs)—each chartered by Congress to facilitate operations in the secondary market for mortgages and MBS.
As wholly owned agencies of the federal government, the financial viability of Ginnie Mae, the FHA, and the RHS is directly subsidized by federal taxpayers. The GSEs, on the other hand, were chartered as private financial corporations, though they have benefitted from numerous federally financed subsidies not conferred to other corporations. Over the years, for example, these federal subsidies have included lines of credit with the U.S. Treasury, exemptions from regulatory filing requirements, and various tax advantages. Because of the special privileges provided to these GSEs, financial market participants assumed, correctly, that these corporations have the implicit guarantee of the federal government. This implied guarantee became explicit when Fannie Mae and Freddie Mac, after suffering devastating financial losses during the 2007–2009 housing crisis, were placed into conservatorship under the Federal Housing Finance Agency (FHFA) and, combined, received several hundred billion dollars in direct bailout terms set by the U.S. Treasury. Overall, federal taxpayers currently cover more than $6 trillion (60 percent) of single-family residential housing mortgage debt.
As these institutions increase in size and influence over the housing finance system, their market activities, including the vast accumulation of debt, expose federal taxpayers to greater cost of bailouts during events of financial failure. Yet, Congress has repeatedly decided not to end the failed experiments, and has instead accomplished many reforms of the FHFEs that have only further enmeshed federal taxpayers to the institutions. Nevertheless, there is a viable window for accomplishing federal policy reform that would shut down these institutions, thereby eliminating the distortions they create in the housing finance system. Congress can and should take the necessary steps to dissolve these FHFEs, and allow the conditions for a vibrant free market in housing finance that can best provide individuals with durable and truly affordable homeownership opportunities over time.
Origins of the Federal Housing Finance Enterprises
The Federal National Mortgage Association. Congress authorized the creation of national mortgage associations in the National Housing Act of 1934, and then in 1938, the government-owned Reconstruction Finance Corporation (RFC) used this authority to establish a subsidiary agency titled the National Mortgage Association of Washington, which soon became known as the Federal National Mortgage Association. Over the first decade of its existence, Fannie Mae predominantly purchased mortgages insured by the Federal Housing Administration, although Fannie Mae’s purchases expanded in the 1940s to include mortgages insured through a program established for military veterans. The federal government reorganized in 1950, which included the transfer of Fannie Mae from the RFC to the control of the newly formed Housing and Home Finance Agency (predecessor to the Department of Housing and Urban Development). Then in 1954, Congress altered Fannie Mae’s federal charter and provided it a means to raise private capital through the issuance of shares in common stock—although the federal government acquired shares of the preferred stock which established Fannie Mae’s initial capitalization.
Indeed, Congress set a path toward privatization for Fannie Mae in the federal charter established by the Housing Act of 1954. This charter authorized Fannie Mae to remain a constituency division of the Housing and Home Finance Agency under the general control of the federal government. The federal legislation also authorized the federal government to provide the initial capitalization and acquire shares of preferred stock in Fannie Mae, while including provisions for the drawdown (retirement) of the government-held shares of preferred stock. The 1954 charter enacted a method for Fannie Mae to raise private capital over time, largely from required (and nonrefundable) contributions to a capital surplus account by mortgage lenders selling home loans to the corporation. Fannie Mae determined the issuance and distribution structure of common shares to mortgage lenders largely based on these contributions. In the secondary market, Fannie Mae was authorized to conduct operations and create liquidity for residential mortgages eligible (and, as amended) under the National Housing Act, and thus this activity was focused on home loans insured by the FHA and through the home loan program established for military veterans.
In 1968, Congress again reformed Fannie Mae, only this time chartering it as a government-sponsored private corporation, and partitioned a portion of its financial portfolio to the newly created Ginnie Mae. This legislative maneuvering amounted to shifting the debt portfolio for Fannie Mae off the official books of the federal government—a main impetus behind the passage of this section of the Housing and Urban Development Act of 1968—and provided some semblance of protection for federal taxpayers from liability for covering its debt. Indeed, the 1968 Housing Act gave Fannie Mae the ability to raise capital through the issuances of common shares of publicly traded stock, and for the corporation to continue to facilitate secondary mortgage market operations for mortgages authorized (and, as amended) under the National Housing Act. Fannie Mae’s secondary mortgage market operations therefore were concentrated to the government-insured home loan market until in 1970 Congress expanded Fannie Mae’s authority to include operations in the secondary conventional (non-government-insured) mortgage market.
