[Senate Hearing 112-339]
[From the U.S. Government Publishing Office]
S. Hrg. 112-339
HOUSING FINANCE REFORM: CONTINUATION OF THE 30-YEAR FIXED-RATE MORTGAGE
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HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
EXAMINING THE PROS AND CONS OF CONTINUING THE 30-YEAR FIXED-RATE
MORTGAGE
__________
THURSDAY, OCTOBER 20, 2011
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.fdsys.gov /
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Charles Yi, Chief Counsel
Erin Barry Fuhrer, Professional Staff Member
William Fields, Legislative Assistant
Andrew Olmem, Republican Chief Counsel
Chad Davis, Republican Professional Staff Member
Dawn Ratliff, Chief Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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THURSDAY, OCTOBER 20, 2011
Page
Opening statement of Chairman Johnson............................ 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 2
WITNESSES
Janis Bowdler, Director, Wealth-Building Policy Project, Office
of Research, Advocacy, and Legislation, National Council of La
Raza........................................................... 3
Prepared statement........................................... 25
Response to written question of:
Senator Shelby........................................... 67
John Fenton, President and CEO, Affinity Federal Credit Union, on
behalf of the National Association of Federal Credit Unions.... 5
Prepared statement........................................... 31
Anthony B. Sanders, Ph.D., Distinguished Professor of Finance,
George Mason School of Management.............................. 7
Prepared statement........................................... 39
Response to written question of:
Senator Shelby........................................... 68
Paul S. Willen, Ph.D., Senior Economist and Policy Advisor,
Federal Reserve Bank of Boston................................. 8
Prepared statement........................................... 45
Response to written questions of:
Senator Shelby........................................... 69
Susan E. Woodward, Ph.D., President, Sand Hill Econometrics...... 10
Prepared statement........................................... 47
Response to written question of:
Senator Shelby........................................... 69
HOUSING FINANCE REFORM: CONTINUATION OF THE 30-YEAR FIXED-RATE MORTGAGE
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THURSDAY, OCTOBER 20, 2011
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:02 a.m. in room SD-538, Dirksen
Senate Office Building, Hon. Tim Johnson, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN TIM JOHNSON
Chairman Johnson. I call this hearing to order.
I would like to thank our witnesses for being with us
today. This will be the 11th housing finance reform hearing
held by the Committee. Before we began our series of hearings,
I released my agenda for the Committee which included several
priorities for housing finance reform. Maintaining the widely
available 30-year, fixed-rate, prepayable mortgage was one of
those priorities.
I firmly believe that we need to reform our housing finance
system, but I am concerned about the unintended consequences
for our housing market and economy that could result. A new
system that eliminates the most popular and stable mortgage
product in the country would be a step backwards rather than an
improvement to our housing market.
Let me be clear. I am not advocating that the 30-year
fixed-rate mortgage be the only product available. Shorter-term
fixed-rate loans, like the 15-year or 20-year mortgage, can be
appropriate for certain borrowers or families refinancing their
mortgages. Well-underwritten, conventional, adjustable-rate
mortgages can also be appropriate for borrowers who can afford
them. However, any new housing finance system must ensure that
the 30-year fixed-rate mortgage continue to be widely available
to qualified borrowers across the country.
The prepayable, long-term fixed-rate mortgage allows
households to budget their finances better and establishes a
stable housing cost which is not always available by renting.
Homeownership is not the right choice for everyone, but for
those who choose to own a home, the 30-year fixed-rate mortgage
is the most predictable option for financing a home.
Witness testimony during our last hearing stated that under
some proposed systems, the 30-year fixed-rate mortgage would
likely require substantial downpayments, higher incomes, and
higher interest rates, restricting the number of borrowers to a
substantially small number compared to today. This is the last
thing our housing recovery needs.
Our witnesses have extensive experience and knowledge about
the impact the 30-year fixed-rate mortgage has had on
homeowners, the mortgage market, and the economy. I look
forward to hearing their testimony regarding its merits and
risks as well as the options for Congress if we are to continue
what I believe is a necessary product.
With that, I will turn to Senator Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman.
Today's hearing, as you said, will examine the pros and
cons of the Federal Government continuing basically to
subsidize the 30-year fixed-rate mortgage. During the Great
Depression, the Federal Government established direct and
indirect subsidies for 30-year fixed-rate mortgages. For many
Americans, the 30-year fixed-rate mortgage has made
homeownership possible, yet the failure of Fannie and Freddie
and the $169 bailout of those institutions demonstrate that the
Federal Government's support for the 30-year mortgage comes
with a cost.
Accordingly, if this Committee ever decides to undertake
housing finance reform, it will need to determine whether the
benefits of the Government's support for the 30-year fixed-rate
mortgage outweigh the costs. In addition, if it decides to
continue to subsidize the 30-year fixed-rate mortgage, the
Committee will need to find a way to protect taxpayers from
having to pay for bailouts in the future.
Today's hearing should provide some insight into how the
Federal Government's support for the 30-year fixed-rate
mortgage impacts consumers and taxpayers. For example, is the
30-year fixed-rate mortgage always the best option for
consumers? Is the prepayment option included in these 30-year
fixed-rate mortgages truly free? And what has the subsidy of
this product already cost the American taxpayer? And can this
product be offered without that subsidy?
Consumer choice I think is very important. Consumers should
be able to purchase a 30-year fixed-rate mortgage at the
appropriate market rate if they determine that that product is
best for them. I think we must not create incentives that
should push people toward a 30-year fixed-rate mortgage even
when it would be harmful to them.
I also hope to learn from today's hearing how subsidizing
the 30-year fixed-rate mortgage impacts our financial system.
For instance, is the claim that the financial crisis could have
been averted if only more people possessed the 30-year fixed-
rate mortgage a fact or fiction? What unintended consequences
have been created by subsidizing the 30-year fixed-rate
mortgage?
These are all important questions, and there are many more
that I think need to be answered as we go along. For many
people it is assumed that the narrative surrounding the 30-year
fixed-rate mortgage has already been written and that there is
no need to investigate the facts. As we proceed with housing
finance reform, I think we must seek a full understanding of
the facts. In other words, legislating by anecdote is not
acceptable.
We need to take a hard look at this product and determine
if the preferential pricing resulting from these subsidies
truly creates a public good. Only by doing a thorough, fact-
based analysis can we develop sensible, profound housing
policy.
Thank you, Mr. Chairman.
Chairman Johnson. Thank you, Senator Shelby.
Are there any other Members who wish to make a brief
opening statement?
[No response.]
Chairman Johnson. Thank you all.
I want to remind my colleagues that the record will be open
for the next 7 days for opening statements and any other
materials you would like to submit.
Now I would like to welcome the witnesses for our panel
today. Our first witness is Ms. Janis Bowdler. She is the
Director of the Wealth-Building Policy Project with the
National Council of La Raza.
Mr. John Fenton is President and CEO of Affinity Federal
Credit Union and is appearing on behalf of the National
Association of Federal Credit Unions.
Dr. Anthony Sanders is a Professor of Finance at George
Mason University School of Management.
Dr. Paul Willen is Senior Economist and Policy Advisor with
the Federal Reserve Bank of Boston.
And, finally, we have Dr. Susan Woodward, who is the
President of Sand Hill Econometrics and the former Chief
Economist at the SEC and prior to that HUD.
We welcome you all here today and thank you for your time.
Ms. Bowdler, you may proceed with your testimony.
STATEMENT OF JANIS BOWDLER, DIRECTOR, WEALTH-BUILDING POLICY
PROJECT, OFFICE OF RESEARCH, ADVOCACY, AND LEGISLATION,
NATIONAL COUNCIL OF LA RAZA
Ms. Bowdler. Thank you and good morning, and thank you for
having me. My name is Janis Bowdler. I am the Director of the
Wealth-Building Policy Project at the National Council of La
Raza. My project promotes fair markets where Latino families
can obtain assets and build wealth they can share with their
children. I hope that today's hearing will shed light on a
critical issue: the importance of the 30-year fixed-rate
mortgage. Without this flexible financing tool, homeownership
would become a luxury reserved for the affluent. We urge
Congress not to abandon their commitment to providing a path to
homeownership, which has long been the cornerstone of middle-
class wealth.
This morning I will provide a brief overview of the
importance of the 30-year fixed-rate mortgage. I will also
share our ideas on how to maintain a responsible path to
homeownership for future generations. Let me start with the
benefits of the 30-year fixed.
The long term makes the asset more affordable. The fixed
rate provides certainty. Modest downpayments open the door for
those with sufficient incomes but who lack the family wealth.
The amortization feature means the borrower can predict the
final payment and build wealth as principal is repaid. Finally,
most prime 30-year fixed-rate notes are prepayable, which means
that the borrower can refinance or sell without penalty.
In sum, there are two key reasons why supporting the 30-
year fixed-rate mortgage is good public policy. It makes
homeownership affordable to working- and middle-class families
who did not inherit wealth, and it provides stability to
families who have to budget carefully to keep their biggest
asset and investment--their home. Together, these features have
helped create a stronger middle class. This is especially true
for Hispanic and black homeowners for whom home equity makes up
the majority of their wealth.
Unfortunately, the benefits of homeownership have not been
equally available. An abundance of research has documented the
unfair steering of borrowers of color to toxic mortgages, even
when they qualified for prime loans. The subprime loans are not
only expensive, they are also more likely to end up in default.
So it is not surprising that Latinos have been hit hard by the
foreclosure crisis. In fact, new data shows that wealth held in
white households exceeds that of Latinos by a staggering 18:1,
and 20:1 for African Americans. This gap is attributed to
differences in home equity and the loss of homes through
foreclosure.
Critics of the 30-year fixed note will argue that families
would be better off in adjustable mortgages. However, most
families do not view their home as a get-rich-quick scheme.
They do not play the markets and they do not hedge interest
rate risk. Rather, they are investing in a nest egg and a
community with the anticipation of long-term returns. The
predictability and security of a 30-year fixed-rate mortgage
helps them meet those goals.
Of course, no one is suggesting that a family enter
homeownership unprepared, and we definitely need a robust
rental market for families for whom homeownership is not
available or desirable. That said, now is not the time to
abandon our commitment to putting ownership in reach of
qualified families when it is their time. Several decades of
innovative, affordable lending has taught us how to reduce the
risk of lending to new buyers and low-wealth households.
For example, in a recent comparison of like borrowers where
the only difference was the kind of loan they received, an
affordable 30-year versus a subprime loan, the 30-year fixed
dramatically outperformed the subprime loan. This reflects our
own experience with first-time homebuyers. Over the last 13
years, NCLR Homeownership Network counselors have helped more
than 25,000 moderate-income families purchase a home with a
prime mortgage. This evidence shows that when families receive
the right loan with the right support, they can be successful
homeowners and build wealth, even with modest incomes and low
downpayments.
Unfortunately, tight credit standards, pricing adjustments
by the GSEs, and overlays on FHA are limiting prime loans in
the market today and preventing qualified families from taking
advantage of low rates and home prices. However, it is the
threat to the future of affordable lending that has us most
concerned. Earlier this year, Federal bank regulators promoted
the idea of a wealth standard that would cement high
downpayment requirements and regulations, and critics of Fannie
and Freddie are going further by pushing for a complete
dismantling of our current secondary market system, even though
lenders, especially small community lenders, say they would not
be able to offer a fully amortizing 30-year loan in a
completely private system.
Rather than dismiss a proven finance tool and affordability
features, we should work together to preserve those aspects of
our housing finance system that work well. I have attached to
my written statement a set of principles to guide our thinking
on GSE reform. It is signed by NCLR and 16 other civil rights
organizations. In addition to the principles laid out in that
letter, I offer three specific recommendations today:
Maintain secondary market liquidity for affordable 30-year
fixed-rate loans that are made equally available to all
qualified families;
Support pre-purchase housing counseling and other credit
enhancements that we know work for working families;
And reduce barriers to purchasing a home by eliminating
loan level pricing adjustments and expanding the use of proven
affordable lending models.
Thank you, and I would be happy to answer any questions.
Chairman Johnson. Thank you.
Mr. Fenton, you may proceed.
STATEMENT OF JOHN FENTON, PRESIDENT AND CEO, AFFINITY FEDERAL
CREDIT UNION, ON BEHALF OF THE NATIONAL ASSOCIATION OF FEDERAL
CREDIT UNIONS
Mr. Fenton. Good morning, Chairman Johnson, Ranking Member
Shelby, and Members of the Committee. My name is John Fenton,
and I am testifying today on behalf of NAFCU. We appreciate the
opportunity to share our views on housing finance reform and
the value of the 30-year fixed-rate mortgage to credit unions
and our members.
Credit unions were not the cause of the recent economic
crisis, and an examination of their lending data indicates that
credit union mortgage lending has outperformed bank mortgage
lending during the downturn. Credit unions focused on placing
their members in solid products that they could afford.
Furthermore, there is no evidence that the recession and
collapse of the housing market was due to the presence of 30-
year fixed-rate mortgages. Congress gave credit unions the
authority to offer 30-year mortgages back in 1977, and it has
since been our dominant instrument in mortgage originations.
The fixed-rate mortgage is regarded as a consumer-friendly
instrument because it is straightforward, easy to understand,
and provides a predictable monthly payment schedule. With a
fixed-rate mortgage, the lending institution assumes the risk
associated with interest rate risk increases. Having too many
long-term fixed-rate mortgages in the portfolio subjects the
financial institution to greater interest rate risk and can be
cause for examiner concern. At Affinity we mitigate risk in our
long-term fixed-rate mortgage portfolio by hedging with
interest rate swaps, caps, and matched borrowings. Selling on
the secondary market to Fannie and Freddie is also an important
risk mitigation tool. The securitization activities of Fannie
and Freddie help lower the relative cost of 30-year fixed-rate
mortgages and are an important factor in its viability.
Without a Government role in the secondary market, the 30-
year fixed-rate mortgage may still exist, but likely with
higher cost to the consumer and scarce availability. Long-term
fixed-rate mortgages will become riskier propositions for
credit unions. For safety and soundness reasons, consumers may
face additional costs to mitigate risk. The lack of a
Government role as a stabilizing force in the secondary market
would have a significant impact on the ability of credit unions
to offer affordable, consumer-friendly mortgages such as the
30-year fixed-rate mortgage. We believe that it would further
limit the availability of long-term fixed-rate mortgage
products and substantially increase the costs of mortgages to
consumers.
Fannie and Freddie, as well as the Federal home loan banks,
are valuable partners for credit unions who seek to hedge
against the interest rate risks by selling their fixed-rate
mortgages to them on the secondary market. Because Fannie and
Freddie will buy loans on the secondary market, the credit
union is not only able to mitigate the risks associated with
these interest rates, but the liquidity created allows them to
reinvest those funds into their membership or institution by
making new loans. Without these relationships, credit unions
would be unable to provide the services and financial products
that their memberships demand and expect.
NAFCU would like to stress the importance of retaining a
system that provides credit unions with access to the secondary
market necessary to serve the mortgage needs of our 93 million
members. As you consider legislative proposals for housing
finance reform, we believe there is a core set of principles
that must be considered to ensure that credit unions are
treated fairly.
One, a healthy and viable secondary market must be
maintained.
Two, there should be at least two GSE-type entities to
ensure competition and to perform the essential functions
currently performed by Fannie and Freddie.
The U.S. Government should issue explicit guarantees on the
payment of principal and interest on mortgage-backed
securities.
Four, during any transition to a new system, credit unions
must have uninterrupted access to the GSEs and, in turn, to the
secondary market.
Five, credit unions could support a model for the GSEs that
is consistent with a cooperative or a mutual entities model.
Six, a board of advisors should be formed to advise the
FHFA regarding GSEs.
Seven, while a central role for the U.S. Government in the
secondary market is vital, the GSEs should be self-funded. GSE
fee structures should place increased emphasis on quality of
loans. Risk-based pricing for loan purchases should reflect
that quality difference.
Eight, Fannie and Freddie should continue to function,
until such time as necessary to repay the Government debts.
And, ten, reform of the Nation's housing finance system
must take into account the consequence of any legislation on
the health and reliability of the Federal home loan banks.
In conclusion, the 30-year fixed-rate mortgage remains the
most popular mortgage product to credit union members today. As
such, it is necessary for the health of the housing market and
the continued recovery of our economy that it remains a readily
available product. The ability of credit unions to make these
loans and to mitigate the interest rate risk by selling them to
GSEs on the secondary market is important. With efforts to
reform the Nation's housing finance system, it is important to
consider the impact reforms may have on credit unions and make
sure that they maintain access to a viable secondary market.
We thank you for your time and the opportunity to testify
before you here today, and I would welcome any questions you
have.
Chairman Johnson. Thank you.
Dr. Sanders, you may proceed.
STATEMENT OF ANTHONY B. SANDERS, Ph.D., DISTINGUISHED PROFESSOR
OF FINANCE, GEORGE MASON UNIVERSITY SCHOOL OF MANAGEMENT
Mr. Sanders. Mr. Chairman and distinguished Members of the
Committee, my name is Dr. Anthony B. Sanders, and I am the
Distinguished Professor of Finance at George Mason University
and a senior scholar at the Mercatus Center. It is an honor to
testify before this Committee today.
The fixed-rate mortgage occupies a central role in the U.S.
housing finance system. The dominant instrument since the Great
Depression, the FRM currently accounts for more than 90 percent
of mortgage originations. One reason why it enjoys enduring
popularity is that the FRM is a consumer-friendly instrument.
Not only does the FRM offer payment stability, the instrument
provides a one-sided bet in the borrower's favor. If rates
rise, the borrower benefits from a below-market interest rate.
If rates fall, the borrower can benefit from exercising the
prepayment option in the FRM to lower their mortgage interest
rate.
But these consumer benefits have costs. It is costly to
provide a fixed nominal interest rate for as long as 30 years.
And the prepayment option creates significant costs. If rates
rise, the lender has a below-market rate asset on its books. If
rates fall, the lender again loses as the mortgage is replaced
by another one at a lower interest rate. To compensate for this
risk, lenders incorporate a premium in mortgage rates that all
borrowers pay regardless of whether they benefit from a
refinance or not. Exercise of the prepayment option in the
contract also has significant transactions costs for the
borrower and imposes additional operating costs for the
mortgage industry.
The adjustable-rate mortgage, or ARM, and shorter-maturity
mortgages also have consumer-friendly benefits that are often
overlooked. Banks, S&Ls, and other lenders will originate and
hold 30-year fixed-rate mortgages even without the Government
guarantee, just like they have done in previous years. This may
be a short-term effect if some claim they cannot do this simply
because Freddie Mac, Fannie Mae, and the FHA have cornered the
mortgage market.
Second, we are the only country in the world with such a
high 30-year fixed-rate concentration and Government housing
mortgage subsidies. Most countries have higher percentages of
shorter-maturity mortgages and ARMs than the United States and
did not suffer the magnitude of the housing bubble burst that
the United States experienced.
Third, the U.S. homeownership rate is comparable to that of
other countries that have higher ARM and short-maturity
mortgages, so there is nothing magical about the 30-year fixed-
rate mortgage and homeownership.
Fourth, ARM rates such as 5/1 ARMs are typically less
expensive to consumers than fixed-rate mortgages, generally
from 100 to 150 basis points.
Fifth, all 30-year fixed-rate mortgage borrowers pay for
the prepayment option even if they do not use it. Why not give
consumers a choice of a less expensive non-prepayable mortgage
that carries a lower rate of interest or a mortgage with
refinancing penalties, again, resulting in a lower mortgage
interest rate for consumers?
Sixth, the 30-year fixed-rate mortgage, which has a 95-
percent market share, is risky for consumers since the
principal pays down so slowly, small house price declines
coupled with low downpayments put the borrowers into a
stressful negative equity position, often very quickly. Should
we be promoting 10- and 15-year mortgages instead, or 7? The
30-year fixed-rate mortgage leads to consumption of larger
housing compared with 15-year mortgages since the payments are
reduced via slower principal amortization. Is that our public
policy objective, to put households in the biggest houses they
can afford?
Eight, ARMs actually are consumer friendly in that by
sharing the interest rate risk with lenders and investors,
borrowers will be more careful about taking on more debt; that
is, buying too much house even if the underwriting allows them
to.
Ninth, if we examine FHFA's 2001-02 enterprise loan
acquisitions, we find that ARMs actually had lower default
rates than fixed-rate mortgages.
And, tenth, please bear this in mind. Homeowners, according
to the Federal Reserve, lost $7.25 trillion from the peak of
the housing bubble. Can we afford to do this again? Should we
be putting everybody into low downpayment, 30-year, slow
amortization mortgages which are catastrophic to those
households if the market tanks again?
I understand why some consumers like the comfort of the
fixed mortgage payments where they can prepay and lower their
mortgage payment at will, but comfort comes at a cost in terms
of higher mortgage rates and costs to taxpayers.
On the other hand, I do not equate Government policy
encouraging households to buy larger houses and take on greater
risk that they can afford as consumer friendly.
Thank you for the opportunity to testify.
Chairman Johnson. Thank you.
Dr. Willen, you may proceed.
STATEMENT OF PAUL S. WILLEN, Ph.D., SENIOR ECONOMIST AND POLICY
ADVISOR, FEDERAL RESERVE BANK OF BOSTON
Mr. Willen. Thank you. Chairman Johnson, Ranking Member
Shelby, and distinguished Members of the Committee, I thank you
for your invitation to testify today. My name is Paul Willen,
and I am a senior economist and policy advisor at the Federal
Reserve Bank of Boston. I come to you today, however, as a
researcher and not as a representative of either the Boston Fed
or the Board of Governors.
What I am going to take on today in my spoken remarks is a
kind of conventional wisdom about the fixed-rate mortgage, and
it starts with the invention of the fixed-rate mortgage, which
is widely attributed to the FHA. The conventional wisdom is
that in the 1930s most--prior to the 1930s, prior to the
Depression, most American families or almost all of them had
short-term variable-rate mortgages. These mortgages exposed
them to volatile payments and caused massive disruptions during
the Depression. And so the FHA, the conventional wisdom says,
in order to solve this problem invented a new type of mortgage,
which was the long-term fixed-rate mortgage. And the point of
it was that the payment the borrower made never changed until
the loan was paid off. Month in, month out, the borrower was
never vulnerable to payment shock. And I think the conventional
wisdom sort of views the fixed-rate mortgage as a sort of
safety mortgage, sort of like the safety elevator came along.
Before the safety elevator, if the cable in an elevator
snapped, the passengers plunged hundreds of feet to certain
death, and the safety mortgage took something that was very
risky, like the previous elevators, and replaced it with
something that was sort of inherently safe.
The conventional wisdom goes on to say that in the 2000s
lenders forgot the lessons of the 1930s and started issuing
complex, exotic, adjustable-rate mortgages. Borrowers were hit
with these payment shocks, and the critical number of these
payment shocks is what caused the crisis. So I am going to take
on this conventional wisdom and argue that these basic premises
do not fit the facts.
The first thing is the long-term fixed-rate mortgage was
not invented in the 1930s by FHA. It was invented 100 years
earlier by building and loan societies, and building and loan
societies were not some niche player in the housing market.
They were the single largest source of funding for the typical
American family when they got a mortgage. They were widely
used, and in 1929, the year immediately preceding the
Depression, when they were supposedly invented, 40 percent by
dollar value and a much higher number in number of the
mortgages originated were originated by building and loan
societies, and 95 percent of those originations were long-term,
fixed-rate, fully amortizing mortgages. You can see it is in
Table 2 in my prepared testimony. Despite offering only long-
term fixed-rate mortgages, building and loan societies were
devastated by foreclosures during the Depression.
In the recent crisis, you say, well, maybe it was not an
issue in the Depression, what about the most recent crisis,
wasn't that cause by payment shocks and adjustable rate
mortgages? So in Table 1 of my prepared testimony, I show some
data that we put together, but everyone who has looked at the
individual level data, who has looked at it, the mortgage level
data or property level data, has come to the same conclusion.
Our sample is a sample of 2.6 million foreclosures, so these
are all borrowers who lost their home, and what we show is that
88 percent of them suffered no payment shock prior to
defaulting on their mortgage. The mortgage payment they made
when they defaulted on the loan was exactly the same as the
payment they made when they got the loan, the initial payment
on their mortgage. In fact, of that sample, 59 percent of them
actually had fixed-rate mortgages. That is something like 1.6
million mortgages. That alone should disabuse us of any notion
that a fixed-rate mortgage is an inherently safe product.
OK. So let me just conclude by saying that when owning a
home financed by a mortgage, a family faces many risks. There
is job loss. There is illness. There is business failure. There
is divorce. And what we have learned recently, the most
important one of all, there is falling house prices. What our
research has shown over and over again is that, compared to
those risks, fluctuating mortgage payments present a small
problem. So let me just say that the benefits in terms of
foreclosure prevention of ensuring availability of a mortgage
with a payment that can never go up in my opinion is very
small.
Let me say I hope you find that these findings add insight
to your work as policymakers, and thank you again for the
opportunity to appear today. I would be happy to address any
questions.
Chairman Johnson. Thank you.
Dr. Woodward, you may proceed.
STATEMENT OF SUSAN E. WOODWARD, Ph.D., PRESIDENT, SAND HILL
ECONOMETRICS
Ms. Woodward. Senators and Committee staff, I am honored to
be invited to share my views with you. Thank you so much for
inviting me.
I am Susan Woodward. I am here representing myself. I am an
independent economist now, but I lived for 10 years in
Washington and served 4 years as Chief Economist at HUD and
another 4 years as Chief Economist at the Securities and
Exchange Commission.
