Housing Finance Reform: Preserving Access to Mortgage Credit in Good Times and Bad

December 22, 2016

By Jane Dokko and Sam Valverde

This blog post is the second in a Treasury Department series on reforming the housing finance system. Our first brief discussed the need for housing finance reform to provide access to affordable housing for all Americans. This second brief examines the need to preserve access to mortgage credit through the U.S. economy’s ups and downs. In the coming weeks, we also will address the need to create a level playing field for financial institutions of all sizes and to promote robust regulatory oversight to protect the broader housing system.

The future housing finance system must support access to housing in both good and bad economic times. Doing so is important not only to the families directly affected by fluctuations in the housing market but also to the health of the broader economy. The housing sector is naturally “pro-cyclical” in that it tends to track the business cycles of the broader economy. Moreover, it tends to play an outsized role in these business cycles. When the economy expands and contracts, the housing sector usually expands and contracts to a greater extent, as it is more volatile than the overall economy. A housing finance system that pulls back credit during downturns not only hurts families trying to buy homes, but can exacerbate the broader downturn.

A clearly-defined government role in the housing finance system is necessary to protect families from this harm. The specific tools can be incorporated across a range of frameworks for housing finance reform. By ensuring access to safe and responsible mortgages in good and bad times, countercyclical policy tools can also help mitigate housing sector weakness during downturns.

We believe the economic security of millions of families would be better served with stronger countercyclical policy tools in the housing finance system. We note, however, that the absence of an explicit government role in a future housing finance system would not prevent the government from supporting the housing market during a downturn. Indeed, recent experience suggests the government would almost certainly need to intervene in the event of a sufficiently severe shock to the housing or mortgage market to avoid a collapse in access to credit for creditworthy borrowers. However, without a clearly-defined role for the government in the housing market, these interventions would be costly to taxpayers and their effectiveness would likely be more limited.

Housing, like many durable goods, is naturally more volatile than the overall economy for several reasons. Because buying a home is often the largest financial transaction for many families, prospective buyers are more likely to delay home purchases than other types of expenditures when incomes fall or the risk of job loss increases. Additionally, home purchases and residential construction projects generally depend on the ability of borrowers to take out a reasonably priced mortgage. During a recession, financial market disruptions lead to tight lending standards that constrain access to mortgage credit, which slows housing activity. The resulting reduction in housing demand feeds back into the broader economy by amplifying the business cycle through swings in home construction activity and consumer spending on housing-related goods.

The Great Recession is an example of a particularly severe recession or “catastrophic” downturn. In catastrophic downturns, losses to household wealth, jobs, and economic output can be staggering. During the Great Recession, residential investment declined far more than overall economic activity. Economic output fell 4 percent from peak to trough in real terms, while residential investment plunged 57 percent. Residential investment also took far longer to begin a steady recovery than the overall economy.

Catastrophic downturns have severe and sometimes lasting consequences for households, small businesses, and communities, and by making sure responsible mortgage credit remains available, the housing finance system can play a role in lessening these hardships. In the Great Recession, millions of Americans lost their jobs. Sharp declines in house prices caused homeowners’ net worth to plunge and put millions of borrowers underwater on their mortgages. Unable to make their mortgage payments, many families suffered through foreclosures, losing their homes and their potential to obtain another mortgage if and when their financial situation improved. Reduced property and sales tax revenues meant that states and municipalities had to cut back on the services they provided to their communities. The housing bust and rise in unemployment hit some areas especially hard. This included entire states, like Florida and Arizona, which saw their foreclosure rates rise significantly, but also urban areas like Detroit and Cleveland, which saw a spike in vacant and blighted properties. The downturn was particularly harmful to communities of color. Several years into the recovery, the average wealth gap between white and minority households remained pronounced and widened compared to before the Great Recession. For Hispanics, the gap increased by 29 percent, and for African Americans, by 33 percent.

In response to this severe downturn, the government took extraordinary steps to help stem the decline of the housing sector and the overall economy. The Housing and Economic Recovery Act (HERA), passed in 2008, authorized measures to provide significant capital support to Fannie Mae and Freddie Mac (collectively, the government sponsored enterprises, or GSEs), using taxpayer funds to bolster confidence in the market. In addition to mitigating financial market collapse, these measures helped stem the decline in the housing market and prevented a worsening housing crisis from further prolonging the recession. These actions, however, were not a permanent solution to the structural weaknesses of the housing system.

Building countercyclical support into the future housing finance system is therefore essential to maintaining access to credit in downturns. Three key features of a reformed housing finance system would help smooth access to affordable credit in good and bad times: (i) a catastrophic mortgage insurance fund (MIF) to provide stability to the secondary market through the economic cycle, (ii) countercyclical regulatory tools to ensure access to safe and responsible mortgages in good and bad economic times, and (iii) broad-based modification and refinancing authority so that homeowners can readily access lower monthly mortgage payments during a downturn. With these tools, a housing finance regulator can help protect American families’ access to affordable and sustainable mortgages and rents in all economic conditions, and mitigate the spillovers from weakness in the housing sector to the broader economy.

Explicit Government Guarantee and Catastrophic Insurance Fund

As we noted in our previous issue brief, and as the President articulated in 2013, a reformed housing system must ensure access to safe and affordable mortgages in all economic conditions. A stable supply of affordable mortgage credit to borrowers depends on investors having confidence in the stability of the secondary market. To this end, the Administration supports an explicit government guarantee on a defined class of mortgage-backed securities (MBS). As discussed in our previous brief, these types of securities form the foundation of the secondary mortgage market by providing a source of funds for mortgage lending. Guaranteeing the timely payment of principal and interest on the MBS, the explicit government guarantee would be funded by financial institutions and would act as insurance against catastrophic losses. With this guarantee in place, investors who provide a source of funds for mortgage lending would be assured that the secondary market would continue to function regardless of the state of the economy.

