Future Government Role in the US Mortgage Securitization Market - July 2013

8/12/2019 Future Government Role in the US Mortgage Securitization Market - July 2013

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© 2013 Promontory Financial Group, LLC

The Future Government Role in the

U.S. Mortgage Securitization Market

July 2013



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Table of Contents

I. Introduction ........................................................................................................................... 1

II. Goals and Constraints ............................................................................................................ 8

a. Maintain Consistent Supply of Affordable Mortgage Credit .............................................. 8

b. Minimize Taxpayer Exposure ............................................................................................ 18

III. Methodology ........................................................................................................................ 34

a. Problems with Comprehensive Reform ............................................................................. 34

b. A More Modest Approach ................................................................................................. 41

IV. Proposal ............................................................................................................................... 45

a. Mechanics ......................................................................................................................... 45

b. Candidates for Government Guarantor ............................................................................ 50

c. Creditworthiness of PMIs .................................................................................................. 55

d. Attainment of Goals .......................................................................................................... 63

e. Variations and Alternatives .............................................................................................. 67

f. Ancillary Questions............................................................................................................ 80

V. The Treasury/HUD Options Revisited .................................................................................. 84

VI. Conclusion ............................................................................................................................ 89

Appendix A: Mortgage Market Reforms Since 2007 .................................................................... 90

Appendix B: Bibliography .............................................................................................................. 92



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I. Introduction

The recent collapse of the U.S. residential mortgage market had many interrelated causes. In

consequence, reform must cover many fronts. Reforms to the pre-crisis housing finance system are

in place or underway in many areas, including consumer protection, originator oversight,

underwriting and appraisal standards, securitization accounting and disclosures, and incentive

compensation, to name a few.1 But the debate over one critical aspect of reform remains

unresolved: the government sponsored enterprises (GSEs) and the proper role of the federal

government in the secondary mortgage market.

In September 2008, the Federal Housing Finance Agency (FHFA) placed Fannie Mae and

Freddie Mac into conservatorship. Concurrently, the U.S. Treasury Department committed to

provide financial assistance to offset the GSEs’ mounting losses. The GSEs remain in Treasury-

supported conservatorship as of this writing. Meanwhile, they continue to back more than two-

thirds of new U.S. mortgages, while the Federal Housing Administration (FHA) and U.S.

Department of Veterans Affairs (VA) back almost all the rest.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)

required the Treasury to study and submit recommendations to Congress on GSE reform. In

February 2011, the Treasury and U.S. Department of Housing and Urban Development (HUD)

responded with a report titled “Reforming America’s Housing Finance Market.” The brief report

described three options for long-term structural reform. Under the first option, a privatized system

would replace the GSEs, while existing federal mortgage insurance programs, including the FHA

and VA, would continue to provide targeted guarantees. The second option would place a federal

backstop behind a broader portion of the market. The backstop would maintain a minimal presence

during normal times but scale up during a crisis. The third option would also involve a federal

1 See Appendix A for additional detail on these and other reforms.



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backstop. But instead of scaling up during a crisis, it would maintain a more consistent presence

throughout the market cycle. Under the third option, significant private capital from mortgage

securitizers and/or private mortgage insurers (PMIs2 ) would stand in front of the backstop.

Since early 2011, legislators from both sides of the aisle have introduced a variety of housing

finance reform bills. Congressional Republicans have introduced legislation consistent with the

Administration’s first option (i.e., full privatization except for FHA, VA, and other federal

programs). Legislation consistent with the Administration’s third option (i.e., a continuous federal

backstop) has also been introduced. Meanwhile, many non-governmental voices — including think

tanks, market analysts, and academics — have contributed to the housing finance reform debate

through dozens of published papers. The bibliography at the end of this paper provides a partial list

of these and earlier works.

As the debate continues, the FHFA has released a conservatorship strategic plan to prepare

the way for whatever institutional structure policymakers devise.3 The plan’s stated goals are to: (1)

build a new infrastructure for the secondary mortgage market; (2) gradually contract the GSEs’

dominant presence in the marketplace while simplifying and shrinking their operations; and (3)

maintain foreclosure prevention activities and credit availability for new and refinanced mortgages.

However, fully realizing the fruits of the FHFA’s infrastructure-building efforts will require a

resolution of the legislative debate.

To facilitate such a resolution, Genworth Financial has asked Promontory Financial Group

to prepare this paper on the future structure of the GSEs and the reforms necessary to meet U.S.

housing policy objectives. This paper aims to make a distinctive contribution to the debate with an

2 We use the acronym PMI to refer to private mortgage insurance or private mortgage insurer, as thecontext requires.

3 See FHFA, A Strategic Plan for Enterprise Conservatorships: The Next Chapter in a Story that Needs an Ending (February 21, 2012),http://www.fhfa.gov/webfiles/23344/StrategicPlanConservatorshipsFINAL.pdf .

http://www.fhfa.gov/webfiles/23344/StrategicPlanConservatorshipsFINAL.pdf





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approach that is simultaneously interdisciplinary, non-partisan, and pragmatic. Our efforts have

drawn on Promontory professionals and consultants with real-world expertise in economics,

financial regulation, law, risk management, capital markets, legislative process, housing policy, and

the mortgage industry. Our team includes experts who have worked in administrations and on

congressional staffs of both parties, as well as former regulators, bankers, traders, and lawyers with a

variety of party affiliations and worldviews. In analyzing potential solutions, we consider the

practical feasibility of transitioning from one structure to another, exploring the impact of path-

dependence and transition costs on the attractiveness of various options. We also consider the U.S.

political system’s ability both to adopt proposed reforms and to sustain ongoing political support for

the new system through the inevitable ups and downs of the market.

Our analysis begins by considering the goals of the housing finance system and the practical

constraints that complicate efforts to achieve them. We conclude that a purely private system might

fall unacceptably short of satisfying U.S. housing needs, particularly if implemented on a fixed

schedule. At this time, one cannot predict with a reasonable degree of confidence the impact of

complete privatization on mortgage interest rates, which are a primary determinant of home

affordability. Since at least the 1930s, the U.S. mortgage market has depended heavily on federal

support. The federal government’s abrupt withdrawal from the majority of the housing finance

market would, therefore, fundamentally alter the dynamics for other participants. GSE MBS

investors would hesitate, and perhaps refuse, to replace their federally guaranteed investments with

private label securities. Legal and contractual constraints would preclude many MBS investors from

investing as much, or at all, in private label MBS. Others might choose not to accept credit risk or

simply lack the technical skills to manage it. A mass exodus from the MBS market would be a

plausible consequence of full privatization, with attendant consequences for credit affordability.



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A housing finance system that renders housing “unaffordable” to broad segments of the

middle class would, as a practical matter, be difficult to sustain in the United States today. Most

Americans live in homes that they own, and many who rent desire to own in the future. These

desires and expectations are largely a product of federal housing policy. While the financial crisis

may have dampened somewhat the public’s enthusiasm for homeownership, and the government

may attempt to moderate it further over time, a perceptible decline in home affordability below

levels generally prevailing over the last 40 years would likely engender popular discontent.

This does not mean that the taxpayers must continue to bear risks commensurate with those

posed by the old GSE system. To the contrary, our analysis concludes that a properly designed

government guarantee can minimize taxpayer exposure by positioning multiple layers of private

capital in front of the government backstop. Nor must the government support a large portion of

the housing finance system indefinitely. Instead, a carefully designed government backstop should

incorporate mechanisms that can reduce reliance on the federal backstop over time, thereby

effecting an orderly shift toward purely private financing in a manner sensitive to fluctuating political

and economic conditions. Indeed, over time, the purely private market might achieve sufficient

scale and stability that policymakers decide to remove the government backstop altogether.

In designing a new system, it is important to minimize unnecessary transition costs and

market disruption. Thus, our approach focuses on what went wrong with the last system and fixes it

in the most efficient way possible, creating as few new financial institution charters and government

agencies as possible. This approach builds upon proven aspects of the pre-crisis system,

acknowledges the significant reforms already underway, and recognizes the political and market

infrastructure challenges posed by more sweeping changes.

Following our approach, we recommend abolishing the GSEs as we know them and

replacing them with a model under which private entities would both issue and guarantee their own



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The government guarantor’s payment obligations would be triggered only if the private

issuer were unable to fulfill its payment obligations. Even then, the government guarantor

would not incur significant losses unless the PMI were unable to pay claims, or losses on a

significant number of defaulted mortgages exceeded the deeper PMI coverage levels we

recommend. With the proper safeguards, this scenario should only materialize in the event

of a catastrophic collapse of the housing market.

Neither private issuers nor PMIs would be guaranteed against failure. The explicit federal

guarantee would apply only to the MBS.

The government guarantor would shrink the government footprint in the mortgage market

over time by raising fees and narrowing eligibility standards as the private market revived. It

could use similar mechanisms to support the market in the event of another housing crisis.

A portion of the personnel and infrastructure necessary for the government guarantor to

manage this new framework would transfer from Fannie Mae and Freddie Mac (consistent

with the FHFA’s conservatorship strategic plan).

Our proposal is not a take-it-or-leave-it proposition. In the course of our discussion, we

identify potential variations and alternatives to our proposed structure and consider their advantages

and disadvantages. We conclude that some (though not all) of the variations would accomplish the

key policy goals we identify — though perhaps less efficiently than our recommended system.

Examples of variations that might work include:

Creating a new type of federally chartered private entity to aggregate and securitize

mortgages, rather than relying on existing financial institutions to perform these functions.

Permitting alternative forms of credit enhancement, such as structural subordination and

originator risk retention.



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Limiting the extent of issuer liability for losses, thus reducing issuer capital requirements and

expanding lending capacity, albeit at increased risk to the government.

After reviewing potential variations and alternatives, we identify important ancillary

questions that this paper does not resolve but that nevertheless require attention. Finally, we discuss

the relationship between our proposed system and the three options set forth in the Treasury/HUD

report.

A note on independence: Genworth Financial commissioned this paper in support of its

efforts to play a meaningful role in the debate over the future of housing finance in the United

States. At the time it engaged Promontory, Genworth had no established positions on the key issues

addressed in this paper, including the necessity of a federal backstop, the institutional structure of

the secondary market, or an expanded role for PMI. Accordingly, Genworth imposed no

constraints on the conduct or outcome of the study. The Promontory team independently

conceived and developed every aspect of the proposal advanced in this paper — including an

expanded role of PMI not previously contemplated by Genworth. That said, in recommending a

proposal in which PMIs play a central role, we are mindful of the appearance of bias that could

follow from Genworth’s sponsorship, an appearance that no protestations of independence can ever

fully erase. Ultimately, the only true remedy for this perception is to present compelling arguments.

We hope that readers will consider our proposal on its merits.



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II. Goals and Constraints

Our proposal pursues two main goals, which we believe are widely shared across the political

spectrum: (1) to maintain a consistent supply of affordable mortgage credit; and (2) to minimize

taxpayer exposure to mortgage credit risk.4 These goals reflect not only what is desirable in a

housing finance system, but also limitations on what is possible. In that sense, they operate as both

goals and constraints. This section explains what the goals mean, why they are important, and how

they relate to each other.

a. Maintain Consistent Supply of Affordable Mortgage Credit

The first goal itself has two elements — affordability and consistency. As discussed below,

we believe neither can be achieved reliably without some form of government backstop.

i. Affordability

The relationship between a borrower’s income and required mortgage payments is the

principal driver of mortgage affordability. The principal amount and interest rate of the mortgage

determine the size of the required payments. Typically, a creditworthy borrower can qualify for a

mortgage that, given prevailing interest rates, requires payments not exceeding a certain percentage

of the borrower’s monthly pre-tax income — generally 28% for conventional mortgages.5 The size of

the mortgage for which the borrower qualifies determines the maximum home price that the

borrower can afford.

As mortgage interest rates rise, required monthly payments also rise, making it more difficult

for a prospective borrower to afford a given property. For example, under conventional

4 Secondary goals include: (1) minimizing the costs and economic disruption of the transition to anew system; and (2) ensuring that small originators continue to enjoy robust access to the secondarymortgage markets.5 “Conventional” mortgages are mortgages without loan-level insurance by a government agency.Mortgages insured by the FHA, VA, and similar agencies are “government” mortgages.



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underwriting standards, a prospective borrower with an annual income of $61,000 (median family

income in the United States)6 can afford monthly mortgage payments, including homeowner’s

insurance and property taxes, of about $1,425. Similarly, a prospective borrower with an annual

income of $103,000 (median family income in the greater Washington, DC metropolitan area) 7 can

afford monthly payments of about $2,405. Table 1 depicts the maximum amount that these

households can borrow at various interest rates without having their mortgage payments exceed

28% of monthly pre-tax income. Figures are shown with and without PMI premiums. (The GSEs

currently require PMI in cases where the mortgage amount exceeds 80% of the property’s appraised

value.) Loan amounts are based on a 30-year fixed rate mortgage.

Table 1: Maximum Loan Amount8

Maximum Loan Amount (rounded to the nearest $1K)

Median Family Income: US ($61K) Median Family Income: Washington DC MSA ($103K)

Loan Amount Loan Amount Loan Amount Loan Amount

APR w/o PMI w/ PMI w/o PMI w/ PMI

5% $214,000 $206,000 $367,000 $353,000

7% $178,000 $172,000 $305,000 $295,000

9% $151,000 $147,000 $259,000 $252,000

11% $130,000 $126,000 $222,000 $217,000

6 See U.S. Census Bureau, 2011 American Community Survey,http://factfinder2.census.gov/faces/tableservices/jsf/pages/productview.xhtml?pid=ACS_11_1YR _S1903&prodType=table. 7 Ibid.,http://factfinder2.census.gov/faces/tableservices/jsf/pages/productview.xhtml?pid=ACS_11_1YR _S1903&prodType=table.

8 The table makes the following assumptions:

(1) Debt-to-income ratio does not exceed 28%;(2) Monthly housing costs include principal and interest, PMI (as applicable), homeowner’s

insurance, and property taxes;(3) “ w/o PMI” scenarios assume a 20% down payment; “ w/ PMI” scenarios assume a 5%

down payment;(4) Annual PMI premium of 50 bps of initial loan amount (as applicable);(5) Annual homeowner’s insurance of $600; and(6) Annual property tax rate of 1% of home value.

http://factfinder2.census.gov/faces/tableservices/jsf/pages/productview.xhtml?pid=ACS_11_1YR_S1903&prodType=table












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These examples illustrate the significant impact of mortgage interest rates on home

affordability. They also suggest that affordability concerns affect a large portion of the U.S.

population and are not limited to “low- and moderate-income” borrowers.9 In 2012, the median

sale price of an existing single-family home in the United States was $177,000.10 The median sale

price for an existing single-family home in the greater Washington, DC metropolitan area was

$352,000.11 Table 2 shows how interest rate increases can effectively price many households out of

the housing market, even at a time when median sale prices are depressed by several years of price

depreciation and a large inventory of foreclosed properties.

Table 2: Maximum Home Price Affordable to Median Family12

Maximum Home Value (rounded to the nearest $1K)

Median Family Income: US ($61K) Median Family Income: Washington DC MSA ($103K)

Home Value Home Value Home Value Home Value

APR w/o PMI w/ PMI w/o PMI w/ PMI

5% $268,000 $217,000 $459,000 $372,000

7% $223,000 $181,000 $381,000 $311,000

9% $189,000 $155,000 $324,000 $265,000

11% $163,000 $133,000 $278,000 $228,000

Of course, interest rates also affect home prices. If rates rise, home prices may decline in

response to the reduced purchasing power of homebuyers. However, this market mechanism has its

limits. In the short term, sellers tend to resist lowering their asking prices in response to market

changes and will often take a house off the market rather than sell below a certain price. 13 Even in

9 Federal housing policy typically defines “low- and moderate-income” as 80% or less of area medianincome.10 See National Association of Realtors (NAR), “Sales Price of Existing Single-Family Homes,”

http://www.realtor.org/topics/existing-home-sales/data. 11 See NAR, “Median Sales Price of Existing Single-Family Homes for Metropolitan Areas,” http://www.realtor.org/topics/metropolitan-median-area-prices-and-affordability .

