Housing Finance Reform: Regulatory Oversight for a Stronger Secondary Mortgage Market

January 13, 2017

By Jane Dokko and Sam Valverde

This blog post is the third in a Treasury Department series of issue briefs on reforming the housing finance system. Our first two briefs discussed the need for housing finance reform to provide access to affordable housing for all Americans and promote sustainable mortgage lending across the U.S. economy’s ups and downs. This third and final brief examines how a thoughtful regulatory framework for the secondary mortgage market can help American families benefit from a more robust housing finance system.

American families participate in our housing finance system in two ways — as consumers who purchase and rent homes, and as taxpayers who provide critical capital support in the amount of $258 billion for Fannie Mae and Freddie Mac (the government-sponsored enterprises, or GSEs). Under the current system, should another housing downturn occur, taxpayers will be on the hook to keep the GSEs solvent and the housing finance system functioning. As the Administration has repeatedly stated, this status quo is unsustainable and comprehensive, legislative housing finance reform is necessary to fix vulnerabilities in the system.

This final issue brief will lay out how regulatory oversight of the secondary market can guide a reformed system to serve consumers and financial institutions of all sizes, as well as promote the safety and soundness of a stronger housing finance system. As we noted in our previous issue brief, an explicit government guarantee on a defined-class of mortgage-backed securities (MBS) is a key ingredient in providing broad and affordable access to housing for American families. Discussions of regulatory priorities in housing reform often focus on the safety and soundness of the housing finance system, but regulators today, and in the future, also have an important role in making sure all consumers — and not just financial institutions and mortgage investors — benefit from the government guarantee.

Regulatory Oversight to Promote Consumer Benefits

Taxpayer support makes it possible for secondary mortgage market institutions, which connect mortgage lenders and investors in a single market, to participate in a system with government-guaranteed MBS that has clear benefits. In exchange for this support, these institutions have a responsibility to pass these benefits on to American families. A strong regulator in a reformed housing finance system should have the authority to encourage participating institutions to meet these responsibilities.

In our first brief, we laid out our support for a requirement that secondary market institutions provide broad access to credit for consumers. Any institution that benefits from being able to issue securities with a government guarantee needs to serve a broad range of markets across all geographic areas. Without this mandate, these institutions may choose markets selectively. A future system should extend the benefits of a government guarantee to a wide range of creditworthy borrowers from all communities.

American families also benefit when lenders of all sizes have equal access to the benefits of government-guaranteed MBS. In the past, larger lenders enjoyed certain price concessions from the GSEs that were not available to smaller lenders. The regulatory framework for the secondary mortgage market should support fair competition across all lenders, regardless of size or type.

Promoting a level playing field for lenders large and small has a number of benefits for American families. First, it fosters competition among mortgage lenders that, in turn, benefits consumers through greater innovation and lower mortgage rates offered to borrowers. Second, it provides competitive access to funds that smaller institutions use in providing mortgages, which has both local and economy-wide benefits. From rural to urban settings, community banks, credit unions, and local lenders are in an advantageous position to assess and address the credit needs of their customer base. Moreover, a diverse market presence from lenders of all sizes can lead to more effective risk assessment and better outcomes for borrowers and investors alike. Strengthening access for small lenders also helps secondary market institutions support their obligation to serve a broad range of markets and geographic areas.

The current system has several features that support a level playing field for all lenders and should be preserved in any reform proposal. First, small lenders can sell the mortgage loans they originate to larger financial institutions or directly to the GSEs through their “cash window.” Through their retained mortgage portfolios, the GSEs can pool loans from a number of small lenders into securities, thereby providing a key outlet and source of funds at competitive pricing to smaller financial institutions. In 2015, more than 40 percent of GSE acquisition volume came from small and very small lenders, much of it through this cash window. This delivery option is an important feature of the current system that supports more competition among lenders.

Second, the GSEs are not permitted by the Federal Housing Finance Agency (FHFA), in its capacity as conservator, to charge significantly higher fees to their smallest lender customers while giving discounts to their largest customers as they did prior to entering conservatorship. As a result, the difference in guarantee fees between the largest and smaller lenders has largely been eliminated. This intervention demonstrates the important role a regulator can play to enhance competition between small and large lenders, which in turn increases the choices available to borrowers in the mortgage market. Policymakers should ensure that a regulator is given sufficient authority to preserve reliable secondary market access for all lenders, irrespective of size.

Regulatory Oversight to Protect the Safety and Soundness of the Secondary Market

Our national housing system necessarily requires careful coordination between regulators that have separate responsibilities across the primary and secondary mortgage markets. This need for coordination will continue in a reformed housing finance system and should build on the important primary mortgage market consumer protections put in place since 2010. For secondary market institutions with access to a government guarantee, a single regulator should have two key mandates: (i) safeguarding broad access for consumers and financial institutions, discussed above, and (ii) managing the financial safety and soundness of secondary market institutions — referred to as prudential authority. As we articulated in our second brief, safeguarding broad access means, among other things, mitigating sharp contractions in the supply of mortgage credit during bad economic times. For a secondary market regulator, this means having authority to adjust certain industry requirements for the secondary market when economic conditions warrant.

For safeguarding broad access and prudential oversight, a secondary market regulator must have both supervisory and enforcement authority. Market participants subject to supervision should face penalties for the violation of rules designed to protect American families in their capacity as both consumers and as taxpayers.