The critics of the 30-year fixed-rate loan claim that it is
unfair for homeowners to benefit from the risk avoided by
fixed-rate loans while taxpayers bear the risk from it. I think
what this claim forgets is that taxpayers are homeowners, too.
If we consider the lifetime exposure of homeowner/taxpayers,
there is nothing unfair about this tradeoff. In fact, I think
it is a really important piece of social policy. But let me
offer first a few facts.
While the homeownership rate now stands between 65 and 70
percent, the fraction of households that eventually become
homeowners at some point in their lives is more like 85
percent.
Second, household incomes rise over time and peak at about
age 55.
Third, homeowning households on average have higher incomes
and pay more taxes than others. Thus, the people who benefit
from the availability of a 30-year fixed-rate loan are also the
same people who pay taxes if and when problems arise. The
benefits come when families are young and have more need for
security, and the same people potentially bear a cost when they
are older and have more income. This is a fair tradeoff. Ask
the taxpayer/home-owners. Tell them what the deal is. My guess
is all of them will say, yes, we want the 30-year fixed to be
available.
And we should not forget the risk of adjustable-rate loans.
This has been downplayed so far, but in the current
environment, I think there is some considerable risk. The ARM
design is basically flawed because it does not link payment
changes to household income changes. To take an example based
on numbers that are relevant to today, suppose the rate of
inflation picked up from, say, 2 percent to 4 percent, moving
the homeowners rate from 4 percent to 6 percent, the likely
change in the homeowner's income is the current inflation rate
of about 4 percent. But the borrower's payment on a young-ish
mortgage will rise about 25 percent. Only affluent households
with a lot of room to maneuver can tolerate this level of cash-
flow uncertainty. And it was mostly affluent households that
prior to this financial crisis had the adjustable-rate loans.
ARMs threaten the economy, too. The recession of 1980-82
would have been far worse with far higher levels of mortgage
defaults and an even bigger collapse in economic activity if
all borrowers had had ARM loans then. That is my first point.
Yes, the 30-year fixed-rate loan has some risk of potential
cost to taxpayers, but since taxpayers are virtually all
homeowners also, there is nothing unfair about this tradeoff.
OK. The second issue, do we need Government support for the
30-year fixed? I believe that the answer is yes, that it helps.
The two most important innovations in financial markets in the
20th century were undertaken by the Federal Government. The
first was FHA's support for long-term, amortizing, fixed-rate,
and prepayable loans. Now, Paul and I have discussed this
before the hearing, exactly what FHA's role was. It made the
amortization baked in and more precisely scheduled, not tied to
ownership of shares in building and loan societies. And it also
pooled the default risk nationwide through the FHA insurance
fund. And so borrowers really were better off, and banks were
better off, too, because they were much more comfortable making
these loans than with the situation that we had before. So it
was a huge innovation, and it improved the stability of housing
finance and the quality of life for households, too.
The second big innovation was Ginnie Mae. Ginnie was and is
an astounding success. Ginnie Mae's role is to package already
insured FHA loans into traded securities. When Ginnie was
introduced, FHA borrowing rates fell 70 basis points. With a
long-term real mortgage rate of about 4 percent, that is a big
number.
What is more, I believe that there is no cost to taxpayers
from Ginnie Mae. This was all entirely already insured FHA
Loans, and what this was was an improved packaging of them.
And so at the end of the day, we are not going to have
institutions like Ginnie or Fannie and Freddie without some
Government push, especially now when the large banks have such
better access to the capital markets than the smaller lenders
do. If we are going to give the smaller lenders that access
also, and I believe there are many reasons that we should, then
we should have a continued role of the Federal Government in
the market.
Thank you.
Chairman Johnson. Thank you.
Dr. Woodward, what elements of today's housing finance
market must be preserved to ensure the availability of the 30-
year fixed-rate mortgage for borrowers in rural areas like
those in my State of South Dakota?
Ms. Woodward. I think that the really essential function if
Ginnie Mae, Fannie, and Freddie is to be able to turn illiquid
whole loans into liquid securities through an entity like them.
Chairman Johnson. Dr. Willen, in the past 4 years, we have
seen a major dip in the origination of adjustable-rate
mortgages as the credit markets dried up and an increase in
percentage of 30-year fixed-rate products. If the 30-year
fixed-rate mortgage were eliminated, how would the availability
of credit to average Americans change in times of economic
turmoil?
Mr. Willen. Well, I think there are two separate questions
here. Again, I think we need to make sure, I think in all these
conversations, that we separate out what it is--the 30-year
fixed-rate mortgage, really what we are here discussing I think
is the fixed-rate part of it. I think there is an issue. What
happened in the last 4 years, when the mortgage market
collapsed in 2008, is that every part of the mortgage market
collapsed, including the Government-insured part of it,
including Fannie and Freddie. And so if Fannie and Freddie had
been doing--or if the mortgage market--if the Government was
going to intervene to back up the market, they could have just
as well intervened to back up the adjustable-rate market. The
point was that the portion of the market that we intervened to
help was the fixed-rate part of the market, and that is why the
fixed-rate part of the market was the part that survived. So,
for example, when the Federal Reserve engaged in large-scale
asset purchases, we almost exclusively bought mortgage-backed
securities backed by fixed-rate products.
Chairman Johnson. Ms. Bowdler, I have a question for you
about eliminating the Government guarantee. How would the
absence of a Government guarantee affect the availability of
the 30-year fixed-rate, prepayable mortgage? How would this
ultimately affect the average American borrower?
Ms. Bowdler. Our understanding, from having talked to a lot
of lenders, is that without that guarantee they would not only
offer--they would not offer 30-year fixed-rate mortgages, and
they would not be able to offer long-term financing at rates
that the average person can afford. And so, yes, some sort of
financing may continue to exist without the next generation of
Fannie and Freddie, but it would not be for the average middle-
class family. It would only be for families that have large
amounts of inherited wealth that they can put toward
downpayment or that they can use to ride out interest rate
shock.
Chairman Johnson. Dr. Woodward, in your research what
skills do borrowers need to have to evaluate the risks of
adjustable-rate mortgages or understand how their interest
rates would adjust?
Ms. Woodward. They need at least an MBA. I think it cannot
be even 1 percent of households that really understand the
interest rates that are behind ARMs, the London Interbank
Borrowing Rate, even the 1-year Treasury rate, I had a friend's
panicked daughter come to me in 2007 because she could not
refinance her ARM. And so I looked at her loan documents, and
her ARM was tied to the 12-month moving average of 1-year
Treasurys. I know exactly where to look up this number. It is a
fairly benign ARM index. But she was completely panicked. She
had no idea to what rate her loan might reset. Once I told her
what it was going to look like, then she calmed down, and she
just let the ARM reset. It was fine. But I think that almost no
households really understand the interest rates to which their
ARMs are linked.
Finance is hard. People have to stay in school a long time
to learn finance
Chairman Johnson. Mr. Fenton, what are the characteristics
of the borrowers that come to your institution and request 30-
year fixed-rate mortgages? Why is that product so popular?
Mr. Fenton. The characteristics are very diverse. We have
all different segments of the community come in to borrow, and
the product itself is important at different times. You have to
offer members choice. They have all different levels of credit
backgrounds and understanding of the products that are out
there. But the key to it is to understand that in a time of low
interest rates you need to be able to support a product like a
30-year fixed-rate mortgage, and in times of rising interest
rates you might look at a different type of product. And in our
case, we evaluate each member as they come in based on their
needs and what is the best product for them.
Chairman Johnson. Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Dr. Sanders, a central argument made by some advocates for
the continuation of the Federal guarantee of mortgages is that
without the guarantee the 30-year fixed-rate mortgage would not
be available to consumers. For the moment, if we could just set
aside the question of whether the 30-year mortgage is always
the best product for consumers and go to this: Based on your
research, if a consumer desires this product, would it be
available even if there is not a Federal guarantee? Just
anecdotally, I can go back to myself many years back, and I
bought a house. It was a conventional 30-year mortgage from an
insurance company. There was no Federal guarantee involved. The
Federal Government was not involved. We had to come up with a
pretty healthy downpayment, but that is what we wanted to do.
Elaborate.
Mr. Sanders. Well, again, like yourself, my experience has
been I have had home loans, both ARMs and fixed-rate mortgages
from S&Ls and banks, and they were never touched by Fannie and
Freddie. So the answer is that once we get out of this rut we
are in, they will start making loans again. The problem we have
now is since Fannie, Freddie, and FHA have such a dominant
presence in the securitization market, and as Mr. Willen has
pointed out, one of the key things of our various bailouts is
that we bailed out the 30-year fixed and not the ARM, so we de
facto have made it the contract of choice in the United States.
So we kind of undercut the private sector so that they do not
want to hold the interest rate risk.
And, by the way, just to follow up on something, everyone
here is mentioning the fact that there is interest rate risk
associated with a 30-year fixed, but they are more than willing
to dump them on the taxpayers and Fannie and Freddie because
they do not want to be touched by the--and I understand it, but
we should be forcing consumers to bear a part of that risk as
opposed to having somebody in Keokuk, Iowa, suddenly get hit
with a higher tax bill because somebody had a fixed-rate
mortgage that went underwater again. But it will come back.
Senator Shelby. The prepayment option, in your testimony
you discuss how borrowers who have a 30-year fixed-rate
mortgage with a so-called free prepayment option are, in fact,
paying for that option whether or not they realize it or not.
Explain what you mean.
Mr. Sanders. Well, in other countries they actually have
non-prepayable mortgages. You sign up, and unless you move or
sell the house or some other form of termination, you are stuck
with the interest rate you get. And if we compare in other
countries the non-prepayable mortgages with a prepayable one,
there is a substantial difference in interest rates. It can be
anywhere from 30 to 70 basis points. So, in other words, we
could help consumers out by actually offering them a non-
prepayable mortgage, and it would actually cut their expenses.
ARMs are cheaper, 15-fixed are cheaper. I do not know why we
are bent on the most expensive of the contracts to give
consumers. To help them?
Senator Shelby. I do agree with the economist here that a
lot of consumers do not understand the adjustable-rate
mortgage. What can we do to make them understand? Can we be
more explicit in their terms when they are buying a house or
making a loan and say, ``look, you are paying X today, but this
could go up, it might go down,'' you know, rather than just
``sign here, sign here''? A lot of them do not understand, and
they are not that sophisticated. A lot of them are very
sophisticated.
Mr. Sanders. Two issues. We discussed this at one of the
Wharton mortgage conferences where we said it was very simple
to have a simple cover sheet, like we do in securities, where
we have a risk page, saying that--in fact, we sort of do have
this, but saying here is your current rate, and it will be
fixed for this amount of time, and at the end of that time it
goes up to whatever LIBOR plus some spread, have that laid out
explicitly, and I know Susan is going to kick me after this
thing is over, but I just want to point out one thing. If a
consumer sees something and it has terminology like LIBOR in
the contract and they have no idea what it is, why did you sign
it? I would suggest a little research by consumers to help
themselves to look into these things.
And, again, I think--and Susan actually clarified this
quite nicely. It is much more benign than we are making it
sound. LIBOR-indexed ARMs are not a problem. But, again, we
could make it more clear perhaps. But that is not because of
the problem in the country.
Senator Shelby. Dr. Willen, I want to direct this to you,
if I could. I want to say this. Dr. Woodward states, quoting
her, ``The 30-year fixed-rate loan is unquestionably easier for
households to understand than any adjustable-rate mortgage.''
She further states that the average household will not
understand what risk it is undertaking with an ARM, adjustable-
rate mortgage.
Dr. Woodward's behavior on economics approach, as I
understand it, to this issue suggests that consumers are not
capable of making educated choices. I think they could make
those choices.
Based on your research, Dr. Willen, have you seen any
evidence that suggests that consumers are not sophisticated
enough to handle an adjustable-rate mortgage and this has led
to an increase in foreclosures? And let me ask a follow-up to
this. Are there in stances in your research in which the 30-
year fixed-rate mortgage could actually be more harmful to a
borrower than an adjustable-rate mortgage?
Mr. Willen. All right. So let me answer.
Senator Shelby. First, first.
Mr. Willen. First, first. There are many things we deal
with in life that we do not--where we have as much
understanding as we need. So most people do not understand what
a transmission is or how it works, but that does not stop them
from driving cars.
The risk embedded in an adjustable-rate mortgage--this is
what I keep coming back to--compared to employment risk,
compared to the risk they face in their jobs, the income risk
that they face in their jobs, is tiny and no one understands
employment risk. You know, to understand the distribution of
your labor income next year, no one understands that, and yet
everybody lives with--you know, those people who do not work
for the Government live with income risk all the time, and
they----
Senator Shelby. And that is most people, isn't it?
Mr. Willen. And that is most people, and they deal with it.
And it is much bigger. So, you know, if the mortgage payment is
a third of your income and it goes up by 10 percent, that is 3
percent of your income. People deal with 25-percent income loss
in a year, and they do not end up in foreclosure, and they do
not end up bankrupt. So I think people can handle risk, so that
is the answer to your first question. Remind me of the second?
Oh, the benefits.
Senator Shelby. That is right.
Mr. Willen. So, actually, I think in this crisis we have
seen exactly how much damage the fixed-rate mortgage can do. So
everybody focuses on the fact that rates on adjustable-rate
mortgages can go up, and we completely dismiss the fact that
they can go down. And they do not go down randomly. They go
down when interest rates go down. And when do interest rates go
down? Usually they go down in recessions, and they have gone
down by 500--LIBOR has gone down by 500 basis points. We looked
in the data. So people who had fixed-rate mortgages from 2005
and 2006 and 2007, most of them are paying 5.5 percent or more
on those mortgages. These are the people with negative equity.
The people who had adjustable-rate mortgages, their rates are
under 4.5 and a third of them are paying less than 3.5 percent
on their mortgages. They do that without any assistance
whatsoever from anyone. They do not have to beg their lender.
They do not have to get a modification. The only people with
fixed-rate mortgages and negative equity who are paying low
interest rates are people who have fought bitterly with their
servicer to get a modification.
So the adjustable-rate mortgage has this automatic built-in
stabilizer property which the fixed-rate mortgage does not.
Just one more thing. Prepayment is not free. You have to
get an entirely new mortgage, and that costs----
Senator Shelby. It is built in to the price, isn't it?
Mr. Willen. No, no. When you get the--in other words, the
option is not free, that is right. But even when you get the--
right now why are we having this problem? Why are we having
hearings about the fact that people cannot refinance their
mortgages? It is because between the closing costs, getting new
title insurance, you know, covering the transaction costs to
the lender and all of that, it costs 2 points. So there is no
free prepayment, forgetting the option price. That is why so
few people are refinancing right now.
Senator Shelby. But in all fairness, adjustable-rate
mortgages, you have got to tell the consumer it can go down,
which it has been doing because of the price of money.
Mr. Willen. Absolutely.
Senator Shelby. But it could go up, too.
Mr. Willen. Absolutely.
Senator Shelby. And oftentimes I think a lot of people have
not realized that. But they should.
Mr. Willen. They should. Let me say, just going back to
this, at least in Massachusetts, there is a rider on an
adjustable-rate mortgage which every borrower signs, which goes
through--it does exactly what you describe. It says this is
your rate, this is what it is tied to, this is where you can
find it out, and this is what will happen if the rate goes up
and this is what will happen if the rate goes down.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Johnson. Senator Reed.
Senator Reed. Dr. Willen, in your testimony you point out,
I believe, that adjustable-rate mortgages are defaulting more
than fixed-rate mortgages--or, in your words, fixed-rate
mortgages default less often than adjustable-rate mortgages. I
will put it precisely. So if there is this automatic correction
benefiting from falling rates, why are people with adjustable
mortgage rates defaulting more?
Mr. Willen. OK, so let me be careful about that. There is a
difference. It is a relatively small difference. It is not
anywhere of the order of magnitude of the increase in
foreclosures that we have seen. In other words, going from 1 or
2 percent of borrowers or 1 percent of borrowers to 5 percent
of borrowers, that is not because of adjustable-rate mortgages.
That is because of falling house prices. So they do default
more. I think what I said in my written testimony is the people
who take out adjustable-rate mortgages are different from the
people who take out fixed-rate mortgages. The assumption here
is that if they took out fixed-rate mortgages, they would also
be more likely to default. So for people who intend to keep
properties for a short period of time--there are a lot of
unobserved factors in the data. The fact that the borrower did
not intend to keep the property for a long time, that is why
they went with an adjustable-rate mortgage, and people like
that are more likely to be people who are speculating on
property. That is what we think that difference is picking up,
not anything about the product itself. There is no evidence
that the product--and as I said--there are two things. In point
of fact, adjustable-rate mortgage defaults have been much lower
relatively than we expected, partly because of the falling
interest rates. So the notorious option ARMs, which were the
sort of poster child for the complicated mortgage product,
because interest rates have fallen a lot, those loans have
ended up performing much better than we expected back in 2007.
So I think the--so let me just say the other thing, which is--I
keep coming back to here that the reason people default on
their mortgage is negative equity and something else--job loss,
illness, some life event that hits them. That is why they
default on the mortgage. That does not depend on a fixed or
adjustable-rate mortgage. There is nothing you can do about
that. But since we have spent a lot of time in the last 2
months talking about how we can stimulate consumption by
getting people into lower interest rate products, the
adjustable-rate mortgage product does that automatically.
You know, it is difficult to measure in the data, but
presumably the people with adjustable-rate mortgages have more
free cash-flow with which to consume. At least that is the goal
that we have.
Senator Reed. Dr. Woodward, what is your view of this
differential between adjustable-rate defaults and----
Ms. Woodward. I think that Paul is right, that the
households that sign up for ARMs are different from the
households that sign up for fixeds.
Now, in terms of, you know, when interest rates change, how
they change, how it affects households, remember that we had an
episode of rising interest rates from 1970 to 1980, and there
were ARM loans outstanding then, but they were all very
affluent households that had those ARM loans. They were not
ordinary households.
So then from 1980 until now interest rates have come down,
down, mostly down, and so we have not really seen the full
force of what happens when ARMs reset upwards.
Now, today we look at sort of the term structure of
interest rates. It is pretty flat. It does not predict that
interest rates are going up much, but could they? Yes, they
could. It is certainly much more likely that they could go up a
lot than that they could go down a lot, because we are so close
to zero we cannot go down very much. And it is the case that if
the ARMs reset up 2 points, the payment is going to rise 25
percent, and the household income increase is not going to be
that big.
So you want households that are good at managing their
finances, not bad at managing their finances, taking that risk.
And what we can see in the ARM data is that the default rates
are higher, and they are higher, other things equal. You know,
the same credit score, same debt-to-income ratio, same loan-to-
value ratio, the households that sign up for ARMs are taking
some risk somewhere else, too, that we cannot observe.
Senator Reed. We had an experience in the 1980s where we
had a significant increase in the interest rates.
Ms. Woodward. We did. I am old enough to remember, too.
Senator Reed. My father told me about it.
[Laughter.]
Senator Reed. In Canada, they had, I think, much less of a
commitment to 30-year fixed-rates, and they saw a lot of
turbulence in their housing market.
Ms. Woodward. They did.
Senator Reed. And that was an example where--in fact, that
might be the example which has influenced a lot of people to
get into 30-year fixeds, that if you were, like I was and like
you were, I suspect, about 25 to 26 in the 1980s, having a
fixed-rate looked really good then.
Ms. Woodward. It looked really good.
Senator Reed. We might be sort of captives of our history.
Ms. Woodward. Two things about the Canadian market. Yes,
they did have a lot of defaults in the early 1980s as ARMs
reset, and that is even in a market where the rate to which
they reset is kind of managed by the Government. You know, it
is not a completely objective rate like LIBOR or 1-year
Treasurys. There is some pushing against it at the Federal
level. But they still had big defaults.
Senator Reed. Thank you all.
Thank you, Mr. Chairman.
Chairman Johnson. Senator Corker.
Senator Corker. Thank you, Mr. Chairman.
As we look at the GSEs and the low guarantee rate that has
been charged and the fact that, you know, credit was available
all the way through, it seems that it had two effects. Number
one, when you have an artificially low interest rate, it
actually drives up the prices of housing because people are
looking at what their mortgage payments are. I go back to Dr.
Woodward. I think that is, generally speaking, what people are
looking at when they go buy a home, is what is their payment
going to be, regardless of all those other issues.
And so what we have had is a situation where our Government
guarantees, which artificially kept prices lower than they
should have been, have actually done the opposite thing for
consumers that we like to see happen, and that is, it has
actually driven up home prices. It has. There is no question.
And I am not asking a question. It is just a fact. It has.
And then you have a situation where you do not have any
price signals; in other words, because we continue just to have
these--as we had this bubble, you know, we had nothing in the
market that was slowing that down, and without this Government
guarantee, I think the private sector, which we do have a 30-
year mortgage market in the private sector today without
Government guarantees, and it is not as robust as it was
because we had this housing crisis. But it seems to me that
much of what has happened could have been avoided without the
GSEs playing the major role they did. And I wonder if you might
respond to that, Dr. Sanders or Dr. Willen.
Mr. Sanders. I will take the first crack at it. I would
say, yes, the GSEs, courtesy of the guarantee, whether it was
implied or explicit later, did help--they underpriced their
insurance; therefore, they could charge lower rates to
consumers. It sounds good, but when you couple that with lower
downpayment mortgages and sort of easing of credit standards
over time, we got what Austrian economists would call a nice
``credit bubble.'' We got housing prices climbing up, and once
in the house I put that, and I said, ``This is making housing
affordable?'' Which you will notice Fannie and Freddie no
longer have that as a slogan, which they did a couple decades
ago.
We created a bubble, and it burst. And as I said, $7.25
trillion of home equity has been lost, which has been
devastating, particularly for lower- and middle-income
households. So I think those guarantees are dangerous
instruments, and they have got to be pared back or taken away.
Senator Corker. I know that there has been a whole industry
sort of built around those, and it is sort of interesting to be
here in Washington in various sectors, not just this one. There
is a whole infrastructure that is built around making money off
what sort of the Government has put in place. And I know that
we all thoughtfully want to move away from that. I think
everybody wants to see us move away regardless of where you sit
today from where we are today. I think that is universal. We
want to do it in an appropriate way.
But let us just move back to where the GSEs are at this
moment. I never have understood why we do not have a built-in
prepayment penalty. I mean, why has it been in sort of the
psychology of what we have done here a one-way street? You
know, I own commercial buildings, or have in the past. When you
pay the loan off, you have got to pay a penalty. I am sorry.
You know, if it is not--if rates are lower than when you have
financed, you have got to pay a penalty. Why have we not had
that? It seems like that would solve a big part of the problem
we have today?
Mr. Sanders. Yes, I was going to put that into my
testimony, that on the commercial side we have ARMs galore, and
they have either lockouts, prepayment penalties, yield
maintenance, or something, saying that if you are going to
refinance, you are going to pay a hefty price.
One of the reasons why we do not in the residential market
is we have built kind of a huge empire of mortgage-backed
securities that are agency--Fannie, Freddie, and Ginnie Mae.
And to facilitate trading, you want to have liquid prepayments,
meaning that the option to prepay is what everyone likes to
speculate on, how it is going to do, and they really avoid
having prepayment penalties or non-prepayable mortgages because
there is not a lot of action in them, so to speak, on the
market. But that should not be driving public policy, the fact
that mortgage-backed security traders like the prepayment
option.
Senator Corker. Any other comments regarding the prepayment
only?
Ms. Woodward. Yes.
Senator Corker. Yes, go ahead, Dr. Woodward.
Ms. Woodward. You know, it is my understanding that the
absence of prepayment penalties is mostly a matter of State
law. Essentially all 50 States have limits on the prepayment
penalties that can be created. And as far as the mortgage-
backed securities market goes, what the mortgage-backed market
wants is not necessarily the absence of prepayment penalties.
What they want is securities where the prepayment penalties are
all the same so that they can trade as liquid instruments.
Senator Corker. So the penalty is zero.
Ms. Woodward. Well, it does not matter whether it is zero
or it is $100 or $1,000. What they want is for all mortgages to
have the same prepayment penalties so that they can trade
identically.
Senator Corker. Well, my time is up. I would just--go
ahead.
Mr. Sanders. I agree with Susan on that statement, but I
would say if you looked at the number of prepayable mortgages
with huge prepayment penalties or yield maintenance or
something, you are going to find the number close to zero at
Fannie, Freddie, and the FHA. They are just non-existent.
Senator Corker. May I ask another question?
Chairman Johnson. Yes.
Senator Corker. What do you think would happen if Fannie
and Freddie all of a sudden said, you know, we will continue
doing what we are doing, and we all know they are jacking up
their G-fees and all of that. But what if they also said, but
we are going to have yield maintenance on these things, and,
you know, candidly, if you want to refinance in 7 years, which
is what most people--that is what the average is. If you want
to refinance in 7 years but have the opportunity for a 30-year
low fixed-rate mortgage, you are going to pay yield maintenance
on that. What would happen in the marketplace.
Mr. Sanders. Well, what would happen is that mortgage rates
would actually decline because since you are sharing some of
the risk with consumers--and, again, the risk, I guess with
Paul, is relatively negligible. But since you are sharing some
of that risk, that leads to the rate declining because, once
again, the prepayment option raises mortgage rates, which is
one of my arguments in HAMP. Why weren't we refinancing
households into ARMs, 5/1 ARMs? Why did we pick 30-year fixed?