12 The table uses the same assumptions as Table 1. See footnote 8, above.13 Some of these sellers cannot sell below a certain price (generally the amount of their outstandingmortgage debt), while others have personal biases that lead them away from economically “rational” behavior.

http://www.realtor.org/topics/existing-home-sales/data


http://www.realtor.org/topics/metropolitan-median-area-prices-and-affordability






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the long term, home prices can only drop so far. Numerous factors place a floor under the cost of

owner-occupied housing. These factors include: the value of rental property; the costs of

construction inputs, such as labor and raw materials; the scarcity of land in reasonable proximity to

jobs and families; and the need to achieve a minimum level of construction quality. While some of

these factors have a close, if complex, relationship with mortgage rates, others are largely

independent. Thus, rising mortgage interest rates will drive down home prices to an extent, but not

necessarily enough to offset the decrease in affordability. Only a commensurate increase in real

incomes would fully offset the impact of rising interest rates on home affordability.

Some observers believe that removing federal homeownership subsidies will only result in a

modest decline in the homeownership rate. We believe they are answering the wrong question.

Although the homeownership rate may be the best proxy for measuring historical home affordability

over time, it is not necessarily the most relevant metric for our purposes. Americans will experience

any material decrease in mortgage affordability as a tangible decline in living standards and a

disappointment of cultural expectations. Some families that expected, based on their incomes and

experience, to own homes will find themselves unable to do so. Other families will need to settle

for houses that are smaller, more crowded, less well-located than, or otherwise perceived as inferior

to, houses that those of comparable means could afford in the recent past.

This subjective experience is the most relevant metric of “affordability” for purposes of

GSE reform. Disappointed expectations regarding who can buy a house and what kind of house

they can buy have far more power to drive political and economic forces than the homeownership

rate. Indeed, in many cases, the effects described above would not fully register as changes to the

homeownership rate. The U.S. Census computes the homeownership rate by dividing the number

of owner-occupied housing units by the number of occupied housing units or households. Thus,

the homeownership rate would not reflect changes in the size and quality of homes affordable to



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families in a given set of circumstances. Nor would it reflect an increase in young families living

with their parents, or of older Americans living with their children, due to an inability to afford a

home of their own. Moreover, since most households are not attempting to purchase a home at any

given time, acute declines in mortgage affordability will translate into only small changes in the

homeownership rate in the short term.

Even so, many observers contend that cheap credit and abundant federal housing subsidies

have caused housing consumption in the United States to reach excessive levels. Some further argue

that the pursuit of affordability is misguided insofar as it requires government subsidies and exposes

taxpayers to risk. According to the latter viewpoint, mortgage interest rates should be whatever the

private market will bear without government interference. Those who cannot afford larger houses

can purchase smaller ones (or cohabitate with extended family); those who cannot afford

homeownership can rent; and those who cannot afford a rental can register for rent subsidies, if

available, or fend for themselves.

We do not pass judgment on the merits of this argument. But as a practical matter, a

housing finance system that reduces credit affordability below levels generally prevailing in the last

40 years would be difficult to sustain in the United States today. Most Americans live in homes that

they own, and many who rent desire to own in the future. These desires and expectations are largely

a product of federal housing policy. Policies going back as far as the Great Depression have

encouraged and subsidized homeownership — from the creation of the FHA and Fannie Mae in the

1930s, the VA mortgage guarantee program in 1944, and Freddie Mac in 1970, to the “Ownership

Society” policies of the George W. Bush Administration and the persistence of the mortgage interest

deduction for the past 100 years. Federal policy played a decisive role in creating the suburban

neighborhood of mostly owner-occupied detached houses, which shaped the institutions, social

relationships, and cultural expectations that dominate American life. To reverse the American



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enthusiasm for homeownership — and ownership of detached single-family houses in particular —

would require fundamental social change.

Over the past 80 years, the U.S. political system has shown little appetite for this type of

change. Policymakers consistently have intervened to preserve affordable credit availability,

particularly in response to credit contractions. The most dramatic of these contractions occurred

during the Great Depression, when unprecedented declines in property values made lenders loath to

refinance maturing mortgages. Because mortgages at the time had much shorter terms than today

and often required borrowers to make balloon payments at maturity,14 the shortage of refinancing

credit yielded a wave of foreclosures. The federal government responded with extraordinary

measures to refinance, insure, and purchase mortgages. Through the Home Owners’ Loan

Corporation, the government purchased defaulted mortgages and replaced them with longer-term,

fixed-rate, fully-amortizing mortgages. To ensure the ongoing marketability of these mortgages, the

government established its own mortgage insurer, the FHA. The government also created Fannie

Mae (a public entity between its inception in 1938 and its privatization in 1968) to purchase and hold

FHA-insured loans.15

Policymakers employed the federal housing apparatus created during the Great Depression

to cushion subsequent mortgage credit contractions that threatened affordability. For example, a

sudden contraction of mortgage credit in 1966 — caused by rising Treasury yields and ensuing

deposit outflows — prompted Fannie Mae to expand its support of the mortgage market dramatically

by purchasing over $4 billion worth of mortgages. Responding in part to the 1966 crisis and a

14 In the years preceding the Great Depression, mortgage terms typically ranged from 5 to 10 years.See Richard K. Green and Susan J. Wachter, “The American Mortgage in Historical andInternational Context,” 19 Journal of Economic Perspectives Issue 4 (Fall 2005), 94,http://repository.upenn.edu/cgi/viewcontent.cgi?article=1000&context=penniur_papers&sei-redir=1#search="The+American+Mortgage+in+Historical+Context.

15 See generally ibid., 94-96.

http://repository.upenn.edu/cgi/viewcontent.cgi?article=1000&context=penniur_papers&sei-redir=1#search=%22The+American+Mortgage+in+Historical+Context







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similar crisis in 1969, Congress restructured and privatized Fannie Mae, created Freddie Mac, and

authorized both to purchase conventional mortgages, marking the GSEs’ first foray beyond the

government-insured mortgage market. Freddie Mac issued its first participation certificate, the

predecessor to modern MBS, in 1971.16

In the late 1970s, soaring interest rates led to a sharp contraction in the availability of

mortgage credit by placing severe stress on savings and loans (S&Ls), decreasing the capacity of

banks to carry fixed-rate mortgage loans, and materially increasing monthly payments on new

mortgages. Congress responded with a variety of measures, including S&L deregulation and

preemption of state laws prohibiting adjustable-rate mortgages. (The continued expansion of

securitization — Fannie Mae issued its first MBS in 1981 — ultimately helped preserve the viability of

the 30-year fixed-rate mortgage.) During the most recent crisis, of course, the government has

intervened in extraordinary ways to ensure a continuous flow of capital into the mortgage market

through the Federal Reserve, the GSEs, federal mortgage insurance programs, and insured

depository institutions.

The government’s willingness to intervene to preserve affordable credit availability seems

likely to persist, albeit within evolving boundaries. The level of perceived affordability achieved at

the height of the housing bubble, reflected in a homeownership rate around 69%, relied on

unsustainable expectations of rising home prices and uncompensated risk-taking by private actors

and the federal government. This rate had to come down, and it may have further to go.17 Gradual

16 See ibid., 97-98; Sarah Quinn, “ Things of Shreds and Patches: Credit Aid, the Budget, andSecuritization in America,” Working Paper (October 2009), 4, 26; and Raymond E. Owens andStacey L. Schreft, “Identifying Credit Crunches,” Federal Reserve Bank of Richmond WorkingPaper 93-2 (March 1993), 7-23,http://www.richmondfed.org/publications/research/working_papers/1993/pdf/wp93-2.pdf .

17 A Federal Reserve study concludes that the “effective” homeownership rate— after discountingnegative equity households — is approximately 5.6 percentage points below the official rate. See Andrew Haughwout, Richard Peach, and Joseph Tracy , “The Homeownership Gap,” Federal

http://www.richmondfed.org/publications/research/working_papers/1993/pdf/wp93-2.pdf





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long-term declines in affordability may remain imperceptible to the political system until after the

fact, particularly if they occur slowly enough for the evolution of cultural expectations to keep pace.

But a perceptible decline below levels generally prevailing over the last 40 years would likely

engender popular discontent.

Indeed, we believe some advocates of a rapid transition to full privatization would

reconsider their position once its potential consequences became fully apparent. For example, the

affordability debate to date has focused on the difference between the “sustainable” pre -bubble

homeownership rate — 65% in 1985 —and the “unsustainable” rate of 69% reached at the market’s

peak.18 But the 65% rate reflected almost all of the federal housing subsidies that exist today,

including the implicit government guarantee of Fannie Mae and Freddie Mac. As discussed below,

the lower limit of homeownership in a fully privatized system is unknown. Before the introduction

of federal homeownership subsidies, it was consistently below 50% (see Figure 1). It is hard to

believe that a new system in which most American families cannot obtain a mortgage could earn and

maintain political support over the long term.

Reserve Bank of New York, Current Issues in Economics and Finance 16, no. 5 (May 2010),http://www.newyorkfed.org/research/current_issues/ci16-5.pdf . 18 For homeownership statistics, see U.S. Census Bureau, “Housing Vacancies andHomeownership,” http://www.census.gov/housing/hvs/.

http://www.newyorkfed.org/research/current_issues/ci16-5.pdf


http://www.census.gov/housing/hvs/







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Figure 1: Historical U.S. Homeownership Rates

40.0%

45.0%

50.0%

55.0%

60.0%

65.0%

70.0%

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Source: U.S Census Bureau, http://www.census.gov/hhes/www/housing/census/historic/owner.html.

Thus, the goal of affordability reflects political preferences as an underlying constraint. For

purposes of assessing the viability of possible reforms to the U.S. housing finance system, we define

“unaffordable” as the point at which home purchase affordability falls below a politically acceptable

level. While the financial crisis may have dampened somewhat the public’s enthusiasm for

homeownership, and the government may attempt to moderate it further over time, one must

nevertheless acknowledge its existence.

ii. Consistency

The second element of the first goal —“consistent supply” of credit— addresses the extent to

which affordability persists over time. A consistent supply of credit does not evaporate — either

locally or nationally — during periods of market turbulence. It proves resistant to sudden panics.

Ideally, the housing finance system should limit investor incentives to flee to relative safety during a

market downturn. It should also prove capable of withstanding failures of individual institutions

without severe or prolonged disruptions to the supply of credit.

http://www.census.gov/hhes/www/housing/census/historic/owner.html






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While desirable for its own sake, consistency within the mortgage market also helps prevent

damage to the broader economy. Housing equity is the largest asset of many U.S. households. As a

result, sharp drops in home prices create a negative wealth effect that reduces consumer spending

and economic growth.19 Such drops also reduce the property tax revenues on which most local

governments depend. The resulting layoffs and tax increases can further aggravate the downturn.

All financial markets are susceptible to sudden withdrawals of capital, and the U.S. mortgage

market is no exception. As discussed above, such withdrawals have occurred numerous times in

U.S. history, including during the Great Depression, the 1960s, the S&L crisis, and today. In each

case, the federal government intervened to mitigate impacts on affordable credit availability.

Extraordinary government intervention continues to ensure a continuous flow of capital into the

mortgage market today. Private mortgage capital, on the other hand, has largely evaporated. To be

sure, private capital might have returned to the market more quickly absent competition from

expanded government programs. But mortgage markets still would have been disrupted for an

extended period, as illustrated by recent experiences with some types of consumer lending. For

example, auto securitization virtually ceased between March 2009 and October 2010.20

Credit card

securitizations weakened significantly, with private issuances from only a handful of well-regarded

issuers — such as JPMorgan Chase — from the fourth quarter of 2008 to the end of the third quarter

of 2010.21 Most of the auto and credit card loans extended during these periods originated from

banks relying on government-guaranteed funding and, in many cases, government-supplied capital.

19 The disruption can be especially deep and protracted when home values drop below mortgagebalances for significant numbers of households.

20 See Asset-Backed Alert’s ABS Database and the Federal Reserve, http://www.federalreserve.gov/newsevents/reform_talf.htm#data.

21 Ibid.

http://www.federalreserve.gov/newsevents/reform_talf.htm#data





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Without government support for mortgage securitization, the economic impact of the Panic of 2008

would have been far more severe.

b. Minimize Taxpayer Exposure

The second goal of GSE reform, minimizing taxpayer exposure, addresses a fundamental

flaw in the old GSE model: privatized gains and socialized losses. For years the GSEs paid large

dividends to shareholders and high compensation to senior executives. Yet the Treasury has now

committed at least $200 billion in taxpayer funds to shore up the ailing GSEs. The implicit federal

guarantee on the GSEs’ obligations, once disavowed publicly by the government but widely assumed

by market participants, compromised normal market discipline. Relying on the implicit guarantee,

investors had less incentive to monitor the risks taken by the GSEs. Taxpayers are now paying the

price.

As detailed above, since at least the 1930s, the U.S. mortgage market has depended heavily

on federal support. All agree that the future housing finance system must do more to protect

taxpayers from exposure to the mortgage market. But full protection for taxpayers may not be

possible without sacrificing the consistent availability of affordable credit. These competing goals

require balancing. The following sub-section explains why.

We begin this sub-section by reviewing the ways in which mortgages are financed in the

United States, including how the different financing methods allocate credit and interest rate risk

among market and government actors. Understanding the structure of the U.S. mortgage market is

helpful in grasping the significance of the government’s role. We then consider whether it is

possible to predict how transitioning to a purely private secondary market for conventional

mortgages would affect consistent credit affordability. We conclude that complete privatization on a

fixed schedule would constitute an unnecessary and imprudent gamble, even for those who hope to

see the market completely privatized in the long term. Finally, we explain why a federal backstop



19

precludes the complete elimination of taxpayer risk yet could achieve our consistency and

affordability objectives with much less risk than the pre- or post-crisis GSE system.

i. Financing U.S. Mortgages

U.S. mortgages are financed in two primary ways: portfolio funding and securitization.

Portfolio lenders and investors hold whole loans on their balance sheets and allocate capital to

support these loans (see Figure 2). Given prevailing mortgage rates, earning attractive returns on

prime mortgages requires leverage and low funding costs. As a result, banks, thrifts, and the GSEs

are the dominant practitioners of portfolio funding of prime mortgages. Banks and thrifts fund

their mortgage portfolios largely with insured deposits or Federal Home Loan Bank advances.

22

Prior to conservatorship, the GSEs funded their retained portfolios largely with inexpensive senior

debt that carried an implicit government guarantee. In conservatorship, the GSEs have continued

to fund themselves with senior debt which does not bear a direct Treasury guarantee but comes

close to it.

Figure 2: Portfolio Funding

Homeowners Lenders

Loan payments

$ for home purc hase

Servicers

In the conventional mortgage securitization market, lenders fund loans by transferring them

(either directly or through third-party securitizers) to special purpose trusts, which then issue debt

securities (i.e., MBS) to investors. The lender accepts the proceeds from the debt issuance in

exchange for transferring the loans to the trust. Acting through a servicer and other agents, the

trustee passes borrower payments and other cash flows from the loans, less servicing costs, through

22 Covered bonds, which are more prevalent in Europe, are discussed in Section III.a.



20

to the investors (see Figure 3). Thus, funding for securitized loans largely comes from MBS

investors, not portfolio lenders or depositors (although many depository institutions are also MBS

investors).23

Figure 3: Private Securitization Financing

Securitization

Trusts

Loan payments

MBS Investors$ for MBS

MBS payments /

MBS

HomeownersLenders /

Securitizers

$ for home

purchase

Whole

loans$ for whole

loansServicers

Since its initial growth during the 1970s and 1980s, securitization has become the primary

source of mortgage funding, for several major reasons. First, securitization generally enables a

lender to originate more mortgages using a given amount of capital (although recent accounting

changes and the risk retention requirements of the Dodd-Frank Act reduce this advantage in some

circumstances). Second, securitization shifts unwanted interest rate risk and prepayment risk 24 from

lenders to investors, a feature discussed in more detail below. Third, aggregating many mortgages

into a single pool can reduce credit risk 25 through diversification (depending on the composition of

the pool). This makes MBS attractive to a broader range of investors, particularly those with less

tolerance for credit risk. By expanding the investor universe, lenders enjoy greater fee income

23 Depository institutions may prefer to hold MBS, particularly government-backed MBS, rather than

whole loans because MBS can be more liquid and face lower capital charges.24 Prepayment risk is the risk that the borrower will repay the loan ahead of schedule. Most U.S.mortgages do not have prepayment penalties. In a declining interest rate environment (when manyborrowers refinance), investors generally cannot re-invest prepayments at equally attractive interestrates. Thus, prepayment risk is closely related to interest rate risk, although other factors also play arole.