Until the mid-1980s, Fannie Mae’s business activity in the secondary mortgage market primarily consisted of the purchases of whole loans in the conventional and government-insured mortgage markets. Fannie Mae’s strategy of concentrating on the acquisition of whole mortgages resulted in negative interest rate margins (the difference between its income derived from interest payments and borrowing (interest) costs) that led to several years of severe financial losses during the 1980s. The General Accounting Office (now, the Government Accountability Office) reported that Fannie Mae suffered “cumulative net losses of over $350 million in 1981, 1982, 1984, and 1985.” Fannie Mae was extended several privileges at federal taxpayers’ expense that included “regulator forbearance” (in other words, the problem was ignored) and a special tax provision that effectively allowed the corporation to forgo paying federal income taxes for up to 10 years. In the wake of these financial losses, Congress revised the degree of federal oversight required of the corporation (along with several other GSEs, including Freddie Mac), and in 1992, Fannie Mae was officially moved under the direct supervision of the Office of Federal Housing Enterprise Oversight, a division of the Department of Housing and Urban Development.
During the early 1990s, Congress also established requirements for Fannie Mae related to the advancement of “affordable” housing policies—federal policies that were primarily aimed at subsidizing homeownership and rental housing assistance for low-income and moderate-income households. Over the next several decades, Fannie Mae committed an enormous amount of its overall business activity to its affordable-housing initiatives, including a pledge in 1994 that the corporation would purchase $1 trillion in mortgage and mortgage-related securities associated with home loans to low and moderate income households. As has been documented by numerous housing policy experts, these federal affordable-housing policies beginning in the 1990s prompted a dramatic deterioration in underwriting standards for residential single-family homes, and represented some of the government policies that led to the 2007–2009 housing market collapse. Fannie Mae, given its size and influence in the secondary mortgage market, was crucial to the systematic increase in mortgage credit (and high-risk mortgage lending) that contributed to the collapse in the housing market.
These so-called affordable-housing policies were central to the unraveling in the U.S. housing market between 2007 and 2009, as well as the severe decline in financial solvency of Fannie Mae. Indeed, as a result of significant and sudden increases in loan defaults and home foreclosures, Fannie Mae began to suffer devastating financial losses in 2008 and was placed into federal conservatorship. During the FHFA conservatorship, the federal government has effectively nationalized Fannie Mae, which includes bailout terms with the U.S. Treasury that have resulted in the federal government acquiring approximately $140 billion worth of preferred and senior-preferred shares of stock in Fannie Mae and warrants to acquire 79.9 percent of the shares of common stock. To make matters worse, Fannie Mae continues to hold significant influence in the housing finance system, covering more than $3 trillion in outstanding single-family and multi-family housing residential mortgage debt. Federal taxpayers remain exposed to significant risk of covering any further financial losses given the scheduled depletion of Fannie Mae’s capital reserve account by 2018, and should there be any significant increase in interest rates or downturn in general conditions in the housing market.
The Government National Mortgage Association. Congress created Ginnie Mae in 1968 to function as a wholly owned corporate instrumentality of the U.S. government, and provided that it finances the guarantee of the timely payment of pass-through income to investors, to carry the full faith and credit of the U.S. government. Ginnie Mae received authority to issue and guarantee pass-through income on MBS in 1968, and this mortgage securities market officially took off in 1970. There was a special emphasis between the Federal Home Loan Bank Board (FHLBB) and Ginnie Mae to coordinate the early issuances of the guaranteed MBS, and this market remained concentrated to those securities issued by Ginnie Mae and Freddie Mac until 1977 when Bank of America began to issue the first private-label MBS. Over the next several decades, Ginnie Mae’s total guarantee portfolio has steadily increased, and as of the end of the second quarter of 2016, it guaranteed approximately $1.6 trillion (16 percent) in outstanding unpaid balances on single-family residential housing mortgages.