That is a problem across the whole system. If we are interested
in homeowners, we should have lowered the rates if we believed
that theory. We should have done 5/1 ARMs or 3/1 ARMs for
consumers that were getting loan mods, but we did not.
Senator Corker. Thank you.
Mr. Fenton. Senator, if I may?
Senator Corker. Yes, sir.
Mr. Fenton. I would like to disagree with that to some
extent. I believe it is an affordability issue, and if you add
on prepayment penalties to the consumer, you are shifting that
cost out to the consumer and in the long-term effect, it is
going to have a negative effect on the real estate markets as
we go forward.
I think you have to have a choice. There are members in
every life segment and every life style, and so depending on
where you are in those, there are options for you. Prepayment
may be one of those. Adjustable rates may be one of those. We
cannot just have one product, but there are different timings
of it all and you have got to have an effect. The consumer
should not bear all of the cost on this, nor should any one
segment. Risks should be spread balanced over all of the
segments.
Senator Corker. Well, it seems to me that the person who
has taken a loan out should bear the cost of that loan. I mean,
I do not understand what you are saying about consumers not--
that is a really weird statement to me. I mean, if I am
borrowing money and I decide that--and there is a cost to
society of me taking certain actions, it seems that I should
bear that cost. That is a strange statement, it seems, that you
just made.
Mr. Fenton. Well, it is how you view cost. Cost is an
investment sometimes, and it depends on which angle you are
looking at it from. From a public policy perspective, I think
the cost is an investment that returns in a more vibrant
economy eventually. And so there is return for us making that
investment. It should not be borne by the consumer because the
consumer, A, does not understand it fully enough, and sometimes
it is going to affect their ability to go into it, and so
rather than go into it, they will rent a home as opposed to
buying it. And again, I think that has a negative impact on the
economy. So you need to look at it from all different angles,
from the policy statements as well as what the effect is on the
consumer.
Senator Corker. Thank you.
Chairman Johnson. Dr. Sanders, the fixed-rate mortgage has
been criticized as problematic for homeowners when interest
rates and home values fall because homeowners cannot take
advantage of lower interest rates without refinancing. Do all
ARMs allow for a drop in interest rates?
Mr. Sanders. Yes. Virtually all ARMs allow you to
refinance, but you--yes, they do. But, again, most people
refinance at the reset dates.
Senator Johnson, can I finish my answer?
Chairman Johnson. Yes.
Mr. Sanders. One of Susan and my common friends, maybe
Paul, too, is a famous person locally in the mortgage market
and he only uses ARMs. Why? Because he did a study showing that
ARM rates continually, with a couple of episodes, have always
been lower than fixed rates, so he just says, I will either
roll them over if the rates stay low. If they are not, I will
just--and the reset has been always very trivial in comparison.
So other than one shock, we have not seen a problem with them.
Chairman Johnson. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman.
I appreciate the witnesses being here. I certainly
appreciate Mr. Fenton from New Jersey, who is well known as an
expert in the financial industry and in our home State, as well
as Ms. Bowdler, who has worked for La Raza and has been
extraordinary.
I am concerned that there is a universe of borrowers who,
in fact, can be responsible borrowers, but at the end of the
day, without the guarantee of a 30-year fixed mortgage ends up
eliminating the opportunity for them to be a responsible
borrower and basically gets them out of the market.
I have noticed that even though there are those who argue
that the private sector alone will do this, that we have not
really seen much securitization at all of jumbo mortgages in
this marketplace, so the private sector has not come in as of
now to provide the opportunity to do that.
So if we do not have an evidentiary set of circumstances
under the most probably propitious opportunity for the private
sector to come in and they have failed to come in to accomplish
them, then how is it that we expect individuals who can be
responsible borrowers under a long-term fixed rate to be part
of the marketplace? Do any of you have a comment on that?
Mr. Fenton. Senator, I do agree with you that the
securitization and jumbos is a great example of where
privatization has not entered the marketplace. You cannot rely
solely on privatization to come in and bring capital in without
some offset to the risks that they are going to take. Risk is
offset by price, and in this case, I think the price would
negatively affect a different segment, which is the consumer
segment. And so we need to be able to balance that, and that is
where the Government has a role to come in to try to encourage
the private sector to bring their capital to the table.
Senator Menendez. Yes, Ms. Bowdler.
Ms. Bowdler. I would also point out that while we have this
issue on the jumbo side, we have the same problem on the lower
end of the market. I mean, right now, what Fannie and Freddie
are financing is essentially middle market, affluent, sort of
the best of the best. I mean, they are taking cream of the crop
right now, and borrowers who are qualified but maybe live in a
neighborhood that they have deemed not desirable or lack the
family wealth to make sizable downpayments are getting left out
of the market. And those are borrowers that we know, the
research shows, right product with the right support, those can
be qualified families who perform very well and we do not see
the private market stepping in to help those families, either,
and Fannie and Freddie is not serving them.
Senator Menendez. Dr. Sanders, welcome back.
Mr. Sanders. Thank you very much, Senator Menendez.
Senator Menendez. You are a regular at our hearings, so----
Mr. Sanders. That is right. I am a Jersey boy, so----
Senator Menendez.----our Subcommittee hearings, so we
appreciate it.
Mr. Sanders. Let me just take a little bit different spin
on it, although I do not disagree with what anyone is saying.
What I am saying is that the guarantee in the 30-year fixed,
the low downpayment mortgages, when you combine that all into a
ball, what we have done is we have really encouraged households
to take on more risk than they ordinarily would have. We give
them the illusion that everything is going to be fine with a
30-year fixed, and then, lo and behold--I have said this about
five times already today--from the peak of the housing bubble
to now, $7.25 trillion--that is a mind-boggling number if you
want to figure out one of the reasons why our economy is not
jump starting very well--we lost that much wealth in the
housing market, and that is terrible.
So again, I am saying, if we can figure out a way to pare
back some of this, we are not encouraging people to take this
risk that turned out to be a bad pony. Housing was great for a
while during the run-up, but it had a catastrophic collapse and
a lot of middle-income and lower-income households really got
creamed in it. And so I am just saying----
Senator Menendez. Dr. Sanders, let me interrupt you there
for a moment. But the reality--a bubble, regardless of when
that bubble is, is problematic whether you are in a fixed
mortgage or whether you are in an adjustable rate mortgage. As
a matter of fact, it seems to me that part of our challenge
that created this bubble was that we had all of these
instruments, including no doc loans and teaser rates and a
whole host of other set of circumstances, that brought people
into a market that probably should not have been, certainly not
under those circumstances. And that is part of creating the
bubble.
So I do not know that a bubble itself is the reason not to
look at a 30-year fixed-rate mortgage. On the contrary, it
seems to me that there is long-term stability there for the
individual to know what their responsibility is and not
necessarily with engaging in the fluctuations of the
marketplace, including on the mortgage side, which some of the
adjustables and no downpayment and interest rates ended up
being. So I appreciate your comment about the bubble, and I
understand that. I just do not necessarily subscribe it to a
30-year mortgage.
And the final point I would like to make is I am
increasingly concerned, because my dear friend and colleague,
Senator Isakson, who has a long-term experience--he is actually
someone who has been a Realtor for, I think, 30-some-odd years
and knows this pretty well--he made a comment on the floor
yesterday on an amendment we have which is it is not just the
size of the loan, but it is the lending criteria. And he
commented that the lending criteria has been almost so pristine
now and so difficult that the risk is dramatically downsized,
and I get concerned, in addition to the 30-year issue and
having some Government role, that I think the least we can do
in a very difficult, to say the least, housing market is to do
no further harm, at least in the short term.
It is this whole issue of what is the down, because, you
know, saying that a qualified residential mortgage is now 20
percent, well, that is going to eliminate a whole universe of
people who can, again, be responsible borrowers. I mean, I look
at it, a middle--a median single-family home cost approximately
$170,000 in 2009. Median household income is approximately
$50,000. Just think about how long it will take for a family
earning twice the median to save $17,000, much less--that is
about 10 percent--much less 20 percent as a mandatory.
So it seems to me lending criteria is important to
determine who will be a responsible borrower and not permit the
bubble to take place, but that lending criteria is not in and
of itself that you have got to have 20 percent down. In other
words, you could have 20 percent down and still not have the
other criteria to be a responsible borrower. Is that a fair
statement?
Mr. Fenton. Senator, if I can, I would go further with
that. Lending criteria is one of the keys that actually was a
major influence in the crisis that we are just coming out of.
There were a lot of lax credit standards, so we ignored some of
the rules that we had actually established for ourselves, and
that is what had more of an effect than interest rates, whether
it is adjustable rates or 30-year fixed-rates, on this whole
situation.
So what stops us from lax credit standards? The GSEs had
set those--established those standards and allowed them to
become more lax. There were certainly different components in
the unregulated market. They were selling products that were
not good for the consumers. Credit unions have always stood by
and looked at the consumer and said, let us figure out what is
best for you. If it is a 30-year or a 40-year fixed, it may not
be the best thing for them. So we try to look beyond that. I am
suggesting that that was not done in all parts of the economy.
Senator Menendez. All right. My time is over, but maybe,
Ms. Bowdler, you can make a final comment if the Chair permits
it.
Ms. Bowdler. Sure. So in my written statement, I went
through some things that we know that can make borrowers very
successful and I think that is the better place to focus this
conversation, not about taking options away, but what makes
borrowers at any income range really succeed in their
mortgages. What makes them responsible. Certainly, that is
underwriting criteria, but there are other things we can do, as
well, like housing counseling, which we are a big proponent of.
We have invested a lot of money in helping families figure out
how to eat their veggies. Let us get your budget right. Let us
get your credit right and step into this when it is your right
time.
I am concerned that there has been a dichotomy here that
somehow everybody who got ARMs were really savvy consumers and
people who are getting 30-year fixed are somehow the chumps
that do not really understand interest rate markets. In fact, I
think people are making these choices because, at least in
part, it works for them.
Now, I completely agree that there should be choices and
there is certainly not a single product for everybody, but a
good housing counselor or other advisor like a credit union can
help families evaluate those options and make the choices that
really fit for their family and their long-term financial
plans.
Senator Menendez. Thank you, Mr. Chairman.
Chairman Johnson. I would like to thank all of our
witnesses for being here with us today. This hearing has been
very useful to the Committee as we continue to explore the
future of the housing finance system and the financial products
for that system.
This hearing is adjourned.
[Whereupon, at 11:16 a.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
follow:]
PREPARED STATEMENT OF JANIS BOWDLER
Director, Wealth-Building Policy Project
Office of Research, Advocacy, and Legislation
National Council of La Raza
October 20, 2011
Good morning. My name is Janis Bowdler. I am the Director of the
Wealth-Building Policy Project at the National Council of La Raza
(NCLR). NCLR is the largest national Hispanic civil rights and advocacy
organization in the United States, dedicated to improving opportunities
for Hispanic Americans. I oversee our research, policy analysis, and
advocacy on issues that are critical to building financial security in
Latino communities, such as homeownership, consumer credit, auto
lending, and financial planning. In this capacity I have produced a
number of publications on related issues, including The Foreclosure
Generation: Long-Term Impact of the Housing Crisis on Latino Families
and Children; American Dream to American Reality: Creating a Fair
Housing System that Works for Latinos; and Jeopardizing Hispanic
Homeownership: Predatory Practices in the Homebuying Market.
The NCLR Wealth-Building Policy Project promotes fair and
accessible financial markets where Latino families have the opportunity
to obtain assets and build wealth in a manner that will last a lifetime
and can be shared with the next generation. NCLR conducts research and
analysis on public policy affecting the financial security of Latino
families, such as threats to sustainable Hispanic homeownership, access
to affordable financial services, and access to affordable credit. The
NCLR Homeownership Network (NHN) provides financial, homebuyer and
foreclosure prevention counseling to more than 65,000 families
annually. Our subsidiary, the Raza Development Fund (RDF), is the
Nation's largest Hispanic community development financial institution
(CDFI). Since 1999, RDF has leveraged more than $680 million in
financing for local development projects throughout the country. This
work has increased NCLR's institutional knowledge of how Latinos
interact with the mortgage market, their credit and capital needs, and
the impact of Government regulation on financial services markets.
I hope that today's hearing will shed light on a critical issue--
the viability and advantages of the 30-year fixed-rate mortgage. For
nearly eight decades, 30-year fixed-rate mortgages have put
homeownership within reach of America's middle class and first-time
homebuyers. Long-term financing allows credit to be extended at a price
that is affordable to middle-income families, and the fixed rate
provides certainty around housing costs. Without this flexible
financing tool, homeownership will become a luxury reserved for the
affluent, and the majority of families will be left without the
appreciable asset that has long been the cornerstone of middle class
wealth.
In my testimony today I will discuss the role of the 30-year fixed-
rate mortgage and explain its advantages for homeowners. I will also
share our perspective on how to maintain a viable path to homeownership
for future generations of homebuyers.
Advantages of a 30-Year Fixed-Rate Mortgage
The 30-year fixed-rate mortgage has become so ubiquitous that some
have taken its benefits for granted. However, such financing has not
always been available. Prior to the creation of the Federal Housing
Administration (FHA) in 1934, most loans were limited to 50 percent of
the home value, which means that a family would have to pay the other
50 percent in cash to purchase a new home. Such loans were often short-
term notes where a family would have to refinance every few years to
cover the final balloon payment. Even this payment schedule could not
be counted on. In the lead-up to the Great Depression, cash-strapped
banks could call the note for immediate repayment, forcing many into
foreclosure.\1\ President Franklin D. Roosevelt and Congress responded
by creating FHA mortgage insurance to reduce barriers to purchasing a
home and provide banks and consumers with certainty and predictability
in the transaction. This, along with the introduction in 1938 of the
Federal National Mortgage Association, popularly known as Fannie Mae,
standardized the 30-year fixed loan and made it available nationwide.
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\1\ Jacob Gaffney, This housing crisis is the not the Great
Depression, HousingWire, June 16, 2011, http://www.housingwire.com/
2011/06/16/this-housing-crisis-is-not-the-great-depression (accessed
October 16, 2011).
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The 30-year fixed-rate mortgage remains an essential financing tool
for homebuyers in the modern mortgage market. By spreading the cost of
the home purchase over a 30-year term, the asset becomes more
affordable. The fixed interest rate provides certainty, allowing a
family to budget their housing costs and make long-term financial
plans. Modest downpayment requirements have opened the doors of
homeownership to families with incomes sufficient to cover monthly
mortgage payments and maintenance costs but who lack the family wealth
for a high downpayment. The amortization feature of the 30-year fixed-
rate loan means the borrower knows when the final payment will be due
and their family wealth grows as principle is repaid. Finally, most
prime 30-year fixed-rate notes are prepayable, which means the
homeowner can refinance their loan or sell without penalty.
The standard structure of the 30-year mortgage has opened
homeownership to millions of families over the last seven decades. As a
result of this financing tool, two out of three Americans own their own
home today, the vast majority of whom relied on some type of mortgage
to finance their purchase. Building wealth through home equity can fuel
retirements, business ownership, and the advanced education of one's
children. Those fortunate enough to own their home or land are able to
pass their wealth to their children, a practice that has helped expand
America's middle class.\2\ Even without dramatic increases in home
values, the home acts as a forced savings account that captures some of
the income put toward house payments, which is unavailable for
individuals who do not own their homes. Over the last 50 years until
the most recent recession, wealth among American households grew
steadily, peaking at $65 trillion in 2007.\3\ While home equity does
not account for the entirety of that wealth, a home is still the
highest valued asset for most Americans. This is especially true for
Hispanic and Black homeowners, for whom home equity makes up 65 percent
and 59 percent of household wealth, respectively. For Hispanic
households, no other asset type besides a home, e.g., interest-earning
assets at financial institutions constituted more than 10 percent of
total net worth in 2005.\4\
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\2\ Melvin Oliver and Thomas Shapiro, Black Wealth, White Wealth: A
New Perspective on Racial Inequality (New York: Routledge, Taylor &
Francis Group, 2006).
\3\ Chris Isidore, America's lost trillions, CNN Money, June 9,
2011, http://money.cnn.com/2011/06/09/news/economy/household_wealth/
index.htm (accessed October 17, 2011).
\4\ Paul Taylor, Richard Fry, and Rakesh Kochhar, Wealth Gaps Rise
to Record Highs Between Whites, Blacks, Hispanics (Washington, DC: Pew
Research Center, 2011).
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Unfortunately, the benefits of homeownership have not been equally
available to all. Historical discrimination in the distribution of
land, unfair restrictions on FHA mortgage insurance and redlining, and
exploitation by predatory subprime lenders has left communities of
color with lower homeownership and wealth rates.\5\ Latino and Black
homeowners were more likely to receive exotic mortgage products, even
when they had solid credit that warranted a sustainable 30-year fixed
loan.\6\ When the toxic mortgages began to reset and brokers and
lenders could no longer maintain their refinance schemes, a recession
ushered in record-high foreclosure rates. Since the dawn of the crisis
in 2007, more than six million homeowners have lost their home to
foreclosure.\7\ The foreclosure crisis has been particularly acute
among Latino homeowners. For example, nearly half of foreclosures in
California have been on Latino families.\8\ In fact, recent research
revealed that wealth in White households exceeds that of Hispanic
households by a staggering 18-to-1 ratio and by 20-to-1 for Black
households a gap that is attributable largely to differences in home
equity and the loss of homes through foreclosure.\9\
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\5\ Meizhu Lui et al., The Color of Wealth: The Story behind the
U.S. Racial Wealth Divide (New York: The New Press, 2006).
\6\ Robert B. Avery, Kenneth P. Brevoort, and Glen Canner, The 2007
HMDA Data, Federal Reserve Bulletin 94 (December 23, 2008); and Debbie
Gruenstein Bocian, Keith S. Ernst, and Wei Li, Unfair Lending: The
Effect of Race and Ethnicity on the Price of Subprime Mortgages
(Durham, NC: Center for Responsible Lending, 2006). For a review of
predatory practices aimed at Hispanic families see Janis Bowdler,
Jeopardizing Hispanic Homeownership: Predatory Practices in the
Homebuying Market (Washington, DC: National Council of La Raza, 2005).
\7\ Center for Responsible Lending, Snapshot of a Foreclosure
Crisis, 2010, http://www.responsiblelending.org/mortgage-lending/
research-analysis/snapshot-of-a-foreclosure-crisis.html (accessed
October 17, 2011).
\8\ Debbie Gruenstein Bocian et al., Dreams Deferred: Impacts and
Characteristics of the California Foreclosure Crisis (Oakland, CA:
Center for Responsible Lending, 2010).
\9\ Wealth Gaps Rise to Record Highs.
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Our present foreclosure crisis demonstrates the importance of
preserving the standard 30-year fixed-rate mortgage. Critics of the 30-
year fixed note argue that families pay a premium in their interest
rates for the benefit of extending the term. However, most families do
not view their home as a strict financial transaction or a get-rich-
quick scheme. Rather, they are investing in a nest egg and a community
with the anticipation of long-term returns. Most homeowners are not in
the position to play the markets or hedge interest rate risk. The
predictability and security of a 30-year fixed-rate mortgage is worth a
modest premium in the interest rate.
Paving the Way for Sustainable Homeownership
Research shows that families who lack the cash for high
downpayments can be successful in a well-underwritten prime
mortgage.\10\ The Center for Community Capital compared low-income
homebuyers who received flexible but responsible conventional prime
mortgages with similarly situated borrowers who received subprime
mortgages. Those with subprime loans have suffered foreclosure at a
rate three to five times that of borrowers who received flexible yet
responsibly underwritten 30-year fixed loans. In fact, not only were
the borrowers with the responsible loans less likely to foreclose, they
also gained an average of $20,000 in home equity as of 2009. NCLR's
experience with Latino first-time homebuyers tells a similar story.
Over the last 13 years, NHN counselors have helped more than 25,000
moderate-income families purchase a home with prime mortgages.
Counselors overwhelmingly report that few, if any, of their clients who
received counseling before they bought their home returned for
foreclosure prevention counseling. This evidence shows that when
families receive the right loan with the right support, they can be
successful and sustainable homeowners and build wealth even with modest
incomes and low downpayments.
---------------------------------------------------------------------------
\10\ Lei Ding et al., Risky Borrowers or Risky Mortgages:
Disaggregating Effects Using Propensity Score Models, working paper
(Chapel Hill, NC: UNC Center for Community Capital, 2010), http://
www.ccc.unc.edu/documents/Risky.Disaggreg.5.17.10.pdf (accessed October
17, 2011).
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Several decades of innovative affordable lending have taught us how
to mitigate the risk of extending credit to first-time homebuyers, low-
wealth borrowers, and underserved communities. For example, mortgage
insurance a longstanding requirement by lenders and investors on home
loans where the loan-to-value (LTV) ratios exceed 80 percent allows
banks and credit unions to lend safely and responsibly to qualified
families with higher LTVs. Analysis conducted on behalf of Mortgage
Insurance Companies of America (MICA) of 43 million loans made between
2001 and 2008 with LTVs up to 97 percent found that those with mortgage
insurance outperformed noninsured loans, and performed well considering
the economic downturn.\11\ Housing counseling is another excellent risk
way to mitigate risk. Research shows that objective advice from an
independent, trained housing counselor prior to purchase effectively
reduces the likelihood of default.\12\ Similarly, recent research has
shown that counseling during a delinquency improves cure rates and
lowers rates of redefault.\13\ Finally, a homeowner's own savings can
provide a cushion in times of unexpected financial distress. Modest-
income borrowers would better positioned to manage unexpected expenses
if they have some cash liquidity, rather than storing all of their cash
savings in their home via a large downpayment.
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\11\ MICA regulatory comment letter on credit risk retention,
August 1, 2011, http://www.privatemi.com/news/pressreleases/
attachments/MICA_QRM_Letter.pdf (accessed October 17, 2011).
Specifically, see attached analysis: Kenneth Bjurstrom, Johnathan
Glowacki, and Tanya Havlicek, Mortgage Insurance Loan Performance
Analysis as of March 31, 2011, July 28.
\12\ Abdighani Hirad and Peter M. Zorn, A Little Knowledge Is a
Good Thing: Empirical Evidence of the Effectiveness of Pre-Purchase
Homeownership Counseling (Joint Center for Housing Studies, Low-Income
Homeownership Working Paper Series, Boston, 2001).
\13\ Neil Mayer et al., National Foreclosure Mitigation Counseling
Program Evaluation: Preliminary Analysis of Program Effects September
2010 Update (Washington, DC: The Urban Institute, 2010).
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Moreover, the affordable housing market continues to innovate with
the 30-year fixed loan as a foundation. New tenure forms, such as
community land trusts, lease-purchase, and shared equity mortgages, can
help families take important steps toward ownership with far less risk
overall to the lender, consumer, and the market. Affordability tools
such as soft second loans and mortgage revenue bonds often used by
housing finance agencies can reduce the upfront cost of realizing
homeownership.\14\ To achieve scale that is sufficient to move such
options into the mainstream housing market, these innovative approaches
require the same ingredients that made the affordable 30-year fixed
mortgage a market standard: secondary market liquidity, credit
enhancements, and a stable, competitive marketplace. Of course,
deciding to buy a home is a major family decision and must come at a
time when a family is financially prepared. Therefore, policymakers
must also support a robust rental market that provides affordable
options for future buyers and families for whom homeownership is not
desirable or possible.
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\14\ For a review of five successful examples, see David Abromowitz
and Janneke Ratcliff, Homeownership Done Right: What Experience and
Research Teach Us (Washington, DC: Center for American Progress 2010),
http://www.americanprogress.org/issues/2010/04/pdf/
homeownership_done_right.pdf (accessed October 17, 2011).
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Despite all of the evidence demonstrating the importance and
viability of affordable 30-year fixed-rate mortgages, this market
staple is restricted in the current credit environment. The January
2008 Federal Reserve Senior Loan Officer Opinion Survey revealed that a
significant number of prime lenders had tightened their credit
standards, and subsequent surveys show that little change has occurred
over the last 3 years. The Community Reinvestment Association of North
Carolina found that loan-level pricing adjustments (LLPAs) imposed by
Fannie Mae and Freddie Mac add significant costs to loans and reduce
access to credit, particularly for Latino and Black homebuyers.\15\
Furthermore, challenges have surfaced among FHA loans, which have been
the primary financing tool available to borrowers of color since the
collapse of the mortgage market. The National Community Reinvestment
Coalition revealed that national lenders were layering additional
credit criteria on FHA mortgages, thereby restricting their
availability.\16\ Consequently, despite the average 30-year mortgage
rate having dropped to below 4 percent, fewer borrowers are able to
take advantage of the low rates and lower home prices.
---------------------------------------------------------------------------
\15\ Adam Rust, The New Hurdle to Homeownership: How Loan Level
Pricing Changes the Cost and Access to Credit (Durham, NC: Community
Reinvestment Association of North Carolina, 2011), http://cra-nc.org/
sites/cranc.org/files/pdf/The%20New%20Hurdle%20to%20Home%20
Ownership.pdf (accessed October 16, 2011).
\16\ National Community Reinvestment Coalition, Working-Class
Families Arbitrarily Blocked from Accessing Credit (Washington, DC:
National Community Reinvestment Coalition, 2010), http://www.ncrc.org/
images/stories/mediaCenter_reports/fha%20white%20paper-120810-final.pdf
(accessed October 17, 2011).
