Markets In Action

Understanding housing finance reform: A primer

The Trump administration, members of Congress from both parties and financial industry leaders have all signaled support for housing finance reform—specifically, fixing the government-sponsored enterprises (GSEs) that originate and hold most of the nation’s mortgage debt today.

GSEs play a huge and critical role in the nation’s housing market, yet that role is not always well understood by the general public. If you’re not up to speed on the world of mortgage financing and why it matters to the larger economy and financial system, here’s a quick primer that explains the key players and what’s at stake in the debate—and why reform of this vital area is needed.

What are government-sponsored enterprises and what do they do?

At the simplest level, a GSE is a financial services corporation chartered by the U.S. federal government. The principal GSEs in housing financing are the Federal National Mortgage Association (colloquially known as “Fannie Mae”) and the Federal Home Loan Mortgage Corporation (known as “Freddie Mac”).

Fannie Mae was established in 1938, but converted to a shareholder-owned corporation in 1968. Freddie Mac was created as a corporation in 1970 to compete with Fannie Mae. (A separate entity, the Government National Mortgage Association, “Ginnie Mae,” was spun off from Fannie Mae to service some types of mortgages. Unlike Fannie Mae and Freddie Mac, Ginnie Mae remains a government corporation.)

The mortgage finance GSEs were conceived with the mission of making homeownership more affordable and accessible for Americans. They do so primarily by purchasing home mortgages from lenders and bundling them together into mortgage-backed securities (MBS), essentially a type of debt security or bond that is packaged and sold to investors.

The purchase and bundling of existing mortgages as investment products brings more investors into the housing finance market, making more money available for lending and increasing liquidity. This dynamic also helps to keep interest rates low.

While Fannie Mae and Freddie Mac are technically private companies, in 2008 they were placed under the conservatorship of the Federal Housing Finance Agency (a regulator), and received access to a large pool of capital from the U.S. Treasury department.  Fannie Mae and Freddie Mac are perceived to effectively have a government guarantee by market participants, although they technically do not have an official guarantee.  Ginnie Mae, on the other hand, is a government agency, and its MBS do carry a full government guarantee. In either case, the bondholders know their investment is protected. As a result of this government involvement, GSEs and Ginnie Mae are subject to additional levels of Congressional oversight.

How big a role do the GSEs play in housing finance?

Government controlled entities, Fannie Mae, Freddie Mac and Ginnie Mae, play a significant role in the housing finance market, accounting today for a combined 78% of residential mortgage lending. That percentage has grown since the 2008 financial crisis, as fewer private lenders are active in the housing finance market now compared to a decade ago.

In fact, many experts have grown concerned by the size of the GSEs footprint, since it could reflect a lack of competition and innovation in the mortgage lending sector.

For example, Federal Reserve Governor and Chairman-nominee Jerome Powell warned in a July 2017 speech that the current status quo in the housing market, with the GSEs as the overwhelmingly dominant player in mortgage financing, is “unsustainable.” He suggested a greater role in housing finance for private lenders could reduce the risk to taxpayers, lenders and borrowers.

“Today, the federal government’s role in housing finance is even greater than it was before the crisis,” Powell explained. “The overwhelming majority of new mortgages are issued with government backing in a highly concentrated securitization market. That leaves us with both potential taxpayer liability and systemic risk.

“It is important to learn the right lessons from the failure of the old system,” Powell continued. “We can also apply lessons from post-crisis banking reform. Above all, we need to move to a system that attracts ample amounts of private capital to stand between housing sector credit risk and taxpayers. We should also use market forces to increase competition and help to drive innovation.”

As Congress considers proposals to reform housing finance, expect to see a number of proposals to scale back the GSE’s market share in hopes of encouraging a higher level of private sector lending and securitization.

Why are GSEs under government oversight today?

As mentioned above, the GSEs today are in a state of “conservatorship,” under the oversight of a regulatory agency, as a result of the 2008 financial crisis.

There were a variety of complex factors that interacted to create the financial crisis, and lowered lending standards in the housing finance sector, in the form of subprime loans, were one of the contributing factors. The good news is that since then, post-crisis regulations helped to address weaknesses in the housing finance sector.

However, like other large financial firms, Fannie Mae and Freddie Mac were affected by the crisis.  As a result of their losses in 2008, the federal government provided support of more than $187 billion to stabilize the GSEs and to protect investors and homeowners. Since then, Fannie and Freddie have returned more than $240 billion in dividends to the Treasury, more than paying back what they received from taxpayers during the crisis.

As part of the regulatory response to the financial crisis, Fannie Mae and Freddie Mac were placed into conservatorship under the oversight of the Federal Housing Finance Agency (FHFA), a regulatory agency created in response to the crisis. Under the terms of the conservatorship arrangement, the FHFA was charged with overseeing the GSEs’ operations on a temporary basis to restore them on the path to solvency. However, as the GSEs enter their tenth year of conservatorship, many experts believe it’s time to enact reforms that will allow them to leave the receivership arrangement and function independently. 

Why is housing finance reform important? 

As a result of farsighted bipartisan leadership during the financial crisis, these government-sponsored enterprises were made more stable and resilient. However, for GSEs to be the overwhelmingly dominant player in the housing finance market makes the market less diverse, which could place the system at greater risk in the event of a downturn.

“Housing finance reform remains the most significant piece of unfinished business following the crisis, and it is important to build bipartisan support for a path forward,” Sen. Mike Crapo, the chairman of the Senate Banking Committee, explained in May.

Moreover, as the Federal Reserve’s Powell noted in his speech urging reform, the lack of competition in mortgage financing may be leaving some Americans behind, particularly those with lower credit scores and fewer financial standards.

“While mortgage credit is widely available to most traditional mortgage borrowers, those with lower credit scores face significantly higher standards and lower credit availability than before the crisis,” said the Federal Reserve’s Powell. “We can all agree that we do not want to go back to the poor underwriting standards used by originators prior to the crisis. But it may also be that the current system is too rigid, and that a lack of innovation and product choice has limited mortgage credit availability to some creditworthy households.”

After eight years, it’s time for Congress to move forward with reforming these critical enterprises, which play a vitally important role in making home mortgage loans affordable and accessible for a broader range of Americans.

What is needed to reform GSEs and the housing finance market?

There are a variety of perspectives on what is needed to reform and repair the housing finance market, now that the market has stabilized, and it will be up to Congress to set the agenda for what happens next.

However, at a minimum, the key objectives of any reform should include protecting taxpayers against the need for another bailout of the GSEs; ensuring access to affordable housing and preserving access to the standard 30-year fixed-rate mortgage; and maintaining stable and liquid markets for mortgage financing.

Moreover, SIFMA believes that whatever final form the reform may take, policymakers should take care to ensure the continued functioning of the “To-Be-Announced” (TBA) market for mortgage securities. The TBA market is a highly liquid secondary market, in which standardized GSE or Ginnie Mae mortgage-backed securities can be bought and sold in advance of issuance, that serves to make mortgage lending more efficient and affordable. Ultimately, a liquid and properly functioning TBA market will be essential to ensure investor confidence and attract private lenders back to the mortgage market. (For a fuller explanation of how the TBA market works, check out SIFMA’s fact sheet.)

Finally, Congress should approach GSE reform with a bipartisan spirit to build a consensus for responsible reform, with the ultimate goal being the long-term health and stability of the housing finance market. Given the importance of the housing market to the overall U.S. economy, it’s vital that Congress take the needed steps to get it right, to ensure a housing finance system that will remain strong and resilient for the future.