As I stated in my testimony in May before this subcommittee, the main purpose in addressing housing finance reform should be to promote the efficient provision of credit to finance mortgages for single-family and multifamily housing. Legislation is needed to restructure and strengthen our nation’s housing finance system and to resolve the enterprise conservatorships.
Ensuring an orderly transition will be essential to avoid disrupting the housing finance system at this critical juncture, when markets are still very fragile. It is also important to consider how the recent enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act will address certain deficiencies and make substantial changes to some long-standing policies and practices. The new law may affect the products offered to consumers and the manner in which financial institutions engage in various lending activities, as a result of new risk retention and borrower protection standards.
Currently all conventional mortgages purchased by Fannie Mae and Freddie Mac benefit from the financial support agreements with Treasury. In the future design of our housing finance system, careful consideration should be given to targeting subsidies to specific groups that lawmakers determine warrant that benefit. For example, the explicit government guarantees that the Federal Housing Administration and Veterans Administration provide reflect policymakers’ judgment as to the public benefits from targeting certain borrowers with those programs. There may be other categories of borrowers for whom a direct form of government subsidy is appropriate, as determined by Congress.
It is reasonable to question whether all conventional mortgages warrant a government guarantee. Recently there has been a growing call for some form of explicit federal insurance to be a part of the housing finance system of the future. While such an outcome has certain merit and some attractive features, I believe that the potential costs and risks associated with such a framework have not yet been fully explored. To put it simply, replacing the enterprises’ “implicit” guarantee with an explicit one does not resolve all the shortcomings and inherent conflicts in that model, and it may produce its own problems. I offer three observations in that regard for your consideration.
First, the presumption behind the need for an explicit federal guarantee is that the market either cannot evaluate and price the tail risk of mortgage default, at least at any price that most would consider “reasonable” or cannot manage that amount of mortgage credit risk on its own. But we might ask whether there is reason to believe that the government will do better? If the government backstop is underpriced, taxpayers eventually may foot the bill again.
Second, if the government provides explicit credit support for the vast majority of mortgages in this country, it would likely want a say with regard to the allocation or pricing of mortgage credit for particular groups or geographic areas. The potential distortion of the pricing of credit risk from such government involvement risks further taxpayer involvement if things do not work out as hoped.
Third, regardless of any particular government allocation or pricing initiatives, explicit credit support for all but a small portion of mortgages, on top of the existing tax deductibility of mortgage interest, would further direct our nation’s investment dollars toward housing. A task for lawmakers is to weigh such incentives against the alternative uses of such funds.
I would be remiss if I did not mention the Federal Home Loan Banks, which factor into any discussion of the future role of housing GSEs. FHLBank assets have been on a decline since September 2008 and now stand at $937 billion. Over that same time period, advance activity has steadily declined. As of June of this year, advances were at $540 billion, 46% lower than record levels reached in October 2008. While the decline appears to be slowing, it represents a stark contrast to the 2007 response to the liquidity crisis, when the FHLBanks increased advances to members by 58% in 15 months. The steady decline since that time is primarily a reflection of member balance sheets, which are now characterized by strong deposit growth and tepid loan demand.
Although the credit quality of mortgages held by the FHLBanks is much better than the industry average, the FHLBanks have pulled back from mortgage purchase activity as well. As of June 2010, the FHLBanks held $66.8 billion in mortgage loans, which represents only 7% of their combined assets. The decline results from both the reduction in new activity and an increase in prepayments.
Overall, the cutback in mortgage holding reflects an assessment by many FHLBanks that the returns associated with mortgages are insufficient to outweigh the associated funding and hedging risks.
Ten of the 12 FHLBanks reported a net profit in the second quarter of 2010, and the 12 collectively reported a net income of $326.4 million. This figure is nearly unchanged from the first quarter of 2010, as credit impairments on private-label MBS were offset by higher net interest income and lower mark-to-market losses.
However, the FHLBanks have not escaped without some financial adversity associated with the deterioration of mortgage markets. As of June 30, 2010, the FHLBanks held private-label MBS equivalent to 4.9% of assets. To date, shortfalls of principal or interest have occurred on only 1% of the number of private-label MBS held by the FHLBanks. Still, collectively the system has taken $3.3 billion in credit-related impairments on these investments and recorded an additional $10.8 billion in noncredit-related, other-than-temporary-impairments.
Three of the FHLBanks that have recognized other-than-temporary-impairments on their private-label MBS investments—Pittsburgh, Seattle and San Francisco—have filed complaints in state courts that allege fraud, misrepresentation, and violations of state and federal securities laws in connection with their purchase of certain securities. The complaints seek rescission of the purchase transactions and the defendants’ repurchase of the securities for the original purchase price. The aggregate original principal amount of the securities in question is approximately $20 billion.
I would like to raise one more important safety and soundness matter concerning the FHLBanks. Based on recent trends, it appears that the FHLBanks will fulfill their obligation within the next 18 months or so to pay a portion of the interest on bonds issued by the Resolution Funding Corp. as part of the savings and loan cleanup of 1989. Today, each FHLBank’s REFCORP obligation is 20% of its net earnings.
In the 20 years in which the FHLBanks have had this obligation, their retained earnings, a key component of their capital structure, have been less than would otherwise have been the case. With this obligation, most or all FHLBanks have not rebuilt or maintained retained earnings adequate to the size and risks of their current business.
As their safety and soundness regulator, this is of concern to FHFA. The fulfillment of the REFCORP obligation presents an opportunity to help the FHLBanks work through current financial problems and be better prepared for the future by accelerating the rate at which the FHLBanks build their retained earnings. I have asked FHFA staff to begin work on an approach that would achieve that end when the REFCORP obligations are satisfied.
During conservatorship, the enterprises have made significant progress in improving the quality of new mortgages purchased. In addition to eliminating riskier types of products, the enterprises have tightened their underwriting guidelines and reduced risk layering.
New enterprise mortgage guarantees have been for borrowers with higher credit scores and loans with lower LTV ratios, two factors that affect expected default rates.
Edward DeMarco is the acting director of the Federal Housing Finance Agency.