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The threats to affordable, long-term housing financing are not
limited to today's credit crunch. Unfortunately, the future
availability of affordable 30-year fixed loans for working families is
in question. Earlier this year Federal bank regulators promoted the
idea of a wealth standard in their proposed risk retention rule, which
would unnecessarily cement high downpayment requirements in
regulations. The idea of requiring a high downpayment for loans secured
by Fannie Mae and Freddie Mac and those insured by FHA was also
introduced by the Department of Housing and Urban Development and the
Department of the Treasury in a white paper sent to Congress.\17\ Such
strict regulatory requirements will decrease the availability of
responsible and affordable credit to qualified families. Critics of
Fannie Mae and Freddie Mac are going further by pushing for a complete
dismantling of our current secondary market system through
privatization, even though lenders especially small community lenders
say that they would not be able to offer fully amortizing 30-year notes
in a completely private system.\18\
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\17\ U.S. Department of the Treasury and U.S. Department of Housing
and Urban Development, Reforming America's Housing Finance Market.
Washington, DC, 2011, http://portal.hud.gov/hudportal/documents/
huddoc?id=housingfinmarketreform.pdf (accessed October 18, 2011).
\18\ See: Lew Sichelman, ``The End of the 30-Year Fixed-Rate
Mortgage?'' Urban Land, June 22, 2011, http://urbanland.uli.org/
Articles/2011/June/Sichelman30yr (accessed October 17, 2011). In this
article, Sichelman quotes members of the mortgage industry asserting
that the 30-year fixed-rate mortgage would become either extremely
expensive or disappear altogether without the secondary market
liquidity provided by Fannie Mae and Freddie Mac. Sichelman also quotes
critics who question the benefits of fixed-rate financing and argue for
a fully privatized housing finance system.
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Recommendations
Rather than dismiss a proven finance tool such as the 30-year
fixed-rate mortgage and affordability features such as low
downpayments, policymakers should be exploring those factors that set
families up for success. The conservatorship of Fannie Mae and Freddie
Mac is neither desirable nor sustainable from a public policy or market
perspective. However, we caution against throwing away portions of our
housing finance system that work well. In a letter to President Obama,
NCLR and 16 other civil rights organizations outlined a set of
principles to guide housing finance reform in a manner that ensures
equitable and sustained access to credit for all qualified homebuyers.
I have attached a copy of this letter for the record.
Without the advantages of long-term fixed-rate financing, many
qualified, middle-income families will be shut out of homeownership
opportunities, particularly Hispanic and Black borrowers and other low-
wealth households. Policymakers should take steps to strengthen the
role of the classic, 30-year fixed-rate mortgage and other market
innovations that build off its success. In addition to the principles
outlined in the attached letter, NCLR offers three specific
recommendations to the Committee:
Maintain secondary market liquidity for affordable 30-year
fixed-rate loans that are made equally available to all
qualified families. The 30-year fixed mortgage is the
foundation of affordable homeownership. A robust secondary
market that provides liquidity throughout the Nation is
critical to keeping this popular home financing tool broadly
available to working families. The Federal Government must use
its resources to facilitate a stable, liquid housing finance
system that will extend credit and capital on an equitable
basis to all borrowers and in all communities, with the goal of
achieving parity between communities of color and Whites.
Families should not be relegated to substandard mortgage
products because a bank refuses to lend in their neighborhood
or employs discriminatory practices. Such policy implementation
should be further bolstered by support for a robust,
integrated, and affordable rental market.
Support prepurchase housing counseling and other credit
enhancements. Prepurchase counseling has been shown to serve as
a credit enhancement by reducing the likelihood of default. Yet
funding for this proven method of reducing risk was eliminated
by Congress and the administration for fiscal year 2011.
Recently, the Senate Appropriations Committee passed the
Transportation and Department of Housing and Urban Development
appropriations bill with $60 million allotted for housing
counseling. While this represents a serious cut from the
industry high of $87.5 million in fiscal year 2010, it is a
critical step in restoring the program. NCLR also calls on the
private mortgage industry to step up its support for housing
counseling. Lenders, investors, and mortgage insurers benefit
from a well-educated consumer. The industry has long viewed
housing counseling as a philanthropic endeavor, but we
encourage financial institutions to create business
partnerships with nonprofit counseling providers. Finally,
credit enhancements such as housing counseling, mortgage
insurance and shared equity models require the support of
Fannie Mae and Freddie Mac to achieve scale. The entities
should leverage proven and promising approaches in their
current lending, and policymakers must ensure that this element
is maintained as we reform our housing finance system.
Reduce barriers to financing experienced by today's
borrowers. Rigid credit markets are making it difficult for
working families to obtain mortgages. This slows the recovery
of the housing market and leaves neighborhoods at the mercy of
absentee investors with little interest in the up-keep of the
property or its impact on the surrounding community. These
burdens could be reduced with the elimination of LLPAs and the
use of proven underwriting criteria such as modest downpayments
for counseled borrowers.
Thank you. I would be happy to answer any questions.
______
Civil Rights Statement of Principles for Secondary Market Reform
Equal access to mainstream financial services and affordable rental
and owner-occupied housing is a critical step toward providing all
families with access to wealth-building opportunities, good jobs,
schools, transportation, health care, and other factors that determine
positive life outcomes. Providing this access has been, and must
remain, an important Government policy goal.
One of the lessons of the current financial crisis is that our
Nation's housing finance system has not worked well for people of color
and other underserved groups. Perverse incentives in the secondary
market often drove unregulated brokers to target borrowers in
communities of color with unsustainable loans. This fed a
securitization regime so poorly understood and regulated that it
ultimately destabilized the global economy. As the secondary market
helped to drive this phenomenon, it also failed to make necessary
investments in rental housing that met the needs of communities and
opened opportunities for people.
Unregulated and often predatory subprime lending not only failed to
maintain or promote sustainable homeownership opportunities but also
established a dual credit market where factors other than a borrowers
creditworthiness determined the type and terms of the mortgages that
were sold. All too often, families were denied the best credit for
which they qualified, and their communities were flooded with
unsustainable mortgage credit. As these unsustainable loans failed, the
housing finance system failed to provide these families with the home-
saving options that they were due. Instead of being able to use
homeownership as the path to wealth-building and financial stability
that our public policy promises, families have had their wealth
stripped away and are facing financial setbacks that will take a
generation or more to overcome.
It is because of this unfortunate history of exclusion of
underserved communities from sustainable credit and housing options
that civil rights organizations are invested in the housing finance
reform debate and should be counted on as important civic partners.
This debate is unfolding in the context of four decades of widening
income and wealth inequality that have kept many borrowers from
accessing the financial tools and options that provide an economic
ladder to the middle class. Federal housing policy must reverse this
and incorporate bold policy solutions to address inequality and
segregation in the United States. It is in this spirit that we offer
the following principles for secondary mortgage market reform. The
principles were drafted by a group of more than 20 organizations that
serve millions of members of underbanked communities throughout the
United States, including African-American, American Indian, Asian-
American, Pacific Islander, Latino, and low-income populations, as well
as people with disabilities and the elderly. The points below are
critical in shaping the future secondary mortgage market.
1. Federal housing finance policy must align with and support
longstanding Federal housing goals to protect against
discrimination. The secondary mortgage market must promote
residential integration, the elimination of housing
discrimination, and the provision of safe, decent, and
affordable housing for all.
2. The Federal Government has a responsibility to ensure that the
secondary market serves all borrowers in a fair and equitable
manner and to foster the equalization of homeownership rates.
Despite clear demand from qualified families, the mortgage
market does not reach all segments of borrowers and geographic
areas. It is incumbent upon the Federal Government to use its
resources to facilitate a stable, liquid housing finance system
that will extend credit and capital on an equitable basis to
all borrowers and in all communities, with the goal of
achieving the same rates of homeownership among communities of
color as among whites. While not all household heads must
become homeowners, a commitment should be made to achieve
similar homeownership levels across all communities. In
addition, the system must be made accessible by a wide range of
lending institutions for both owner-occupied and rental
housing.
3. A reformed housing finance system must eliminate the dual credit
market. Such a market has relegated people of color and other
underserved groups and communities to riskier, higher cost
forms of credit that strip wealth and undermine financial
security. To accomplish this goal, reform of the secondary
market must be coordinated with reform in the primary market
for housing and other types of credit.
4. Regulatory oversight of the housing finance system must be
rigorous and comprehensive and must include effective fair
lending enforcement. Further, oversight and enforcement must
extend to all secondary market entities, whether or not they
avail themselves of any Federal guarantee or other support.
5. Secondary market transactions must be transparent and accountable
to the public. Detailed, granular data about the operations of
all secondary market entities must be made available to the
public on a timely and consistent basis. This includes data
about the race, gender, national origin, and other relevant
characteristics of borrowers; how a loan was serviced,
purchased, and securitized; and the terms and conditions of the
loans.
6. The system must have an affirmative obligation to offer capital
and credit in communities devastated by the foreclosure crisis
and offer access to families who were targeted for
inappropriate and unsustainable mortgages. It must engage with
community-based financial institutions and community-based
organizations to design sustainable solutions that are
appropriate for specific locales.
7. The housing finance system must provide capital for sustainable
rental and ownership development in all communities.
Neighborhoods require affordable and sustainable rental and
homeownership opportunities to thrive. Capital, especially that
which comes with a Government subsidy or guarantee, should be
directed to underserved areas and investments in opportunity-
rich neighborhoods. This balance will provide the maximum range
of housing choices for all, as there is not currently an
adequate supply of affordable housing for underserved families.
8. The housing finance system must support product flexibility and
sustainable innovation and offer access to institutions of all
sizes and in all geographic areas. To do so requires that the
secondary market avoid over concentration and that secondary
market institutions have the ability to retain loans in their
portfolio. Local institutions are often the first responders to
local needs, adapting underwriting models to fit their
clientele and funding innovation through their own deposit-
based portfolios. Without a secondary market outlet, the volume
of these loans will always be constrained. Further, because
innovation is not always immediately scalable or easily
standardized, it runs the risk of being overlooked by large
financial institutions or secondary market purchasers.
The following organizations contributed to and support the principles
above:
Center for Responsible Lending
David L. Bazelon Center for Mental Health Law
Kirwan Institute
NAACP
NAACP Legal Defense & Educational Fund, Inc.
National Community Reinvestment Coalition
National Council of La Raza
National Council of Negro Women
National Fair Housing Alliance
National Urban League
North Carolina Institute of Minority Economic Development
National Coalition for Asian Pacific American Community Development
PICO National Network
PolicyLink
Poverty and Race Research Action Council
The Leadership Conference on Civil and Human Rights
The Opportunity Agenda
______
PREPARED STATEMENT OF JOHN FENTON
President and CEO, Affinity Federal Credit Union
on behalf of the National Association of Federal Credit Unions
October 20, 2011
Introduction
Good morning, Chairman Johnson, Ranking Member Shelby and Members
of the Committee. My name is John Fenton, and I am testifying today on
behalf of the National Association of Federal Credit Unions (NAFCU). I
appreciate the opportunity to share my views with the Committee on
housing finance reform and the value of the 30-year fixed-rate mortgage
to credit unions and our members. Thank you for holding this important
hearing.
I am president and chief executive officer of Affinity Federal
Credit Union, headquartered in Basking Ridge, New Jersey. I also serve
as chairman and chief executive officer of Affinity Financial Services,
LLC, a wholly owned subsidiary of Affinity Federal Credit Union.
Affinity Financial Services provides diversified financial services,
including insurance, investment products, and mortgage origination and
servicing.
Prior to joining Affinity in 1995, I was president and CEO of
Synergy Federal Credit Union from 1987 to 1995. I have also held the
positions of vice president of administration and finance at East
Bergen Teachers Federal Credit Union (1982-1987) and vice president of
finance at the Clifton Savings and Loan Association (1975-1982).
Affinity Federal Credit Union was chartered on December 13, 1935,
the year after the Federal Credit Union Act was passed and signed into
law by President Roosevelt. It was formed as the W. E. Headquarters
Federal Credit Union to provide cooperative credit and to serve
employee-member needs of Western Electric Company.
In 1974, the membership base of the credit union was extended to
include AT&T employees and the credit union changed its name to GHQ
Federal Credit Union (General Headquarters).
In 1984, with assets of $93.7 million, headquarters were moved
across the river from New York City to New Providence, New Jersey, and
GHQ became the second largest credit union in the State of New Jersey.
At the close of 1986, the credit union changed its name from GHQ to
AT&T Employees Federal Credit Union (AT&T EFCU) to more accurately
reflect the current membership.
In 1995, I was named the new President and CEO, and was charged to
be a catalyst for change. Although serving a single sponsor for most of
these 60 years, the announcement that AT&T would be split into three
separate companies encouraged the credit union to adopt a new name and
Affinity Federal Credit Union was chosen.
Today, Affinity is the largest credit union in the State of New
Jersey with 21 branches, more than 137,000 members from more than 2,000
businesses and organizations, and total assets in excess of $2 billion.
As you may know, NAFCU is the only national organization
exclusively representing the interests of the Nation's federally
chartered credit unions. NAFCU-member credit unions collectively
account for approximately 62 percent of the assets of all federally
chartered credit unions. NAFCU and the entire credit union community
appreciate the opportunity to participate in this discussion regarding
housing finance reform and the continuation of the 30-year fixed-rate
mortgage.
Background on Credit Unions
Historically, credit unions have served a unique function in the
delivery of necessary financial services to Americans. Established by
an act of Congress in 1934, the Federal credit union system was
created, and has been recognized, as a way to promote thrift and to
make financial services available to all Americans, many of whom would
otherwise have limited access to financial services. Congress
established credit unions as an alternative to banks and to meet a
precise public need-a niche credit unions fill today for nearly 93
million Americans. Every credit union is a cooperative institution
organized ``for the purpose of promoting thrift among its members and
creating a source of credit for provident or productive purposes.'' (12
USC 1752(1)). While over 75 years have passed since the Federal
Credit Union Act (FCUA) was signed into law, two fundamental principles
regarding the operation of credit unions remain every bit as important
today as in 1934:
credit unions remain totally committed to providing their
members with efficient, low-cost, personal financial service;
and,
credit unions continue to emphasize traditional cooperative
values such as democracy and volunteerism. Credit unions are
not banks.
The Nation's approximately 7,200 federally insured credit unions
serve a different purpose and have a fundamentally different structure
than banks. Credit unions exist solely for the purpose of providing
financial services to their members, while banks aim to make a profit
for a limited number of shareholders. As owners of cooperative
financial institutions united by a common bond, all credit union
members have an equal say in the operation of their credit union--``one
member, one vote''--regardless of the dollar amount they have on
account. These singular rights extend all the way from making basic
operating decisions to electing the board of directors-something
unheard of among for-profit, stock-owned banks. Unlike their
counterparts at banks and thrifts, Federal credit union directors
generally serve without remuneration--a fact epitomizing the true
``volunteer spirit'' permeating the credit union community.
Credit unions continue to play a very important role in the lives
of millions of Americans from all walks of life. As consolidation of
the commercial banking sector has progressed, with the resulting
depersonalization in the delivery of financial services by banks, the
emphasis in consumers' minds has begun to shift not only to services
provided, but also--more importantly--to quality and cost of those
services. Credit unions are second-to-none in providing their members
with quality personal financial services at the lowest possible cost.
Credit Union vs. Bank Mortgage Lending
Credit unions were not the cause of the recent economic crisis, and
an examination of their lending data indicates that credit union
mortgage lending has outperformed bank mortgage lending during the
recent downturn. This is due in part to the fact that credit unions
were not the cause of the proliferation of subprime loans, instead
focusing on placing their members in solid products that they could
afford. The graphs below highlight how credit union real estate loan
growth has outpaced banks during the downturn, and how credit unions
have fared better with respect to real estate delinquencies and real
estate charge-offs. The fourth graph demonstrates how credit unions are
holding more long-term real estate loans as a percentage of total real
estate loans than banks.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The 30-Year Fixed-Rate Mortgage
The 30-year fixed-rate mortgage (FRM) we know today had its origins
in the reforms of President Franklin Delano Roosevelt's New Deal.
Congress created the Federal Housing Administration (FHA) in 1934 as
part of the National Housing Act of 1934 (Housing Act) during President
Roosevelt's first term. The goal of the Housing Act was to enable home
ownership for a broad sector of the American public. President
Roosevelt's measure was in response to the Great Depression, which
included a collapse of the banking system and subsequent mass
foreclosures.
When the FHA was created, the housing industry was in dire straits.
Millions of Americans lost their homes. Two million construction
workers had lost their jobs. Terms were difficult to meet for
homebuyers seeking mortgages. Mortgage loan terms were often limited to
50 percent of the property's market value, with a repayment schedule
spread over three to 5 years, and ending with a balloon payment.
America had become a Nation primarily of renters. Only 40 percent of
occupied homes were owned.
At this time Fannie Mae and the Federal Deposit Insurance
Corporation (FDIC) were also formed. The creation of these entities
allowed the Government to restructure loan opportunities and create the
30-year fixed-rate mortgage (FRM). These entities have allowed tens of
millions of home mortgages and tens of thousands of multifamily
projects to come to fruition.
Prior to the introduction of the 30-year FRM, U.S. homeowners were
at the mercy of adjustable interest rates. After making payments on a
loan at a fluctuating rate for a certain period, the borrower would be
liable for the repayment of the remainder of the loan (balloon
payment). Before the innovation of the 30-year FRM, borrowers could
also be subject to the ``call in'' of the loan, meaning the lender
could demand an immediate payment of the full remainder. The 30-year
FRM was an innovative measure for the banking industry, with lasting
significance that enabled mass home ownership through its
predictability. Congress gave credit unions the authority to offer 30-
year mortgages in 1977.
Over the long-term, a 30-year FRM can be more expensive than an
adjustable-rate mortgage (ARM). The ARM, however, is subject to
fluctuations of a number of indicators in the market, and therefore
carries greater risk to the borrower. Homebuyers who value more
certainty in mortgage payments, and who can resist the lure of more
risky but possibly cheaper financing, the 30-year fixed-rate mortgage
offers the greatest long-term option, as it protects borrowers against
interest rate spikes.
The FRM is the dominant instrument of mortgage originations. The
FRM is regarded as a consumer-friendly instrument because it is
straight forward, easy to understand, and provides for a predictable
monthly payment schedule. The table on the next page outlines first
mortgage activity (both new and outstanding) at federally insured
credit unions for the first half of 2011. As you can see longer term
fixed-rate mortgages (defined as greater than 15 years) make up the
largest percent of the total loans granted and outstanding in terms of
dollar amounts. Shorter term fixed-rate mortgages (15 years and under)
are the next highest, buoyed by the current low interest rate
environment. In 2009, during a higher interest rate environment, fixed-
rate mortgages made up over 80 percent of the total loans made, with
longer term fixed-rate mortgages accounting for over 55 percent of the
total loans made by insured credit unions.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
With a fixed-rate mortgage, the lending institution assumes the
risk associated with any interest rate increase. Having too many long-
term fixed-rate mortgages in portfolio subjects the financial
institution to greater interest rate risk, and can be cause for concern
for examiners. At Affinity FCU we mitigate risk in our long-term FRM
portfolio by hedging with interest rate swaps, caps, and matched
borrowing. Selling on the secondary market to Fannie Mae and Freddie
Mac is also an important risk mitigation tool. The securitization
activities of Fannie Mae and Freddie Mac help lower the relative cost
of the 30-year FRM and are an important factor in its viability.
Credit unions cannot raise funds from the capital markets, only
from their members. The development of secondary markets for loans and
mortgage backed securities (MBSs) through Government-sponsored
enterprises (GSEs) was key to allowing credit unions to offer loans of
longer terms. Credit unions were able to offer longer-term funding to
match the terms of the mortgages and transfer some of that risk through
loan sales to secondary markets. Without the Housing Act and the
support of the GSEs, it is not clear that today's mortgage loans would
have a 30-year term. Without a Government role in the secondary market,
the 30-year FRM may still exist, but likely with higher cost to the
consumer and scarce availability. The system of long-term fixed-rate
mortgages financed through stable securitization has helped provide
remarkable stability in the U.S. economy, as well as strong and
sustainable homeownership.
There is no evidence that the recent economic downturn and collapse
of the housing market was due to the presence of long-term fixed-rate
mortgages, especially at credit unions. The success of credit unions
during the economic downturn is evidence of this. Credit unions did not
aid in the proliferation of subprime ARMs. Credit union loans are seen
as quality loans, and their performance has backed that up. This is
evidence that the 30-year FRM is not problematic by itself, and can be
an important product for consumers and financial institutions. At
Affinity FCU, we found that when our members got into trouble it was
not from a particular first mortgage product; rather, it was likely
from one of the following two factors: 1) loss of a job or
unemployment; and 2) a decline in home value after a large amount of
equity was pulled out in a line of credit.
The Future of the 30-year FRM
Full privatization of the secondary market is not a good option
because the focus will shift away from the best interest of the
consumer and overall housing market, to a business' bottom line. The
existence of private label securitization of real estate loans was a
significant factor in the recent housing market crisis. Going forward,
a totally privatized secondary market will not allocate enough capital
because of the inherent risks, both credit and interest rate, without
some sort of Government guarantee. Without a Government role, 30-year
(and other longer term) fixed-rate mortgages will become riskier
propositions for credit unions. For safety and soundness reasons,
additional risk will have to be passed on to the consumer. While some
additional risk being borne by the consumer may not be a bad thing in
and of itself, lack of a Government role as a stabilizing force in the
secondary market would have a significant impact on the ability of
credit unions to offer affordable, consumer-friendly mortgage products
such as the 30-year FRM. We believe that it would further limit the
availability of long-term, fixed-rate mortgage products, and
substantially increase the costs of mortgages to the consumer.
It should be noted that the Government support for the secondary
market does not only come from support and guarantees for the GSEs, but
also in an indirect way when Government entities purchase mortgage
backed securities (MBSs). This Government role in the market helps
serve as a check on interest rates for the consumer. The loss of this
Government role would likely drive up rates.
If the Government totally withdrew from the housing market, it
could lead to an absence of, or at least a limited availability of,
longer term FRMs. This would cause risk to be shifted back to the
consumer and the cost associated with that risk would likely drive many
low and moderate income consumers out of the homeownership market.
Furthermore, not having an outlet to sell 30-year FRMs currently held
in portfolio, if needed, could create additional risk for financial
institutions such as credit unions.
The Housing Act, its creation of the FHA, and the resulting
introduction of the 30-year fixed-rate mortgage, brought long-term
stability to the American housing market and helped to stimulate
economic recovery in the United States in the wake of the Great
Depression. Accordingly, NAFCU believes that limiting the availability
of the 30-year fixed-rate mortgage in these tough economic times will
further drive down the already struggling housing market.
The 30-Year FRM and other products at Affinity Federal Credit Union
At Affinity FCU, we offer fixed-rate mortgage products in 10, 15,
20, and 30-year terms. Our 30-year FRM has traditionally been the most
popular loan product with our members as it drives affordability and
accounts for over 64 percent of our fixed-rate mortgage portfolio and
nearly 48 percent of our overall loan portfolio. Our 15 and 20 year
fixed-rate mortgages combined make up nearly another 22 percent of our
total loan portfolio. This demonstrates a clear interest from our
members in having a longer term fixed-rate mortgage product.
I should note that in the current record low interest rate
environment, we are seeing increased interest in the shorter term
fixed-rate products, as monthly payments are more affordable. This has
also been seen in our adjustable-rate products, as people who have
shorter timeframes may opt for the historic low rates of ARMs in this
current rate environment. We believe it is important that any reforms
do not try to limit financial institutions to offering only ``plain
vanilla'' products. As member-owned institutions, credit unions have a
strong track record of offering products our members want, working to
place them in the right product for their needs. It is important that
housing finance reform does not close the door on the ability of credit
unions to match the member with the best mortgage product for them.
We also believe preference for mortgage products is somewhat
generational. Post World War II and the baby boom generation tended to
prefer the stability of long-term fixed-rate products, as many bought
houses that they were going to live in for a number of years. Today, in
a more mobile society, we see members who are approaching retirement or
know they may be moving in a set time opting for a shorter term product
to build faster equity when they buy or refinance. At the same time, we
see many first-time or younger home buyers still opting for the
stability of longer term fixed-rate products. It is important to note
that few 30-year mortgages ever go to their full term, as homeowners
will likely move, refinance or pay off the loan early long before loan
maturity. Still, we have found that our members prefer the certainty of
these longer-term fixed-rate products in their financial planning.
Managing Interest Rate Risk
Recent trends in asset portfolios, coupled with the current
interest rate environment presents a unique challenge to credit union
management. Over the last few years, interest rates have fallen to
record lows, credit unions have experienced vigorous share growth, and
credit union participation in the mortgage lending arena has increased
to historic highs. Given these trends, it is more important now than
ever to have a solid risk management program. The National Credit Union
Administration (NCUA) has been active in watching interest rate risk at
credit unions from long-term fixed-rate mortgages, issuing a letter to
credit unions on the matter as far back as September 2003 and issuing
an interagency (along with banking regulators) interest rate risk
advisory in 2010. Additionally, they are currently in the process of
finalizing a new interest rate risk rule.
The low interest rate environment is an additional deterrent for
attracting private capital. In any housing reform, Government support
is going to be a necessity for the foreseeable future. Curtailing that
support will lead to additional credit stress on individuals and
further threaten the safety and soundness of the financial system.
Rates will rise exacerbating an already stressed economy if lenders do
not have readily available avenues to manage risk.