The Ginnie Mae MBS are almost entirely structured from government-insured mortgages, and the guarantee provides investors with the assurance of the timely payment on pass-through income. The pass-through income paid to investors is generally derived from a portion of the principal and interest payments in the mortgage pools that comprise the MBS. Ginnie Mae has typically relied on financial institutions to both issue the MBS for purchase by investors and then to service the pass-through income on the securities, although in recent years it has implemented an option for these financial institutions to issue the securities and transfer the servicing rights to Ginnie Mae. Ginnie Mae charges fees in return for the guarantee on the pass-through income, which shields investors from certain risks, primarily credit (default) risk, in these investment securities. Ginnie Mae is protected by the guarantee fees in addition to the viability of the financial institutions issuing and servicing the MBS.
Overall, Ginnie Mae provides liquidity for government-insured home loans in the housing finance system, which occurs as mortgage lenders sell home loans to financial institutions used in the structuring of the MBS. Ginnie Mae requires insurance coverage on the mortgages in the pools used for the MBS, and the mortgage insurance is almost entirely covered by direct federal government agencies. The Ginnie Mae-guaranteed MBS almost entirely derive from pools of home loans insured by the FHA, and to a lesser extent those home loans covered by the U.S. Department of Agriculture’s Rural Housing Service, the Department of Housing and Urban Development’s Office of Public Indian Housing, and the single-family home loan guarantee program of the Department of Veterans Affairs. In fact, FHA-insured mortgages alone make up roughly 86 percent of the insured loans in the MBS pools, while only 5 percent of loans are covered in the conventional (non-government-insured) mortgage market. These government insurance programs, particularly those of the FHA and the RHS, operate with comparatively high rates of default. Therefore, the overall liquidity created by the Ginnie Mae guarantee structure increases the level of government-subsidized mortgage credit and expands the federal government’s influence in the housing finance system.
The Federal Home Loan Mortgage Corporation. Congress chartered the Federal Home Loan Mortgage Corporation in July 1970 with the general authority to purchase home loans that were originated in the government-insured and conventional markets in addition to the facilitation of MBS guaranteed by Ginnie Mae. The 1970 federal charter of Freddie Mac restricted ownership of shares in its common stock to the Federal Home Loan Banks. Throughout the 1970s, Freddie Mac and Ginnie Mae remained influential in the U.S. secondary-mortgage market, particularly the MBS market, which remained concentrated to these two institutions. In 1977, the private-label MBS market emerged with the first issuances structured by Bank of America.
Freddie Mac survived the interest rate volatility (spikes) during the 1980s largely because it did not concentrate its financial portfolio in the holding of long-term (debt) notes. Other financial institutions, such as the savings and loan institutions (S&Ls) and Fannie Mae assumed enormous interest rate risk and incurred financial losses because of the negative interest rate yields in their debt portfolios. Freddie Mac was able to get through this period by its focus on MBS that primarily allowed it to pass interest rate risk to investors in capital markets. In the late 1980s, Congress altered Freddie Mac’s charter to allow the corporation to raise capital by issuing publicly traded shares of (voting) common stock, in addition to the shares of (non-voting) common stock restricted to ownership by the Federal Home Loan Banks.
Then, in the early 1990s, Freddie Mac was placed under general regulatory oversight of the federal government within the domain of the Office of Federal Housing Enterprise Oversight, a division within the Department of Housing and Urban Development. For nearly the next two decades, Freddie Mac (as was Fannie Mae) was used as an instrument to accomplish federal housing policies in the advancement of “affordable” housing, particularly geared toward single-family homeownership. Indeed, in the early 1990s, Congress took legislative steps that exposed Freddie Mac to the political whims of affordable-housing advocates by instituting requirements for the corporation to meet specified goals relating to the advancement of affordable-housing opportunities for underserved groups, particularly geared toward low-income and moderate-income households. These federal affordable-housing policies, as discussed already, were indeed central to the deterioration of underwriting standards, the increase in high-risk mortgage lending, and the eventual mortgage credit bubble that resulted in the 2007–2009 housing market collapse.
