In this third installment summarizing a Getting on the Right Track: Improving Low-Income and Minority Access to Mortgage Credit after the Housing Bust,the Joint Center on Housing makes concrete suggestions for reforming the housing market.  

Moving from crisis response to long-term mortgage market reforms will not be easy or quick. Both political and technical obstacles stand in the way of implementing key elements of the Dodd-Frank Act and of extending the agenda to CRA, FHA, and GSE reform.  Ongoing efforts to stop implementation reminder us there is little consensus on the path forward.

Dodd-Frank was expected to build a fairer and more responsible mortgage finance system from the ground up.  Two years later, implementation of more than 200 mandated rulemakings is well underway (with several issued in final form over the last two weeks).   Policymakers must next  complete key structural reforms to avoid a report of the recent boom and bust in housing.  Changes must include elimination of the distorting influence of "too big to fail" financial institutions, bolstering the traditional role of FHA to service minority and low income populations and develop innovative mortgage products, and reducing the presence of Fannie Mae and Freddie Mac in the secondary mortgage market. "These shifts should be implemented with a sense of urgency that pushes against the inertia of federal regulatory agencies, but slowly enough to allow all participants to adjust to the new market environment and to preserve widespread access to good mortgages."

With the housing and mortgage recoveries well underway, FHA should reduce its involvement and encourage private sector lending to come back into lower-income and minority neighborhoods. Many borrowers now getting FHA loans are creditworthy and could qualify for and afford to pay conventional loans. The challenge will be to encourage private lenders to originate loans in neighborhoods they still perceive of as risky rather than channel borrowers into FHA- insured loans while FHA should focus on reaching borrowers traditionally not well served by others in the industry.

Failure to reposition FHA would result in a new form of disparate treatment where minorities are unable to obtain a conventional loan on the same terms and pricing as otherwise similar white households. This would not only be unfair but would also divert resources from FHA's primary social mission of broadening access to borrowers who have not yet benefited from the revolution in mortgage finance.

Although FHA did not participate in the race to the bottom during the lending boom, the FHA Mutual Mortgage Insurance (MMI) fund, which supports its core single-family insurance product, suffered severe losses when house prices collapsed and it then became the lender of last resort during the crisis.  More than one in four FHA mortgages originated in 2007 is expected to result in an insurance claim.

While the MMI has yet to require a "bailout" to cover losses, FHA has drawn down reserves accumulated over the years from the payment of insurance premiums. As of the end of fiscal 2011, FHA's reserves (the combination of the financing and capital reserve accounts) totaled $33.7 billion-an increase of $400 million from 2010, but uncomfortably low relative to the nearly $1 trillion of FHA insurance in force.

Because FHA is required to maintain a 2 percent capital reserve which by 2008 was down to 3 percent the agency took a number of steps to improve its credit policies, risk management, lender monitoring, and consumer protections.  These included appointing a Chief Risk Officer, raising both up-front and annual fees, and changing credit standards. HUD also announced new mortgage products to allow creditworthy lower-income borrowers to take advantage of historically low interest rates while reducing risk to the system.

FHA, founded in 1937, originally represented an innovative public-private partnership, combining government backing with business expertise to offer products and services that competed in the marketplace. Since then FHA has lost much of its operational flexibility becoming subject to numerous statutes and regulations governing public disclosure, personnel, and other areas which impinged on its ability to adapt its product line quickly to an ever-changing market.

The authors say we must restore FHA's ability to operate more like a business and appear to endorse previous bi-partisan recommendations that FHA be restructured into a wholly government-owned corporation within HUD.  To ensure that the agency does not itself become "too-big-to-fail," a new FHA Corporation should be subject to financial and other reporting requirements.  Its affiliation with HUD would enable it to collaborate closely with the department on production and preservation of affordable homeownership and rental opportunities.

The new FHA could be led by a CEO nominated by the President, confirmed by the Senate, and answerable to Congress in the same manner as a cabinet secretary but with a term that overlaps administration.  The CEO would be supported by an advisory board appointed by key congressional leaders.

FHA needs to be retooled as more than a first responder in a financial market emergency. It should have the ability to experiment with mortgage features and adjust pricing as conditions warrant without having to wait for the next legislative appropriation and authorization cycle.

Even without another crisis some form of federal intervention into housing and residential mortgage markets is still needed, especially on behalf of lower-income and low-wealth families who have yet to benefit fully from the revolution in mortgage finance. One important task for the new FHA  should be to identify workable and cost-effective alternatives to today's widely used prepayable, 30-year, fixed-rate loans.  While both the stability and flexibility is critical to borrowers investors need to be compensated for assuming both interest rate and prepayment risk.  

A reformed FHA would offer solutions for lower-income borrowers facing intense affordability pressures even in the best of times, perhaps by expanding the downpayment assistance programs now run by state and municipal housing finance agencies (HFAs) to other private and nonprofit entities but with the internal capacity and legal authority to quickly alter or terminate any new program that appears unsound.  HUD could also provide counseling to help potential homebuyers save toward a downpayment.

Few decisions are more important, more complex, and more controversial, the Center says, than determining the future of Fannie Mae and Freddie Mac.  The two GSEs have been operating under government protection since 2008 with an explicit 100-percent guarantee on their mortgage-backed securities. In that time hundreds of assessments have addressed  structural problems in the GSEs' charters, proposals to reduce their market share and/or replace them with new entities. All merely illustrate the complexities of reforming this part of the system.  GSE reform is also intricately entwined Dodd-Frank and its mandates about what constitutes a good mortgage product, as well as with risk retention rules and FHA reform.