Credit unions hedge against interest rate risk in a number of ways,
including interest rate swaps, caps, borrowing and selling products for
securitization on the secondary market. Lenders, such as credit unions,
must be able to manage risk. Funding low-rate long-term fixed-rate
paper with short-term deposits is a recipe for disaster. Lenders must
have continued and unfettered access to hedging mechanisms.
Unfortunately, the three ways that lenders manage interest rate risk
(loan sales, term FHLB borrowings and plain vanilla interest rate
swaps) are in the crosshairs of public policy debates.
Some of the options put forth as part of housing finance reform
such as tighter underwriting standards, increasing guarantee fees,
reducing conforming loan limits, increasing downpayments and limiting
FHLB borrowings all could impact lender access to risk management
tools. These ideas must be carefully orchestrated so that lenders can
manage risk, rates are kept at a level that supports the recovery and
consumers have access to credit on reasonable terms.
Fannie Mae and Freddie Mac, as well as the Federal Home Loan Banks,
are valuable partners for credit unions who seek to hedge against these
interest rate risks by selling their fixed-rate mortgages to them on
the secondary market. Because Fannie and Freddie will buy loans on the
secondary market, the credit union is not only able to mitigate the
risk associated with interest rates, but they are also able to reinvest
those funds into their membership or institution by offering them new
loans or additional forms of financial services. Without this
relationship with Fannie and Freddie credit unions would be unable to
provide the services and financial products that their memberships
demand and expect.
It should also be noted that the Government plays an important role
in helping to set standards and bring conformity to the housing market.
The tools that Fannie and Freddie provide help smaller institutions,
such as credit unions, make the conforming loans that are sought on the
secondary market. Changing standards to eliminate or make conformity
difficult could make it hard for credit unions to sell loans on the
secondary market, constraining their ability to manage risk in this
way.
Housing Finance Reform
In the 3 years since the Federal Government took control of Fannie
Mae and Freddie Mac from their stockholders through conservatorship,
the future of the Government-sponsored enterprises and the secondary
mortgage market has become a topic of debate. The development and
reform of housing finance policy is highly significant to NAFCU and
credit unions.
In February, the Department of Treasury released a proposal that
would ultimately wind down Fannie Mae and Freddie Mac by offering three
different scenarios for moving forward with varying degrees of
Government involvement. Several pieces of legislation, from
comprehensive to piecemeal approaches, have also been introduced in the
House and Senate.
NAFCU would like to stress the importance of retaining a system
that provides credit unions with the secondary market access necessary
to serve the mortgage needs of their 93 million members. As you
consider legislative proposals, NAFCU would like to reiterate a core
set of principles we believe must be considered to ensure that credit
unions are treated fairly during any housing finance reform process:
A healthy and viable secondary mortgage market must be
maintained. A secondary mortgage market, where mortgage loans
are pooled and sold to investors, is essential in providing the
liquidity necessary for credit unions to create new mortgages
for their members.
To effectuate competition and ensure access for credit
unions, there should be at least two Government Sponsored
Enterprises (GSEs) that would perform the essential functions
currently performed by Fannie Mae and Freddie Mac.
The U.S. Government should issue explicit guarantees on the
payment of principal and interest on MBSs. The explicit
guarantee will provide certainty to the market, especially for
investors who will need to be enticed to invest in the MBSs and
facilitate the flow of liquidity.
During any transition to a new system (whether or not
current GSEs are to be part of it) credit unions have
uninterrupted access to the GSEs, and in turn, the secondary
market.
Credit unions could support a model for the GSEs that is
consistent with a cooperative or a mutual entities model. Each
GSE would have an elected Board of Directors, be regulated by
the Federal Housing Finance Agency, and be required to meet
strong capital standards.
A board of advisors made up of representatives from the
mortgage lending industry should be formed to advise the FHFA
regarding GSEs. Credit unions should be represented in such a
body.
While a central role for the U.S. Government in the
secondary mortgage market is pivotal, the GSEs should be self-
funded, without any dedicated Government appropriations. GSE's
fee structures should, in addition to size and volume, place
increased emphasis on quality of loans and risk-based pricing
for loan purchases should reflect that quality difference.
Credit union loans provide the high quality necessary to
improve the salability of many agency securities.
Fannie Mae and Freddie Mac should continue to function,
whether in or out of conservatorship, and honor the guarantees
of the agencies at least until such time as necessary to repay
their current Government debts.
NAFCU does not support full privatization of the GSEs
because of serious concerns that small community-based
financial institutions could be shut-out from the secondary
market.
The Federal Home Loan Banks (FHLBs) serve an important
function in the mortgage market as they provide their credit
union members with a reliable source of funding and liquidity.
Reform of the Nation's housing finance system must take into
account the consequence of any legislation on the health and
reliability of the FHLBs.
A vibrant and responsive secondary market for 30-year fixed-rate
paper and access to term funding through the FHLB system are essential
for community-based lenders so they can manage risk, offer a continuing
supply of credit to consumers and small businesses and support the
economic recovery.
NAFCU strongly believes that any reforms must not disrupt the
fragile housing finance system that is slowly beginning to recover. As
you know, any such disruption could trigger a ``double-dip'' recession
and such an occurrence will have a devastating impact on our country's
economy as well as the global finance system. In addition, we believe
it is critical that the essential functions of Fannie Mae and Freddie
Mac are retained until taxpayer dollars that the Federal Government
injected into the GSEs are recovered. The essential functions include,
but are not limited to, purchasing and guaranteeing mortgages
originated by credit unions.
Conclusion
The 30-year fixed-rate mortgage product remains the most popular
mortgage product available today. As such, it is necessary for the
health of our housing market and continued recovery of our economy that
it remains readily available. The ability of credit unions to make
these loans and mitigate their interest rate risk by selling these
loans to GSEs on the secondary market is as important to economic
vitality as their availability in the marketplace. By allowing credit
unions to hedge against interest rate risk by selling these mortgages,
credit unions are better able to serve their members by continuing to
offer products and services they want and need.
We thank you for your time and the opportunity to testify before
you here today on this important issue to credit unions and our
Nation's housing market. I would welcome any questions that you may
have.
______
PREPARED STATEMENT OF ANTHONY B. SANDERS, Ph.D.
Distinguished Professor of Finance
George Mason University School of Management
October 20, 2011
Mr. Chairman, and distinguished Members of the Committee, my name
is Dr. Anthony B. Sanders and I am the Distinguished Professor of
Finance at George Mason. It is an honor to testify before this
Committee today.
The FRM occupies a central role in the U.S. housing-finance system.
The dominant instrument since the Great Depression, the FRM currently
accounts for more than 90 percent of mortgage originations. One reason
why it enjoys enduring popularity is that the FRM is a consumer-
friendly instrument. Not only does the FRM offer payment stability--the
instrument provides a one-sided bet in the borrower's favor. If rates
rise, the borrower benefits from a below market interest rate. If rates
fall, the borrower can benefit from exercising the prepayment option in
the FRM to lower their mortgage interest rate.
But these consumer benefits have costs. It is costly to provide a
fixed nominal interest rate for as long as 30 years. And the prepayment
option creates significant costs. If rates rise, the lender has a below
market rate asset on its books. If rates fall, the lender again loses
as the mortgage is replaced by another with a lower interest rate. To
compensate for this risk, lenders incorporate a premium in mortgage
rates that all borrowers pay regardless of whether they benefit from
refinance. Exercise of the prepayment option in the contract also has
significant transactions costs for the borrower and imposes additional
operating costs on the mortgage industry.
Another major reason for the FRM's dominance is Government support
and regulatory favoritism. The FRM is subsidized through the
securitization activities of Fannie Mae, Freddie Mac and Ginnie Mae.
Their securities benefit from a Government guarantee that lowers the
relative cost of the instrument, which is their core product. These
guarantees have a significant cost as the Government backing of Fannie
Mae and Freddie Mac has exposed taxpayers to large losses.
Are the FRM's benefits worth its costs? Would the FRM disappear if
Fannie and Freddie stopped financing it? Are there mortgage
alternatives that balance the needs of consumers and investors without
exposing the taxpayer to inordinate risk? These are important questions
and the answer is that short-term FRM and ARMs have decided benefits to
consumers and taxpayers over the vaunted 30-year FRM.
Benefits of FRMs
A long history of Government support is not the only reason for the
FRM's dominance.\1\ The instrument offers consumers several advantages.
First and foremost, it provides nominal payment stability, which helps
consumers budget and reduces the likelihood of default. The monthly
payment on an FRM is the same throughout the life of the loan, whereas
borrowers with ARMs can experience payment shock in a volatile
interest-rate environment, making them more likely to default.\2\ The
FRM is also a simple instrument for borrowers to understand, which has
lead to proposals that lenders be required to offer the instrument to
consumers applying for a mortgage.
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\1\ See Michael Lea and Anthony B. Sanders, 2011, ``Government
Policy and the Fixed-Rate Mortgage,'' Annual Review of Financial
Economics.
\2\ ARMs have had a much worse default experience during the
recession. In part, this reflects the predominance of ARMs in the
subprime market. It also reflects a selection bias whereby riskier and
more speculative borrowers went into ARMs.
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The option to prepay an FRM without penalty is another consumer
advantage.\3\ This feature effectively converts the FRM into a
downwardly adjustable-rate mortgage. When market interest rates fall,
the borrower can refinance into a new loan at a lower rate. When rates
rise, the fixed-rate feature protects the borrower against rising
mortgage payments. Thus, the FRM (as opposed to a short-term ARM, for
example) shields borrowers from most interest-rate risk. But the risk
does not disappear--the lower the risk for the borrower, the greater it
is for the lender/investor.
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\3\ Prepayment is not costless, however. There are significant
transaction costs associated with refinancing.
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Costs of FRMs
The instrument's supporters point out that it is easier for
investors than consumers to manage interest-rate risk. It is true that
lenders and investors have more tools at their disposal to manage
interest-rate risk. But managing prepayment risk is costly and
difficult and many institutions have suffered significant losses as a
result (e.g., savings and loans in the 1980s; hedge funds and mortgage
companies in the 1990s and 2000s).\4\ Furthermore, borrowers rarely
stay in the same home or keep the same mortgage for 15 to 30 years,\5\
so one can reasonably ask why rates should be fixed for such long
periods (increasing the loan's cost and risk). Also, the taxpayer
ultimately bears a significant portion of the risk through support of
Fannie Mae and Freddie Mac.
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\4\ The uncertainty about prepayment leads to considerable
speculation on the future direction of mortgage rates that has little
social benefit. Hedging also increases systemic risk through
counterparty exposure. The huge hedge positions of Fannie and Freddie
were one reason why the Government placed them in conservatorship in
2008.
\5\ Over the past 50 years the average life of a 30-year mortgage
has never been higher than 12 years (during periods of high interest
rates) and often no more than 5 years (during period of lower interest
rates).
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One of the lingering questions about Government loan modification
programs is why borrowers are refinanced into longer-term FRMs rather
than less expensive ARMs, such as a 5/1 ARM.
Does the FRM Promote Financial and Housing Market Stability?
It has been argued that the FRM promotes financial- and housing-
market stability. A system dominated by ARMs or short-term fixed-rate
mortgages is more sensitive to interest-rate fluctuations than one
dominated by the FRM and can contribute to boom-bust cycles in housing.
Housing demand is more rapidly influenced by monetary policy with ARMs
relative to FRMs. But FRMs hardly eliminate housing cycles. The United
States has experienced pronounced housing cycles in most decades since
World War II, including a massive housing boom and bust in the last
decade. Min attributes the most recent cycle to the rapid growth in
short-duration mortgages. In large part, the shortening average life of
mortgages reflects the widespread exercise of the FRM prepayment
option.
The FRM has a uniquely one-sided design that protects the borrower
at the expense of the lender/investor. But such protection comes at a
cost. Longer-term fixed-rate loans have higher rates than shorter-term
fixed-rate loans in most interest-rate environments (Table 1). Having a
range of fixed-rate terms allows the borrower to tradeoff monthly
payment stability with overall mortgage affordability. For example, a
mortgage whose interest rate is fixed for 30 years will usually have
the highest interest rate, while a 3:1 ARM, whose interest rate is only
fixed for the first 3 years, will usually have the lowest interest
rate.
Also, prepayable mortgages have higher rates than non-prepayable
mortgages. In effect, all U.S. mortgage borrowers pay for the option to
refinance, regardless of whether they exercise it. This system differs
from the Canadian and European systems. In those systems, the borrower
receives a short- to medium-term fixed-rate loan without a free
prepayment option. If the borrower wants to prepay for financial
reasons (as opposed to moving), they must pay a penalty equivalent to
the investor's or lender's cost to reinvest the proceeds at the new,
lower market rate. The option's cost is thus individualized--borne by
the individual exercising the option. In the United States, the
option's cost is socialized, with all borrowers paying a premium in
their mortgage rates (on average, around 50 basis points, or 0.5
percent). In effect, the prepayment option is a tax on all borrowers.
Because all borrowers pay for the prepayment option, borrowers who
do not exercise the option effectively subsidize those who do. Most
often, unsophisticated borrowers who are intimidated by the refinance
process or who are credit impaired pay the subsidy. The latter group is
most likely to benefit at the margin (e.g., by lowering the risk of
default) but least able to refinance.
The 30-Year FRM, Slow Principal Amortization and Negative Equity
The potential for negative equity with a slowly amortizing mortgage
product is daunting. When the principal is very slow to pay down and
house price drop suddenly (as they did during the housing bubble
burst), The FRM can create negative equity for borrowers in a rising
interest-rate environment as well. When interest rates rise, a house's
value may fall. And the economic value of the mortgage falls. However,
the borrower is still responsible for repaying the loan at par value
(the nominal outstanding balance). The combination of falling house
price and constant mortgage value can lead to or exacerbate negative
equity. Homeowner negative equity can also produce significant economic
costs in that they are less likely to move in order to change their
housing consumption or to take advantage of job opportunities. Negative
equity has made loan modifications under private and public programs
quite difficult and would have been far less of a problem if short-term
mortgages (and faster principal amortization) had been the pre-dominant
mortgage design.
Rising interest rates cause other problems for FRM borrowers and
investors. If rates rise because of expected inflation, FRMs create
affordability problems for new borrowers.\6\ Unhedged investors
experience an economic loss on their holdings of FRM-backed securities
when interest rates rise (they also do not benefit from a rate decline,
as noted earlier).\7\ Rising interest rates also create an extension
risk (the risk that the average life of securities rises) for
investors. As rates rise, prepayments slow and the effective maturity
of the securities increases beyond that expected by investors.
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\6\ This scenario occurred during the 1970s in the United States.
\7\ Hedging uncertain prepayment is both costly and risky. It leads
to considerable speculation on the future direction of mortgage rates
that has little social benefit. Hedging also increases systemic risk
through counterparty exposure. The huge hedge positions of Fannie and
Freddie were one reason why the Government placed them in
conservatorship in 2008.
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Interest-rate Volatility and the 30-Year FRM
Volatile interest rates cause problems for both borrowers and
lenders. Long-term fixed-rate instruments have greater sensitivity to
interest-rate changes than shorter-term instruments do. Volatility in
pricing also makes mortgage shopping more difficult for borrowers in
that mortgage prices can vary significantly on a daily (or even
intraday) basis.\8\
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\8\ Mortgage shopping in the United States is also complicated by
the use of points to adjust pricing. Borrowers are confronted with an
array of rate and point combinations that differ across lenders. Points
were introduced in the 1970s when market rates rose above FHA rate
ceilings--another effect of Government regulation.
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Interest-rate volatility also causes refinancing waves, which
increase costs for mortgage originators and borrowers. As interest
rates rise and fall, mortgage origination volume is subject to massive
swings. Mortgage originators and servicers have significant costs
associated with managing such volatility. For example, origination
volume rose from less than $3 trillion in 2002 to nearly $4 trillion in
2003 and fell to less than $3 trillion in 2004. Thus, the industry had
to increase capacity by 33 percent in 1 year and reduce it by 25
percent the following year. FRM refinancing was the main reason for
this volatility. For mortgage borrowers, the cost of refinancing lies
in the thousands of dollars they must pay in origination fees simply to
lower their mortgage rates.\9\ The effect of the 30-year FRM on
prepayments can be seen in Table 1 where the Mortgage Bankers
Association Refinancing Index has become more volatile with
progressively declining interest rates; shorter-term mortgages do not
have the volatility of prepayments than longer-term mortgages.
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\9\ Refinancing transactions costs could be eliminated with use of
a ``ratchet mortgage,'' in which the rate is automatically lowered
without transaction costs.
---------------------------------------------------------------------------
The FRM has also created significant costs for taxpayers. Until
1981, federally insured depositories were prohibited from offering
ARMs. Predictably, when inflation and interest rates rose in the 1970s
and early 1980s, reliance on this instrument effectively killed off the
S&L industry. In 1982, approximately 80 percent of the S&L industry was
bankrupt and insolvent due to the mismatch between FRM assets and the
short-term deposits that funded them. A similar mismatch rendered
Fannie Mae insolvent. When numerous thrifts eventually failed, the
taxpayer picked up a significant tab to restructure the industry.\10\
---------------------------------------------------------------------------
\10\ Although the popular press tended to focus on excessively
risky nonresidential mortgage investments as the cause of the S&Ls'
failure, the fact was that they were bankrupted by the asset-liability
mismatch and tried to grow out of their earnings and capital problems
through investment in high-risk assets.
---------------------------------------------------------------------------
Learning from the experience, banks and thrifts continued to
originate 30-year FRMs, but only if the loans could be sold to Fannie
Mae, Freddie Mac, or guaranteed by the Ginnie Mae. In other words,
banks and thrifts did not retain the interest-rate risk that they
created by originating the FRMs. Instead, investors absorbed the risk.
As the ultimate risk bearers, private investors attempted to price and
manage the risk (with varying degrees of success). The GSEs hold a
significant portion of the FRM inventory,\11\ so when interest rates
rise, they may suffer large losses that will be borne by taxpayers.
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\11\ The GSEs hold whole loans in their portfolios. They also
repurchase securities they guarantee-in effect investing in the cash-
flow risk associated with funding callable mortgages with a blend of
callable and non-callable debts of different maturities.
---------------------------------------------------------------------------
The FRM's popularity and its Government backing produce another
significant risk for the Government. In order to finance the FRM and
allocate the interest-rate risk to investors, the Government--through
FHA insurance and Fannie/Freddie guarantees--absorbs the mortgages'
credit risk. Ironically, it was credit risk that led to the failures of
Fannie and Freddie in the financial crisis. While part of their losses
can be attributed to speculative investments in subprime and Alt-A
backed securities (mostly non-fixed-rate mortgages), a significant
portion of their losses have come from FRM defaults.\12\ The Federal
Housing Finance Agency now projects GSE losses to be $220 to $360
billion. A portion of these losses can be attributed to the policy goal
of ensuring the FRM's availability through the Government's absorption
of the credit risk.
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\12\ Federal Housing Finance Agency (FHFA) projections of GSE
losses found that most of the losses are due to their purchased loans
rather than securities. See FHFA, ``Projections Showing Range of
Potential Draws for Fannie Mae and Freddie Mac,'' October 21, 2010
(Attachment to the Press Release FHFA Releases Projections Showing
Range of Potential Draws for Fannie Mae and Freddie Mac).
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Alternative Designs in International Mortgage Markets
The FRM is a unique instrument by international standards. Only one
other country, Denmark, has a long-term, fixed-rate, prepayable
(without penalty) mortgage.\13\ Several other countries have long-term
fixed-rate products (e.g., France, Japan, and Germany), but the typical
terms are shorter and prepayment is subject to penalty. Shorter
amortization periods benefit both borrowers and lenders because
borrowers accumulate equity faster.
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\13\ The Danes add a unique twist to the instrument in that the
loan is backed by an individual mortgage bond. If rates rise, the
borrower can buy the bond at a discount and cancel the loan with the
lender. This feature facilitates automatic deleverage and reduces the
likelihood of negative equity.
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A more common fixed-rate instrument is the rollover mortgage, which
is the dominant instrument in Canada and several European
countries.\14\ Its interest rate is typically fixed for up to 5 years
and ``rolls'' into a new fixed rate at the end of the term. The new
rate is negotiated with the lender and is set at market. These loans
also have prepayment penalties during the fixed-rate term but allow
total repayment without penalty at the end of the term.
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\14\ Canada subsidizes mortgages through CMHC. The degree of
support is far less that U.S. support for housing (around 50 percent
insured and 30 percent securitized) and the Canada bond program was
designed to eliminate the prepayment volatility because investors don't
like it (through cash-flow swaps with private investors).
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Adjustable-rate loans are the dominant instrument in a number of
countries, including Australia, Spain, and the United Kingdom. Table 2
shows the types of mortgages available in different countries and how
common each product is.
Many countries have had housing booms and busts during the last
decade (e.g., Australia, Denmark, Ireland, Spain). Yet only Ireland has
had as severe of a downturn as the United States (Table 3). Some have
attributed the U.S. housing cycle to a shortening of the duration of
mortgages over the past two decades, which caused house prices to
become more sensitive to interest rates. Low interest rates, ample
credit and borrower demand clearly contributed to the boom--however,
throughout the boom period a majority of loans were in fact fixed
rates. Most of the reduction in average mortgage maturity was due to
borrowers exercising the prepayment option in their FRM contracts. And
much of the shortening was for cash-out refinances to facilitate
consumption at the expense of wealth accumulation. The inability of
households to refinance FRMs to reduce negative equity has exacerbated
the current crisis as noted above.
The prepayment option on the 30-year FRM is far from free. While
only some borrowers will actually utilize the prepayment option,
everyone has to pay for it (even if consumers don't want it). Fannie
Mae and Freddie Mac will only purchase prepayable mortgages, even
though non-prepayable mortgages may be in many borrowers' best
interests.
Are The Benefits of the FRM Worth the Costs?
The fundamental question remains: Are the benefits of the FRM worth
the costs? All borrowers pay a substantial tax--50 basis points or
more--for this instrument. Furthermore, taxpayers have absorbed
substantial losses in order to support this instrument, first through
the S&Ls and now through Fannie Mae and Freddie Mac. Should the
Government subject taxpayers to the risk of another catastrophic
meltdown to preserve the FRM? Are there alternatives that maintain some
of the FRM's benefits while greatly reducing the costs?
If the Government abolished Fannie Mae and Freddie Mac, the FRM
would not cease to exist. Private-label securitization in the United
States and covered bonds in Denmark have funded this instrument in the
past and are fully capable of funding it in the future. Investors are
sophisticated enough to price both credit risk and interest-rate risk.
Conventional wisdom suggests that U.S. investors won't accept both
credit risk and interest rate risk for large volumes of mortgages and
the reason is clear: private investors can get the Government to absorb
the credit risk at a lower cost than would be charged by the private
market. The loss experiences of Fannie and Freddie suggest that they
were funding mortgages at below-market (risk-adjusted) rates. Without
Fannie and Freddie, the FRM would still be offered by lenders, but not
at a subsidized rate. The FRM would have a smaller market share, but it
would not disappear, as some have asserted. Nor would the only
alternative be a short-term ARM as international experience suggests.
What would emerge as the ``standard'' U.S. mortgage instrument
without Government support of the FRM? A rollover mortgage similar to
that offered in Canada and several European countries is the likely
candidate.\15\ This instrument offers borrowers short- to medium-term
payment stability, and borrowers can manage interest-rate risk by
adjusting the fixed-rate term upon renewal. Modern international
experience does not bear out the assertion by some that borrowers would
be unable to refinance. Borrowers could hedge the interest-rate risk by
locking in a forward rate in advance of renewal. German lenders offer
forward rates up to 5 years--certainly U.S. lenders could do the same,
given the deep derivative market. Alternatively, borrowers can adjust
the degree of risk by varying the length of the fixed-rate period.
---------------------------------------------------------------------------
\15\ Canada supports its mortgage market through default insurance
and cash-flow guarantees comparable to FHA insurance and Ginnie Mae
guarantees in the United States. The market share of Government-backed
mortgages is considerably less, however, with approximately 50 percent
of mortgages backed by Government insurance and 25 percent of mortgages
backed by guarantees. European countries (with the exception of the
Netherlands) do not support their mortgage markets through insurance or
guarantees.
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A complete and robust housing-finance system should offer borrowers
a menu of mortgage options, ranging from short-term ARMs for borrowers
who can handle payment change to long-term FRMs for borrowers who value
payment stability. To assert that the FRM is the preferred alternative
for most borrowers is naive. Many borrowers have shorter-term time
horizons and can handle some interest-rate risk. The reason borrowers
select a longer-term fixed rate is the fact that Government guarantees
subsidizes the rate. International experience does not support the
assertion that the switch to shorter-duration instruments would lead to
massive defaults if and when interest rates increase.
The prohibition of prepayment penalties on fixed-rate mortgages is
also misguided. Borrowers should be given a choice--long-term versus
short-term fixed rates, with and without prepayment penalties. The
market will price the differences, giving price breaks to those
borrowers willing and able to handle interest-rate risk. Following
Canadian and European tradition, the imposition of a prepayment penalty
should be limited. It should not apply to borrowers moving house and it
should be limited in term.\16\
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\16\ For example, the maximum term over which the penalty applies
is 5 years in Canada and the Netherlands and 10 years in Germany.