Freddie Mac, given its exposure to the large number of poor-quality (high-credit-risk) mortgages, suffered significant losses during the downturn in the housing market between 2007 and 2009. In response, Congress authorized the transfer of the financially insolvent Freddie Mac in 2008, along with Fannie Mae, under the conservatorship oversight of the FHFA. During the FHFA conservatorship, the federal government has effectively nationalized Freddie Mac, which has included specific ownership terms accompanying the federal bailout by the U.S. Treasury. In the bailout process, the U.S. Treasury has acquired shares of senior preferred and preferred stock totaling nearly $90 billion, and retains warrants to purchase up to 79.9 percent of the shares of common stock. Overall, federal taxpayers remain in a vulnerable position to cover further financial losses incurred by Freddie Mac, which could likely occur given the scheduled depletion of the corporation’s capital reserves, ongoing uncertainty in the housing market, and potential volatility (increases) in interest rates.
The Federal Home Loan Bank System. Congress passed legislation in 1932 that established 12 Federal Home Loan Banks, which were created with the intent to increase liquidity in the mortgage finance system by purchasing home loans from specialized mortgage lending institutions and life insurance companies. These purchases by the FHLBs afforded the specialized lenders additional capacity in their respective portfolios to originate new home loans. To meet that goal, the 12 FHLBs funded these purchases by taking on debt, known as advances, so that they could provide loans to member financial institutions. Until the late 1980s, membership in the FHLB system was predominantly restricted to the specialized thrift lending institutions (mostly S&Ls).
The FHLB system has evolved considerably over its more than 80 years of operation, with a significant pivot in 1990 when Congress expanded FHLB membership to include federally insured depository institutions in addition to the S&Ls. When Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989, it authorized a bailout for the S&Ls, as well as new federal housing slush funds to advance so-called community and affordable-housing development. FIRREA required that 10 percent of the earnings retained by member institutions be used to pay the interest cost on bonds issued to finance the S&L bailout, and that 10 percent of the FHLBs’ retained earnings be used to finance affordable-housing and community-development initiatives. At present, FHLB membership is open to most financial institutions provided that residential home loans comprise at least 10 percent of their balance sheets.
The FHLB system currently consists of 11 regional FHLBs with commercial banks representing more than half of the member institutions in the consortium, and the Office of Finance serves as the FHLB system’s fiscal agent, including the issuance of the advances. Each of the regional FHLBs is a separate, government-chartered, mutual organization owned by its member financial institutions and, as such, can be required to cover the financial obligations of the other FHLBs. The FHLBs effectively function as wholesale purchasers of home loans issued by their member financial institutions. As of the end of 2015, the FHLBs combined had assets totaling $969.6 billion (almost two-thirds in the form of loans called advances), and there were 7,235 member institutions (4,669 commercial banks) in the FHLB system.
Similar to the other two housing GSEs, Fannie Mae and Freddie Mac, the FHLBs benefit from the implied guarantee of the federal government that is assumed by market participants given the various special privileges, including the exemption of certain taxes and regulatory requirements, as well as lines of credit to the federal government. The FHLBs fund the majority of their market activity through the issuance of debt, which in the event of significant financial failure could result in taxpayer bailouts, similar to the federal government’s intervention during the aftermath of the S&L crisis of the 1980s, or the bailouts that occurred during the 2008 financial crisis with Fannie Mae and Freddie Mac. Thus, while the exact incentives may differ from other GSEs, the federal subsidies have led to higher levels of debt liability at the FHLBs, and increases the risks to federal taxpayers of covering the cost of bailouts should the banks begin to experience severe financial losses.