The Center suggests some broad principles to underpin reform and continue the dialogue concerning the rationale for government intervention into secondary markets.

Federal intervention in secondary markets has always had two main goals: (1) to help promote market efficiency and ensure a stable nationwide supply of residential mortgage financing, and (2) to increase the affordability of these mortgages and extend homeownership opportunities to a wide range of households.  Liquidity is a key component of these efforts, so the government established the framework to allow residential mortgage securitization and development of Ginnie Mae, Fannie Mae, and Freddie Mac as an efficient marketplace for those securities.

A federal presence in the secondary mortgage market is less important than when the three institutions were chartered because standardization has increased and automated systems have made it possible for investors to better assess risk. Indeed, a number of financial institutions are now willing and able to securitize mortgages.

The authors repeat their contention that the GSEs contributed greatly to the instability of the mortgage market by relaxing their underwriting standards, but had little to do with the rampant growth of subprime lending.  "This is not to say that eliminating and/or privatizing the GSEs would have no impact on housing markets. Because of their implicit government guarantee, the GSEs did enjoy a funding advantage over other highly rated financial securities. Even so, the impact is likely to be minimal."  

On February 11, 2011, HUD and Treasury released a white paper summarizing proposals for reforming America's housing finance system. The report rejected proposals to completely privatize mortgage markets, first because, with few exceptions, the private sector has always originated all mortgages, and, when guided by an effective set of consumer protections, has done so effectively. Except for its failure to extend mortgage credit to low-income borrowers and communities without explicit government guarantees, private sector originations have proven to be fairly innovative and cost-effective. There is little doubt, however, that without a government-backed secondary market, private capital would not be widely available in difficult-to-serve markets and perhaps even questionable whether the private sector would even serve the broader market for longer-term fixed-rate mortgage products.

The paper presented three options for GSE reform that build on the foundation of a financially strong and mission-driven FHA.

• Limit government support to a narrowly targeted group of people covered by FHA and other federal agency guarantee programs.  This roughly parallels proposals to reform FHA to focus on credit-impaired borrowers and thus encourage the return of private capital to the broad conforming market.
• A backstop guarantee covering a larger slice of the secondary market with a minimal presence in a normal market but which could scale up when private capital withdraws in times of financial stress. The secondary market guarantee fee might be priced sufficiently high so as to only be competitive during crises or be rationed by restricting the amount sold to the private market in normal times, but ramped up when necessary.
• A catastrophic reinsurance program under which well-capitalized and well-run financial institutions would guarantee strictly underwritten mortgage-backed securities.  The government would, for a fee, provide reinsurance for the holders of these securities in catastrophic situations, but only when losses would exceed their capital reserves and shareholder equity, This option would likely attract a pool of investors to the mortgage market, increasing the availability of capital to support the prepayable 30-year fixed-rate conforming mortgage for a broad range of homebuyers and owners.  By its nature, however, such reinsurance exposes the government to risk and moral hazard and if oversight of private mortgage guarantors was inadequate or reinsurance pricing was too low, taxpayers might once again have to pick up the tab.

Beyond providing access, federal housing policy focuses on making homes more affordable for lower income owners and renters. A key question raised by the recent crisis is whether the housing finance system is the fairest, most cost-effective, and most politically feasible way to deliver targeted assistance. Much of the literature on alternative subsidies relates to rental housing, but on the owner side of the market federal support for the GSEs apparently did lower the cost of home mortgages, if modestly.  It appears that direct and explicit subsidies are a more efficient method of providing downpayment assistance than embedding the subsidies in complex financing schemes.

At the same time, however, the tax code provides the biggest housing subsidy of all, supporting homeownership through the deductibility of mortgage interest and property taxes, and through favorable treatment of capital gains on residential properties. These benefits may be fairly small for low- and moderate-income families, who often claim the standard deduction on their tax returns and generally face lower marginal income tax rates. Tax incentives may also lead households to change their behavior in socially undesirable ways, such as purchasing very large homes that far exceed their need for shelter.

In this sense, reforming the GSEs or FHA could be considered part of a larger effort that combines tax reform and the best way to use public resources to meet the housing needs of low- and moderate-income households, but linking these issues to a broader discussion of income redistribution would only delay progress on financial reform, which is now of utmost importance.

At the most basic level, mortgage markets rest on the ability of individual borrowers to repay their loans. This is why GSE and FHA reforms must build upon the foundation created by other elements of financial sector reform. Suggested principles include:

• Private capital should be the primary source of mortgage funding and bear the burden of losses.
• Mortgage markets should be free from the counterparty risks present in large systemically important financial institutions and the problems associated with "too big to fail."
• Government support should be limited, explicit, and transparent.
• Rules and regulations should apply uniformly to financial institutions and entities performing similar functions.
• Good-quality conforming mortgages should be widely available at reasonable rates while government-subsidized home purchase options should be available to low-income and low-wealth borrowers.

It took years to create today's complex system-both the good components and the bad. It will also take years to build a replacement. Steps in the transition should include:

• Carefully winding down Fannie Mae and Freddie Mac while identifying a set of private sector successors.
• Correcting the flaws that caused the old private-label market to collapse and implementing incentives to bring private capital to the new market
• Enhancing the capacity of federal entities to monitor newly created mortgage insurance or guarantee products

While there is no clear agreement on the proper role of government in housing finance, there is remarkable consensus that comprehensive reform of the system is urgent. If there is a silver lining to the mortgage market boom and bust, it is that the crisis will lead to a fairer, more stable, and more efficient system in the future.