With the November election in the rearview mirror, some observers believe that Republicans’ new control of both the House and Senate will make reform of the federal housing agencies more likely. This view is a bit optimistic for several reasons.
First, there is no pressing political catalyst for reforming the federal housing agencies. Both Fannie Mae and Freddie Mac operate just fine under government conservatorship. Members of both political parties are content with the current arrangement, whereby the Treasury Department receives most of the net income from both government-sponsored entities. Moreover, most reform proposals start with the false assumption that the GSEs need to be recapitalized to perform their function. But as long as the GSEs have the backing of the U.S. taxpayer, they do not need to retain any capital, as I noted in an earlier article for American Banker, “How Much Capital Does a GSE Need?”
The second reason that GSE reform is unlikely to move forward is that the House and the Senate continue to have a dramatic "conflict of visions," to borrow the title of Thomas Sowell’s wonderful book, over the direction of reform.
Rep. Jeb Hensarling, the Republican chairman of the House Financial Services Committee, wants to eliminate Fannie and Freddie, leaving only the Federal Housing Administration to support housing. Were the House Republican vision realized, home mortgage lending in the U.S. would plummet, even below the anemic $1 trillion in new originations for 2014. The to-be-announced or "TBA" market, which allows mortgage lenders to hedge their interest rate risk, would disappear. Even Republicans who strongly oppose the idea of a government-supported housing market recognize that this approach is not feasible. Indeed, Hensarling’s proposal would probably never pass in the House.
The Senate, on the other hand, seems inclined to combine the GSEs into a new federally backed mortgage guarantor that would be funded by the mortgage industry and at least in part by private investors. The proposals floated in the Senate over the past several years represent an incremental change that leaves the prime mortgage market dominated by the largest Wall Street banks. Were the Senate proposals to become law, the mortgage market would likely continue to move sideways in terms of origination volumes and consumer access to credit.
Moreover, both the House and Senate visions for the private sector's role in the housing market are largely at odds with reality. To listen to members of the House and their allies who reside in conservative think tanks, you might believe that private investors are prepared shoulder the credit and market risk of single-family mortgages. This is simply not the case. Private capital has not played a significant role in the U.S. housing market since the Great Depression, and then only when attractive arbitrage opportunities made investors ignore the difficult economics of mortgage lending. Liberals, on the other hand, are largely indifferent to the idea of attracting private capital into housing, being content with the idea of a government-controlled market.
While GSE reform is unlikely to move forward in the new Congress, there are a number of important areas where changes can be made to help revive mortgage lending and improve consumer access to credit. The Obama administration has already attempted to adjust some of the regulations that govern Fannie and Freddie to encourage new lending, but further regulatory and legislative changes that must be made in order to fix what is wrong with the housing market.
First and foremost, the GSEs need to remove all loan-level pricing adjustment fees that were put in place during the financial crisis. These LLPAs were put in place in late 2008 to prevent homeowners from prepaying high-coupon loans and represent a tax on lower-income consumers that adds enormously to the cost of a mortgage. The GSEs should also provide lenders with relief from putback risk when they refinance loans that are guaranteed by Fannie or Freddie in order to accelerate refinancing in the U.S.
While these changes are significant, the most urgent area of reform is to reopen the Dodd-Frank law and reverse the limitations on loan terms and pricing that bar roughly a third of all Americans from achieving homeownership. Limits on coupons, prepayment penalties and mortgage fees put in place by Congress in 2010 are directly responsible for the precipitous decline in mortgage lending. Indeed, unless Congress acts to reform Dodd-Frank, it is likely that mortgage lending volumes will continue to fall between now and the 2016 presidential election.
Expect the constituents of the housing industrial complex — including realtors, lenders, mortgage bankers and home builders — to demand that Congress take action to modify Dodd-Frank as opposed to tackling GSE reform. The troubles affecting the mortgage lending market thanks to Dodd-Frank are urgent and immediate, while the idea of GSE reform is a topic for polite debate among policy elites. Look for action on the former and more talk on the latter.
Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency, where he is responsible for financial institutions and corporate ratings.