---------------------------------------------------------------------------
Summary
The private sector would continue to originate and hold/sell 30-
year FRMs without Government guarantees if there was continued consumer
demand, but it is hoped that shorter-term mortgages and ARMs become
more popular in the future. The most important result of a shift away
from the FRM would be a reduction in taxpayer liability for mortgage
risk. There is nothing so special about housing finance that Government
should absorb the credit risk of the vast majority of the mortgage
market or underwrite the interest-rate risk of that market. Two
episodes of massive taxpayer losses should convince us of that fact.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
______
PREPARED STATEMENT OF PAUL S. WILLEN
Senior Economist and Policy Advisor
Federal Reserve Bank of Boston
October 20, 2011
Chairman Johnson, Ranking Member Shelby, and distinguished Members
of the Committee, I thank you for your invitation to testify today. My
name is Paul Willen, and I am a Senior Economist and Policy Advisor at
the Federal Reserve Bank of Boston. I come to you today, however, as a
researcher and not as a representative of the Boston Fed, the other
Reserve Banks, or the Board of Governors. My main objective today is to
lay out some basic facts about long-term fixed-rate mortgages. The main
benefit of fixed-rate mortgages, according to proponents, is that they
eliminate the possibility of ``payment shocks'' and thus would have
prevented many of the foreclosures we have seen in the last 5 years. I
will explain that, contrary to popular belief, payment shocks played
little role in the crisis and, in fact, most borrowers who lost their
homes in the last 5 years had long-term fixed-rate mortgages. I will
also discuss how long-term fixed-rate mortgages have been widely used
throughout American history, including the years immediately preceding
the Great Depression, and were as ineffective at preventing
foreclosures in the 1930s as they are now.
``Payment Shocks'' Did Not Cause the Crisis
One popular theory places mortgage payment shocks at the heart of
the crisis. According to this theory, the explosion of foreclosures
that started in 2007 occurred because borrowers took out complex
mortgages with fluctuating payments. Borrowers who took the loans
either did not realize the payments could increase, did not expect the
payments to increase, or thought they could sell or refinance before
the payments increased. The theory suggests that, when payments went
up, borrowers found themselves facing unaffordable increases in monthly
mortgage costs, the aforementioned payment shocks, for which
foreclosure was the unfortunate outcome. According to the theory, long-
term fixed-rate mortgages would have largely mitigated the crisis
because long-term fixed-rate mortgages guarantee a fixed payment for
the life of the loan.
But the data refute that theory. The data say that payment shocks
played, at most, a minor role in the crisis. As you can see in Table 1,
we studied 2.6 million foreclosures and, for 88 percent of them, the
payment when the borrower defaulted was the same or lower than the
initial payment.\1\ In other words, in only 12 percent of
foreclosures--less than one out of eight--did the borrower suffer any
payment shock at all prior to defaulting. Why didn't payments go up? It
turns out that almost 60 percent of the borrowers who lost their homes
had fixed-rate mortgages. This fact alone should dispel the
misconception that a fixed-rate mortgage is inherently safe. But even
borrowers who had adjustable-rate mortgages saw payments stay the same
or go down. Why? Because contrary to popular belief, adjustable-rate
mortgages do not only adjust up; if interest rates fall, payments
either fall or stay the same. Starting in 2007, as in most recessions,
interest rates fell. Indeed, in 2010, borrowers who lost their homes
were almost as likely to have seen a payment reduction as a payment
increase.
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\1\ ``Defaulted'' here refers to the first default in the
delinquency spell that led to the foreclosure.
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If payment shocks don't cause foreclosures, what does? Our research
has shown that life events such as job loss, illness, and divorce have
been at the heart of this crisis all along, even before unemployment
surged in the fall of 2008. It may seem counter-intuitive that life
events can explain the surge in defaults in 2007, because there was no
underlying surge in unemployment or illness that year. To better
understand, one needs to know how falling house prices and life events
interact to cause default. Foreclosures rarely, if ever, occur when
borrowers have positive equity, for the simple reason that a borrower
is almost always better off selling the house than defaulting. Thus,
detrimental life events have no effect on foreclosures when prices are
rising. Consider that in 2001, after 6 years of rising house prices,
Massachusetts suffered a fairly severe recession which led to a large
increase in delinquencies, but the number of foreclosures fell to a
record low. You can see this evidence in Figure 1. On the other hand,
when house prices fall, some borrowers can no longer profitably sell.
It is then that disruptive life events--which are always present, even
in normal times--take a toll. Thus we do not need to have a surge in
life events to get a surge in foreclosures. Rather, a fall in house
prices, as we have seen, will trigger a foreclosure surge. The problem
is only amplified by rising job loss and other disruptive life events.
It does turn out that fixed-rate mortgages default less often than
adjustable-rate mortgages, but that fact reflects the selection of
borrowers into fixed-rate products, not any characteristics of the
mortgages themselves. In 2008, my colleagues and I showed that even
accounting for observable characteristics of the loans--such as credit
score, loan-to-value ratio, payment-to-income ratio, change in house
prices, and change in payment--borrowers were more likely to default on
adjustable-rate mortgages than on otherwise similar fixed-rate
mortgages.\2\ The difference in default rates existed even for pools of
loans where adjustable interest rates fell, further confirming that it
was unobservable characteristics of borrowers, not of mortgages, that
caused the difference. One possible explanation is that borrowers who
intended to sell did not value the long-term certainty of fixed rates,
gravitated to adjustable-rate loans, and those borrowers were the ones
most likely to default when prices fell.
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\2\ ``Just the Facts: An Initial Analysis of the Subprime Crisis.''
With Chris Foote, Kris Gerardi and Lorenz Goette. 2008. Journal of
Housing Economics, 17(4):291-305.
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Long-term Fixed-rate Mortgages Were Widely Used Before the Great
Depression
The misconception that long-term fixed-rate mortgages are
inherently safe has a long history. It is widely believed that the
absence of long-term fixed-rate mortgages prior to the Great Depression
was a major contributor to the ensuing foreclosure crisis. Again, the
facts do not bear this out. As you can see in Table 2, building and
loan societies accounted for 40 percent of U.S. residential lending
during the Depression. Almost all loans from building and loan
societies were long-term fixed-rate mortgages that provided for full
amortization. As with the most recent crisis, it was the combination of
falling house prices and massive economic dislocation that caused the
foreclosures, something a fixed-rate mortgage is powerless to stop.
The facts also disprove a closely related narrative about the
Depression, which is that policymakers invented long-term fixed-rate
mortgages, or were the first to use them widely. In fact, building and
loan societies, the first of which began lending in 1831, always
originated long-term fixed-rate mortgages and were, for much of the
pre-depression era, the largest single source of funding for
residential mortgages.
I hope these findings add insight to your work as policymakers.
Thank you again for the opportunity to appear today; I would be happy
to address any questions.
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PREPARED STATEMENT OF SUSAN E. WOODWARD Ph.D.
President, Sand Hill Econometrics
October 20, 2011
The focus of this hearing is the potential risk and unfairness of
30-year fixed-rate loans. While these loans are appealing to borrowers
for their simplicity and certainty, they have the potential for
problems elsewhere in the economy, ultimately falling on taxpayers.
Let's go directly to the risk issues first.
The critics of the 30-year fixed-rate loan argue that this is
unfair for households to get the benefits of reduced risk of fixed-rate
loans while the taxpayers bear the risk. This criticism forgets that
homeowners are taxpayers too. If we consider the situation over the
lifetime of homeowner/taxpayers, there is nothing unfair about it.
Indeed, it is a very desirable piece of social risk-sharing.
First, we need a few facts:
1. While the homeownership rate is between 65 and 70 percent right
now, a much higher fraction of households, close to 85 percent,
become homeowners at some point in their lifetime.
2. Individual incomes tend to rise over time, and peak at about age
55.
3. Home-owning households on average have higher incomes than non-
homeowning households, and as a result pay more taxes.
This means that the overlap between homeowners and taxpayers is
even higher than the 85 percent lifetime ownership rate. The people who
benefit from our mortgage finance systems are thus the same people who
pay taxes when problems arise. People benefit from the availability of
a fixed-rate mortgage when they are young and have greater need for the
security it provides, and the same people potentially bear a cost when
they are older and have more income. The same folks who benefit from
the availability of a 30-year fixed-rate loan are the ones who
potentially could bear some costs from it. This is a fair tradeoff and
one that most taxpayer/homeowners and potential homeowners ought to
find an appealing part of national housing policy.
So that's my first point: Yes, the 30-year fixed-rate loan
potentially has some cost to taxpayers, but since taxpayers are
virtually all homeowners too, there is nothing unfair about this
situation.
As an aside, somewhat more equity in lending institutions could
also provide an additional buffer between mortgage finance and
taxpayers.
Adjustable-rate loans have different problems, problems that are
both individual households and to the wider economy. These problems
appear to be more difficult to address than the potential problems of
the FRM.
The problem with ARMs is that the standard design is flawed. ARMs
fail to link payment changes to household income changes. The designers
of ARMs saw this problem and put in caps on the rate adjustment,
typically 2 points for a given year and 5 for the life of the loan.
This moves the ARM is the direction of being fixed rate. Nonetheless,
the threat to household budgets is still substantial. For example,
suppose the rate of inflation picked up from say, 2 percent to 4
percent, moving the homeowners' rate from 4 percent to 6 percent. The
likely change in the borrower's income is the current rate of
inflation--6 percent. But the borrower's payment will rise 25 percent!
Only affluent households with a lot of room to maneuver can tolerate
this level of cash-flow uncertainty. People are not choosing badly when
they opt for a fixed-rate loan.
In addition, the ARMs can pose risks to the economy too. The
recession of 1980-1982 would have been much worse, with much higher
levels of mortgage defaults and an even bigger collapse in economic
activity, if all borrowers had had ARM loans. How bad the macroeconomic
damage can be from U.S.-style ARM loans in a recession with all ARMs is
something we don't know, an experiment we have never performed.
For both fixed-rate and adjustable-rate loans, risk arises mainly
from fluctuations in the rate of inflation, so let's talk about
inflation uncertainty.
If the rate of inflation remains low, as it has since 1987 when the
Federal Reserve made a new commitment to a low and stable inflation
rate, changes in interest rates pose little threat to either borrowers
or lenders, and thus little to taxpayers either. On the other hand,
with inflation this stable, the 30-year fixed-rate loan presents no
risk either. With low and stable inflation, the 30-year fixed-rate loan
is better because it is simpler and easier for borrowers to understand.
Borrowers do not have to struggle to understand the indexes that
underly ARM mortgages, and they do not have to understand the potential
fluctuations in these, nor do they need to worry about exotic features
of their loan that may have escaped their attention.
The FRM creates problems when the rate of inflation is higher than
was expected. Lenders in the United States have, they have funded long-
term fixed-rate mortgages with either deposits or with other borrowing
that is shorter-term than the mortgages. If the rate of inflation picks
up, the cost of the short-term funding for them rises. The value of the
assets fall, but the value of the liabilities does not, and the
institution is potentially insolvent. Taxpayers can potentially be
asked to bail out the insolvent institutions, and they were once.
Though as another aside, the lenders who failed mainly failed because
of the risks they took when they were ``de-regulated'' in the early
1980s. Those who stuck with their old portfolios recovered without
bailouts.
When this happens, the homeowners have a gain, while lenders and
the taxpayers potentially have a loss. These net out to zero. And as I
pointed out before, the homeowners and the taxpayers are the same
folks. The benefits are larger earlier in their lives, and the
potential costs come at a later point when they are paying more taxes.
This is a good trade, there is nothing unfair about it.
Now on to the second issue: Do we need Government support for the
30-year fixed-rate mortgage?
I believe the answer is Yes.
The two most important innovations in mortgage finance in the 20th
century were undertaken by the Federal Government. The first was the
creation of a long-term, amortizing, fixed-rate and prepayable mortgage
loan. Loans of this type were made available by FHA just after FHA's
creation. Mortgage loans available before this were shorter in term,
usually 5 to 10 years, and were not amortizing. They were what we would
today call ``balloon'' loans. FHA also provided, and still provides,
insurance on these loans, which serves the function of making lenders
more willing to lend against residential property.
The second innovation was the creation of a secondary market via
Ginnie Mae. Ginnie was and is an astounding success. Ginnie Mae's role
is to package already-insured FHA loans into securities that are liquid
and tradable. Ginnie's creation in 1968 lowered FHA borrowing rates by
70 basis points. Given that the long-run real interest rate on
mortgages is about 4 percent, this is a substantial savings to
homeowners. There is no cost to taxpayers from this re-packaging of FHA
loans. The loans were already fully insured, and this insurance is paid
for by FHA borrowers. The additional risk from packaging the loans into
securities is trivially small. So we get a big benefit from a
Government program that has no cost to taxpayers.
Why is the benefit so large? Because all parts of the financial
market, including lenders themselves, prefer to hold a liquid asset
than an illiquid one. It is that simple. By packing the loans into
securities, illiquid whole loans are transformed into liquid securities
that lenders are happy to hold at lower yields.
Ginnie was such a success that the thrifts immediately created
Freddie Mac, to perform the same function for the conventional mortgage
market. Fannie expanded into creating securities somewhat later, but it
became the most important part of Fannie's function also.
Could the private market not create such an entity? Yes, it could,
and once it did. When the thrifts created Freddie Mac, they copied the
Ginnie design for themselves. I would not expect this to happen again
now. When Freddie was created, even the largest thrift had only a tiny
share, less than 1 percent, of the market. Both the larger and the
smaller lenders had much to gain from better capital market access and
more liquid assets. But now, with a few large lenders dominating
mortgage lending, we should expect that the large players would not
voluntarily create an institution to the benefit of their smaller
competitors. These barriers to cooperation are much larger now than
they were in 1968.
The private market has done some securitization of mortgages
outside of our three large institutions, but it has not created the
market-wide benefits that securitization through Ginnie, Freddie and
Fannie has. The reason is that these one-off securitizations are
designed to make today's issue sellable, not with the view of creating
an effective, liquid market for all lenders. If we are to have
institutions that perform a function similar to what Ginnie Mae,
Freddie Mac and Fannie Mae do, in re-packaging mortgages into liquid
securities, we need some push from the Government to make sure they
exist.
I would hope to see one major reform to Fannie and Freddie or their
successors: create a restraint so they could not again provide funding
to new and unproven ideas like subprime lending. Ginnie Mae stood by
and shrunk mightily as subprime expanded, while Freddie and Fannie
rushed in. Ginnie's strategy was by far the better.
To make sure I cover everything of interest, I will address the
Committee's specific questions for this hearing.
1. What would the national housing market would look like in the
absence of the FRM, taking into account the accessibility and
affordability of credit for the average middle class American
family as well as the importance of stable finances?
Without some Federal support, specifically the support of the
secondary market for FRMs, there will be a lot more adjustable-rate
loans. We can expect a variety of ARMs, tied to different indexes, with
different re-set periods, different caps, and different margins, much
like the ARM market that was active prior to the financial crisis, but
larger, with more varieties.
The 30-year fixed-rate loan is unquestionably easier for households
to understand than any adjustable-rate mortgage. This simplicity is not
in dispute. Even with the 30-year fixed-rate loan, we have substantial
evidence that there is still borrower confusion. The terms that
borrowers get demonstrate this confusion. The borrower confusion levels
can only be higher on ARMs.
Survey work of mortgage borrowers indicates that essentially none
of them understand the indexes to which adjustable-rate loans are tied.
Finance is difficult and arcane, and people stay in school a long time
to learn it. The London Interbank Borrowing Rate (Libor)? The 1-year
Treasury rate? A twelve-month moving average of the 1-year Treasury
rate? We cannot expect any ordinary household to understand where any
of these interest rates come from or to have any idea of what is the
likely variation in such interest rates over the next 30 years. Only
the most sophisticated households would understand them. Even Ph.D.
economists have a difficult time predicting the level and volatility of
interest rates. The average household will not understand what risk it
is undertaking with an ARM. It will be more work for regulators to
oversee an all-ARM market to try to curb abuse by lenders.
And of course we will not be free of potential macroeconomic
problems coming from the mortgage market. If the inflation rate rises,
and ARMs reset higher, there will be households unable to make their
payments and who will default. The full force of this remains to be
seen and will depend on the nature of the ARM loans that are
outstanding.
2. The Committee would appreciate your thoughts on the benefits of
long-term fixed-rate financing for homeowners in positive and
negative economic times.
When times are good and inflation is low, there is still a benefit
to the FRM because it is simpler for borrowers to understand. Mortgage
finance is difficult enough on even fixed-rate loans, and it is more
difficult on ARM loans. With an all-ARM market, lenders and finance
professionals have more tools and varieties to take advantage of
borrowers who are not financially sophisticated.
In tougher times, the benefits of the FRM are less subtle. If the
rate of inflation rises, the standard ARM loan puts borrowers in a
difficult situation because their payments rise much faster than their
incomes do. The simple result is more mortgage defaults.
3. Please also identify pieces of our current system that are
necessary if the 30-year fixed-rate prepayable mortgage is
going to continue to be widely available.
To begin, we should keep FHA mortgage insurance and the Ginnie Mae
program for securitizing FHA (and VA) mortgages. They provide a source
of stability and a continuous demonstration of what is possible in
effective and constructive mortgage finance. In addition, we need
Government backing for a at least one entity to provide securitization
to the conventional market, and entity like Freddie Mac between 1970
and 1989. The portfolio role of Fannie Mae and the post-1989 Freddie
Mac are not clearly essential. We have solid evidence that effective
securitization lowers rates for borrowers about 70 basis points. The
benefit of the portfolios in addition is not established.
The secondary market entity could charge for a Federal backstop,
and could include private mortgage insurance, much as it has for 40
years. The important feature is not for the Federal Government to
assume all of the risk, but to provide an institution that effectively
provides liquidity in the secondary market.
4. Finally we would like you to discuss any concerns that you may
have regarding interest rate risk for both borrowers and
lending institutions, how that risk can best be mitigated and
by whom.
Lending institutions are well-informed specialists in assessing
interest rate risk. Thus, the real key to avoiding insolvent lenders is
high levels of capital. There seems to be general agreement now that
bank capital standards ought to be higher than they were before the
financial crisis, to make insolvency less likely from mortgage defaults
and interest rate fluctuations as well.
As for risks posed to the taxpayers, the first line of defense is
well-underwritten home loans that borrowers can afford. The second line
of defense is the equity in lending institutions. The third line is for
the Government to bear some risk, as it does through deposit insurance.
Taxpayers are nearly all home owners too, so the folks who potentially
pay for any risks of FRMs also get the benefit of them. This trade of
benefit for risk is fair and constructive for society.
This issues I discuss here I have also discussed at greater length
in a paper that I wrote for the Joint Center for Housing Studies at
Harvard last year. I attach that paper as well.
______
The Future of the Capital Markets: Connecting Primary Consumer and
Mortgage Credit Markets to Global Capital
Susan E. Woodward *
---------------------------------------------------------------------------
* Thanks to Barry Zigas and to the reviewers at the Joint Center
for suggestions and improvements. All remaining errors are my own.
---------------------------------------------------------------------------
Prepared for the Joint on Housing Studies Center Symposium, February 18
& 19, 2010 draft of August, 2010
Policy Issues: The Roles Fannie Mae and Freddie Mac Emerging from the
Financial Crisis of 2008
There are three moving forces that are central to understanding the
role of Government-sponsored institutions in the mortgage market.
Understanding these forces helps clarify the features of the GSEs that
are most important and should be preserved. Briefly, these forces are:
1) The 30-year, fixed-rate, pre-payable mortgage likely would not
exist without Government support.
2) The original and still most important support provided to the 30-
year fixed-rate loan is the encouragement, by regulation and
capital standards, to depositories and the GSEs to hold these
loans.
3) Securitization of mortgages through a standardized process lowers
mortgage interest rates by a substantial amount. Securitization
by Wall Street has never been nor should be expected to be
similarly successful.
Each of these forces is discussed in detail. There is one more
important feature, only recently learned, that makes the GSEs more than
useful:
4) Without the Government-sponsored institutions, Ginnie, Fannie,
and Freddie, the current financial crisis would be much worse
than it has been.
1. The special role of the 30-year, fixed-rate, prepayable residential
mortgage.
The 30-yr fixed-rate pre-payable mortgage is a creature of the
Federal Government. This loan design was created by Government fiat by
FHA in 1934. Prior to its introduction, residential mortgage loans in
the United States had terms of 5 to 10 years and were not amortizing--
they were what we would today call balloon loans, simple short-term
copies of the ordinary bonds issued by Government and corporations,
which paid interest regularly until maturity, at which time the
principal amount was refunded.
Other developed countries have also encouraged residential mortgage
markets with amortizing long-term loans (20 to 30 years), but in all
others (save one small special case, Denmark), these loans all have
adjustable rates and re-price at least every 5 years. The United States
is unique in supporting a residential mortgage that is long-term,
amortizing, fixed-rate, and pre-payable. The pre-payability is a
feature of State law in all 50 States.
The 30-year fixed-rate mortgage created by FHA was intended to calm
down both sides of the residential credit market and encourage the
resumption of borrowing and lending. Real estate lending troubles were
at the center of the sharp decline in economic activity that we call
the Great Depression, though we cannot blame real estate ``bubbles''.
Instead, it was the conscious and deliberate monetary policy of the
time that led to a profound deflation (the price level fell 30 percent
in 3 years between 1930 and 1933) that precipitated the decline in real
economic activity.
In addition to the sharp rise in unemployment caused by this
decline in the price level, the deflation also disturbed the
relationship between assets and liabilities of borrowers. The dollar
(nominal) price of real assets and wages fell with the overall price
level, while debts were denominated in dollars, and still owed in
dollars. The deflation increased the real value of these nominal debts.
The situation can be thought of as dollar prices of assets declining
while dollar prices of debts stayed fixed, raising debtors'
indebtedness. Or it could be thought of as real values of assets
staying fixed while real values of debt rose. Expressed either way,
borrowers were in trouble.
Borrowers were in trouble because even if they were still employed,
their dollar incomes fell 30 percent (unless they were Government
employees, whose incomes stayed the same in dollar terms) along with
the price level while the dollar obligations on their debts remained
the same. Borrowers could not pay their mortgages nor could they
refinance them.
The FHA-insured 30-year mortgage succeeded in calming both sides of
the market. Lenders were more willing to lend because FHA took the risk
of default. Borrowers were more willing to borrow because the loans
were long-term and did not require them to refinance before the loan
was paid off in the way the earlier 5 to 10 year term, nonamortizing
loans did. Both sides felt more secure.
The biggest risk the Government was taking by insuring FHA
mortgages was not the particular default risk, but the risk of a large
change in the price level. It was the change--decline--in the price
level between 1930 and 1933 that bankrupted borrowers, caused
widespread default, and thus bankrupted banks too. It was anticipated
at the time of FHA's creation that the price level would be stable
long-term, because the dollar was still tied to gold. It was believed
at that time that so long as we were on the gold standard, a serious
inflation could not occur.
Why was the Government willing to take on the risk of mortgage
default when private insurers were not? A short and easy answer was
simple desperation to get markets to resume borrowing and lending. But
a deeper answer is that the insurer--the Government--also had control
over the most important variable that could influence defaults (and had
caused the eruption of defaults that had just occurred)--the price
level. Anyone who borrows or lends in dollar (nominal) terms is betting
on the future value of the dollar, which is the same as betting on the
rate of inflation, to be determined largely by future monetary policy.
Borrowers gain from inflation rates higher than expected, because
inflation erodes the real value of their debt. Debtors lose from
inflation higher than expected, because inflation erodes the value of
their assets. Borrowers lose from deflation, because a deflation raises
the real value of their obligations, while debtors gain. Some have
suggested that the Fed has a mismatch issue (liabilities and assets
have different durations). Of course the Fed has a mis-match issue;
unlike others with a mismatch issue, the Fed has control over future
rates of inflation, and consequently future interest rates.
But a change that is very extreme in ether direction creates
problems for lenders, especially leveraged lenders such as U.S.
depositories, and thus the economy in general. If deflation is so
extreme that borrowers can no longer meet their dollar-denominated
obligations, as in the Great Depression, defaults by borrowers cause
lenders to become insolvent. If inflation is so extreme that the equity
of financial institutions is wiped out (because an increase in the
long-run inflation rate lowers the value assets by more than it lowers
the value of liabilities), as it was for many Savings and Loan
Associations in the late 1970s and early 1980s, institutions again fail
from insolvency. These two kinds of insolvencies are very different,
but they both result in stress on the financial system when
institutions cease to be trusted and cease to trust each other, and
hence do not transact. Both kinds of insolvencies are (and were) the
result of conscious, deliberate monetary policy.
Thus, economies that are large and complex have never had, and I
imagine never will have, truly laissez-faire credit markets because the
single most important player, the monetary authority, has the power to
redistribute wealth between borrowers and lenders, and more. In the
United States, close to 70 percent of nonfinancial credit (nonfinancial
credit is the sum of borrowings by businesses, households, and
governments at all levels, with intermediaries netted out) is touched
by Federal policy through an assortment of policy tools: the Federal
Government's own debt, the tax-exemption of interest on municipal
bonds, all borrowing intermediated through insured depositories, loans
held by and guaranteed by the Government-sponsored enterprises
(including the Farm Credit system), plus various other direct and
guaranteed Government lending programs (including FHA and VA mortgage
insurance and guarantees).