The Influence of the FHFEs in the U.S. Housing Finance System
The presence of the federal housing finance enterprises is antithetical to a free market in housing finance, and the FHFEs’ interference in the housing finance system has led to less discipline by market participants. These FHFEs create moral-hazard dilemmas for market participants that ultimately put homeowners, taxpayers, and private shareholders at greater risk of financial loss, all while increasing home prices relative to what they would be otherwise. Moreover, the FHFEs have encouraged an explosion of mortgage debt over the past several decades, while national homeownership is at the lowest rate since the mid-1960s. Homeownership can provide certain benefits to individual households, but this certainly does not mean that the federal government should interfere with the housing choices of individuals. The federal government would better serve citizens by getting out of the way of the market’s ability to guide individuals toward affordable and sustainable levels of mortgage debt when purchasing homes.
There are real costs associated with the federal government’s intervention in the housing finance system, which include the market-distorting subsidies that federal taxpayers grant the FHFEs. The federal subsidies have the effect of masking the risks involved with the financial management and governance of the FHFEs, and alter incentives among market participants to reliably and prudently align with the interests of individuals looking to take on home mortgages. Too often there is tremendous motivation for politicians to use the FHFEs as instrumentalities to advance federal housing policy, which has certainly included the “affordable” housing policies over the past several decades. Of course, when the errors lead to periods of financial insolvency at the FHFEs, federal taxpayers too often step in to cover the cost burden of these failures. The subsidies extended to the FHFEs thus cost federal taxpayers during normal market periods, and certainly during episodes of federal bailouts as the FHFEs have suffered financial insolvency.
As for any benefits, the FHFEs appear to have done little more than provide borrowers with minimally lower interest rates on home loans. Economic research suggests that the benefit to borrowers is likely only on the order of 10 basis points (0.10 percentage points) in lower interest rates on mortgage loans, and that shareholders and management of the FHFEs are likely to retain the majority of the benefits conferred by the taxpayer-financed subsidies. To be sure, these estimates relate to the pass-through of the interest rate subsidy to borrowers of mortgages guaranteed by Fannie Mae and Freddie Mac. Separate academic research has also posited that removing this subsidy would enhance overall welfare and would likely improve economic outcomes in the housing market, especially for low-income and low-asset households. Removing the interest rate subsidy would alter incentives for lower-income and lower-asset households in deciding when and how much mortgage debt to take up, and would likely encourage lower (more efficient) levels of home loan debt for these households.
Moreover, shutting down the FHFEs would by no means leave individuals without financing options for purchasing homes. Indeed, winding down the FHFEs would only prevent private financial corporations from issuing and purchasing government-insured mortgages, while removing government guarantees and insurance that currently crowd out private companies from providing such solutions. Private lending institutions already issue non-government-guaranteed home loans in the jumbo mortgage market (mortgages that exceed the loan limits in the conventional mortgage market), and to a lesser degree in the non-jumbo mortgage market (mortgages that would otherwise qualify for purchase by Fannie Mae or Freddie Mac). Nevertheless, if Congress were to shut down the FHFEs, any increase in interest rates due to the removal of the insurance and guarantee subsidies in the mortgage market would occur during a period of historically low interest rates.
Time to Shut Down the Federal Housing Finance Enterprises
Congress can create truly affordable and sustainable homeownership opportunities for Americans by establishing the conditions for a free enterprise housing finance system. To achieve this vision of a free market in housing finance, Congress should shut down the FHFEs and relinquish the system of market-distorting housing subsidies it has constructed over more than 80 years. To this end, Congress should initiate the dissolution of the FHFEs, and in so doing, preclude the transfer of the FHFEs’ authority to another GSE or the federal government except for the limited powers essential for the disposition of the respective mortgage and financial portfolios.
Until the FHFEs are shut down, Congress should implement policies that gradually reduce the market operations carried out by the FHFEs, and thus encourage private capital to return to the housing finance system.