25 Credit risk is the risk of loss arising from borrower default.



21

through increased origination, securitization, and servicing volumes, and borrowers enjoy access to

more and cheaper credit.

Historically, most MBS have attracted buyers seeking “credit-risk-free” investments in quasi-

governmental or AAA-rated debt. These investors typically have little or no tolerance for credit risk

in the segments of their portfolios that include MBS. In some cases, this low risk tolerance arises

from a generally conservative investment philosophy. But for the institutional and professional

investors that dominate the MBS market, the low risk tolerance is often dictated by legal or

contractual investment restrictions, portfolio allocation needs, regulatory capital requirements, or

simply lack of technical capacity to analyze credit risk. Therefore, when an investment loses its

“risk -free” status— as many private MBS did during the financial crisis — these investors typically

reallocate their capital to other low-risk investments, rather than following the affected asset down

the credit ladder. In some cases, the investor may still purchase the asset for other — generally

smaller — portfolio segments. In other cases, the investor abandons the asset altogether.

These investor preferences help explain the relative volumes in the three principal mortgage

securitization channels. The smallest channel, the purely private market, lacks any federal guarantee.

Securitizers in this channel historically employed “structural” credit enhancements, such as

subordination and over-collateralization,26 to mitigate credit risk to investors and earn a nearly “risk -

free” AAA rating for the largest, most senior class of their MBS. Securitizers could also obtain

third-party credit insurance at the individual loan level or pool level to help achieve this objective, as

illustrated in Figure 4. But “private label” MBS have had difficulty securing AAA ratings since the

onset of the credit crisis, while expanded GSE eligibility criteria have reduced the volume of

26 Subordination refers to the practice of carving mortgage pools into distinct risk slices, or“tranches.” Holders of senior tranches receive payments before holders of junior tranches. Theyalso receive lower returns. Overcollateralization describes the practice of issuing MBS with anaggregate face value lower than the face value of the associated mortgage collateral. The extracollateral provides a buffer against higher-than-expected default rates.



22

mortgages potentially available for this channel. As a result, new private label issuance has been

reduced to a trickle dominated by mortgages that exceed GSE size limits (called “jumbo”

mortgages).

Figure 4: Private Financing with Third-Party Insurance

MBS Insurers

Securitization

Trusts

Loan payments


MBS payments /

MBS

Fee for “wrap” ofMBS (as applicable ) Pays investors when

cash flows from

mortgages fall short

Homeowners

Loan-Level

Insurers

Payment of

claims (as

applicable)

Lenders /

Securitizers

$ for home

purchase

Whole

loans$ for whole

loansServicers

(as applicable) (as applicable)

Insurance

premiums (as

applicable)

At the other extreme of the credit risk spectrum, Ginnie Mae guarantees the timely

repayment of principal and interest on MBS backed by mortgages that are insured by the FHA, VA,

and other government agencies. Under the Ginnie Mae securitization framework, approved private

issuers assemble pools of government-insured mortgages and issue Ginnie Mae MBS backed by the

pools.27 Rather than purchasing or securitizing loans itself, Ginnie Mae simply guarantees the MBS

(see Figure 5). At first glance, Ginnie Mae’s MBS-level guarantee may appear to duplicate the loan-

level guarantee provided by another government agency. But it is instrumental in protecting

investors from possible delays in scheduled payments, since the loan-level insurers typically do not

pay claims until after foreclosure. The guarantee also protects investors from fraud or underwriting

mistakes that might void the underlying coverage.

27 Ginnie Mae issuers use independent custodians, rather than trusts, to hold the assets.



23

Figure 5: Ginnie Mae Securitization

Ginnie Mae

Lenders /

Approved Issuers

Loan payments


MBS payments /

MBS

Fee for Ginnie Mae

“wrap” of MBS Pays investors if

approved issuers

default

Homeowners

Government

Insurers (FHA, VA,

etc.)

Insurance

premiums Pay claims

when

homeownersdefault

$ for home p urchase

Servicers

The third and largest securitization channel operates through the GSEs, Fannie Mae and

Freddie Mac. The GSEs purchase loans meeting specific underwriting criteria (“conforming loans”)

from lenders and aggregators, package the loans into pools, and sell MBS to investors. Like Ginnie

Mae, they guarantee the timely payment of principal and interest to investors (see Figure 6). As a

result of the widespread (and ultimately correct) assumption that the U.S. government stood behind

the GSEs, these investors also assumed effectively no credit risk. As commonly observed, investors

in GSE MBS received the best of both worlds: they enjoyed higher yields than investors in explicitly

guaranteed securities, but they had practically no loss exposure in light of the U.S. government’s

effective guarantee.



24

Figure 6: GSE Securitization

GSEs / GSE

Trusts

Loan payments


MBS payments from

trusts / MBS

Homeowners

PMIs

Payment of

claims (as

applicable)

Lenders$ for home

purchase

Whole

loans $ for wholeloans

Servicers

(as applicable)

Insurance

premiums (onloans > 80%LTV)

GSEs pay investors

when cash flows

from trusts fallshort

Each of these various mortgage financing methods — portfolio funding, private label

securitization, Ginnie Mae securitization, and GSE securitization — represents a different way of

apportioning risks arising from the underlying mortgages. Portfolio lenders retain credit risk

(sometimes mitigated by mortgage insurance), interest rate risk, and prepayment risk on loans they

hold in their portfolios. Securitization typically transfers interest rate and prepayment risk to MBS

investors. But the ultimate holder(s) of credit risk after securitization varies with the particular

structure. Table 3 describes how credit risk is distributed in the various financing channels.



25

Table 3: Allocation of Credit Risk



26

Since the financial crisis, securitization has remained the primary financing method for new

mortgages in the United States, and the GSEs and Ginnie Mae have supported almost all new

mortgage securitizations (see Figure 7). Bank portfolio lending, which accounted for roughly 15%-

20% of mortgage originations in the years immediately preceding the crisis, declined sharply as the

crisis unfolded.28 One reason for the decline in bank portfolio lending (and, arguably, private label

securitizations) is the temporary expansion of eligibility criteria for GSE and government-insured

loans. Another reason is the domination of new production by 30-year fixed-rate mortgages, which

depository institutions, with their short-term variable rate funding, have only limited capacity to hold

(as discussed further in Section III.b, below). As mentioned above, private label securitizations have

virtually ceased (aside from a trickle of jumbo mortgage securitizations).

Figure 7: Share of New Securitizations

Source: 2012 Mortgage Market Statistical Annual, Inside Mortgage Finance; Inside MBS & ABS (July 6, 2012).

28 See John Krainer, Federal Reserve Bank of San Francisco Economic Letter 2009-33, “RecentDevelopments in Mortgage Finance” (Oct. 26, 2009), Figure 3,http://www.frbsf.org/publications/economics/letter/2009/el2009-33.html.

http://www.frbsf.org/publications/economics/letter/2009/el2009-33.html





27

While current levels of direct government support are anomalous, the government has

always played a major, if not dominant, role in the post-war U.S. mortgage market. This was true

even at the peak of private label MBS production. Although the private label market constituted

56% of new MBS issuance in its peak year of 2006, private label MBS constituted only 31.9% of

outstanding MBS in 2007.29 The GSEs and Ginnie Mae constituted the remainder of the

securitization market.30

ii. A Serious Gamble

The federal government’s abrupt withdrawal from the majority of the housing finance

market would fundamentally alter the dynamics for other participants. GSE MBS investors would

hesitate, and perhaps refuse, to replace their federally guaranteed investments with private label

securities. Legal and contractual constraints would preclude many MBS investors from investing as

much, or at all, in private label MBS. Others might choose not to accept credit risk or simply lack

the technical skills to manage it. A mass exodus from the MBS market would be a plausible

consequence of full privatization.

It is difficult, if not impossible, to estimate the potential magnitude of the rate increase in

this scenario.31 It is tempting to look to historical interest rate spreads between non-GSE-eligible (or

“jumbo”) loans and GSE (“conforming ” ) loans for guidance. This jumbo-conforming spread

reflects the risk premium investors demand for foregoing the safety and liquidity provided by the

GSEs. As illustrated in Figure 8, the spread was relatively small in the decade immediately preceding

29 OFHEO, “A Primer on the Secondary Mortgage Market,” Mortgage Market Note 08-3 (July 21,2008), 2-3, http://www.fhfa.gov/webfiles/1242/MMNOTE083.pdf .

30 The GSEs’ share of outstanding MBS in 2007 was 62%. Ginnie Mae’s share stood at 6.1%. Seeibid., 2.

31 See Mark Zandi and Cristian deRitis, “The Future of the Mortgage Finance System ,” Moody’s Analytics (Feb. 7, 2011), 11, http://www.economy.com/mark-zandi/documents/Mortgage-Finance-Reform-020711.pdf .

http://www.fhfa.gov/webfiles/1242/MMNOTE083.pdf



http://www.economy.com/mark-zandi/documents/Mortgage-Finance-Reform-020711.pdf








28

the mortgage crisis but grew significantly once the crisis commenced. However, even this larger

jumbo-conforming spread likely understates the potential rate increase in a purely private system, for

several reasons. First, private label securitization accounted for only a small minority of MBS during

this period. If the private label market had to expand in size to support the entire housing market —

approximately 20 times current levels — interest rates could increase even more. As noted above, the

universe of investors willing and able to purchase non-guaranteed MBS is much smaller than the

universe of guaranteed MBS investors, especially now that previously ubiquitous AAA-rated MBS

are not available.32 Even the spread at the peak of the private sector market, in 2006, has limited

predictive value, since we now know that these rates were grossly inadequate to compensate

investors for the risk they assumed.

Figure 8: Interest Rate Spreads on 30-year Fixed Mortgages

Source: J.P.Morgan, “2011 Securitized Products Outlook” (Nov. 24, 2010), citing bankrate.com.

In any event, the issue is not the exact magnitude of the mortgage rate increase associated

with a purely private system, but the impossibility of estimating it within a reasonable margin of

32 See J.P.Morgan, “2011 Securitized Products Outlook ” (Nov. 24, 2010), 20-21.



30

Establishing nationwide standards for mortgage servicers;

Eliminating conflicts of interest for mortgage servicers;

Limiting the ability of a borrower to obtain a second mortgage without the approval of the

first mortgage holder;

Requiring disclosure of loan-level information at issuance and periodically thereafter;

Standardizing securitization documentation, such as pooling and servicing agreements with

model representations and warranties; and

Clarifying legal and accounting sales treatment.

Meanwhile, uncertainty surrounding key regulations has further impeded the revival of

private label securitization. As of this writing, the industry has begun to digest new regulations

concerning borrower “ability to repay ,” but regulations concerning securitizer risk retention remain

in draft form. The proposed risk retention regulations, developed by federal regulators pursuant to

section 941 of the Dodd-Frank Act, generally would require securitizers to retain 5% of the credit

risk associated with securitized mortgages sold to investors. The statute exempts certain loans from

this requirement, including “qualified residential mortgages” (QRMs), a term regulators have

considerable flexibility to define. Industry commenters have argued that a narrow definition would

limit lenders’ ability to participate in the private label securitization market.

Once reforms are implemented in both segments of the housing finance system —

government-backed and private label — the government can encourage increased private label market

share by increasing the federal guarantee fee and/or narrowing the classes of mortgages eligible for

Subcommittee of Capital Markets and Government Sponsored Enterprises of the House Committeeon Financial Services, September 7, 2011,http://financialservices.house.gov/Calendar/EventSingle.aspx?EventID=257327.

http://financialservices.house.gov/Calendar/EventSingle.aspx?EventID=257327





31

the guarantee.35 In an ideal world, the government backstop will recede in importance over the

years, or even become obsolete. Indeed, if the private label market attains sufficient scale and

stability, policymakers could choose to remove the federal guarantee altogether (after weighing

attendant risks to the consistent supply of affordable credit). Equipped with the appropriate tools,

the government could manage the shift toward privatization in a gradual manner that is sensitive to

fluctuating political and economic conditions.36

Thus, while this paper proposes reforms that preserve, for the time being, a broad role for

government-guaranteed MBS, we do not believe the existence of government-guaranteed MBS

would preclude robust private label activity in the future. Nor do we believe that a reformed federal

backstop need necessarily persist forever. Rather, this paper suggests a set of institutional reforms

to the conventional conforming mortgage market that serve the dual objectives of protecting

taxpayers and ensuring the consistent availability of affordable mortgage credit for as long as it is

necessary and desirable to do so. When policymakers and industry participants have implemented

reforms to revitalize the private label market and its potential becomes clearer, policymakers can

then determine the appropriate balance, if any, between the government-guaranteed and private

label mortgage markets. At this moment, it is a false choice.

iv. Tail Risk and Taxpayer Exposure

The present need for a government backstop does not mean that the government must

accept as much credit risk as under the GSE system, whether before or after conservatorship. Some

35

There is precedent for such supra-competitive pricing. The Federal Reserve is required by law toinclude a Private Sector Adjustment Factor (PSAF) in the fees it charges for providing services todepository institutions such as checks, Automated Clearing House, Fedwire funds, and Fedwiresecurities. The PSAF is designed to prevent the Federal Reserve from undercutting private sectorproviders of these services. A similar mechanism might be utilized here.

36 While we believe removing the federal backstop on a fixed schedule is not appropriate,policymakers could consider designing market-based triggers for reducing the scope of the backstopor requiring legislative re-authorization of the backstop after a fixed period.



32

increase in the cost of mortgage credit should occur as the system decreases uncompensated risk-

taking and increases the amount of private capital supporting the risk. Indeed, as discussed below,

the objectives of affordability and consistency can be achieved with risk to taxpayers that is highly

remote. If structured properly, a federal backstop creates potential taxpayer exposure only during a

catastrophic market breakdown.

That said, as long as a federal backstop exists, the realities of tail risk in the mortgage market

will make total elimination of taxpayer risk impossible.37 “Tail risk” refers to the potential for highly

unlikely but catastrophic losses.38 It poses particular difficulties in markets characterized by long

periods of healthy growth punctuated by sudden contractions of unpredictable timing and severity.

The U.S. mortgage market is such a market. While the present credit crisis represents the first

serious national housing downturn in the United States since the Great Depression, such downturns

occurred on a regional scale in the 1980s and early 1990s. Federal intervention cushioned the

impact of larger scale shocks, as described above. These contractions can have both

macroeconomic causes (e.g., high unemployment) and causes internal to the mortgage market (e.g.,

poor underwriting). While prudent regulation and countercyclical capital requirements can help

minimize the depth of any contractions, there is no reason to believe they can prevent them.

Furthermore, the severity of downturns cannot be predicted with confidence. A vicious cycle of

default, foreclosure, and housing price depreciation — or a downward spiral in the broader

economy — can yield massive losses. Although the most extreme loss scenarios seem unlikely even

over a long time horizon, they cannot be ruled out.

37 Even in the absence of an explicit federal backstop, total elimination of taxpayer risk is likelyimpossible, since markets may nevertheless believe the government will intervene in a crisis.

38 The term “tail risk” originates from the graphical curves used to represent statistical probabilitydistributions. The extreme outer edges —or “tails”— of such curves represent outcomes whoseoccurrence is highly improbable.



34

III. Methodology

Housing finance reform is an enormous task. Decades of policies promoting housing have

woven subsidies and incentives into our economic and social fabric. The future role of government

in the secondary mortgage market is just one aspect of housing finance reform, albeit a critical one.

The task is further complicated by the potential consequences of poor policy decisions. As the last

financial crisis demonstrated vividly, the central role of the housing sector in the U.S. economy

amplifies any mistakes made in housing policy. Given the consequences of error, we must proceed

carefully.

a. Problems with Comprehensive Reform

As an initial matter, we make no attempt to offer a proposal for “comprehensive” ref orm of

the housing finance sector. As explained below, wholesale abandonment of existing financing

methods and institutions would be difficult and costly, and the potential benefits are far from clear.

i. Difficulty of Comprehensive Reform

Comprehensive reform is very difficult to get right. Policymakers contemplating housing

finance reform confront a daunting array of variables, many of which influence other variables in

unknown or unpredictable ways. Changes to one aspect of the system create new challenges in

other areas that require time and resources to tackle. The interactions among the many players

involved in housing finance, the possibility of unintended consequences, and the continued fragility

of the housing sector and overall economy suggest that experimenting with radical change is

imprudent.

