By Annaly Capital Management
The next voice to be heard in the debate on the future of housing finance in the United States will be that of the Treasury Department, which is slated to release its report on the subject sometime this month. Given the sensitive political and economic nature of the topic, the complexity of the problem and the current tenuousness of the housing market, we imagine that Treasury’s contribution will be not so much a shout, more like a polite throat-clearing.
Mortgage-Backed Securities (MBS) investors are an important constituency in the housing finance debate, because since the advent of securitization it is the MBS investor—in particular the Agency MBS investor both here and around the world—who has provided the majority of the capital to the $11 trillion US residential mortgage market. Roughly 70% of American residential mortgages are pooled and held in securitized form by investors of all kinds. When various constituencies discuss how the market will look under the wide range of future potential housing finance paradigms, the MBS investor needs to be at the table, because we are the ones who will price out the MBS relative to competing opportunities in the market, which ultimately drives the pricing of primary mortgage rates.
The core of the debate over housing finance reform is the government’s role in the mortgage market. Right now, that role is significant, largely through the credit guarantee that is wrapped around Agency MBS. Fannie Mae and Freddie Mac, of course, are the most prolific providers of this guarantee (although Ginnie Mae is catching up thanks to the credit crisis), because most of the borrowers in the United States are of the conforming variety. The discussion over the government’s role is often conflated with the history, performance and expense-to-taxpayers of Fannie and Freddie. We can all agree that Fannie and Freddie as business models were seriously flawed—private companies with a public charter, poor incentives for management, excess leverage for their book of credit risk, and so forth—and they are rightly being effigized for it. The former operating models of Fannie and Freddie, particularly their retained portfolios, will likely not survive this exercise (although the effective government backing of their MBS will).
But is government involvement necessary for the housing finance system in the United States? The short answer is no, but this is a complex issue without any short answers. Again, it all comes down to price. There would be consequences to a housing finance system that had no government involvement and, depending on how different the new system is from the current one, these consequences could be significant. In other words, if mortgage rates and house prices were not an issue, the government would never have been involved in housing finance in the first place.
To argue, however, that the US mortgage market doesn’t need government involvement because other countries without a Fannie/Freddie/Ginnie model have similar home-ownership rates and manageable mortgage costs misses some very significant points. First, the mortgage capital stack in the US is unique. Whereas securitization is the largest capital formation tool in housing credit in the US, in Europe bank balance sheets and covered bonds fund most mortgages. Not only isn’t there anywhere near enough bank capital in the US to supplant securitization, it is difficult to conceive that the universe of “rates” buyers will become mortgage credit buyers or move over to covered bonds (which default to the issuing bank’s credit ratings), at least not at the same price levels and in the same size.
Second, the government guarantee is such a powerful advantage for US homeowners looking to buy or refinance a primary residence. The current housing finance system, certainly the one that prevailed until underwriting standards started to slip around 2004, is the most efficient credit delivery system in the world. Securitization allows borrowers of similar creditworthiness using similar mortgage products to receive the benefits of scale in pricing, and the government guarantee to make timely payments of interest and principal scales the process even further. The to-be-announced market is the window through which much of this scale occurs; it levels the playing field for smaller loan originators and community banks and enables lenders to offer longer rate-locks for borrowers. It is what makes possible the very popular 30-year fixed-rate mortgage with a down payment that is manageable for a wide swath of creditworthy borrowers (20%, with or without primary mortgage insurance for a conforming borrower), but also maintains other underwriting standards as well.
Third, and we say this only half in jest, anyone who suggests that a money-center bank, European or otherwise, is not a government-sponsored enterprise hasn’t been reading the papers lately.
Aside from all this, and perhaps most importantly, the price and availability of credit and the value of our housing stock matter a great deal to current and prospective homeowners, the vast majority of whom pay their mortgages on time, take pride in their homes, form the basis of solid communities in America and have already seen their home values fall 25% or more. If one were to ask them to chime in on this issue, our guess is they would want to maintain the best aspects of the current system.
The message from the bond market is loud and clear: We are prepared to fund our neighbors’ homes, in size and at relatively attractive rates, particularly if there is a government wrap involved. Yes, protect the taxpayers by guaranteeing only soundly underwritten mortgages and charging appropriate guarantee fees, and allow for a vibrant and competitive private-label market by carefully defining the conforming box, implementing sensible risk retention rules and setting risk-priced guarantee fees. If policymakers, however, resolve to have no government involvement at all, the bond market will price it out for you, but the likely outcome is a residential mortgage market that is smaller, more expensive, and less liquid.