Principles of Housing Finance Reform: The Imperative of Rebuilding the System

By Susan M. Wachter and Joseph Tracy

In the fall of 2008, the world watched in horror as the U.S. housing finance system shattered, triggering a global financial panic and ultimately the Great Recession. Now, nearly a decade later, the long and slow recovery has reached a critical moment. Though the housing finance system has stabilized, it remains in the hands of the federal government, leaving taxpayers, rather than private capital, largely exposed to the credit risk. Fannie Mae and Freddie Mac—the government-sponsored enterprises (GSEs) responsible for most of the country’s residential mortgage securitization—continue to be held in conservatorship by the Federal Housing Finance Agency (FHFA). Meanwhile, private funding remains mostly on the sidelines, with the source of ongoing financing necessary for sustainable, affordable homeownership still unknown. An eager young generation is unable to access the credit or afford the down payments necessary to successfully transition from renting to owning. This lingering inertia is a critical weakness in the American economy. The system must be rebuilt.

Housing finance reformers have not been short of options. In the wake of the Great Recession, proposals have arisen across the political spectrum, spanning the range from immediate privatization to complete government takeover, center(ing) around four points of consensus.

First, the thirty-year fixed-rate mortgage should remain available as a source of funding for households, correctly priced for risk. This mortgage allows households to own and hedge rent increase risk while also hedging interest rate risk. The mortgage product shifts that risk to capital markets, which are better equipped to manage rate risk than households. This mortgage is also simple to understand and to evaluate in terms of the household’s ability to pay. To ensure this, the to-be-announced (TBA) market, is necessary to ensure a liquid secondary outlet, without which originators would be far less willing to issue this type of loan. This liquid secondary outlet helps to keep this mortgage affordable.

Second, borrowers followed by private capital must take the first losses when mortgages default. Market discipline is necessary to prevent borrowers, originators, and MBS investors from taking excessive risks. Equally important, however, is government support for catastrophic losses that the private market cannot sustain without total collapse. In contrast to the past, this support should be priced going forward.

Third, securitization must operate in daylight with some form of standardization—on a common, transparent platform where investors and regulators can obtain information for pricing. All participants must understand the risks involved in securitization, unlike the information asymmetries that allowed underpriced credit to fuel the latest housing bubble.

Fourth, the government should not abandon its policy of encouraging affordable housing by simply leaving the free market to its own devices. Across the country, rapidly rising rents and tightened underwriting standards have combined to make the cost of housing a significant strain on the budgets of an American middle class that is already suffering from decades of income stagnation and is still struggling to deleverage. However, government efforts to support affordable mortgages must also ensure that they are sustainable.

These principles must be implemented through a newly structured system that is sustainable with fundamental restructuring for stability. To this end, the authors in this book present proposals for long-term structural reforms. Each chapter suggests reforms that would infuse new life into our housing finance system as well as providing long-term stability.

Susan M. Wachter is Co-Director of Penn IUR and Albert Sussman Professor of Real Estate, Professor of Finance, the Wharton School. Joseph Tracy is Executive Vice President and Senior Advisor to the President, Federal Reserve Bank of NY. This article is adapted from the authors' new book, Principles of Housing Finance Reform.