Comprehensive reform is also very difficult to get done. Building the requisite broad-based

political support for comprehensive reform would be challenging in any political climate, let alone

the current one.



35

ii. Path Dependence and the Cost of Transition

The second argument against a comprehensive approach is that it does not seem worth the

cost. Radical change would impose on a still-fragile market the considerable costs of assembling

new infrastructure and resolving the problems that arise in the course of transitioning to any new

system. Thus, any radical departure from the existing system must have compelling advantages and

minimal disadvantages. This might be described as a “path dependence” problem: the current

system evolved along a certain path, and the relevant players devised interrelated sub-systems to

address many specific hurdles along the way. This far down the road, turning back is expensive.

The many problems caused by path dependence range from highly disruptive to merely

costly. An example of the former is the risk of significant disruptions to the To Be Announced

(TBA) market. The TBA market allows investors to buy and sell MBS with predetermined

characteristics (e.g., interest rate, term, etc.) that have not yet been issued. The trades are then

settled following issuance. The TBA market allows lenders to hedge interest rate risk between the

time they commit to lend and the time they sell the loan into the secondary market. This enables

lenders to guarantee (or “lock”) a borrower’s rate between pre -approval and closing. Without such

locks, many home purchases would fall through when rate changes prior to closing alter the

borrower’s monthly payment (and thus the amount of credit available). The higher “fallout” rates in

mortgage origination pipelines would also increase the costs of mortgage origination and thus the

cost of mortgages.

Deep and efficient markets in GSE and Ginnie Mae “TBAs” have been operating smoothly

for decades. However, the current TBA market depends on MBS homogeneity and credit risk

guarantees. Major structural changes to the mortgage market — such as elimination of government

guarantees or creation of a large number of different GSEs — risk serious and perhaps fatal



37

employers face significant legal and cultural barriers to terminating employees. Although

unemployment in these jurisdictions can be higher, the probability of an employed borrower

losing his or her job is significantly lower. All other things being equal, these differences

would tend to lower mortgage rates in these other countries.

Health insurance: Health-related expenses are also a leading cause of mortgage defaults in the

United States. Almost all other developed countries have universal health insurance systems

that significantly reduce the chance that health expenses will lead to financial distress. All

other things being equal, these differences would tend to lower mortgage rates in these other

countries.

Social safety net: Other aspects of the social safety net can also affect homeownership rates and

mortgage affordability. For example, more generous unemployment benefit regimes can

also help cushion the blow of job loss to household income. Similarly, strong retirement

security systems can reduce the importance of building home equity over time, while making

it easier for parents to pass their home to their adult children or to assist them with their first

home purchase.

Per-capita housing consumption: As noted in Section II.a, homeownership rates mask many

relevant differences in the nature and extent of housing consumption, including home size,

plot size, household size, and location. All other things being equal, one would expect

higher homeownership rates in housing markets characterized by smaller homes, multifamily

housing, multi-generational households, and higher density urban plans.

Homeownership and/or rental subsidies: Tax subsidies or other forms of government support for

homeownership or rentals influence homeownership rates. Developed countries vary widely

in the nature and extent of housing subsidies provided outside the housing finance system.



38

Restrictive regulations affecting owner-occupied and/or rental properties: Zoning restrictions, rent

control statutes, and other regulatory factors can heavily influence the availability and cost of

homes and rental units.

Without controlling for these kinds of variables — which may not be fully possible given their sheer

number and the difficulty of quantifying them — simple comparisons between homeownership rates

convey limited information about the effectiveness of different housing finance systems.

Setting aside empirical comparisons, we can nevertheless consider whether systems that exist

in other countries seem better from a theoretical perspective. For example, do other countries seem

to achieve consistent and affordable mortgage credit without heavy government involvement? Here

again, the benefits and drawbacks of other systems are more complex than they might appear.

Consider, for example, the typical European covered bonds model, the distinctive Danish covered

bonds model, and the balance sheet lending model prevalent in the United Kingdom and Canada.

Covered bonds, which are common in Europe, offer an alternative financing method for

residential mortgages. Instead of securitizing loans, financial institutions issue debt collateralized by

the loans while retaining them on their balance sheets. Financial institutions are obligated to repay

the debt regardless of loan performance, and investors have priority access to the collateral in case

the issuing financial institution becomes insolvent. In comparison to the “originate to distribute”

model of securitization, many believe that covered bonds improve lender incentives to underwrite

high-quality loans. In addition, European covered bonds do not generally carry an explicit

government guarantee.

However, the benefits of covered bond systems in Europe should not be overstated. Only

in Denmark (discussed further below) do covered bonds provide the majority of mortgage funding.

And only in Denmark does the covered bond market supply predominantly long term fixed-rate

mortgages. In other countries, variable rate or hybrid mortgages saddle borrowers with interest rate



39

risk that they may not be equipped to manage. While the global interest rate environment has been

relatively benign in recent decades, a rapid increase in rates could produce many defaults in countries

that rely mostly on variable-rate mortgages. In addition, covered bond investors generally demand

very strict underwriting standards and high down payments. Without an explicit government

guarantee, investor appetite for serving the riskier segments of the marketplace appears low.

Finally, it is not true that the European covered bond model features minimal government

involvement. Covered bonds have long benefited from a perception that governments will not let

major banks fail. Since 2008, European governments (now acting through the European Union)

have confirmed their commitment to support their banks and prevent losses to bank creditors,

including holders of covered bonds. Thus, in the nature and extent of government involvement, the

European covered bond model seems fairly similar to the old U.S. GSE system of privatized gains

and socialized losses.39

As mentioned above, long term fixed-rate mortgages dominate the Danish covered bond

market. In fact, Denmark is the only developed country besides the United States where these

mortgages are widely available. The Danish housing finance system is characterized by the much-

lauded “balance principle,” whereby each mortgage is funded by a covered bond with matching face

value, maturity, and interest rate. Under this framework, borrowers can refinance their mortgages by

purchasing matching bonds from the market either at par or current market prices, whichever is

more favorable to the borrower. Thus, when interest rates fall, borrowers will generally refinance by

paying off the current principle balance (i.e., par value of the bond). Borrowers in the United States

39 While covered bonds may not represent a potential panacea for the U.S. housing finance system,U.S. policymakers should consider covered bonds as a possible supplement to securitizationfinancing. Ideally, a covered bond market would increase the diversity of U.S. mortgage financingchannels and contribute to system-wide resilience. Lawmakers in the House and Senate arecurrently pursuing legislation to promote a robust covered bond market. As of this writing, thebipartisan United States Covered Bond Act has passed the House Financial Services Committee, anda similar bipartisan bill bearing the same name is pending in the Senate Banking Committee.



40

have the same option. But when interest rates rise, Danish borrowers can extinguish their

mortgages by purchasing the matching bond at its market price, which will typically be discounted to

reflect the new interest rate environment. In this way, Danish borrowers can decrease the amount

owed on their mortgages.

However, nothing is free. In a rising interest rate environment, Danish borrowers will pay

higher interest rates on their refinanced mortgages, thus partially or fully negating the benefit of

reducing their principal balances. For borrowers seeking to relocate, the ability to pay off the

remaining mortgage at a discount would be more beneficial. But these borrowers will also pay for

this privilege — in the form of higher interest rates at origination.

In the United Kingdom and Canada, most mortgages are funded by bank deposits. Since

banks have limited capacity to carry long-term fixed-rate mortgages (as explained below), variable

rate and hybrid mortgages predominate. Moreover, bank deposits in both countries enjoy a mix of

formal and ad hoc guarantees that, if not as comprehensive as in continental Europe, provide a

significant measure of indirect taxpayer support to mortgage finance.

In addition, the Canadian housing finance system relies heavily on direct government

guarantees. Virtually all Canadian mortgages that are securitized carry an explicit government

guarantee. Among those held on bank balance sheets — i.e., the majority of Canadian mortgages — a

substantial portion of the credit risk is also borne, directly or indirectly, by the Canadian

government. Canadian law requires that all mortgages with loan-to-value ratios (LTVs) greater or

equal to 80% be fully insured. The Canada Mortgage and Housing Corporation, an arm of the

government, provides this insurance directly. Private companies, such as Genworth Financial

Canada and Canada Guaranty Mortgage Insurance Company, also provide mortgage insurance in

Canada. But the Canadian government provides reinsurance against 90% of the risk underwritten

by PMIs.



41

As this brief survey of international housing finance systems illustrates, the search for a

single “best” system is misguided. A serious examination of alternative models reveals that they

involve comparable or greater degrees of taxpayer risk, depend on subsidies or legal arrangements

not found in the United States, or do not necessarily achieve the levels of home purchase

affordability that their advocates claim (or at least would not do so in the United States). Choices of

policy objectives, institutional structures, and legal arrangements seem to require a number of trade-

offs about which reasonable people will disagree.

b. A More Modest Approach

For all of the reasons discussed above — including the difficulty, cost, and unclear benefits of

radical reform — we adopt a more modest approach in this paper. We begin by identifying the

design elements central to the U.S. housing finance system and reviewing how they work. We then

assess whether these existing design elements have served their intended purposes. To the extent

they have not, we identify their shortcomings and propose a solution. As described in more detail

below, we preserve as many desirable features of the current system as possible, while modifying

certain institutional arrangements to address identified deficiencies.

i. Building Blocks of the Current System

As discussed in Section II.b, all mortgage finance systems allocate interest rate risk,

prepayment risk, and credit risk in a specific manner. They accomplish this allocation through two

means:

Mortgage instrument design . This includes the contractual terms governing interest rate,

maturity, prepayment, recourse to other personal assets, and other variables.



42

Institutional arrangements . This includes the nature of the various players involved in lending,

securitizing, insuring, and investing in mortgage instruments and the legal and regulatory

framework governing their activities and relationships.

The typical U.S. mortgage instrument is a long-term (usually 30-year), fully pre-payable,

fixed-rate mortgage.40 As noted above, MBS issuance finances the vast majority of fixed-rate

mortgages. In order to entice a broader group of investors to purchase MBS, Fannie Mae and

Freddie Mac provide a guarantee of timely repayment of principal and interest on their MBS. The

guarantee — combined with now-explicit government support — allows investors to ignore credit risk

arising from the underlying mortgages securing each issuance. On high-LTV mortgages (i.e.,

mortgages above 80% LTV) sold to Fannie Mae and Freddie Mac, federal statutes require that PMIs

or other third parties bear much of the credit risk. In the private label market (now almost

nonexistent), both financial institutions and investors bear credit risk. However, most investors

insulate themselves from this risk by purchasing senior tranches of MBS and requiring issuers to

include other “credit enhancements,” such as overcollateralization or pool-level insurance.

Advocates of fixed-rate mortgages argue that they are preferable to adjustable-rate mortgages

because they transfer interest rate risk from borrowers to financial institutions and investors. 41

Borrowers are often ill-equipped to manage fluctuating monthly payments. In contrast, financial

institutions and investors have the capacity and sophistication to manage this risk. But this transfer

of interest rate risk to financial institutions is not without drawbacks. Banks rely on shorter-term,

40

Most states permit recourse to borrowers’ personal assets if foreclosure proceeds are insufficientto extinguish the loan. However, because the process of pursuing deficiency judgments iscumbersome and typically yields low net recoveries, lenders and servicers have done so relativelyinfrequently. See “Lenders seek court actions against homeowners years after foreclosure,”Washington Post (June 15, 2013), http://www.washingtonpost.com/investigations/lenders-seek-court-actions-against-homeowners-years-after-foreclosure/2013/06/15/3c6a04ce-96fc-11e2-b68f-dc5c4b47e519_story.html.

41 Borrowers generally pay a higher rate to compensate these parties for assuming interest rate risk.

http://www.washingtonpost.com/investigations/lenders-seek-court-actions-against-homeowners-years-after-foreclosure/2013/06/15/3c6a04ce-96fc-11e2-b68f-dc5c4b47e519_story.html










43

variable rate funding (e.g., deposits). As a result, they have limited capacity to bear the interest rate

risk associated with long-term fixed-rate mortgages. The failure of many S&Ls as interest rates rose

during the early 1980s focused attention on this problem. Mortgage securitization effectively solved

it. Through securitization, mortgage lenders transfer interest rate risk (along with prepayment risk)

to institutional investors, such as life insurance companies and pension funds, with greater

willingness and capacity to manage and absorb it. Of course, mortgage lenders continue to retain

credit risk and interest rate risk on loans held in portfolio, but capital requirements and interest rate

risk limits tightly constrain their portfolio funding capacity.

To a large extent, mortgage instrument design drives institutional arrangements. For

example, a housing finance system that relies primarily on adjustable-rate or hybrid-adjustable-rate

instruments need not rely to the same extent on securitization or interest rate hedging by financial

institutions. Institutional arrangements are also influenced by the legal powers and levels of

government support provided to key institutions, such as banks, mortgage insurers, and GSEs.

ii. Fixing What is Broken

In light of the various drawbacks and complications associated with “starting from scratch,”

our proposal adopts a more pragmatic approach. Instead of re-thinking the terms of the typical

mortgage instrument — which drive the current allocation of interest rate and credit risk in the

housing finance system — we attempt to resolve the problems exposed by the recent crisis through

changes to institutional arrangements. In doing so, we avoid creating new financial entity charters or

new government agencies where existing participants have the expertise, infrastructure, and

regulatory apparatus to perform the role in question.

Broadly speaking, the recent credit crisis revealed two shortcomings in the GSE system: (1)

too much credit risk creation; and (2) improper credit risk allocation. The first problem was

epitomized by origination of “predatory” sub-prime loans, “no doc” loans, and other mortgages for



45

IV. Proposal

Our proposal would make two fundamental changes to the housing finance system that

preceded the September 2008 conservatorships of Fannie Mae and Freddie Mac. First, our proposal

would replace the implicit, uncompensated federal guarantee on which investors relied before the

crisis with an explicit, compensated guarantee. Second, our proposal would position sufficient

private capital in front of taxpayers such that only a catastrophic market meltdown would pose a risk

of taxpayer loss. Critically, our proposal would minimize transition costs, avoid creating new federal

charters, and preserve to the largest extent possible the elements of the current system that function

well. As discussed above, policymakers might decide to reduce or remove the government

guarantee in the future if the private label market develops sufficiently.

This section describes the mechanics of our proposed housing finance system before

discussing certain aspects in more detail, including the ways in which our proposal would

accomplish the goals described in Section II. We also include a separate sub-section on variations

and alternatives to our proposal. The latter sub-section considers the pros and cons of other reform

ideas currently in circulation, as well as ones that might arise in connection with our proposal.

a. Mechanics

Our proposed mortgage securitization system comprises the following participants:

i. Lenders

Lenders of all sizes would continue to originate mortgage loans and either retain them in

their asset portfolios or, more commonly, sell them into the secondary market.

ii. Government Guarantor

The government guarantor would administer a federal guarantee of timely repayment of

principal and interest on MBS backed by conventional conforming mortgages. Unlike Fannie Mae



46

and Freddie Mac, the government guarantor would not purchase or securitize loans or hold a large

portfolio of MBS. Rather, it would rely on private market participants to perform these functions.

Furthermore, the private MBS issuers would bear primary responsibility for servicing the underlying

loans and making on-time payments to investors. The government guarantor would simply attach

its guarantee, or “wrap,” to privately -issued MBS for a fee, paying out only in the event of issuer

default. In addition, the government guarantor would administer and enforce common standards

for underwriting, servicing, product design, financial strength, and risk management to which the

other system participants must adhere. The government guarantor’s commitments would be general

obligations of the United States.