This astounding figure--close to 70 percent of nonfinancial
credit--has prevailed since at least the end of WWII. The chart below
shows the layers from 1960 to 2004. The bottom layer is tax-exempt
municipal debt. The second layer is the U.S. Treasury's own debt. The
third layer represents debt intermediated through government credit
programs, including GSE debt and securities, plus all other Federal
agency debt plus loans guaranteed and insured by the government. The
fourth layer represents credit intermediated through insured deposits,
with holdings of three lower layers--Treasuries, municipals, GSE debt
and securities, and other loans insured or guaranteed by the U.S.
Government netted out. The top layer represents debt intermediated by
organizations with no special tax treatment and no guarantees, and
consists mainly corporate bonds, other corporate borrowings, plus some
non-depository consumer credit. In 2004 the total touched by Federal
policy was roughly 120 percent of GDP, with total nonfinancial credit
equal to 200 percent of GDP. Thus, as of 2004, the fraction of
nonfinancial debt touched by Government programs was about 60 percent,
slightly lower than the historical average, which is closer to 70
percent. For earlier data, see the 1986 Economic Report of the
President, page 191.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The level is even higher right now, with the Government owning
large chunks of the equity in banks and investment banks, which were
previously in the 30 percent of the credit market not tied to the
Federal Government (mainly corporate bonds and other corporate nonbank
borrowings) as well as other assets, but I have not toted up the
numbers lately. Anyone who thinks that the United States has a laissez
faire financial system is simply ignorant of the proportions of the
Government role in credit markets.
Only a country that is optimistic about its ability to control the
price level long-term would consider encouraging or insuring a long-
term, fixed-rate, prepayable mortgage. The thrift crisis (which, in
retrospect, looks fairly tame), demonstrated that such a policy could
turn out to be costly, and costly as a result of the Government's own
monetary policies. The thrift crisis did not occur because the people
who owned and ran the thrifts were incompetent or witless. It was the
result of deliberate policy choices on the part of the U.S. monetary
authority to raise the rate of inflation above what had been previously
expected. Thrifts were encouraged--by deposit insurance and capital
requirements--to make the loans that policymakers wanted them to make.
I am not suggesting that policymakers knew, when they encouraged
lenders to make these loans, that they were going to raise the rate of
inflation, but only that it was changes in Government policy with
respect to inflation rates that ``caused'' the thrifts to become
insolvent. The equity holders of the thrifts benefited from Government
support in good times, and suffered from it when inflation rates rose.
We have no evidence that a long-term fixed-rate residential
mortgage loan would ever arise spontaneously without Government urging.
Other developed countries that support long-term adjustable-rate loans
have not spontaneously developed, in the private realm of the mortgage
market, long-term fixed-rate loans for household borrowers. The
development of such a loan has happened only once on a large scale,
here in the United States.
The point of this discussion about the uniqueness of the long-term
fixed-rate residential mortgage and role of the Government in the
credit markets is to demonstrate that pleas for ``free market'' forces
in credit markets should be dismissed out of hand. The United States
does not have a ``free market'' in credit, especially residential
mortgage credit, nor does any other large or developed country. The
most important innovations in the mortgage market in the last 80
years--introduction of a long-term amortizing loan, creation of
national liquidity facilities for regional lenders (Fannie Mae),
introduction of a liquid secondary markets in mortgages (Ginnie Mae and
Freddie Mac), and the contract designs to support loan servicing in
securitized markets--were all undertaken by institutions that were
either explicitly part of the Government or had important Government
ties. The largest private innovations, adjustable-rate loans and
subprime loans, cannot be said to be such great successes. Among the
private innovations, the creation of credit scores appears the most
constructive and successful.
What about the possibility of giving up the long-term fixed-rate
loan, and getting along with only adjustable-rate loans, as do nearly
all other developed countries?
At one point in the early 2000s, well before any hint of the
subprime crisis but after the dotcom recession was over, Alan
Greenspan, noting that long-term fixed-rate mortgages were a source of
systemic risk in our financial markets, suggested that one way to
eliminate this systemic risk was for borrowers to simply have
adjustable-rate mortgages instead. He noted that ARMs have lower
interest rates on average (which is true). The extreme public outcry
made him abandon this suggestion with alacrity. People were not
interested that Canada, the United Kingdom, France, Germany, and many
other countries seemed to achieve high rates of home ownership despite
having only adjustable-rate loans. (It turns out that Greenspan himself
had a fixed-rate mortgage. Why? He said he liked the certainty.
Bernanke has a fixed-rate mortgage also, same reason.)
Americans are evidently comforted by their 30-yr fixed-rate loans.
Long-term fixed-rate loans are more expensive than ARMs even when the
credit risk is assumed by a Government-related entity such as FHA or
Fannie or Freddie. This is because all residential loans are
prepayable, and the lender or investor takes the risk of a prepayments
arising from fluctuations in interest rates. Lenders thus charge a
premium to cover this risk. It is not small: on average it is about 125
basis points. Borrowers cannot disclaim their right to prepay a fixed-
rate loan, so the only way for them to avoid paying a premium for pre-
payability is to have a loan with an adjustable rate.
Nonetheless, borrowers clearly prefer fixed rates. It appears that
borrowers should only choose adjustable-rate loans when 1) they are
sufficiently affluent that a substantial change in their mortgage
payment would not seriously disrupt their personal finances (as in the
jumbo market, which until recently was about half fixed rate, half
ARMs), 2) when nominal interest rates are very high and the term
structure is steep, making payments on ARMs far lower than on fixeds,
as in the early 1980s, and 3) when borrowers are confident they will
reside in a given house only for a short time. When interest rates
fall, ARM borrowers overwhelmingly refinance from adjustable rates to
fixed rates. Even in the present crisis, default and delinquency rates
on fixed-rate mortgages are about half than those on ARMs, even in the
prime market. This appears to be more of a self-selection phenomenon
than the result of ARM resets. Anyone suggesting, as Greenspan did,
that we abandon rather than accommodate the long-term fixed-rate
prepayable residential mortgage would be in for serious grief.
Americans now seem to regard the availability of long-term fixed-rate
mortgages as part of their civil rights.
2. The role of Government support in the continued existence of the
30-year fixed-rate residential mortgage.
The original and still most important support provided to the 30-
year fixed-rate loan is that U.S. bank regulations encourage
depositories to make and hold these loans. The GSEs were also
encouraged to hold 30-year fixed-rate loans by being allowed low
capital requirements on substantial portfolios of both whole loans and
MBSs. Depositories and the GSEs still hold the majority of 30-year
fixed-rate loans and mortgage-backed securities (MBSs) based on them.
(Many depositories hold MBSs of loans they originated themselves and
securitized through Fannie or Freddie.)
The importance of depositories and the GSEs is readily apparent in
the figures on the holdings of MBS. In particular, defined-benefit
pension plans, which are by nature long-term investors, seem natural
candidates to be holders of long-term mortgages, but they are not. They
hold substantial amounts of Fannie and Freddie debt (straight bonds),
but essentially none of the MBSs. Pension plans fund long-term real
(inflation-adjusted) annuities. Evidently the prepayment risk of long-
term fixed-rate pre-payable loans, which fall in value when the rate of
inflation rises, and prepay when the inflation rate (and interest
rates) fall, is incompatible with this goal. Fixed-rate mortgages are a
worse fit than plain bonds for insuring inflation risk because they
fall in value more when the rate of inflation and interest rates rise,
but do not enjoy a symmetric rise in value when interest rates fall
because they instead prepay.
Default risk in mortgages is largely diversifiable, but prepayment
risk is not. Even in the current recession, the geographic variation in
property value changes and defaults is substantial. By the OFHEO
purchase-only indices (as of December, 2009), national house prices are
down just over eleven percent from their high in early 2007. The census
division with the largest decline is the Pacific, down 28 percent (on a
seasonally adjusted basis), and the one with the smallest decline, West
South Central, down 1.2 percent, is hardly down at all. Defaults are
highly concentrated in the sand States (California, Arizona, Nevada,
and Florida), which are suffering from a combination of the largest
price declines as well as the largest explosions of subprime lending.
(The combination is not an accident.) Aside from the current crisis,
both real estate price changes and defaults have been geographically
concentrated. When defaults are geographically concentrated, holding a
nationally distributed portfolio diversifies much of this risk.
On the other hand, prepayment risk is a systemic risk. Changes in
interest rates influence the behavior of borrowers in all 50 States.
Prepayment risk can be transferred to another party, but not
eliminated. For example, when an investor buys Fannie Mae or Freddie
Mac bonds, the interest paid on loans held in portfolio ultimately pays
the interest on the bonds. Thus, the bondholders bear ordinary interest
rate risk but not prepayment risk, and the equity holders of Fannie and
Freddie bear the prepayment risk on the portfolio loans.
Even REMICs (Real Estate Mortgage Investment Conduits) just re-
shuffle prepayment risk, they do not eliminate it. When a REMIC takes
the form of being tranched (sliced) by prepayment priority, the
earliest-paying tranche will perform much like a short-term bond, while
the later-paying tranches will bear even more prepayment risk than
would an ordinary, un-REMICed, untranched pool of mortgages. By
contrast, in normal times, default risk is diversified away in a big
national pool of loans.
The systemic nature of prepayment risk brings us back again to the
issue of where prepayment risk comes from. When interest rates fall,
borrowers prepay and refinance. When interest rates rise, average
mortgage life lengthens and existing mortgages and mortgage securities
become less valuable. Interest rate fluctuations do not come primarily
from random, uncontrollable forces, but from deliberate policy choices
of the monetary authority. Inflation is, in the first analysis and the
last analysis and most analyses in between, a monetary phenomenon. It
is appropriate that the Government have some role in allocating and
insuring this risk given that it has substantial control over it.
By allowing federally related institutions to make and hold
mortgages of this design, the taxpayers bear the systemic risk, both
from prepayments and from unusual levels of defaults, (rare, but
happening now). Taxpayers bear this risk through their liability for
taxes to make good on the promises made through deposit insurance and
guarantees behind Ginnie, Fannie, and Freddie, and deposit insurance.
The benefits of this system accrue mainly to homeowners. Given that
nearly all income taxes are paid by homeowners, and that nearly all
homeowners begin their home ownership with a mortgage, it is mainly
homeowners who benefit and also homeowners who bear the risk of the
arrangement. Thus, the beneficiaries (homeowners) and the bearers of
risk (the taxpayers) are ultimately the same folks, but at different
points in their lives. This system gives people a hand up when they are
young and cash-constrained, and has the potential to cost them
something, more if they are big successes in making money, later in
their high-earnings years if problems arise. It is not hard to imagine
that most people regard this as a satisfactory tradeoff.
3. The role of the GSEs in securitizing mortgages
The GSEs promote liquidity and therefore low interest rates by:
1) standardizing mortgage terms,
2) standardizing loan servicing, and
3) standardizing mortgage-backed securities.
All three factors help to produce a market of homogeneous securities
that trade at a low cost in a liquid market.
The first mortgage-backed securities (MBS) were created as part of
a new Government program, Ginnie Mae, in 1968. At that time, they were
called pass-through securities because they passed interest and
principal payments on mortgage loans through to security holders. The
Budget Task Force of 1968 was assigned responsibility for getting
Fannie Mae's debt off the Federal budget to make the Federal debt,
which had been growing fast in the 1960s, look smaller. Fannie began in
1938 as a Government agency able to buy and sell mortgages from
depositories, then in 1954 was reorganized as a cooperative among the
lenders who sold mortgages to Fannie. The plan in 1968 was to
reorganize Fannie into a stockholder-owned corporation, with stock that
could be owned by the general public, not just by banks. To achieve
this, the FHA mortgages on Fannie's books were packaged into securities
guaranteed for timely payment of interest and principal by the full
faith and credit of the Federal Government, to be sold to the general
public. FHA loans were already federally insured, so the additional
assumption of risk for the Government was de minimis.
The creation of Ginnie Mae in 1968 lowered FHA borrowing rates by a
startling 60 to 80 basis points. Given that the real (inflation-
adjusted) interest rate on FHA loans is in the range of 4 to 5 percent,
this is a substantial, not trivial, reduction. The reduction in the
interest rate was not the result of additional Federal assumption of
risk, but of a genuine improvement in market design. The decline
appears to be attributable to two things. First, by securitizing loans
through Ginnie, lenders turned illiquid whole loans into liquid
securities, which they were willing to hold at lower yields. Second,
the existence of a national secondary market disseminated high-quality
information about price and made the pricing of mortgages both lower
and tighter nationwide. In sum, the additional cost of risk assumed by
the taxpayers was tiny, but the benefits were substantial.
The benefit was so obvious and large that the thrifts immediately
wanted an institution to perform the same function for their
conventional mortgage loans. (Fannie had traditionally done more
business with commercial banks than with thrifts.) Thus, in 1970,
Freddie Mac (The Federal Home Loan Mortgage Corporation) was created to
securitize conventional mortgages. Freddie was organized as a
cooperative among the thrifts, with ownership and governance through
the Federal Home Loan Bank System, also owned and operated by the
thrifts.
FHA insurance for mortgages had introduced some uniformity in
mortgage instruments as lenders met FHA standards in order to get FHA
insurance. Freddie Mac further standardized the conventional mortgage
market, which until then had many practices that differed by State.
While some differences across States still remain (mainly with respect
to loan foreclosure and its interaction with personal bankruptcy),
mortgage lending rates are more uniform across States now than they
were prior to the creation of Freddie.
The details of the contracts created to make Ginnie and Freddie
work well should command a great deal of respect. One of the issues
securitization created was: who would do the back office work
(servicing) on securitized loans and how could we assure it was done
well? When the lender held the loan and serviced the loan, there was no
conflict of interest. Separating servicing from ownership of whole
loans was a challenge. The solution for Ginnie was to assign 44 basis
points (0.44 percentage points) of interest, calculated as a fraction
of the outstanding principal balance, as income to the servicer. Today
we would call this an interest rate strip of 44 basis points. The
creators of Ginnie knew well that this was more than servicing should
cost, and intended for it to be. They predicted, correctly, that
servicers would bid and pay for the right to collect the 44 basis
points. The investment necessary to purchase the rights to the
servicing (which tends to run about 1.25 percent of loan principal)
would thus manifest itself in the price servicers would pay for
servicing, which would represent the difference in the present value
cost of servicing and the present value of the 44 basis point interest
strip.
The investment made by the servicer to purchase the interest/only
strip becomes a hostage to exchange to assure the performance of the
servicer. And of course, the longer the expected life of the loan, the
higher the present value of the interest rate strip, so the servicer
has a vested interest in preventing foreclosures on loans. Servicers
were also required to collect money monthly from borrowers to be
deposited into escrow accounts to pay homeowner property taxes and
hazard insurance. This helped borrowers meet their obligations by
turning the otherwise lumpy (from a time passage point of view)
payments for taxes and insurance into smooth monthly payments. One of
the stupidest features of the subprime lending debacle (and there were
many) was that most subprime loans had no tax and insurance escrows.
Yet the borrowers had quite low credit scores, indicating that they
were struggling to keep their personal finances in order. These
borrowers needed escrows more, not less, than prime borrowers.
A further discipline to the secondary market is that Ginnie,
Freddie, and Fannie all monitor servicer performance. Ginnie can simply
seize a servicing portfolio (without compensation) and sell it to
another servicer. Fannie and Freddie have the right to force a servicer
who is not performing to sell its portfolio (usually at a loss, since a
nonperforming portfolio will need some investments to be returned to
satisfactory performance) to an approved servicer. This threat gives
servicers another reason to maintain high standards of performance.
Exercise of the threat is fairly rare.
This set of contracts to support MBSs crafted ``by the Government''
has endured as the basic servicing contract on prime loans to today.
Fannie Mae soon followed by creating securitization programs also
after Ginnie and Freddie were up and running. Until 1970, Fannie had
made a secondary market in mortgages only by buying them for its
portfolio, and issuing bonds to fund them. Freddie Mac was focused
entirely on securitization, and had only a small portfolio of loans
(roughly $25 billion) until it was ``privatized'' in 1989 by FIRREA.
Post-FIRREA, Freddie underwent a reorganization similar to that of
Fannie in 1968, in that the thrifts were no longer Freddie's owners and
directors, but Freddie's stock became public and traded on the New York
Stock Exchange. Freddie quickly accumulated a portfolio nearly the size
of Fannie's.
Why can't Wall Street replicate the success of Ginnie, Freddie and
Fannie? The presumption of Federal backing is not the only difference
between them and Wall Street. There are other differences that are more
important. Other differences are:
1) Ginnie, Freddie & Fannie all have standardized loan contracts.
2) All three all have standardized servicing agreements.
3) All issue large and homogenous pools of loans.
4) Wall Street securitizers do not take into account the benefits of
additional liquidity they could add to the rest of the market
by creating similar securities, in other words, they do not
internalize the benefits of additional liquidity to the rest of
the market.
5) Ginnie, Fannie, and Freddie all suppress inefficient information
production in the secondary market for its contribution to
market liquidity. Wall Street wants more unique securities,
more sources of disagreement, not fewer.
Ginnie, Freddie and Fannie all have standards for loans they will
securitize, for both loan structure and loan servicing. I have heard
bank lobbyists complain that Freddie and Fannie have ``commoditized''
mortgage lending. Yes, yes they have, and with great benefits to
mortgage borrowers. This standardization or commoditization lowers
costs to borrowers and causes them little inconvenience.
In contrast, Wall Street did not attempt to create any standards,
and packaged many varieties of loan designs with varieties of servicing
agreements and little by way of reporting conventions. At the June,
2009 conference at the Federal Reserve Bank of Kansas City, a former
subprime investment banker on a panel complained bitterly about the
absence of a standard servicing and reporting agreements in subprime
lending, and appealed for a Federal intervention to create one. When
such an appeal comes to pass, there are no Republicans left.
Wall Street is happy to securitize smaller pools, and eager to get
deals done before customers disappear. Without the patience to assemble
large pools from different lenders, liquidity in the secondary market
later is sacrificed. Liquidity is further sacrificed by tranching the
pools into even smaller and more unique securities, with the
expectation that each security can find a home where the risk taste
best aligned and its value is highest. Wall Street also values knowing
which pieces are owned by whom, so that it can arrange deals when
someone wants to buy or sell. (In Bonfire of the Vanities, there are
characters described as earning their living out of simply knowing who
owns which bonds. This is not entirely fiction.)
When a new mortgage-backed security is created, there is
potentially an externality for the entire MBS market. If the security
is very much like existing securities, the entire market becomes a
little bit more liquid. The entire market benefits from the additional
liquidity. By being large entities with many outstanding securities,
Freddie and Fannie internalize this externality. They do not want a
novel security because it would not create the same liquidity benefits
for the rest of the book. By contrast, the private-label securitizers
are indifferent to creating more liquidity in the rest of the market.
They are focused only on creating a security they can sell to someone
today. Rather than seeking to make a market more liquid, investment
bankers are instead always looking for ``a man with an ax''--an
investor with a specific investment desire that can be carved out of a
pool of loans, leaving a residue that must be packaged and
affirmatively ``sold''.
In additional important difference relates to how the GSEs suppress
inefficient information production by limiting what information is
disclosed about individual mortgage pools. Prepayment speeds differ by
coupon and also with geography. Some areas are growing, others are
contracting. Borrowers move and prepay more in growing markets than in
stable markets. Some areas have higher turnover, and loans prepay when
people move, Ginnie, Fannie, and Freddie's MBSs all efficiently
suppress information about the location of mortgages in individual MBS
pools. Ginnie and the GSEs keep the MBS market liquid despite some
geographical differences in prepayment speeds by not revealing the
geography of loans in any given MBS . . . Wait! What about market
transparency?
More transparency is not always better. This can be understood
easily in a similar arrangement seen in the municipal bond market. A
structure used for promoting liquidity in the municipal bond market is
a random call feature used for bonds that fund small but long-lived
projects. Take a dam, for example. Bondholders are repaid from
citizens' water bills. If the issue is large, such bonds are often
structured in sets that repay at different times, for example, 10
years, 11 years, and so on up to 40 years. For smaller projects, each
slice may be too small to find a liquid market. Instead, the entire
issue is given the same maturity, but a specified fraction of it is
called at random for repayment each year. The investors buy many such
issues, and thus have a good idea of when on average they will be
repaid, and thus easily tolerate the uncertainty of individual issues,
and value the greater liquidity.
Suppose that right after the bonds were sold, the issuer spun the
wheel to select the call date of each bond. Would it be efficient to
release the information early, prior to the call? NO! Once the call
dates were known, the bonds would degenerate into the tiny, illiquid
serial bonds that the market was trying to avoid. What's more, the
issuer and the investors agree that the best arrangement is not to
reveal early. This is a clear case where the optimal level of
information is not the fullest information.
In principle, the value of a set of MBS could be either increased
or decreased by revealing information that distinguishes them from one
another. More pieces might accommodate a greater variety of investors
with pieces precisely tailored to their risk tolerance. Or, it could be
that liquidity concerns dominate, and that a larger, more homogeneous,
more liquid market in MBSs tightens spreads and lowers prices. There
are different ways of homogenizing risk, including pooling risk (MBSs
vs. whole loans, even S&P 500 futures contracts vs. individual stocks
in the S&P 500) (see information theorist Hal Varian's provocative
ideas on subprime koolaid), providing ratings (professional opinions on
risk to make clear where similarities lie), and providing insurance
(assignment of risk to a professional evaluator of risk for a fee).
Each has its pros and cons.
The experiment to show which is more important in the market for
MBS on conventional prime mortgages has been done: Some years ago
Freddie Mac was persuaded (by Wall Street!) to reveal more about the
geography of its MBS pools on the theory that this would make the
pricing more ``accurate'' and securities more valuable. Since then,
Fannie's securities (MBSs) have consistently sold for a slightly higher
price than Freddie's because Freddie tells the market more about each
one, and hence the Freddie MBSs are less perfect substitutes for each
other, and a bit less liquid. The Fannie MBSs trade as if they are more
alike because the market has no information with which to make
distinctions among them. The really interesting thing is that the
market unambiguously prefers the security about which it is less
informed. Over the period since 1998, the current coupon yield for
Freddie MBSs has been above that for Fannie MBSs by on average 3 basis
points, (with a standard deviation of 1.5 basis points). From January
1998 to December 2008, the yield on the Freddie security was never
below that on the Fannie security. And this is despite the feature that
the Freddie securities pay the security holder a few days earlier,
which in principle should make them more valuable. Yes, more
transparency makes the securities of lower, not higher, value, on
average. Below are data from 1998 to 2008 on Fannie/Freddie yield
spreads.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
It is only three basis points on average, but it is a bitter three
basis points, making business slightly less profitable for Freddie.
So perhaps the Freddie securities are more ``accurately'' priced,
but they are without question less valuable as a result because they
are less similar. From a social point of view, the bottom line is in
the pricing: the securities are less valuable when more transparency is
provided, and all things considered, investors and borrowers both gain
when the additional information is not disclosed. The losers are the
market makers and those who would be in the know about who holds the
different securities and make money trading in the secondary market
based on their special knowledge. These are the same folks who created
and made markets in subprime mortgage-backed securities.
But surely not all detail should be suppressed. What kind of
information should be suppressed, what kind should be transparent? To
be efficiently suppressed, information should have the following
properties:
The information should be about factors that are not
systemic.
The risks should not be too large.
The risk should diversify away when investors hold a
variety of different issues.
The arrangement of municipal bonds with random calls for repayment
is ideal because the risk is perfectly diversifiable. The suppression
of information about prepayments is not perfect, but it is an
improvement over full information, says the market.
Even in the market for the U.S. Treasury's own securities there is a
tension between giving Wall Street what it wants by way of maturity
variety versus keeping borrowing costs low for the taxpayers. Wall
Street always wants Treasury's new borrowings to be new securities,
distinct from prior issues, so that the new bonds are not perfect
substitutes for older ones. In many cases, what would be efficient is
for Treasury to re-open an existing issue (especially if it is trading
at a high price relative to the rest of the yield curve) and sell
additional bonds into it. Wall Street intermediaries prefer a larger
number of unique issues in order to keep trading spreads wide and to
put themselves in the position of having superior information about who
owns which bonds.
Wall Street also fought the introduction of Treasury Inflation-
Protected Securities. IBankers complained that there is little trading
in them (or was in the United Kingdom, where similar bonds existed
already.) About this, they are right, the trading volumes are low. The
volume is not low because there is no interest in these bonds, but
because they such satisfactory assets that buyers just hold them, and
do not trade them much. Nonetheless, on any given day, nearly all TIPS
trade with a spread at the minimum tick--1/32, (one thirty-second of 1
percent of par value) indicating that despite the low volumes, market
markers feel they face very little risk in maintaining an inventory.
The low trading volumes in combination with the narrow spreads do not
mean this security is socially useless, but that it is especially
useful.
If the securitization operations of Freddie and Fannie were shut
down, and all securitization was left to Wall Street, we would see a
market in which:
1) Fewer mortgages will be securitized.
2) We will see a wider variety of types and sizes of securities.
3) Buyers will have to do more diligence before purchasing any given
security.
4) Market-making spreads will be wider.
5) Mortgage interest rates for borrowers will be higher.
The only beneficiaries of this alternative system would be the
intermediaries. Both investors (ultimate holders of the MBS) and
homebuyers would be worse off. And of course, if Ginnie is still
standing (I have heard no pleas to dismantle Ginnie except from AEI),
more business will go to FHA and Ginnie.