Initiate a Five-Year Wind Down of Fannie Mae and Freddie Mac. By the end of the five-year period, Congress should repeal the respective charters to both Fannie Mae and Freddie Mac, and instruct the FHFA director to act as receiver in the dissolution of Fannie Mae and Freddie Mac, which should include shutting down the common securitization platform and any subsidiary (joint) ventures formed by the corporations. In the interim period, Congress should decrease the conventional (conforming) loan limits for mortgages that are generally eligible for purchase by Fannie Mae and Freddie Mac. Congress should also authorize increases in the guarantee fees Fannie Mae and Freddie Mac both charge on their respective operations in the secondary mortgage market. These intermediate reforms should occur irrespective to those scheduled changes for both Fannie Mae and Freddie Mac in current policy, which include the reductions in the allowable limits for the mortgage investment portfolios and the requirements for the effective dissolution of the capital reserve accounts by January 2018.
Initiate a Five-Year Wind Down of Ginnie Mae, the FHA, and the RHS. Congress should shut down Ginnie Mae, the FHA, and the RHS, thereby eliminating their direct provision of taxpayer-financed insurance coverage and guarantees on mortgages and mortgage-related securities. Winding down the FHA and RHS in particular would also eliminate the various rental housing assistance subsidies and subsidized loans guaranteed in the construction of health care facilities subsidized by the agencies. During the process of shutting down the FHA and the RHS, Congress should increase the collateral requirements for insured loans, the guarantee premiums these institutions charge for risk adjustment, as well as the loan limits for mortgages eligible for insurance coverage. Moreover, during the process of shutting down all three federal entities, Congress should ensure that the respective dissolution processes preclude any new guarantee and investment portfolio activity.
Repeal Federal Affordable Housing Goals and Duty-to-Serve Rules. The federal government has pursued “affordable” housing policies by requiring that Fannie Mae, Freddie Mac, and the FHLB system meet specific goals—explicit quotas on the types of mortgages they finance—for low-income and moderate-income households. These so-called affordable-housing goals were fundamental to the collapse of the housing finance system between 2007 and 2009, and they have served mainly to increase consumer debt and inflate home prices. In addition to these affordable-housing goals, the FHFA has instituted an even broader and more nebulous regulatory apparatus that burdens the GSEs with a “duty to serve” specified markets deemed by the agency to lack sufficient access to mortgage credit. Congress should repeal the mandatory affordable-housing goals for the GSEs, including any affordable-housing trust funds, and eliminate the duty-to-serve regulatory rules required of Fannie Mae and Freddie Mac. In so doing, Congress should preclude the transfer of these regulatory systems to any other GSE or direct federal government agency.
Remove the Special Privileges for the FHLBs. The fact that the Federal Home Loan Banks did not require a taxpayer bailout on the scale of the one provided to Fannie Mae and Freddie Mac does not justify continuing the FHLB system as a GSE. The FHLB system could be legally allowed to continue operating as a mutual organization, owned by its member financial institutions, and without a line of credit from the U.S. Treasury. Any other special privileges given to GSEs, such as the exemption of certain taxes and regulatory requirements, should also be eliminated.
Since the New Deal–era federal housing policies of the 1930s, Congress has cobbled together a system of federal housing finance enterprises that today cover more than $6 trillion (60 percent) of the outstanding single-family residential mortgage debt in the U.S. The federal government has used the federal housing finance enterprises to accomplish various policy goals—housing policies too often advanced under the notion of creating “affordable” homeownership opportunities for individuals. Over time, these policies have led to unsustainable levels of mortgage debt for millions of homeowners, and were central to several devastating downturns in the U.S. housing market. Overall, these policies have harmed American homeowners, cost federal taxpayers hundreds of billions of dollars in bailouts, and undermined the resilience of the housing finance system. It is time that Congress end these failed experiments of the federal government, and restore the conditions for a free market in housing finance by shutting down these federal housing finance enterprises.
—John L. Ligon is Senior Policy Analyst and Research Manager in the Center for Data Analysis, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.
This report is part of Prosperity Unleashed: Smarter Financial Regulation. Government policies have—for decades—empowered regulators to manage private risks and mitigate private losses in an effort to prevent financial-sector turmoil from spreading to the rest of the economy. This approach, rarely contemplated in nonfinancial industries, has demonstrably failed. Prosperity Unleashed: Smarter Financial Regulation provides solutions to the core regulatory problems that existed in U.S. financial markets long before the 2008 financial crisis.