The GSEs, currently in conservatorship, would wind down after transferring to the

government guarantor any personnel and infrastructure necessary to perform its new

responsibilities. Alternatively, the GSEs could be nationalized and restructured to serve as the

government guarantor. We suggest other possible candidates for government guarantor below.

iii. Approved MBS Issuers

Private financial institutions would originate and/or purchase new whole mortgages and

issue government-guaranteed MBS to investors. Only issuers approved and monitored by the

government guarantor would exercise this authority. The requirements for approval would parallel

those applied to current Ginnie Mae issuers, but with appropriate adjustments to account for

differences in the number and nature of issuers and the risks they present. Unlike Fannie Mae and

Freddie Mac, which competed with one another for business from the largest issuers through

volume discounts, the government guarantor would be able to offer a level playing field for large

and small issuers alike.42 Therefore, we would expect a large number of approved MBS issuers of

42 In addition, our proposal would narrow or remove the regulatory capital advantage for banks thatsell loans to the GSEs in exchange for GSE MBS (“swap-and-hold” originators), compared with



47

various sizes. Indeed, the government guarantor would need to place limits on issuer concentration

in order to control and diversify its own exposure, whether directly through issuer market-share

limits or indirectly through changes to servicing compensation structures or other economic

variables.

iv. Private Mortgage Insurers

PMIs would provide mandatory loan-level insurance on mortgages underlying government-

guaranteed MBS. In doing so, they would conduct full and independent underwriting of each loan.

Chartered and regulated by the states, PMIs currently insure large numbers of conforming

mortgages. For over 40 years, Congress has required GSE-purchased loans exceeding specified

LTV thresholds to carry third-party credit enhancements, which invariably take the form of PMI. A

comparable requirement for conventional conforming mortgages would help protect the

government guarantor and its issuers from default-related losses. The new structure could

incorporate a mix of PMIs that operate today and new PMIs.

Required coverage levels must be sufficient to ensure that PMIs shoulder substantially all

losses in a given pool of mortgages in all non-catastrophic loss scenarios. We use the term “non-

catastrophic” in this context to describe scenarios that do not arise from “tail risk.” The range of

“non-catastrophic” scenarios should be wide enough to provide a very high degree of statistical

confidence that losses will not exceed coverage levels over the relevant time horizon. There is some

(typically smaller) banks engaged in simple portfolio funding. Currently banks must hold more

regulatory capital against residential mortgage loans than GSE MBS. This provides an incentive toengage in swap-and-hold transactions. But if the swap-and-hold originator were required toguarantee its own MBS, as it would under our proposal, bank capital rules (including newly-finalizedrules implementing Basel III) would require the originator to hold capital against its guaranteeobligation. Even if the originator shifted much of the credit risk to a PMI, as we propose below, it would still be required to hold capital against its guarantee. Moreover, in the event future bankcapital rules provide greater capital relief for PMI, originators seeking to retain mortgage assets ontheir balance sheets will not need to securitize the assets to obtain such relief.



48

room for policymakers to make marginal trade-offs between affordability and taxpayer risk when

setting confidence levels without compromising the system’s basic objectives. Generally, however,

we would expect a “catastrophic” scenario to have an estimated probability on the order of

hundredths of a percentage point, as predicted by rigorous statistical modelling and stress testing.

While 100% (i.e., unlimited) PMI coverage is a possibility, coverage levels calibrated for

“non-catastrophic” scenarios would be more workable as a practical matter. In normal market

conditions — even during downturns — average loss severity does not come close to 100%. A more

reasonable approximation for normal market conditions might be around 40%.43 Even estimates of

average loss severity on loans originated during the height of the mortgage bubble — where fraud

and subprime loans were highly prevalent — do not exceed 80%.44 The capital costs of insuring

deeper layers of risk are prohibitive given the relatively simplistic PMI regulatory capital regime (as

discussed below).

43 See, e.g., Glenn B. Canner, Wayne Passmore, and Brian J. Surette, “Distribution of Credit Riskamong Providers of Mortgages to Lower-Income and Minority Homebuyers ,” Federal ReserveBulletin (December 1996), 1099 (Table B-1) (showing loss severity as a function of original loanamount ranging from around 28% for lower LTVs to around 48% for very high LTVs),

http://www.federalreserve.gov/pubs/bulletin/1996/1296lead.pdf ; Min Qi and Xiaolong Yang,“Loss Given Default of High Loan-to-Value Residential Mortgages,” OCC Economics WorkingPaper 2007-4 (August 2007), 12 (Table 2) (showing loss given default as a percentage of unpaidbalance by combined LTV ranging from 11% to 49% during the economic downturn period of 1990to 1994 in the New England region), http://www.occ.treas.gov/publications/publications-by-type/economics-working-papers/2008-2000/wp2007-4.pdf ; and Vassilis Lekkas, John M. Quigley,and Robert Van Order, “Loan Loss Severity and Optimal Mortgage Default,” Journal of the American Real Estate and Urban Economics Association (1993), 360 (Table 1) (showing averageloss severity as a percentage of mortgage balance not exceeding 25% during the 1975 to 1990 timeperiod), http://urbanpolicy.berkeley.edu/pdf/LQOinAREUEA93.pdf .

44 See, e.g., TCW, Mortgage Market Monitor (Oct. 2012), 43 (showing aggregate loss severity on

subprime loans rising from approximately 20% to 70% of unpaid principal balance over the 2005 to2012 period),https://www.tcw.com/News_and_Commentary/Market_Commentary/Insights/~/media/Downloads/Commentary/Fixed%20Income%20Research/Fixed%20Income%20Commentary/MBS_ABS/110612_Mortgage%20Market%20Monitor%20Oct%202012.ashx; and Fannie Mae 10-Q (June 30,2012), 42 (Table 24) (showing average loss severity rates ranging from 51% to 77% for Alt-A andsubprime loans through 2007 by vintage),http://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2012/q22012.pdf .

http://www.federalreserve.gov/pubs/bulletin/1996/1296lead.pdf


http://www.occ.treas.gov/publications/publications-by-type/economics-working-papers/2008-2000/wp2007-4.pdf



http://urbanpolicy.berkeley.edu/pdf/LQOinAREUEA93.pdf



https://www.tcw.com/News_and_Commentary/Market_Commentary/Insights/~/media/Downloads/Commentary/Fixed%20Income%20Research/Fixed%20Income%20Commentary/MBS_ABS/110612_Mortgage%20Market%20Monitor%20Oct%202012.ashx




http://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2012/q22012.pdf












49

Though we do not recommend a specific coverage level for mandatory PMI, it should be

possible to estimate the approximate range of coverage levels that would be required to cover all

“non-catastrophic” risk. For these purposes, average loss severity— while possibly suggestive — is

insufficient. Instead, detailed information on the distribution of losses would be required,

particularly those losses exceeding the average. Policymakers could use this distribution curve to

select a coverage depth that goes beyond average loss severities in normal market conditions and

downturns and covers all “non-catastrophic” risk.

Even in normal market conditions, however, losses on a small number of “outlier” loans

would exceed deep PMI coverage levels. The issuer would absorb these routine losses using its own

resources or resources embedded within the securitization structure (such as overcollateralization or

reserve accounts). Issuers would also absorb all losses on loans for which PMI coverage has been

rescinded for breach of contractual representations and warranties. In a catastrophic market

scenario, both the PMI and, potentially, the issuer would suffer deep losses. Consequently, they

would share strong incentives to uphold prudent underwriting standards.

We would expect the PMI industry under our proposal to look significantly different from

the existing industry. While existing PMIs are logical participants in this new system, they would

need significantly more capital to insure the volume of loans contemplated by this proposal.

Increased demand for mortgage insurance, combined with different risk profiles associated with

deeper coverage and specific investor risk appetites, may also attract new entrants to the market.

Like all plans for partial re-privatization of mortgage finance, our proposal requires the

availability of fresh equity capital willing to absorb mortgage credit risk. We are fairly optimistic that

such equity will materialize. Historically, the number of PMI industry participants has waxed and

waned based on the demands of the market. Even the height of the present crisis saw the launch of

two significant new entrants and the recapitalization of several existing firms. The demand



50

guaranteed by the PMI mandate will facilitate this capital formation by making valuation easier. In

any event, if such capital is not available, any attempt to re-privatize the market without significantly

shrinking it is probably doomed.

Figure 9: Proposed Structure of the Conventional Conforming Securitization Market

Government

Guarantor

Lenders /

Approved Issuers

Loan payments


MBS payments /

MBS

Fee for government“wrap” of MBS Pays investors if

approved issuers

default

Homeowners

PMIs

PMI premiums

(as applicable)Pay claims

when

homeowners

default

$ for home purchase

Servicers

b. Candidates for Government Guarantor

The role of government guarantor could be played by an existing federal agency, a

nationalized and restructured version of the GSEs, a new federal agency created from scratch, or a

hybrid of these options. This choice does not affect the essential elements of our proposal, since in

each case the government guarantor would perform identical functions. However, as discussed in

the Methodology section, above, we suggest minimizing potential transition costs and dislocation by

harnessing, where possible, existing participants that have the expertise and infrastructure to

perform a given role. In this respect, among existing governmental or quasi-governmental

institutions, the GSEs and Ginnie Mae have the most to offer. Policymakers could simply choose

between these entities and make necessary adjustments, but they should also consider hybrid

solutions. In particular, policymakers could arrange some type of merger between the two entities,

retaining the most desirable aspects of each. Alternatively, policymakers could create an entirely new



52

operates, substituting PMIs for government agencies as loan-level insurers. Notably, like GSE MBS,

Ginnie Mae MBS already enjoy a deep and liquid market, including a TBA market, and many GSE

MBS investors are already authorized to purchase them. As of February 2013, Ginnie Mae had over

300 approved issuers, including mortgage companies, banks, thrifts, credit unions, and state housing

finance agencies.46

Selecting Ginnie Mae as the government guarantor would, in some respects, restore the

institutional arrangements that pre-dated the present system. Ginnie Mae originally arose from the

restructuring of Fannie Mae, which itself had been established as a wholly-owned government

corporation in 1938. Between 1938 and 1968, Fannie Mae purchased government-insured

mortgages (FHA mortgages initially, but also VA mortgages starting in the 1940s) and retained them

in its portfolio, thereby ensuring a liquid secondary market for these mortgages. Increased demands

on Fannie Mae in the late 1960s, combined with government accounting changes, aggravated the

burden of the system on a federal budget already strained by the Vietnam War. The 1968

restructuring alleviated this burden by privatizing Fannie Mae and limiting Ginnie Mae to MBS

guarantees, which have less budgetary impact than loan purchases.47

However, like the GSEs, Ginnie Mae would require significant changes to serve as

government guarantor. Its new duties would require enhancements to Ginnie Mae’s operational

46 Seehttp://www.ginniemae.gov/doing_business_with_ginniemae/issuer_resources/approved_issuers_document_custodians/Pages/single_family.aspx. Ginnie Mae’s president has expressed concern overthe fact that a few firms issue the majority of Ginnie Mae MBS. As a result, these large issuers tendto dominate the Ginnie Mae servicing market. See “GNMA Quandary: Product, but not enough

Issuers,” National Mortgage News (September 5, 2011), http://www.nationalmortgagenews.com/nmn_features/product-not-enough-issuers-1026473-1.html. This poses two possible problems. First, the failure of a large issuer/servicer could have amaterial impact on Ginnie Mae. Second, these issuer/servicers could use their market leverage toimpede or impose constraints in the form of uncompetitive pricing on the ability of smaller lendersto access Ginnie Mae’s guarantee. 47 Ginnie Mae also inherited Fannie Mae’s legacy portfolio of government-insured mortgages, winding down the portfolio over time.

http://www.ginniemae.gov/doing_business_with_ginniemae/issuer_resources/approved_issuers_document_custodians/Pages/single_family.aspx



http://www.nationalmortgagenews.com/nmn_features/product-not-enough-issuers-1026473-1.html









53

infrastructure and risk management capabilities. For example, we believe Ginnie Mae would need to

substantially increase its headcount, which is currently approaching 100 (not including contractors,

on which Ginnie Mae relies heavily).48 In this respect, legislation exempting Ginnie Mae from the

general federal pay schedule would facilitate recruitment and retention of qualified personnel,

including seasoned GSE employees, by enabling Ginnie Mae to set pay commensurate with the

private sector. Removing Ginnie Mae from HUD could help make it more attractive to former

GSE employees and other private-sector financial professionals.

Additionally, Ginnie Mae would need to augment its risk management capabilities and

systems to appropriately manage the new risks it would face. To be sure, Ginnie Mae already

manages significant tail risk, since VA loans comprise approximately 30% of its current volume.

Unlike the FHA, which provides full loan-level insurance (except certain foreclosure-related costs),

the VA provides only a partial guarantee — generally up to 25% of the loan amount. However,

Ginnie Mae has identified outdated information systems as a key area for improvement. 49

Moreover, unlike the GSEs, Ginnie Mae does not currently operate a PMI qualification and

monitoring regime.

In sum, both Ginnie Mae and a consolidated and nationalized version of the GSEs represent

strong candidates for government guarantor, but each would require substantial changes. Their

different strengths and weaknesses could argue for some form of merger that retains the best

qualities of each. Alternatively, policymakers might conclude that political considerations favor

48

In 2010, Ginnie Mae officials called for an increase in staff to 160. GAO, Ginnie Mae: Risk Management and Cost Modeling Require Continuing Attention , GAO-12-49 (November 2011), 19,http://www.gao.gov/assets/590/586247.pdf . Ginnie Mae historically has operated with few staffand many contractors because contractors, unlike staff, can be funded by agency revenues withoutobtaining annual appropriations. Ginnie Mae recently has undertaken efforts to decrease reliance oncontractors for critical functions. Ibid., 24-30.49 See ibid., 30-31. According to Ginnie Mae officials, the agency expects to complete a three yearinformation systems modernization project by late 2013.

http://www.gao.gov/assets/590/586247.pdf





54

creation of an entirely new agency.50 (Indeed, assigning new responsibilities to existing entities could

agitate their detractors.) If so, we recommend that policymakers orchestrate an orderly transfer or

sharing of key systems, personnel, and knowledge between the new agency and existing players.

Ideally, the chosen solution will not only minimize transition costs but also avoid wasteful

duplication of functions within the federal government.

Regardless of which entity or amalgamation of entities becomes the government guarantor,

it and other participants in our proposed system could harness elements of the modernized

secondary market infrastructure currently being developed by the FHFA and GSEs. As reported in

the FHFA’s February 2012 conservatorship strategic plan,51 the FHFA and GSEs are developing key

systems and standards that will be made available to all market participants. Efforts underway

include:

Standardization of mortgage-related data collected and reported by lenders;

Development of improved compensation structures for mortgage servicers;

Uniform servicing protocol for delinquent mortgages (already implemented);

Improved disclosures of loan-level information to investors;

50 For example, the Mortgage Finance Act of 2011 (S. 1963), introduced by Senator Isakson inDecember 2011, would create a new Mortgage Finance Agency to perform functions similar tothose of our government guarantor.51 See FHFA, A Strategic Plan for Enterprise Conservatorships: The Next Chapter in a Story that Needs an Ending (February 21, 2012),

http://www.fhfa.gov/webfiles/23344/StrategicPlanConservatorshipsFINAL.pdf . The FHFAsubsequently incorporated the contents of this document into its draft Strategic Plan: Fiscal Years2013-2017 ,http://www.fhfa.gov/webfiles/23930/FHFA%20Draft%20Strategic%20Plan%202013-2017.pdf . In October 2012, the FHFA released for public comment a white paper further detailing theproposed framework for a common securitization platform and a model pooling and servicingagreement. FHFA, Building a New Infrastructure for the Secondary Mortgage Market (October 4, 2012),http://www.fhfa.gov/webfiles/24572/FHFASecuritizationWhitePaper100412FINAL.pdf .



http://www.fhfa.gov/webfiles/23930/FHFA%20Draft%20Strategic%20Plan%202013-2017.pdf


http://www.fhfa.gov/webfiles/24572/FHFASecuritizationWhitePaper100412FINAL.pdf







55

Development of a modernized securitization platform, with an open architecture that can

accommodate multiple issuers, as well as different kinds of securities and underlying loans;

and

Development of an improved and standardized pooling and servicing agreement.

c. Creditworthiness of PMIs

Our proposed system would rely heavily, though not exclusively, on the creditworthiness of

PMIs. In order to give other market participants confidence in this creditworthiness, our proposal

must address the principal questions surrounding the capacity and willingness of PMIs to pay claims.

