Housing Finance … Seven Years Down the Road

On top of the more ""imminent reform measures"":http://dsnews.comarticles/obama-administration-lays-out-plan-for-winding-down-fannie-and-freddie-2011-02-11 laid out Friday to shore up the nation's housing finance system and begin the process of winding down ""Fannie Mae"":http://www.fanniemae.com and ""Freddie Mac"":http://www.freddiemac.com, the Obama administration's proposal outlines three options for long-term reform and structuring the government's future role in the housing market.
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Treasury stressed in a statement that ""[e]ach of these options would produce a market where the private sector plays the dominant role in providing mortgage credit and bears the burden for losses, but each also has unique advantages and disadvantages"" that will require ""an honest discussion with Congress and other stakeholders.""

Treasury Secretary Timothy Geithner says a realistic timeframe for full reform to be put into action is five to seven years. So what will the landscape of U.S. housing finance look like in seven years. The administration paints three distinct pictures.

Option one would limit the government's role in insuring or guaranteeing mortgages to the ""Federal Housing Administration"":http://www.fha.gov (FHA) and other programs targeted to lower- and moderate-income borrowers. While the government would continue to provide access for this targeted segment, it would leave the vast majority of the mortgage market to the private sector.

The report notes that this option would drastically reduce taxpayer exposure to private lenders' losses; it would deter banks from taking on excessive risks since they'd have no assurance of a government guarantee behind them; and without government backing, investors would be more inclined to put their money into other areas of the economy, potentially leading to more long-run economic growth and reducing the inflationary pressure on housing assets.

On the other hand, Geithner says if there is no guarantee beyond FHA, there is a risk that consolidation in the market would increase and access to credit for many Americans would be greatly impacted. The cost of mortgage credit for those who do not qualify for an FHA-insured loan â€" the majority of borrowers â€" would likely rise and mortgage rates would probably soar.

In addition, without broader government support in the market, the report points out that Congress, FHA, the ""Federal Reserve"":http://www.federalreserve.gov, and other regulators would not be able to play the countercyclical role that they have played throughout the recent crisis, increasing the risk of a more severe downturn.

A second approach entails essentially the same limited government involvement as option one, except it would also allow the government to develop a backstop mechanism to ensure access to credit during a housing crisis. According to the report, this backstop would main-

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tain a minimal presence in the market during normal times, but would be ready to scale up to a larger share of the market as private capital withdraws in times of financial stress.

The administration provides two subset options for this backstop mechanism within the second approach. One would be to price the guarantee fee at a high enough level that it would only be competitive in the absence of private capital and would only expand when dictated by the market. An alternative would restrict the amount of public insurance sold to the private market in normal times, but allow the amount of insurance offered to ramp up to stabilize the market in times of stress.

Option two would give the government the ability to soften a contraction of credit during a crisis, without necessarily taking on all the costs associated with a broad government guarantee during normal times. However, some uncertainty would come with easily the backstop could be scaled in times of crisis. All the benefits of the previous approach would remain, as would the downside of limited access to credit and higher borrowing costs.

Under option three, as in the previous two models, the mortgage market outside of FHA would be placed in the hands of the private sector. However, to increase liquidity and access to mortgages for creditworthy Americans â€" as well as to ensure the government's ability to respond to future crises â€" the government would offer reinsurance for the securities of a targeted range of mortgages.

A group of private mortgage guarantor companies that meet certain capital and oversight requirements would provide guarantees for securities backed by mortgages that meet specific underwriting standards. A government entity would then provide reinsurance to the holders of these securities, which would be paid out only if shareholders of the private mortgage guarantors have been entirely wiped out. The government reinsurer would charge a premium for this reinsurance, which would be used to cover future claims and recoup losses.

This approach would be similar to the FDIC's insurance fund to protect consumers' deposits. The government would be guaranteeing the investment in the securities offered in the event the original guarantor goes under. The guarantor company itself does not benefit from any type of explicit backing except for the fact that investors would feel safer placing their money with them because of the insurance protection offered.

The report says the strength of this approach is that it likely provides the lowest-cost access to mortgage credit of the three options. While mortgage rates would increase due to the cost of the premium and the first-loss position of private capital, the reinsurance will likely attract a larger pool of investors to the mortgage market, increasing liquidity. The administration says it would also provide a more competitive playing field for smaller lenders and community banks, and it would put the government in a position to scale up support in times of distress.

However, this option, too, comes with costs. It increases the risk of artificially inflating the value of housing assets, according to the administration’s report. In addition, the reinsurance of private-lending activity, by its nature, exposes the government and taxpayers to risk and moral hazard.

A copy of the administration’s full 32-page proposal ""can be accessed here"":http://www.treasury.gov/initiatives/Documents/Reforming%20America%27s%20Housing%20Finance%20Market.pdf.