The Administration has supported steps to further protect taxpayers by shifting the risks and rewards of mortgage lending to private actors rather than the taxpayer. In normal times, market-based incentives can guide private sector participants in the secondary market to provide borrowers access to mortgage credit at a reasonable rate. The private sector’s advantages in price discovery, risk diversification, and financial innovation could benefit consumers in the form of lower mortgage rates and better customer service. Market-based incentives, however, heighten the need for prudential supervision. Regulatory oversight must be in place to ensure that private capital is supporting fair and affordable housing opportunities for all American families and that taxpayers are adequately compensated for government support in times of stress.

Lenders, investors and housing advocates, among other participants, play an important role in a well-functioning secondary mortgage market, and a regulator should engage these stakeholders as a part of its rule-writing authority to implement statutory mandates. However, the regulator should be strong and independent enough to withstand pressure from the public and private sectors that may steer it toward relaxing requirements and undermining safety and soundness standards, such as loosening the standards mortgage loans must meet to qualify for the government guarantee. To preserve the ability to withstand this pressure, a future housing regulator should have an independent source of funding, as FHFA has today. Effective oversight and sensible rulemaking requires a high degree of technical sophistication, advanced data analysis, and experienced and expert staff — all of which require significant resources that must not be subject to undue outside influence.

Regulatory Oversight of a Stronger Secondary Market Infrastructure

Experts and policymakers continue to contemplate a range of possible models for a reformed secondary mortgage market. Whether these reform models propose a secondary market made up of private guarantors, lender-owned utilities, or a government corporation, there remain key elements of the secondary market infrastructure that should be implemented regardless of the specific institutional design. Moreover, a thoughtful regulatory framework is necessary to strengthen the secondary market infrastructure.

One piece of this infrastructure is the To-Be-Announced (TBA) market, a unique secondary market for MBS issued by the GSEs and Ginnie Mae. The TBA market facilitates the securitization of broadly-similar, fixed-rate mortgages by allowing lenders to pledge loans for securitization before those loans are made. These features of the TBA market ultimately allow potential homebuyers to “lock-in” a mortgage rate before their loan closes and shop around for better terms, enhancing competition in the mortgage market. Additionally, as securities delivered through the TBA market are highly liquid, they are broadly used throughout financial markets as collateral in a wide variety of transactions.

An explicit government guarantee is critical for the TBA market to provide liquidity, hedging and price discovery to the mortgage market in all economic environments. These, in turn, help lower mortgage rates for consumers. A securitization system that lacks a government guarantee could dramatically reduce liquidity in the TBA market by, for example, undermining the substitutability of MBS, as investors may not be able to separate the risk profile of the issuer from the riskiness of the loans in the MBS. Reducing the substitutability of TBA securities would make it costlier for lenders to originate mortgage loans. Additionally, absent a TBA market, lenders, and, by extension, borrowers would be exposed to interest rate changes between loan financing and loan closing. Reduced liquidity, standardization and certainty would mean higher costs for borrowers and potentially less home buying.

Moreover, the liquidity of the TBA market should be further enhanced through the creation of a uniform secondary market security. Historically, Fannie Mae mortgage securities that are eligible for TBA contracts are more liquid than comparable Freddie Mac securities, despite the fact that the underlying mortgages backing these securities are virtually indistinguishable. As a result, Fannie Mae securities are able to trade at a higher price. This pricing disparity leads to a segmented TBA market, whereas a truly unified TBA market could deliver additional efficiencies for the benefit of consumers. To eliminate this pricing disparity, the FHFA has directed the GSEs to undertake activities toward the creation of a single, uniform GSE mortgage security. The Treasury Department supports this initiative and believes any future secondary market regulator in a reformed system should be responsible for setting standards for a single security that benefits from a government guarantee.

As we explained in our first issue brief, Fannie Mae and Freddie Mac act as “credit guarantors” by charging a fee to guarantee the timely payment of principal and interest on their MBS. However, historically, they also have acted as “securitizers,” by carrying out the complex operation of converting, or “securitizing,” groups of mortgages into MBS to be sold to financial market investors. When Fannie Mae and Freddie Mac became insolvent, the entire secondary market system itself was put at risk because the two GSEs also managed much of the securitization infrastructure. The federal government had to rescue the GSEs when they began to take heavy losses in order to preserve the secondary market securitization system. Failure to do so would have closed the principal channels for mortgage credit for the housing market.

Thus, in a reformed housing finance system, a regulator must keep these two functions, guaranteeing credit risk and securitization, separate from each other. This separation would insulate one function from the other in periods of economic crisis and would allow for the resolution of any credit-risk-bearing institution that becomes insolvent without threating the infrastructure on which the market depends.

Conclusion

Regulatory oversight should support the secondary market in serving consumers and financial institutions of all sizes, as well as safeguarding the safety and soundness of the housing finance system. A reformed system must be carefully supervised by an independent regulator with sufficient resources and enforcement authority to oversee the institutions that benefit from an explicit government guarantee. In turn, these institutions have responsibilities to serve the American families that provide the critical taxpayer support underpinning the market in which they operate.

As we have articulated in numerous forums over the past eight years, maintaining the status quo of the housing finance system is not a viable solution, as it does nothing to resolve the structural weaknesses of a system that resulted in millions of families losing their homes during the Great Recession and erased trillions of dollars in household wealth. Through this series of issue briefs, we have sought to highlight fundamental questions any future system must answer: Are American households gaining greater and more sustainable access to affordable homes to rent or own? Are these households, who are also taxpayers, adequately protected from bearing the costs of another housing downturn? Comprehensive housing finance reform presents the only path to a better and more sustainable system that meets the needs of American families.

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