These are, respectively, capital adequacy and rescission.

i. PMI Capital Adequacy

PMIs are subject to state regulatory regimes specifically tailored to long-term mortgage credit

risk. These regimes include solvency standards designed to enable PMIs to withstand cyclical

volumes of mortgage defaults, which generally peak infrequently but with potentially catastrophic

consequences for the insurer. States also limit the ability of PMIs to take on risk by enforcing

restrictions on PMI investments, risk concentrations, and other business activities.52

The PMI capital regime consists of two principal requirements — the maximum risk-to-

capital ratio and contingency reserves.53 The maximum risk-to-capital ratio — generally set at 25-to-

1 — places a limit on PMIs’ overall leverage. Risk in this context means the maximum potential

claim the PMI might have to pay.

52 For a more extensive discussion of PMI regulatory regimes, see “The Role of Private MortgageInsurance in the U.S. Housing Finance System” (January 2011), http://www.promontory.com/uploadedFiles/Articles/Insights/622%20Genworth%20Study%20I%20-%20Role%20of%20PMI.pdf . 53 PMI loss absorption capacity also includes two principal non-capital components: current earningsfrom new and performing policies and loss reserves reflecting expected losses from delinquentloans.

http://www.promontory.com/uploadedFiles/Articles/Insights/622%20Genworth%20Study%20I%20-%20Role%20of%20PMI.pdf







56

PMIs are also required to accumulate large “contingency reserves” in anticipation of the

more extensive losses they might experience in a deep housing recession. PMIs must generally

retain as contingency reserves 50% of earned premiums for 10 years. If the insurer experiences high

losses during a given year, the insurer may draw down its reserves to pay claims.

The counter-cyclical structure of PMI contingency reserving requirements is designed to

compensate for the mortgage market’s tendency to experience long periods of healthy growth

punctuated by sudden severe downturns. The requirements prevent insurers from declaring

excessive dividends or otherwise dissipating reserves that might be needed to pay claims in a highly

adverse loss scenario. As a result of the contingency reserve requirements, PMIs normally operate

with capital in excess of that required by the 25-to-1 risk-to-capital ratio. During housing

downturns, however, PMIs can draw on their contingency reserves and may approach or breach the

risk-to-capital limit.

The current U.S. housing downturn represents the most severe test of the PMI regulatory

regime since the Great Depression. Since the downturn, three of eight pre-existing PMIs have

ceased writing new policies, one in 2008 (Triad Guaranty Insurance Corp.) and two in 2011 (PMI

Mortgage Insurance Co. and Republic Mortgage Insurance Co.).54 Regulators have ordered the three

firms to pay only partial claims due to uncertainty about their ultimate claims-paying capacity. 55

According to a recent analyst report, the claims obligations of Triad, a relatively small PMI, likely

will exceed its available resources.56 Three other PMIs have exceeded, or are about to exceed,

statutory risk-to-capital ratios and have obtained regulatory waivers or established separately

54 See “Business Curtailed for Old Republic’s Mortgage Insurer,” Wall Street Journal (Jan. 20, 2012).PMI Group, Inc. subsequently filed for bankruptcy.55 zIngenuity, “Mortgage Insurance Industry Report” (July 2012), 1.

56 Ibid., 5.



57

capitalized subsidiaries to continue writing new policies.57 (To date, these three PMIs continue to

pay claims in full and to write new policies.) The industry remains under pressure as a result of tight

credit conditions, a weak economy, high unemployment rates, lower property values, and

dramatically diminished market share relative to the FHA.58 Most of these factors seem unlikely to

abate in the near term.

Capital adequacy ratios eventually may improve as PMI legacy books run off and

delinquency levels drop on more recently-written policies. Ironically, the withdrawal of Triad, PMI

Mortgage Insurance, and Republic Mortgage Insurance as competitors presents the remaining PMIs

with opportunities to earn additional premiums.59 Nevertheless, the fate of the remaining PMIs will

depend on the recovery of the housing market, which remains uncertain.60

We do not take for granted the adequacy of the current PMI capital regime. Critics inside

and outside the industry have voiced reasonable concerns with aspects of the regime. Some have

complained that state-approved special releases from reserves during good times and capital

forbearance during bad times weaken the regime’s effectiveness. Others have observed some

57 See MGIC Investment Corp. Form 10-Q (Nov. 9, 2012), 8, http://phx.corporate-ir.net/phoenix.zhtml?c=117240&p=irol-sec; Radian Group Inc. Form 10-Q (Nov. 13, 2012), 16,http://www.radian.biz/page?name=SECFilings; and Genworth Financial, Inc. Form 10-Q (Nov. 2,2012), 97, http://phx.corporate-ir.net/phoenix.zhtml?c=175970&p=irol-sec. The other legacyPMI, United Guaranty, remains well within its risk-to-capital limit. Seehttps://www.ugcorp.com/about/financial_strength.html.

58 See Standard & Poor’s “Republic Mortgage Insurance Co. and Republic Mortgage Insurance Co.of North Carolina” (July 19, 2011), 3-4.

59 See “Radian Shares Popped: What You Need to Know” (September 7, 2011),

http://www.fool.com/investing/general/2011/09/07/radian-shares-popped-what-you-need-to-know.aspx. On the other hand, new entrants also are picking up some of the slack. EssentGuaranty, Inc. entered the market in 2010 with $600 million in committed capital. Another newentrant, NMI Holdings, Inc., officially launched in April 2013 with over $500 million in capital. Seehttp://essent.us/index.php/home/about/; http://www.nationalmi.com/.

60 See generally zIngenuity, “Mortgage Insurance Industry Report” (July 2012); Standard & Poor’s,“Will The Sea Change In Lending Standards Be Enough To Buoy U.S. Mortgage Insurers?” (Oct. 8,2012).

http://phx.corporate-ir.net/phoenix.zhtml?c=117240&p=irol-sec



http://www.radian.biz/page?name=SECFilings




https://www.ugcorp.com/about/financial_strength.html


http://www.fool.com/investing/general/2011/09/07/radian-shares-popped-what-you-need-to-know.aspx



http://essent.us/index.php/home/about/


http://www.nationalmi.com/














58

potential for arbitrage of established risk limits through use of multiple subsidiaries. Still others have

raised more fundamental concerns about a lack of risk sensitivity in the regime, arguing that the risk-

to-capital rules are too stringent for less risky mortgages and not stringent enough for risky ones.

Some even question whether monoline financial guarantors can ever hold enough capital to remain

healthy during severe downturns in their particular markets.61

We do not believe that these concerns should preclude firms licensed and regulated as PMIs

from playing the role contemplated by our proposal. The current state-imposed capital regime,

whatever its flaws, serves as a sensible starting point for capital requirements in the new system. But

both state and federal authorities can go further. In the new structure, the government guarantor

would inherit the GSEs’ existing authority to set minimum eligibility standards for PMIs. The

government guarantor should be required to address some criticisms of the capital regime — such as

risk insensitivity, corporate group leverage, and forbearance by regulators — to ensure compatibility

with the allocation of risks our proposal contemplates.

At a minimum, we would expect the government guarantor to apply risk limits on a

consolidated basis (i.e., across corporate entities) and to prohibit PMIs from using early releases

from contingency reserves to pay dividends. In the years preceding the recent financial crisis, PMIs

repeatedly obtained regulatory permission to pay extraordinary dividends,62 and it appears that a

significant portion of these dividends were paid from contingency reserves. This practice partially

undermined the contingency reserve framework and has yielded risk-to-capital ratios materially

lower today than they otherwise would be.

61 Their performance during the financial crisis to date, relative to other players, offers at least apreliminary response to this question.62 Under state insurance law, “extraordinary dividend” is commonly defined as any dividend that,together with other dividends issued within the past year, exceeds the greater of: (i) 10% ofpolicyholders’ surplus (as of the preceding year-end); or (ii) net income minus realized capital gains(as of the preceding year-end). See, e.g., N.C. Gen. Stat. § 58-19-30(c).



61

reallocate capital held against mortgage risk, but contingency reserve requirements would limit PMIs’

ability to do the same. In adverse mortgage market conditions, PMIs might strain under the weight

of their concentrated risk, but more diversified issuers could absorb losses with earnings from other

businesses and capital held against other risks. The combination of diversified issuers and monoline

PMIs yields a balanced level of protection for the government guarantor through the cycle.

ii. Rescission

The foregoing discussion has focused on the financial capacity of PMIs to bear risk. In

recent years, relatively high levels of PMI coverage rescissions have also raised questions about the

reliability of PMI coverage agreements, particularly among banks, bank regulators, and private label

MBS investors. PMIs may rescind coverage for fraud or misrepresentation, failure of the lender to

follow prescribed underwriting guidelines, or missing documentation in the loan file. 68

Given the prevalence of fraud and underwriting exceptions during the peak of the housing

boom,69 the recent elevated rates of rescission are not surprising.70 Indeed, rescission rights became

68 See Amherst Securities Group LP, “PMI in Non-Agency Securitizations,” Amherst Mortgage Insight(July 16, 2010), 3, 12.69 The Financial Crisis Inquiry Commission (FCIC) catalogued the growing incidence of mortgagefraud as the housing bubble inflated. See “Financial Crisis Inquiry Commission Report” (January2011), 160, http://fcic.law.stanford.edu/report. For example, in testimony before the FCIC, anexecutive from a risk management firm described the firm’s review of a statistically significantsample of randomly selected closed loans originated by a variety of lenders from 2005 to 2007. Thereview found that 13% of all loans in the sample, and 38% of loans in foreclosure at the time of thereview, contained material misrepresentations or omissions at origination sufficient to justify therescission of mortgage insurance or to form the basis of a repurchase demand. See “Supplemental Testimony of Ann Fulmer” (September 2010), 2-3,

http://fcic.law.stanford.edu/resource/document-archive. Using FBI and Financial CrimesEnforcement Network (FinCEN) data, criminologist and former regulator William Black estimatedthat, at the peak of the mortgage bubble, over 1.5 million loans originated per year contained someelement of fraud. See “Testimony of William K. Black” (September 2010), 17, http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0921-William-Black.pdf . Suspicious Activity Reports (SARs) related to mortgage fraud increased almost 20-fold from 1996 to 2005. SeeFinCEN, “Mortgage Loan Fraud: An Industry Assessment Based on SAR Analysis” (November2006), 2, http://www.fincen.gov/news_room/rp/reports/pdf/MortgageLoanFraud.pdf . A 2007Office of Federal Housing Enterprise Oversight (OFHEO) report noted a “significant rise in the

http://fcic.law.stanford.edu/report


http://fcic.law.stanford.edu/resource/document-archive


http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0921-William-Black.pdf



http://www.fincen.gov/news_room/rp/reports/pdf/MortgageLoanFraud.pdf









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increasingly important during the boom as PMIs expanded delegated underwriting programs. Under

pressure from large originators and the GSEs, quality control audits of loan samples — with

rescission as the remedy for exceptions — increasingly replaced the loan-by-loan “review

underwriting” that long characterized the industry.

That said, even when justified by the conduct of originators and issuers, high rates of

rescission could detract from the effectiveness of PMI as a form of credit protection for the

government guarantor. While disagreements concerning specific policy agreements continue, PMIs

are adopting forward-looking measures to address this broader concern. These measures include

reduced reliance on delegated underwriting, enhanced systems for detecting underwriting and

documentation irregularities at the time of policy origination, and new contractual limitations on the

extent and duration of rescission rights. Under our proposal, we would expect Congress or the

government guarantor to restrict or prohibit the use of delegated underwriting and require a return

to loan-by-loan review underwriting. The government guarantor would also monitor closely the

improvements already underway and impose any additional requirements deemed necessary to

protect taxpayers. Such requirements must strike a balance between the risk that rescissions might

pose to the government guarantor and the need for effective deterrence of issuer misconduct, which

itself poses significant risks to the government guarantor. In a properly functioning system,

rescissions, though less frequent due to loan-level underwriting by PMIs, would continue to serve as

incidence of fraud in mortgage lending ” over the preceding year-and-a-half. See OFHEO, “2007Performance and Accountability Report,” 13,

http://www.fhfa.gov/webfiles/2085/OFHEOPARNovember2007508.pdf . Shoddy documentationmay have contributed to these high levels of fraud. From 2002 to 2007, low- and no-doc loansquadrupled from less than 2% to approximately 9% of all outstanding loans. 80% of Alt-A loanssecuritized in 2006 had limited or no documentation. See “Financial Crisis Inquiry CommissionReport” (January 2011), 110.

70 Rescission rates of 20%-25% have been common during the downturn, compared with long termhistorical rates of 5%-10%. See Moody’s Investors Service, “US Mortgage Insurers’ [sic] Remain Weakly Capitalized,” Special Comment (August 17, 2010), 6.

http://www.fhfa.gov/webfiles/2085/OFHEOPARNovember2007508.pdf





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a necessary enforcement tool against errant lenders.71 However, the culpable lender/issuer, rather

than the government guarantor, would pay the price.

d. Attainment of Goals

Our proposal would accomplish the two goals discussed in Section II while avoiding many

of the transition costs that could accompany more radical restructuring. First, the proposal would

ensure a consistent supply of affordable mortgage credit by retaining the features of GSE MBS that

are attractive to current GSE MBS investors. Like GSE MBS, the “new” MBS would provide a

higher return to investors than Treasury securities. The government’s “full faith and credit”

guarantee would satisfy even the most skittish MBS investor’s concerns about credit risk.

Furthermore, assuming the government guarantor is either Ginnie Mae or a nationalized successor

to the GSEs, its MBS already trade in the highly liquid TBA market. In short, one would not expect

an investor “mass exodus” from the GSE MBS market to follow a trans ition to the new government

guarantor. Nor would MBS investors have cause to flee from the new MBS during a credit crisis,

since the federal government would stand behind the MBS.

The proposed framework would also fulfill our second objective: minimizing risk to

taxpayers. It would do so in three principal ways: (1) positioning multiple layers of private capital in

front of the taxpayers; (2) ensuring that these layers of private capital have strong incentives to

control risk; and (3) imposing appropriate capital requirements on key participants.

The pre-crisis GSE system exhibited major weaknesses in these areas. First, the insolvency

of one type of entity, the GSEs, was enough to expose the taxpayers to massive losses. Guarantees

from other private participants in the system — such as seller/servicers and PMIs — were narrow in

71 An important but easily-overlooked procedural component of this enforcement tool is post-claiminvestigations by PMIs. Any regulatory requirements in this area should strike an appropriatebalance between issuers’ need for timely claims processing and PMIs’ need to investigate claimsbefore payment.



65

GSEs’ on a risk-adjusted basis. In practice, however, the contingency reserve requirement led PMIs

to accumulate much higher capital positions during the boom, providing a cushion when the crisis

materialized. At year-end 2006, PMIs held total capital of $17.5 billion and had $158 billion of risk

in force.72 By contrast, the GSEs held total capital of $78.1 billion and had off-balance sheet

mortgage exposure of $2.9 trillion.73 Thus, even before taking into account on-balance sheet risks,

PMIs held over four times as much capital per unit of exposure as the GSEs (albeit against a riskier

pool of mortgages). Meanwhile, the GSEs’ capital also had to support their highly leveraged

portfolios of mortgage securities, including large holdings of risky collateralized mortgage

obligations. PMIs, on the other hand, had relatively low on-balance sheet leverage and securities

portfolios consisting mostly of investment grade government and corporate bonds. (State laws

generally prohibit PMIs from investing their surplus and reserves in mortgage-related instruments.)

Our proposed system would provide more robust protections for the taxpayers, in large part

by addressing the prior weaknesses discussed above. Under our proposal, multiple layers of private

capital would stand between the federal government and borrower credit risk (see Figure 10). First,

private MBS issuers would bear all losses in front of the government guarantor. In turn, issuers

would rely heavily on PMIs to shoulder virtually all losses resulting from non-catastrophic market

scenarios. Only upon issuer default would the government guarantor make payments to investors.

Even then, it would face no significant losses unless a catastrophic housing crisis left PMIs unable to

pay claims or resulted in unusually severe losses on a significant number of mortgages.