Prior to the Great Recession, financial markets treated the GSEs’ debt and mortgage securities as implicitly backed by the U.S. government. Investors assumed that if the GSEs got into financial trouble, the government and, by extension, the taxpayer would bail them out. This assumption contributed to the GSEs’ ability to take on greater risk with insufficient capital to cover losses in a downturn. In a future housing finance system, this “implicit guarantee” should be made explicit and taxpayers should not be the ones to bail out failed institutions. Private lenders would benefit from a robust secondary market that an explicit guarantee would support. Thus, private lenders wishing to sell their mortgages to be securitized should pay a fee to fund the guarantee that supports the existence of this market at all times. These fees need not necessarily increase mortgage rates for borrowers if the reforms result in liquidity gains from having explicitly guaranteed MBS. Moreover, the degree of pass-through of these fees to borrowers is likely to be lower in models of housing finance reform that promote competition in the secondary market. Fees for this explicit guarantee should be set at an “actuarially-fair” level, which would help ensure that the resulting insurance fund is sufficiently capitalized to protect the taxpayers who ultimately stand behind this explicit government guarantee.

In turn, these fees would fund a Mortgage Insurance Fund (MIF) to be administered by a regulator. The MIF would help stabilize the market and give MBS investors the confidence that timely principal and interest payments will continue through the economic cycle. A MIF can exist in a variety of housing finance systems with diverse forms of private capital, although its exact design will depend on the particular reforms put in place.

Countercyclical Regulatory Responsibilities and Authorities

In a reformed housing finance system, a secondary market regulator should have the flexibility to adjust certain industry requirements for the secondary market when economic conditions warrant action. With this authority, a regulator can help reduce the likelihood of periods where mortgage credit is too costly and ensure it is available in downturns.

First, the regulator could have the ability to temporarily adjust the level of risk-bearing by the private sector during times of stress so as to keep the supply of mortgage credit smooth through the cycle. Second, the regulator could be allowed to alter the criteria for mortgages eligible for a government guarantee, helping support safe and responsible mortgage lending in both good and bad economic times. This could be accomplished, for example, by temporarily increasing loan limits, which cap the size of loans that can be packaged into government guaranteed MBS, in order to allow lenders to extend mortgages to more borrowers. Once the economy improves, the regulator would decrease these loan limits, letting the government’s role return to normal. Third, the regulator could have the authority to adjust the MIF fee described above, essentially adjusting the price of the explicit government guarantee. Temporarily decreasing the MIF fee in a recession means that lenders would find it less costly to securitize and thus lend, which would help support housing demand. To the extent these measures lead to losses for the MIF, plans would need to be in place to recoup the funds through future fee assessments so that the beneficiaries of the guarantee, and not the taxpayers, ultimately bear the cost of that support.

Broad-Based Modification and Refinancing Authority

Finally, a reformed housing finance system should have in place national standards to protect existing borrowers who are facing hardship because of a downturn in the economy. Providing standards for loan modifications for borrowers who have fallen behind on their mortgage payments, as discussed in our previous piece, is one example of a countercyclical tool of this nature. These standards should focus on establishing a sequence of modifications for mortgage servicers to follow for helping distressed borrowers, including term extensions, rate reductions, and principal reduction. Implementing reforms that help borrowers remain in their homes is critical not only for the financial well-being of a family affected by a potential foreclosure, but also for stabilizing their communities and the broader economy.

The housing finance system should also help preserve borrowers’ access to refinancing into loans that have lower monthly payments during downturns. For example, “underwater” borrowers whose home values have fallen to a market value below what they owe on the mortgage should still be able to reduce their payments by receiving a lower interest rate (interest rates typically fall during downturns) or by extending the term of their loan on their remaining mortgage balance. In addition to reducing the chances that a borrower will lose his or her home, refinancing into a lower payment loan can leave borrowers with more cash to keep up with their expenses in the face of job loss or lower pay. Therefore, the ability to refinance in a downturn reduces the hardships suffered by individual families.

The Home Affordable Refinance Program (HARP) instituted in 2009 by the current GSE regulator, the Federal Housing Finance Authority (FHFA), and the Treasury Department provided critical support to families and the economy in this way. By allowing homeowners with little or no equity to refinance their mortgages, HARP helped more than 3.4 million households refinance to lower their monthly payments and to support greater consumer spending among these households. However, this program is set to expire in September 2017.

To support borrower refinancing during economic downturns, a regulator in a reformed housing system should be able to set rules for streamlined refinancing. In such a reformed system, MBS investors would benefit from the certainty of knowing in advance the extent of the countercyclical support the government will provide during periods of economic stress. Furthermore, MBS investors, like other stakeholders in the housing system, stand to benefit from a more durable housing market that provides borrowers effective foreclosure-prevention options.

Conclusion

By mitigating the ups and downs of the housing market and the broader economy, countercyclical tools can preserve access to credit during downturns. At the same time, these tools would better protect taxpayers from bearing the cost of providing this essential support and help bolster the economy during hard times. These measures can help ensure that our housing finance system is resilient enough to serve American families in all economic environments.

Jane Dokko is Deputy Assistant Secretary for Financial Economics. Sam Valverde is a Counselor in the Office of Domestic Finance