72 See MICA 2007-2008 Fact Book & Membership Directory, 21,http://www.privatemi.com/enespanol/news/factsheets/2007-2008.pdf . 73 See Freddie Mac 2006 Annual Report, 118, 130,http://www.freddiemac.com/investors/ar/pdf/2006annualrpt.pdf ; Fannie Mae 2006 Form 10-K,101, 105,http://www.fanniemae.com/ir/pdf/sec/2006/form10k_081607.pdf .

http://www.privatemi.com/enespanol/news/factsheets/2007-2008.pdf


http://www.freddiemac.com/investors/ar/pdf/2006annualrpt.pdf


http://www.fanniemae.com/ir/pdf/sec/2006/form10k_081607.pdf







66

Under our proposal, the government guarantor would be required to ensure that the

combined capital resources of PMIs and issuers are sufficient to absorb all losses short of a

catastrophic collapse of the national housing market. Critically, unlike the GSEs, approved issuers

and PMIs would not benefit from implicit or explicit guarantees at the entity level; these entities

would be permitted to fail. Moreover, under the Dodd-Frank Act, any system participant deemed

systemically significant would be subject to enhanced Federal Reserve Board supervision and to the

FDIC’s Orderly Liquidation Authority in the event of insolvency.

Figure 10: Layers of Credit Protection in the Proposed System

• Homeowners make monthly

mortgage payments

• Improved underwriting

required by Dodd-Frank Act

decreases probability of

default

• PMIs pay claims on mortgages

in default

• Claims generally processed

after foreclosure

• Issuers make up any shortfall

to investors until

reimbursements rec eived

from PMIs

• Issuers permanently absorb

losses where underwriting

representations and

warranties breached or PMI

coverage exhausted

• Government guarantor pays

investors if issuers default on

their payment obligations

• Government guarantor will

typically recover from PMIs

any losses due to issuer

default

• U.S. Government stands

behind government guarantor

• Government guarantor

reco ups any major shortfall

over time through fee

increases

Homeowners PMIs GovernmentGuarantor

Repayment

MBS

Investors

MBS IssuersPayments

To be sure, the government guarantor’s explicit guarantee would reduce market discipline

for approved issuers and PMIs, just as deposit insurance reduces market discipline for banks.

However, our proposal improves incentives that existed under the old GSE system in two important

ways. First, exposure of PMI and issuer stakeholders to severe losses, combined with the absence of

any mechanism for government support, will create market discipline. Market discipline will apply

both within and among institutions. For example, unlike under the old GSE system, individual



67

lender/issuers will have strong incentives to monitor the creditworthiness of PMIs. Just as

importantly, the government guarantor will have strong incentives to ensure that approved issuers

and PMIs are able to meet their obligations. The government guarantor will face a statutory

imperative and congressional pressure to avoid losses, while largely avoiding the competitive and

earnings pressures that plagued the GSEs. Admittedly, the government guarantor will inevitably

face some countervailing political pressure to promote homeownership, and it will surely be

conscious of private sector competition that could shrink its volumes. Even so, it will face a more

desirable mix of incentives than the pre-crisis GSEs. Indeed, to some extent such tensions are

helpful in ensuring that the government guarantor remains responsive to public preferences and

market conditions. Our proposed structure anticipates this need by incorporating some flexibility to

make marginal trade-offs between affordability and taxpayer protection, as discussed above.

e. Variations and Alternatives

We believe our proposed institutional framework represents the most efficient and effective

way to implement the two necessary reforms to the pre-crisis GSE system: establishment of an

explicit federal guarantee and placement of substantial private capital in front of it. However,

numerous potentially workable variations and alternatives exist, including:

Nationalizing the current GSE operating model;

Establishing a pre-funded federal guarantee fund;

Chartering new private entities to replace the GSEs;

Permitting issuers to transfer less or no risk to PMIs;

Authorizing the FHA to provide catastrophic reinsurance to PMIs;

Creating a PMI industry guaranty association;



68

Requiring issuers to create uninsured, subordinated tranches in connection with each

guaranteed issuance; and

Choosing a primary federal PMI regulator other than the government guarantor.

Some of these options would merely tweak our proposed system, while others would fundamentally

change it. This sub-section addresses how these variations and alternatives might work and why we

have not proposed them.

i. Nationalizing GSE Operating Model

Instead of using the current Ginnie Mae operating model as a starting point for reform,

Congress could convert the GSEs to permanent government-owned corporations while otherwise

operating them in the current manner. The new GSEs — or a single consolidated GSE — would

purchase mortgages from lenders and sell government-backed MBS to investors, much as they do

now. But the securities issued by the new GSEs would carry an explicit government guarantee, not

an implicit guarantee, and the new GSEs would not earn profits beyond those needed to build an

appropriate credit reserve.

To minimize risk to taxpayers, the new GSEs could be structured to operate more like

market utilities and less like repositories for non-catastrophic credit risk. For example, they could

require lenders or insurers to bear substantial portions of the credit risk arising from the underlying

mortgages, or at least continue to require third-party credit enhancements on high-LTV mortgages.

Congress could also prohibit the GSEs from holding mortgages or MBS on their books for

investment.

This arrangement would represent a marked improvement upon the pre-conservatorship

GSE structure. Public ownership would address the problem of privatized gains and socialized

losses. To the extent the new GSEs were required to obtain even deeper third-party credit



69

protection than the current GSEs, taxpayers would be more insulated from credit risk. Removal of

the GSEs’ authority to accumulate large retained mortgage portfolios for investment would address

another source of unnecessary risk concentration. Finally, because lenders, investors, and PMIs

already do business with the GSEs, the transition to public ownership need not disrupt established

industry arrangements.

However, since the new GSEs would not invest heavily in mortgages, an important question

arises: why would they need to purchase and securitize mortgages at all? Why not rely on private

entities to perform these functions and simply “wrap” the resulting MBS, as Ginnie Mae does? We

cannot find satisfactory answers to these questions. By relying on approved issuers to aggregate

mortgages and distribute MBS, a Ginnie Mae-type structure removes the government from the

housing finance process one step further, from both operational and risk perspectives. Approved

issuers provide an additional layer of private capital, beyond PMIs, that will absorb losses before the

government. Furthermore, the Ginnie Mae model relieves the government of the need to hold a

large liquidity portfolio, historically a risky and controversial feature of the GSE model. Instead,

issuers and servicers would provide the liquidity to administer the primary MBS guarantee.

ii. Pre-Funded Federal Guarantee Fund

A number of reform proposals call for a “catastrophic guarantee fund” that would hold large

reserves to protect taxpayers from potential losses in a severe market downturn. This fund would

be administered by the federal government and funded by fees on government-insured mortgages or

MBS. Absent such a fund, the government guarantor would maintain loss reserves reflecting

expected losses (i.e., the most likely outcome), rather than potential losses (i.e., the most severe

outcome).

Generally speaking, we are leery of proposals that require the government to accumulate

large reserve funds. While potentially satisfying politically, such funds are often merely creatures of



70

internal government accounting and do not meaningfully increase the government’s capacity to

absorb losses. Alternatively, the existence of a large reserve fund may tempt elected officials to

utilize the fund for purposes not originally envisioned, which may increase taxpayer exposure. A

large standing fund would also require larger fees (essentially taxes) on mortgages. These fees would

reduce credit affordability.

Moreover, while large reserves must exist somewhere in the housing finance system, the

government need not administer all such reserves directly. Under our proposal, PMI contingency

reserves and issuer capital will play the role others envision for the catastrophic guarantee fund. The

government guarantor will have the power to ensure that these funds are adequate to support the

risks that PMIs and issuers are expected to assume. Meanwhile, the funds can be reinvested to

support other productive economic activity.

iii. New Private Entities to Replace GSEs

Some proposals that advocate a government wrap would create a new type of federally

chartered private entity to aggregate and securitize mortgages. Like the private MBS issuers

contemplated in our proposal, the new private entities (perhaps including the post-conservatorship

GSEs) would provide the primary guarantee of timely repayment of principal and interest on the

MBS. Also like our proposed issuers, these entities would pay guarantee fees to a government

insurer to secure the government’s backup guarantee.

We do not see the need for such separately chartered entities. As illustrated by the current

Ginnie Mae operating model, a well-designed federal system can rely on existing financial

institutions to aggregate and issue government-guaranteed MBS. Our proposed system would

feature all of the advantages generally associated with the separate-issuer model, including: federal

oversight of issuer capital levels; segregated loss reserves tailored to long-term mortgage credit risk;

and true sale accounting treatment for originators/sellers (discussed further below). In addition, as



71

discussed in Section IV.c above, reliance on diversified issuers could increase overall system

resilience by counterbalancing the concentrated risk profile of the monoline PMIs. To the extent

equity markets favored dedicated issuing entities, they could be ordinary state-chartered

corporations, subject to solvency standards prescribed by the government guarantor. (With the

approval of banking regulators, the federal thrift charter could also be an option for such specialized

mortgage finance entities.)

iv. Less Risk Transfer from Issuers to PMIs

Our proposal would require issuers to obtain PMI covering all non-catastrophic credit risk.

As an alternative, issuers could retain more of this risk themselves, as do the current GSEs.

We decided against permitting higher levels of uninsured issuer risk for three reasons. First,

issuers would need large countercyclical reserves to manage significant long-term credit risk. As

discussed above, PMIs are currently subject to distinctive capital and reserving requirements, as well

as other prudential requirements, tailored to this risk. Rather than replicating this regulatory

framework at the issuer level — which would be difficult without a separate-issuer model — our

proposal harnesses the existing PMI industry and regulatory structure.

Second, giving issuers sole responsibility for credit risk and decision-making can aggravate

the risks arising from their conflicting incentives. As observed during the mortgage bubble, issuers’

desire to increase MBS sales may diminish their capacity to evaluate and manage credit risk. The

immediate payoff upon securitization can encourage issuers to underestimate the long-term risk.

Issuers that also originate mortgages encounter additional incentive conflicts that promote

the erosion of underwriting standards. The front-loaded compensation of originators during the

bubble often overshadowed the prospect of future losses, particularly from mortgages originated for

sale. Meanwhile, issuers that do not also originate mortgages can lose touch with shifting

underwriting practices and face pressures to weaken costly due diligence practices at the riskiest



72

points in the cycle. The conflict between these short-term origination and securitization incentives

and prudent risk management practices will tend to decrease system stability and increase risk to

taxpayers.

Loan-level insurance by unaffiliated PMIs is less vulnerable to these conflicts. To be sure,

PMIs face long-term pressures if their underwriting criteria are tougher than those of their

competitors. But the revenue that PMIs receive from each loan comes only over time and is

relatively small in relation to their potential losses. This mitigates some of the short-term sales

incentives faced by originator/issuers. In addition, PMIs’ role in the origination process should

enable them to monitor shifting underwriting practices.

The third reason for requiring very high levels of credit-risk transfer from issuers to third-

party insurers is to secure the same accounting and regulatory capital treatment currently enjoyed by

Ginnie Mae issuers. Under current accounting standards, Ginnie Mae issuers treat eligible asset

pools as “sold” and do not need to consolidate such pools (or their related MBS) on their balance

sheets. Consolidation of the pools would significantly increase regulatory capital requirements and

dramatically shrink the capacity of mortgage lenders to extend credit. In the case of Ginnie Mae

issuers, the existing accounting treatment is premised on, among other factors: (1) the significant

level of control that the FHA/VA and Ginnie Mae indirectly exert over the issuer’s management of

insured mortgage assets; and (2) the issuer’s relatively small exposure to the risks of the pool in

comparison to these government entities.74 If the legal and institutional arrangements are structured

properly, issuers should be able to secure such accounting treatment for MBS pools comprised of

mortgages that are fully insured against expected losses by unaffiliated third parties (e.g., PMIs). But

74 For a detailed analysis, see letter from Joshua J. Denney, Associate Vice President of Public Policy,Mortgage Bankers Association, to Wesley Bricker, Accounting Group, SEC, dated February 10,2010, as well as attachment thereto,http://www.mbaa.org/files/Advocacy/2010/MBALettertoSEConDecisionConfirmation.pdf .

http://www.mbaa.org/files/Advocacy/2010/MBALettertoSEConDecisionConfirmation.pdf





73

higher issuer exposure to credit risk would threaten this result. Not only would issuers have higher

exposure to the securitized pools, but they would also likely demand greater control over

management of the assets.

Admittedly, for banking organizations, off-balance sheet treatment would only provide

regulatory capital relief with respect to the current leverage ratio requirement. Bank-issuers would

still have to hold risk-based capital against mortgages in pools they guarantee. Although “prudently

underwritten” single-family mortgages enjoy lower risk-weights than other types of private-sector

exposures, they do not merit the 0% risk weight assigned to the vast majority of mortgages in

Ginnie Mae pools. Such issuer capital is, from a systemic point of view, a substitute for the private

capital supporting mortgage risks at the GSEs under the old system. Although limits on leverage

impact both the availability and price of mortgage credit, the alternative is the excessive leverage that

characterized the pre-crisis housing finance system. Policymakers could choose to limit the impact

of such capital requirements by capping issuer exposure to losses in government-guaranteed pools.

But they must be conscious that every quantum of risk removed from the issuer shifts to the

taxpayer.

v. Government Mortgage Reinsurance

In order to maintain a consistent supply of mortgage credit during adverse market

conditions, our proposed housing finance system must ensure reasonable stability in: investor

demand for MBS, lender supply of mortgage credit, and third-party insurer capacity to underwrite

risk. Under our proposed system, the explicit federal MBS guarantee would remove investor

incentives to flee from credit risk, thereby ensuring relative stability in investor demand. Lender

willingness to provide credit would also remain relatively stable, provided that lenders could

continue off-loading most of the credit risk to PMIs (or other third-parties). But as the entities

holding the largest amount of credit risk, PMIs might need to tighten standards and reduce new



74

insurance underwriting volumes as markets deteriorate. PMI capital and reserves would be large but

not infinite, and the government guarantor’s MBS wrap would not protect PMIs from failure.

Further disruption in the supply of mortgage credit could ensue in the event a large PMI became

insolvent or stopped writing new business.

Reinsurance for PMIs could help alleviate this problem. Under such an arrangement, the

reinsurer would absorb credit losses beyond a certain catastrophic threshold (i.e., “excess-of-loss”

reinsurance), thereby reducing the likelihood of PMI insolvency at the wrong time. However, for a

variety of reasons, independent private mortgage reinsurance is not available. Moreover, private

reinsurers would likely rein in new business at the same time as primary PMIs. A government

instrumentality adopting this role, such as the FHA, would be better positioned to absorb tail risk

and would likely continue underwriting new reinsurance policies in catastrophic market conditions.

However, FHA reinsurance would create additional taxpayer risk. Through the FHA,

taxpayers would be exposed to losses that PMIs would otherwise bear. Furthermore, the

reinsurance backstop could diminish PMIs’ risk sensitivity in certain market conditions. The

arrangement would thus place the government in a more prominent role than our proposed

structure, in which the interests of private institutions in avoiding their own insolvency serve as a

check on taxpayer risk. That said, the extent of the “moral hazard” created by FHA reinsurance

could be reduced by certain design features, such as applying the reinsurance to a PMI’s entire

annual book-of-business (rather than on each individual loan or pool) or conditioning payment of

reinsurance claims on a conservatorship process that dilutes or eliminates the claims of PMI equity-

holders.

Ultimately, disruptions in the supply of mortgage insurance cannot be ruled out absent a

federal guarantee of private insurance entities or federal reinsurance against the risks that would

threaten their solvency. However, potential disruptions can be rendered much less likely through a



75

combination of strong capital and reserving requirements, orderly liquidation/restructuring tools,

and, if necessary, preventative measures to limit the systemic risk posed by individual firms. The

Dodd-Frank Act gives federal regulators new tools to accomplish these ends. Combined with the

regulatory powers we propose for the government guarantor, these tools could well prove sufficient

to maintain a consistent supply of mortgage insurance (and, therefore, mortgage credit) in adverse

market conditions.

vi. PMI Industry Guaranty Association

Under our proposed system, insolvency of one or more PMIs could increase the

government guarantor’s losses from issuer defaults, as well as contribute to issuer defaults directly.

For this reason, the government guarantor would impose eligibility standards on PMIs and monitor

their risk profiles. In light of the government guarantor’s significant indirect exposure to PMI

counterparty risk, additional safeguards are worth considering.

A PMI industry guaranty association (“GA”) would be one means of providing additional

taxpayer protection. In the event that a PMI failed to meet its ongoing obligations, the GA would

impose after-the-fact assessments on all surviving PMIs to cover the shortfall. State insurance GAs

have administered similar industry cross-guarantees within the property/casualty (P&C) and

life/health (L&H) insurance industries since the early 1970s. These existing GAs provide necessary

funds to wind down failing insurance companies and fulfill claims-paying obligations through after-

the-fact industry assessments.75 Policymakers could also authorize the PMI GA to issue

government-backed debt if necessary to meet short-term obligations while spreading out the

industry assessment burden over time.

75 For general background on these guaranty associations, see: http://www.nolhga.com, http://www.ncigf.org .

http://www.nolhga.com/


http://www.ncigf.org/






76

However, the feasibility of a mortgage insurance GA depends on the structure of the PMI

industry that will develop under our proposal. We do not believe it is feasible given the current

market structure. With only six active firms in the PMI industry today (a seventh awaits additional

state licensing approvals to begin issuing policies), the industry may be too small to absorb the

potential costs of a large insolvency. In contrast, the P&C and L&H industries can spread costs

over a much greater number of firms, and high loss events are more likely to be specific to

individual insurers rather than industry-wide. Hobbling the PMI industry for years with significant

cross-guarantee obligations could also impair the industry’s ability to support consistent credit

availability or even jeopardize the solvency of other PMIs. These concerns merit further inquiry.

vii. Structural Subordination

Some GSE reform proposals would require issuers to create uninsured subordinate MBS

tranches within each pool collateralizing guaranteed MBS. These tranches would receive principal

and interest payments only after insured senior tranches. The subordinate tranches would take the

first losses.76

By placing the junior tranches outside the scope of the federal insurance backstop,

subordination would essentially privatize a portion of the market. In other words, limited

subordination would bring the more credit-risk-tolerant segments of the private label investor

universe into government-guaranteed securitizations, an appealing concept from a taxpayer-

protection perspective. We see merit in exploring subordination as a supplement to PMI or other

forms of third-party risk transfer. Just as the private label securitization market will regain market

share in the years ahead, private label investors could potentially grow market share within

76 Another variation would involve issuance to investors of credit-linked notes, with the proceeds ofthe notes held by the issuer as loss reserves and repayment of the notes linked to performance of thereference assets (i.e., mortgage pools).



77

government-guaranteed securitization structures over time through investment in uninsured,

subordinated tranches.

However, a system that mandated subordination instead of PMI would have difficulty

achieving our policy objectives. To the extent the system permitted issuers to retain the

subordinated tranches, it would resemble the “Less Risk Transfer from Issuers to PMIs” variation

discussed earlier in this section, with all of its attendant disadvantages. To the extent issuers were

required to sell the subordinated tranches to third parties in order to issue guaranteed MBS, they

would face the fundamental constraint highlighted in Section II.b: limits on investor appetite for

credit risk. We lack confidence that investor demand for uninsured subordinate tranches will be

sufficient to achieve the goals of our proposal in the foreseeable future, particularly the goal of credit

affordability. Investors could demand high risk premiums for these assets, thereby increasing costs

to borrowers above levels possible under our proposal. Even if demand for subordinate tranches

reached a high enough level, recent experience with private label securitization indicates that this

demand could prove unreliable if loss rates increased. As conditions change, investors can shift

their capital to other markets. (In contrast, PMIs have strong incentives to pursue their business

model through the cycle.)

Some have suggested that the “funded” nature of structural subordination renders it mor e

reliable than PMI. That is, subordinate tranches of a securitization represent a pre-paid loss buffer,

whereas losses covered by PMI must be recouped from a PMI. Indeed, although the PMI

regulatory regime is designed to ensure that PMIs have sufficient “funded” capital on their balance

sheets to pay all claims, PMIs do not hold dollar-for-dollar capital against the risks they underwrite

(to do so would be prohibitively expensive). Therefore, unlike a subordinate tranche, a PMI

potentially could run out of capital, thereby exposing taxpayers.



79

On the other hand, there are possible drawbacks to the government guarantor’s serving as

the primary federal regulator of PMIs. Even after integrating GSE functions for seller/servicer and

PMI oversight, the government guarantor would probably lack the full complement of powers and

personnel possessed by financial regulatory agencies. Moreover, if the government guarantor were

Ginnie Mae, it may be perceived as insufficiently independent or otherwise be exposed to some of

the general political criticism directed at HUD from time to time. Given the longstanding

competitive tension between the FHA and PMIs, some may also fear that Ginnie Mae’s existing

support of the FHA program could result in a bias towards that program over its new conventional

conforming program. Similarly, Ginnie Mae’s long -standing relationships with approved issuers

could result in a bias towards issuers over PMIs.

The FHFA is a possible alternative. The FHFA has specific expertise in housing finance and

mortgage-related insurance and is a fully functional, independent financial regulatory agency (though

not an insurance regulator). However, designating the FHFA as primary PMI federal regulator

effectively would add a second federal regulator for PMIs, since the government guarantor, as the

insurer of last resort under our proposal, must have certain minimum oversight and regulatory

authority over PMIs. In addition, fears of bias against PMIs may arise from the FHFA’s role as

regulator of the Federal Home Loan Banks (FHLBs), which would compete directly with the

conventional conforming system.

The federal agency with the most insurance expertise — the new Federal Insurance Office —

is an unlikely candidate in its current format. The Office lacks regulatory capabilities and housing

expertise, and its location within the Treasury Department may compromise its independence.

However, should future legislation establish more extensive federal regulation of property and

casualty insurance, and vest those regulatory powers in a newly independent Office, it might make



81

constrains the extent to which this calibration can narrow the conforming mortgage definition, there

remains significant flexibility in determining its exact contours.

ii. Servicing and REO Disposition

Under many housing finance systems, including our proposal, the interests of mortgage

servicers may diverge from those of other participants that bear credit risk, such as investors, MBS

guarantors, and PMIs. To the extent credit risk is borne primarily by other parties, servicers may

seek to minimize their own operating costs and exposure to potential lawsuits, rather than

maximizing the value of the underlying assets. To mitigate undesirable incentives, other parties can

exercise control over servicer conduct or structure servicer compensation to better align the interests

of all parties. For example, the GSEs currently impose prescriptive servicing standards on approved

seller/servicers and exercise more direct control over the management and disposition of REO.

Under our proposal, the incentives of approved seller/servicers should be no worse than under the

current GSE system, and perhaps better, since seller/servicers under our proposal would retain

some level of credit risk (i.e., “skin in the game”). However, the particular allocation of credit risk

under our proposal may call for adjustments to existing arrangements for mortgage servicing and

REO disposition.

iii. Role of the FHA

The FHA is widely considered an appropriate repository for credit risk in mortgage market

segments not adequately served by private market participants. The FHA will continue to perform

this function under our proposal. However, the goal of minimizing taxpayer exposure could be

undermined if credit risk simply migrated away from the reformed conventional conforming market

and into the FHA market — where fewer layers of private capital stand in front of the taxpayers.

Policymakers should limit undesirable competition between the conventional conforming market

and the FHA market by appropriately targeting eligibility standards for FHA loans to underserved



82

(but creditworthy) borrowers. This could be accomplished through, for example, limits on borrower

income, debt-to-income, and/or loan amount, with the relevant limit(s) calibrated against area

medians.

iv. Housing Goals

Policymakers must decide whether to modify or abandon the existing “housing goals”

framework. The housing goals require Fannie Mae and Freddie Mac to target a portion of their

activities towards supporting the housing needs of low- and moderate-income individuals, effectively

creating cross-subsidies among different borrower segments. While some believe the housing goals

are necessary to promote credit availability in underserved populations, others contend that they

encouraged Fannie Mae and Freddie Mac to take excessive risk without materially affecting credit

allocation. Our proposal can accommodate a wide range of solutions to this issue, including a

system with opaque cross-subsidies (such as the housing goals), more transparent cross-subsidies

(such as an affordable housing fund funded by guarantee fees), or no cross-subsidies at all.

v. FHFA and the FHLBs

Policymakers must decide the future roles of other institutions in the larger GSE system —

particularly the FHFA and the FHLBs. Under our proposal, the FHLBs could continue to operate

as they do now, subject to regulation by a smaller, more-focused FHFA. To the extent policymakers

adopted the variation discussed above involving separately chartered issuers, the FHFA could also

play a more robust role as their chartering and regulatory authority.

vi. Multifamily

Policymakers must determine the extent to which the multifamily mortgage market merits a

separate institutional structure. Multifamily loans have distinctive characteristics in comparison to

single-family loans. For example, multifamily loans are typically much larger, and the underwriting



83

of multifamily loans — particularly large ones — is less conducive to standardization. Both the GSEs

and Ginnie Mae currently operate separate multifamily programs. In light of the special features of

multifamily loans, policymakers should consider the appropriateness of our proposed single-family

structure to the multifamily universe, including any necessary additions or adjustments.

vii. Apportionment of GSEs’ Legacy Losses

Finally, the wind down of the GSEs called for in our proposal will require policymakers to

decide important questions about legacy loss allocation. For example, should the government

attempt to recoup the Treasury’s full investment in the GSEs? Options for addressing any shortfall

would include special fees on new MBS issuances wrapped by our proposed government guarantor.

But such fees would increase the cost of credit for borrowers that did not necessarily benefit from

the old GSE system. Policymakers must also decide whether to provide continued government

backing for existing GSE debt and MBS. Withdrawal of federal support for trillions in outstanding

GSE commitments could have systemic repercussions. On the other hand, it is more difficult to

justify taxpayer subsidies that no longer support new issuances.

These and other questions deserve serious attention but fall outside the scope of this paper.



84

V. The Treasury/HUD Options Revisited

As mentioned in Section I, the Treasury and HUD released a joint report titled “Reforming

America’s Housing Finance Market” in February 2011. The report suggested three options for

structural reform:

Complete privatization except for targeted FHA/VA/USDA guarantee programs . This option would

privatize the vast majority of the mortgage market. According to the report, possible

benefits would include greater capital allocation to non-housing-related sectors of the

economy (due to decreased incentives to invest in housing) and decreased taxpayer exposure.

They might also include decreased system-wide risk, since private actors would need to

exercise greater caution in the absence of a government guarantee. However, the report

states that this option could seriously impair mortgage credit affordability and consistency

over time. Furthermore, without a government backstop, deteriorating credit conditions

could cause a complete implosion of the market, which might necessitate ad hoc bailouts. In

light of this possibility, it remains unclear whether this option would actually decrease

system-wide risk or risk to taxpayers.

A broader federal backstop that would maintain a minimal presence during normal times and scale up

during a crisis . Like the option above, this option aims to minimize market distortions and

taxpayer exposure during normal times. But it would provide a government backstop during

market crises, thereby averting a complete market implosion or ad hoc bailouts.

Mechanisms for ensuring that the backstop remains minimal during normal times could

include above-market pricing for the federal guarantee and/or limits on the aggregate

quantity of government insurance sold. These mechanisms would adjust during market

crises to permit greater government involvement. However, the report notes that such



85

scalability could prove difficult to achieve operationally. In addition, the absence of a more

consistent government backstop would likely reduce credit affordability during normal times.

A broader federal backstop that would maintain a more consistent presence throughout the housing cycle, but

with significant private capital in a first-loss position. Under this option, the government backstop

would take the form of an MBS wrap. The report suggests that private insurers might

provide primary MBS-level guarantees. The government backstop would charge premiums

for MBS “reinsurance,” and it would pay out only upon the primary insurer’s default.

According to the report, this option would provide the greatest assurance of credit

affordability and consistency. However, it could encourage private investors to allocate

excessive capital to housing. To the extent the backstop were underpriced, it would also

increase system-wide risk and risk to taxpayers.

The structure we propose could accommodate either the second or third option, as well as

points in between. It could also shift between the two options over time, as political preferences

and market conditions changed. The amount of the guarantee fee and the definition of

“conforming mortgage” would be the principal levers for effecting these shifts. High guarantee fees

and a narrower definition would shrink the role of the guaranteed market, while lower fees and a

broader definition would expand it.

Whether the first option would increase or decrease system-wide risk is debatable. Some

commentators consider government bailouts inevitable in a privatized housing finance system. If so,

the decrease in economic distortions that the report suggests might occur under the first option

would be temporary, if not illusory. Ad hoc government bailouts introduce highly undesirable

economic distortions and expose taxpayers to loss. On the other hand, the Dodd-Frank Act

provides federal regulators with new tools to limit the systemic risks posed by individual financial



86

institutions. The potential efficacy of these tools remains unknown at this stage. At any rate,

because the affordability problem renders the first option unworkable, its implications for system-

wide risk and taxpayer protections are not decisive.

With respect to the second option, we are less concerned than the Treasury/HUD report

about the ability of a smaller guarantee system to scale up quickly during a crisis. As described

above, both the GSEs and Ginnie Mae have demonstrated the ability to expand rapidly during the

most recent crisis, as well as previous crises. This capacity could be increased further if, under our

proposed structure, the government guarantor had some limited authority to adjust guarantee fees

and the “conforming mortgage” definition without congressional action.

Still, in the near-term, the second option suffers from the same fatal flaw as the first: it

cannot ensure adequate affordability. Under this option, the government does not insure large

amounts of MBS during normal market conditions. As a result, MBS investors will bear increased

credit risk through most of the credit cycle. This could yield similar consequences for the size of the

investor pool and, ultimately, home purchase affordability, as the first option.

By process of elimination, only the third option remains. Unlike the first two options, the

third option ensures adequate credit affordability. From an investor perspective, an explicit

government guarantee would provide equal or greater safety and liquidity as the pre-conservatorship

GSE guarantee. The fee charged by our proposed government guarantor, in combination with

properly capitalized private issuers and PMIs, may increase the cost of credit somewhat; it is now

obvious that the pre-conservatorship GSE guarantee fees were underpriced. In addition, the GSEs’

disappearance from the ranks of whole-loan and MBS investors could shift aggregate demand for

loan purchases and MBS downward, thereby further increasing the cost of credit. (Unlike the GSEs,

the government guarantor would not keep a retained portfolio.) But the broad universe of MBS



87

investors would remain intact, limiting the magnitude of potential cost increases compared to the

other options.

The Treasury/HUD report identifies two potential weaknesses in the third option. First, the

government guarantee could distort capital allocation in the economy by encouraging more

investment in housing-related securities than would otherwise occur. Increased allocation to

housing can mean decreased allocation to other sectors. However, the economic distortion wrought

by seven decades of federal housing guarantees and other homeownership subsidies is firmly

embedded in our economic and social fabric. Over several generations, such subsidies have shaped

the economic decision-making of households, the fiscal structure of municipal governments, the

formation of human and physical capital dedicated to housing, and the social context in which most

Americans live. Sudden removal of such subsidies — or even the expectation of their removal on a

fixed time table — risks far-reaching economic and social dislocation. It is hard to see how

Americans could accept such dislocation for the sake of the theoretical value of “efficient capital

allocation.” So long as the government backstop accurately measures risk and protects taxpayers, its

influence on capital allocation might be viewed as a matter of popular preference for

homeownership over other social goods.

The Treasury/HUD report also raises taxpayer protection as a potential concern with the

third option. Indeed, although our proposal seeks to minimize such risk, it cannot eliminate it. But

U.S. policymakers have consistently demonstrated some degree of tolerance for taxpayer exposure

when instrumental in achieving important social and economic objectives. The FDIC, FHA, and

Ginnie Mae provide examples of long-standing federal guarantee programs that pose some amount

of risk to taxpayers. These programs have withstood the test of time because they have done a

passable, if imperfect, job of controlling this risk.77 Our proposed government guarantor could be

77 Whether the FHA ultimately will survive the current downturn without a bailout remains unclear.



88

expected to do the same for the conforming mortgage market. However, given the size of the

government guarantor’s potential exposure, policymakers should consider ways to insulate its risk

management processes and pricing policies from undue political influence.



89

VI. Conclusion

As the policy debate on reforming the U.S. mortgage securitization market unfolds,

participants should focus on potential real-world impacts and articulate a coherent methodology for

translating goals into concrete reforms. Given the large number of moving parts in the housing

finance system — from mortgage instrument design to institutional arrangements — an approach that

constructs a new system from scratch will generate many competing solutions, each with little

chance of garnering enough support. Likewise, an approach that bypasses existing institutions and

market infrastructure will impose extra transition costs and dislocation.

This paper adopts a more pragmatic approach. It focuses on specific problems with the pre-

crisis securitization market and, to the extent possible, harnesses existing institutions in addressing

them. We believe this type of approach holds promise from a substantive perspective, as well as

from a political perspective.



93

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