Without Freddie and Fannie, it would be in the interest of mortgage
lenders to create a consortium or cooperative amongst themselves to
securitize mortgages. It would be an organization much like Fannie or
Freddie today, but perhaps more successful in resisting the lure of
subprime securities. Both Fannie and Freddie were run conservatively in
their co-op days. But I do not expect mortgage lenders to be able to
create such an organization. First, there is a conflict of interest
between large lenders, who could securitize at least some loans
themselves, vs. smaller banks, who would likely have to sell loans to
the larger banks for securitization; that conflict is larger now than
when the largest bank had only 1 percent of all bank assets (roughly
1989). All lenders would benefit, but the small banks would benefit
more and the large banks less, thus, strategically, the large banks
have an interest in blocking a co-op. This appears to be the conflict
of interest that inhibited the Federal Home Loan Bank system from
creating a third GSE. We should not imagine that a co-op created among
the banks would be free of Federal responsibilities, because the
members would all be insured depositories.
What about the portfolios?
F&F both have substantial portfolios of loans. Their portfolios are
close to three-quarters of a trillion dollars each, and the difference
between the interest earned on the portfolio and interest paid on the
bonds that fund the portfolio is their largest source of income. I do
not have a strong opinion on how large the F&F portfolios should be.
But experience tells us that any attempt to whittle down the GSE
portfolios will raise mortgage interest rates at least temporarily. In
addition, decreasing the size of Fannie and Freddie's portfolios will
not lead to a reduction of risk exposure by the Federal Government, the
goal of most who advocate such changes. Instead, it would largely
result in an increase of holdings of mortgages and MBS by depositories.
In other words, the 30-year fixed-rate loans are not likely to
leave the Federal umbrella, but only move to another place under it.
Reducing the portfolios would not be without pain for the mortgage and
housing markets. Even in the early 1990s, when the mortgages held by
the dismantled insolvent thrifts had to find new homes, mortgages rates
were clearly elevated by this displacement. It seems unlikely that
policymakers would choose any time soon to force F&F to divest their
portfolios, as this would just depress mortgage values and force
already beleaguered banks to mark down their assets once again. If the
portfolios of F&F are to be whittled down, the least disruptive option
may be to simply not have them buy any more loans for portfolio. As
loans in the existing portfolios mature, the portfolios will shrink.
One caution on dismantling the portfolios of Fannie and Freddie
comes from looking at who is in favor of this policy. The main
proponents, not only of dismantling the portfolios but eliminating
Fannie and Freddie altogether, are the large commercial banks, the
other natural home for mortgages. The large banks are in the best
position to be able to securitize mortgages in F&F's absence (thought
the market would not likely be as efficient, because securities would
not be as standardized and homogenous). They expect, correctly, that
smaller banks would have to sell mortgages to them to access the
secondary market. Theirs is the voice we hear in the Wall Street
Journal. (I remain puzzled as to why the WSJ should be more
enthusiastic about large commercial banks with unambiguous Federal
support of deposit insurance than with other financial institutions
with similar Government backing.) Another F&F combatant is the American
Enterprise Institute, whose opposition is more understandable, since it
is funded by contributions. It is important to remember that commercial
banks are not exactly ``free market'' institutions, but owe much of
their access to inexpensive funding to deposit insurance (which they
pay for) and to Federal regulation.
If Freddie and Fannie were as well-capitalized as the average mid-
size bank, they would be no more risky than the average mid-size bank.
In retrospect, the risk taken on by Freddie, Fannie, and the largest
commercial banks was substantially greater than that taken on by mid-
and small-size banks, who seem to have avoided making or buying any
subprime loans.
Covered Bonds
Covered bonds, used by Denmark to fund its long-term fixed-rate
mortgages, (and by some other countries to fund long-term adjustable
rate mortgages) have been promoted as superior to asset-backed
securities. The ``coverage'' of covered bonds is overcollateralization.
In practice, they are nearly identical to asset-backed securities and
to the arrangements we have had for many years, especially to Fannie
and Freddie MBSs. Essentially, nothing is achieved with covered bonds
that could not also be achieved with higher capital requirements for
Fannie and Freddie. Covered bonds are, like asset-backed securities,
backed by the cash-flows on a pool of assets, in the case of the
mortgage market, a pool of mortgages. And covered bonds, like F&F MBSs,
have more resources behind them than just the mortgages in their pools
to cover losses.
There are two differences between covered bonds and the MBSs issued
by F&F, both essentially cosmetic. One is that the mortgages backing
the bonds remain on the balance sheet of the issuer. Whether the assets
are off the balance sheet is irrelevant so long as the MBS have
recourse to assets on the balance sheet. F&F MBS do have such recourse.
Another is that the pool of assets backing the covered bond is usually
larger in principal value than the bonds themselves, so that the
security is explicitly overcollateralized. The MBSs issued by F&F are
implicitly over-collateralized because they are guaranteed against
default by F&F, but not backed by any particular pool of loans. If the
default losses on a given MBS were sufficiently large, F&F are obliged
to make up the difference from reserves and other assets. All of the
reserves against losses and equity of F&F are ultimately available to
the MBS holders. Thus, in essence, F&F MBSs are already over-
collateralized.
So long as the securities outstanding are MBSs guaranteed by F&F,
and the experience on the mortgages behind them (in terms of defaults
and prepayments) are well-disclosed, and the other assets are also
fully disclosed, it should make no difference whether the securities
are called covered bonds or MBSs or whether the recording of the
securities is on the balance sheet or in some other section of their
regular reports. Covered bonds are not ``the answer'' or even a very
interesting suggestion, or all that different from what Fannie Mae &
Freddie Mac have done lo these many years. The only interesting
variation is how much ``coverage'' is desired. Coverage is essentially
an issue of capital, leverage, and capital standards.
Another disadvantage of covered bonds in the United States would be
that where these bonds are used, they are issued by large banks. In
countries that have only a few large banks, and essentially no small
ones, this creates no comparative disadvantage. In the United States,
with its many smaller banks, the small banks would have to either sell
through the large banks or create a co-operative entity through which
to sell covered bonds together. This cooperative entity would have to
look a lot like either Freddie or Fannie.
And finally, covered bonds are evidently not the panacea claimed by
some. Both Spain and the United Kingdom use covered bonds to fund
mortgages yet both were also fraught with problems in real estate
lending in the recent crisis.
Do we need to return to substantial downpayments?
Offering mortgages to borrowers with good credit histories but
small downpayments was not the core of the financial crisis, instead it
was offering any mortgage to people with poor credit histories, in
large numbers, in concentrated areas. Even with the large decline in
property values in some areas, borrowers with good credit who do not
lose their jobs, become ill, or get divorced are very unlikely to
default, even if their downpayments were slim. A careful study by
Willen et al of all mortgages made in Massachusetts prior to the 1991
recession found that only 6 percent of the prime borrowers who had
negative equity defaulted over the next 3 years.\1\
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\1\ Christopher Foote, Gerardi, Kristopher, and Willen, Paul,
(2008, June) ``Negative Equity and Foreclosure: Theory and Evidence'',
Public Policy Discussion Papers, Federal Reserve Bank of Boston.
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Credit scores are a new feature in the mortgage market. They were
hardly present in 1990, but almost universal by 1996. Prior to 1996,
lenders mainly used high downpayments as their defense against default.
What lenders learned with credit scores is that they could make even
high LTV loans to borrowers with good credit, and these borrowers would
keep paying even if their houses were underwater.
A factor that made the subprime crisis worse than other housing
crises is that the expansion of credit to a new, previously not-served
set of borrowers was so large that it moved house prices. Prices have
fallen most in areas where they rose most, and these are the same areas
in which subprime borrowers were over-represented.
At present, the prime mortgage book is in worse shape (higher
delinquencies) than in most years, but still in much better shape than
the subprime mortgage book. As of June, 2009, the ``seriously
delinquent'' rate for prime conventional mortgages (either held by or
securitized through Freddie or Fannie) is 3.2 percent, while the rate
for securitized subprime loans is 23.7 percent. And of course, the
prime book is only performing as poorly as it is because of the
contraction in real activity caused by the subprime mess and the
subsequent bank panic.
Ownership Structure
There are many possibilities for the structure of Fannie and
Freddie going forward. Some can be easily ruled out as undesirable,
while others area worth more study.
Among the possibilities are:
1) A single entity with Government ownership and control as for FHA
and Ginnie Mae.
2) A cooperative among lenders, as Fannie and Freddie once both had.
3) A cooperative among borrowers, similar to the organization of the
Farm Credit System or the Credit Union system, or even to
borrower-owned and controlled mutual insurance companies.
4) A shareholder-owned, profit making institutions, subject to
limitation on activity by charter and to regulation, as in
their old structure.
A Government program like FHA?
FHA and Ginnie Mae are playing a large and important role right
now, with a market share of originations in 2008 of 25 to 30 percent.
For some years, FHA has operated at a disadvantage to the conventional
market because of the rigidities inherent to being part of the
bureaucracy. First, FHA originations are slower than originations that
go through F&F. According to FHA's January 15, 2009, report on recent
originations, average processing time was 2.5 months, roughly 10 weeks,
from application to closing, even though most transactions used
streamlined systems. FHA was slower to create automated underwriting
systems, introducing them only after Freddie and Fannie both had
systems in place.
Second, FHA is more vulnerable to exploitive behavior on the part
of lenders. Fannie and Freddie have more flexibility for discouraging
exploitation by lenders. F&F can also adjust guarantee fees to reflect
its experience with a given lender, while FHA insurance premiums are
one-size-fits-all. There have been episodes of lender exploitation of
FHA (seller ``gifts'' of downpayments to borrowers, implicitly raising
the loan-to-value ratios and default rates) that required legislation
to fix that would have been promptly corrected by internal policy
adjustments at Freddie and Fannie.
Third, Fannie and Freddie can innovate more nimbly than can FHA and
Ginnie Mae. Both built automated underwriting systems (Desktop
Underwriting and Loan Prospector) and only well after these were in
place did FHA begin to work on such a tool. Even now, FHA lenders will
often consult either DU or LP before approving even an FHA loan.
Among the 6300 non-subsidized loans analyzed in the FHA closing
cost study, nearly a thousand had explicit fees charged to borrowers
for use of either DU or LP, (charges varied from $10 to $150). Such
tools unquestionably speed the loan approval process. It is unlikely
that FHA would have built such a tool without the nudge from Fannie and
Freddie having built such systems.
Pure Government ownership and operation for Fannie and Freddie is
not a good idea. FHA and Ginnie Mae are both purely Government
operations. The good features of their structures lie in their
simplicity. They have strict constraints on what business they can and
cannot do, and what loans they are allowed to insure and securitize.
They are subject to maximum loan size limits that vary with property
values in different areas, they can insure and securitize only the
simplest loans (30-year fixed and simple ARMs), they can insure and
securitize only new loans, no seasoned loans, and lenders from whom
they will accept loans are subject to approval standards and to strict
servicing guidelines. These limits have successfully constrained the
risks that they take.
But FHA and Ginnie Mae perform better because they compete with
Fannie and Freddie, and match at least some of their innovations. If
all of the securitizing entities were Government bureaucracies, the
performance would not be as good as we get from a mix of the two.
A lender co-operative?
Time was when F&F were organized as lender cooperatives. Fannie
began as a Government agency in 1938, and was reorganized as a co-op,
primarily of commercial banks, in 1958. It was reorganized again as a
public company in 1968. Freddie was a co-op among the thrifts, run by
the Federal Home Loan Bank Board, from its creation in 1970 until
FIRREA in 1989. In 1989, the largest commercial bank in the United
States had less than 1 percent of bank assets. While U.S. banking is
still competitive today, it is considerably more concentrated now, and
a handful of large banks now hold close to half of bank assets and do
more than half of mortgage lending. The conflict between smaller banks
and larger banks with respect to how the GSEs should be run would be
greater now than it was in their former co-op days, and makes the
lender co-op idea a worse structure for today than it was in the past.
Any co-operative would be likely be dominated by the largest banks.
There are good reasons not to allow the largest banks to run the
GSEs to the disadvantage smaller banks. Smaller banks deserve an
important place in our banking system. There is accumulating evidence
that smaller depositories treat their customers in a less exploitive
way than do newer, larger, and less regulated financial institutions.
In particular, they are less inclined to exploit financial confusion on
the part of borrowers. See Stango and Zinman, Buck and Pence, who
examine evidence from the Survey of Consumer Finances, and Agarwal et
al. on the mortgage counseling experiment in Illinois, and the FHA
Closing Cost report, http://www.huduser.org/Publications/pdf/
FHA_closing_cost.pdf.
The spectacle Wells Fargo's recently exposed overdraft scam (re-
arranging the timing of presentations to maximize overdraft charges),
described by the judge as manipulative and hidden in a facade of phony
disclosures, should make us all wary of rules that would operate to the
advantage of large banks. It seems hard to imagine that a small
institution, one in which the executives and programmers at the bank
know depositors personally, and look them in the eye regularly, could
have put in place such an exploitive scheme.
How many GSEs should we have?
One might think that with only two organizations securitizing
mortgages, we would see tacit collusion and monopoly pricing such as we
get when two gas stations sit on opposite corners.
The gas station paradigm is instructive. If one station lowers its
price, its rival across the street sees that price change at least as
soon as any customer. The rival can respond right away by lowering
price also. The first mover sells no more gas than the rival, he just
sells the gas for less. Thus, there is no incentive to lower price when
the rival sees the change at least as soon as the customers do.
This paradigm does not fit F&F. Freddie and Fannie do not post
their guarantee fees in the way that gas stations post prices. Each
deal is negotiated, customized, and secret. The ultimate results are
seen only in quarterly summaries of business activity. Thus, customers
do know price before rivals do, and know many about the details about
their own deals that are not known by rivals. Cutting price does
generate more business. Two GSEs thus reach an outcome close to what we
would expect from perfect competition.
On the other hand, the more operators we have in the secondary
market, the harder it is to maintain the standardization and
homogeneity of securities that give us more liquidity and lower
mortgage rates. Two GSEs appear to give the maximum benefit of
standardization and liquidity, but still give us competitive pricing.
In principle, the Federal Home Loan Bank system could have created
a third securitizing GSE. It did not, despite some efforts in that
direction. I imagine that the reason the FHLB system failed to create
another securitizing GSE is that there are conflicts of interest among
the members about how the entity should be structured, with larger
institutions wanting more power than smaller ones. They have a
collective action problem. They all would benefit from having their own
securitization facility, but since some would benefit more than others,
the plan is blocked by those who would get less. They cannot create a
facility only for some members, and have been unable to negotiate their
way to creating a facility appealing to all.
Ownership by private shareholders versus a borrower cooperative
The new charters for Freddie and Fannie should 1) establish higher
capital requirements for Fannie and Freddie, and 2) have different
capital requirements for different lines of business, in particular
higher-default risk business, and 3) price the Government guarantee. It
seems unlikely that we can alter asset markets to entirely avoid price
bubbles (we seem to have had them from time to time as long as we have
had asset markets, and they can be produced in experimental settings
too), either in the stock market or the housing market, and once upon a
time, in tulip bulbs. But if our financial institutions are less
levered, the bursting of a price bubble is of less consequence. The
dotcom recession of 2001 was driven primarily by the fall in asset
values after the world realized that the internet was going to deliver
far more value to consumers than to sellers. The 50 percent margin
requirement (think of it as a capital requirement) plus the centralized
clearing arrangements that monitor account values continuously and
cashes out accounts that fall below required margin limited the fallout
of the decline in asset values. The decline in stock values hardly
touched the banking system. Housing was hardly involved in that
recession, as single family construction chugged right along. This
tells us much about how to limit a contraction in one sector from doing
damage to other sectors.
Given the big decline in house prices beginning in 2007, it was
inevitable that we would have a big decline in residential construction
(the high prices resulted in over-building, and when soaring vacancy
rates made the over-building apparent, prices fell). Residential
construction is a sufficiently large fraction of real activity that its
contraction by half would mean a recession, all by itself. Through the
third quarter of 2008, more than all of the shortfall in GDP was
attributable to the decline in residential construction. Did the credit
crisis make things worse? Certainly, yes. On average, recessions that
included banking panics have been worse than recessions without banking
panics. The dotcom recession of 2001 involved no financial panic,
mainly because the assets that fell in value (stocks) were held with at
most 50 percent borrowed money, and even this money was subject to
closely monitored margin rules. Higher capital requirements can make
the popping of price bubbles less consequential.
So we need higher capital requirements in financial institutions,
and especially to turn pseudo-insurance companies (AIG and other
writers of credit default swaps) into bona fide insurance companies, so
that they are subject to capital regulation. That's the easy part.
What about shareholder ownership, as prevailed until the crisis?
When then were taken over last summer, F&F were owned by private
shareholders, both had stock traded on the New York Stock Exchange,
both operated as profit maximizers subject to constraints in the form
of capital requirements and restrictions on their business activities
imposed by regulators, and some directors appointed by the president
instead of by shareholders.
Two problems arose with this arrangement. First, there was no force
to help F&F resist buying pieces of subprime mortgage securities and
whole Alt-A loans. They could not securitize these mortgages directly,
but they were not precluded from buying the higher-rated pieces. They
did buy Alt-A loans for portfolio securitized them also. Their prime
books are suffering in the current conditions, but the crippling losses
have come not from their traditional business but from the subprime and
Alt-A exposure.
Second, F&F both have outstanding research shops, and each had the
resources to do more research for the benefit of borrowers, for
example, by helping to develop clear and standardized disclosures. But
their main contact was with lenders, and both thought of lenders as
``their customers''. Until very recently, F&F were reluctant to do any
research on disclosure or comprehension of mortgage issues by
borrowers, and this was part of a general reluctance to ``get between''
lenders and the lender's customers, the borrowers. Even Web site tools
making loans easier to analyze brought forth lender complaints from
lenders that ``this was not their job''. Lenders attitudes have changed
since then, and the lenders are now eager for any help on assuring that
borrowers understand the deal. It would be good to institutionalize
these changes in attitude before the current crisis is forgotten.
As an example of work F&F did not do because the lenders were
``their customers'' is became apparent in an episode involving yield-
spread premium analysis. When the first ``yield-spread premium''
disputes were being litigated, the data being examined in the case was
made available to both plaintiff's and defendant's experts for
independent research. One expert sought to cooperate with staff
economists at one GSE, who eagerly began examining the data.
Previously, the GSEs only had HUD-1 data on very-low-credit quality
loans, and on small samples of standard loans. When the parent of the
defendant, a big GSE customer, got wind of this activity, it was
promptly halted.
Seven years later, this data plus another important set of data
collected by FHA for its Closing Cost Report has told the same story
about how mortgage brokers price discriminate and exploit borrower
ignorance of financial matters more aggressively than do direct
lenders, especially than small depositories and credit unions, who
treat their borrowers with more benevolence. It is not a story that
makes Americans feel proud of how financial institutions treat their
citizens, with minorities, the less-well-educated, and older people
charged more than others, other things equal. The GSEs could have been
at the forefront of this research. The economic staff was capable and
eager, but leadership blocked their efforts. In mid-July, 2009, the
Board of Governors of the Federal Reserve voted to prohibit all
practices that tied agent compensation to the interest rate on the
loan, essentially banning yield-spread premiums.
So a serious issue is how to make sure, in the long run, not just
while the crisis is in recent memory, that the GSEs have borrower
interests, not lender and broker interests, close to their hearts. One
possibility is a borrower-owned mutual. For example, the Hartford
insurance company is a mutual insurance company, essentially owned by
its insureds. However, insurance companies have another overlay of
governance from the State regulation of insurance that assures they are
adequately reserved. Credit Unions are another form of mutual
organization, with depositors owning and controlling them. Credit
Unions are among the most benevolent of our financial institutions. Not
only do they set prices to merely cover costs, not to extract all the
market will bear, but they reach out to borrowers to help them be
better borrowers, weaning them from payday loans and excessive credit
card debt. On the other hand, the credit unions' secondary market
facilities, organizations that pooled loans from individual credit
unions and took them to Fannie and Freddie for securitization, did not
escape the lure of subprime. Like Freddie and Fannie, the credit unions
did not make any subprime loans, but their secondary institutions did
buy some subprime securities, and have losses as a result.
Making the MBS guarantee explicit and charging for it could impose
discipline. If the guarantee is priced, there must be a regulator to
price it. And with the pricing will come guidelines as to what is
allowed in the pools. While Government organizations that price loan
guarantees are not perfect, they do not seem as vulnerable to
deliberate underpricing in order to ``maintain a place in the market''
as Fannie and Freddie were, especially with respect to their Alt-A
loans. FHA's market share fell into the low single digits, as the rest
of the market boomed and moved into subprime. In retrospect, FHA's
policies look quite sound. Turns out there was some logic to all that
paperwork.
The issue of organization and governance deserve more study. I do
not know enough about where control of mutual insurance companies
really resides, or even how credit unions are controlled, to offer a
completely firm opinion on structure. It seems that a return to the
structure where the GSEs are owned by outside shareholders but regard
lenders are ``their customers'' is not a good idea. A change that puts
borrower concerns ahead of lender concerns is in order. There are
several ways to move in this direction, the issue is important and
deserves more study.
The GSEs outside of single-family.
Multi-family construction is generally less sensitive to the level
of interest rates than single-family because owners of rental units are
either individuals with accumulated wealth or corporate entities, for
whom cash constraints are not so binding as on households. What
volatility is present in multi-family construction seems to come from
spurts of activity generated by new tax credit programs. Credit
conditions for multifamily fluctuate with the likelihood that intended
condominiums will turn into rentals.
So far, Fannie Mae's multifamily book has not generated much by way
of losses in this recession. Delinquency rates are up from historical
levels, but by absolute standards, they are still quote low (0.36
percent in April 2009, vs. 0.09 1 year ago). Freddie Mac's multi-family
book is even better, with delinquencies at 0.12 percent vs, 0.03
percent a year ago. But rental markets are softening, rents are down,
vacancies are up, and collections down. Fannie's multi-family holdings
are $174 bn, and Freddie's $91 bn.
Freddie and Fannie's multi-family underwriting is conservative.
Fannie requires a 125 percent debt-service ratio, 20 percent
downpayment minimum, and makes 10-year loans. More than 50 percent of
the multi-family book is now held in portfolio, but recent new
production is mainly being securitized. Multi-family loans are not
bundled with single family, but securitized in separate MBS.
Fannie and Freddie provide about three-quarters of all multi-family
lending, and the buildings they finance are occupied primarily by
elderly and low-to-moderate income households.
In all GSE activity, as well as in all activity in depositories,
there is at least a small amount of subsidy coming from Federal
backing, either explicit or implicit. The case for a GSE role is thus
more difficult to make for multi-family lending than for single-family.
On the other hand, given the success of both in underwriting these
loans, there seems little reason to inhibit this activity.
It is very difficult to make a case for the GSEs to have a role in
commercial property lending. Underwriting in commercial property is
more difficult than in either multifamily or single-family residential.
In commercial property busts, the critical factor is nearly always
slackening demand on the part of commercial renters, not the difficulty
of obtaining credit. Given the heterogeneity of commercial properties,
it does not appear that what the GSE's have to offer, other than credit
with the Government's good name, would contribute very much.
How big a difference do Fannie and Freddie make?
Most of the time, rates on mortgages that were eligible for
purchase or securitization by Freddie or Fannie have been cheaper than
larger, ineligible loans (``jumbo'' loans) by 25 to 40 basis points.
When the credit crisis began, one of the early manifestations of it was
a widening of the jumbo-conforming spread, out to 180 basis points
(that's 1.8 percentage points) and higher. The gap still stands at
about 100 basis points today (March, 2010).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The still-gaping jumbo-conforming spread calls for further comment
on our present situation. All of the discussion here has been about the
role of Freddie and Fannie in normal times, and what they can
contribute when markets are otherwise performing smoothly. Though there
are signs of return to normalcy--house prices rose in May and June as
reflected in both the FHFA house price indices and the Case-Shiller
house price indices--the situation is still far from normal.
In 2008, FHA insured nearly 30 percent of new mortgage
originations, up from only 3 percent in 2006. In the first quarter of
2009, Ginnie Mae did 26 percent of mortgage securitizations (FHA plus
VA), Fannie and Freddie did the other 74 percent, and there were no new
private-label securitizations. The FHFA Mortgage Interest Rate Survey
has ceased reporting rates on adjustable-rate loans because there are
not enough of these for statistical reliability. Corporate and
municipal spreads are narrowing, but still wide. Lending standards of
all kinds are more strict now than for many years.
During the financial crisis, our Government-created mortgage
institutions have made the difference between a bad recession and
something much, much worse, especially with respect to housing.
Essentially, credit has continued to flow, but almost entirely through
FHA and Ginnie, Freddie, and Fannie. In 2008, mortgage originations
totaled about $1.5 trillion, of which 89 percent were either FHA and VA
or conventional, conforming, prime loans. The other 11 percent were
mainly jumbo prime, with a sliver of subprime and Alt-A loans. Nearly
all of these new originations were securitized. Loan securitizations
were 74 percent Freddie and Fannie, and 26 percent FHA/VA. There were
no private-label securitizations (data from Inside Mortgage Finance).
While most of this discussion was about the operation of the GSEs
in more normal economic environments, the role of the GSEs in the
crisis deserves attention also. Their presence makes a bigger
difference, not a smaller one, in times of great confusion and
uncertainty in financial markets. One way of thinking about the wide
credit spreads we see today is that rates are not necessarily so high
for the usual borrowers, but that rates for the Government are
unusually low. It is a great irony of the crisis that although it was
caused by United States policies (with contributions from the United
Kingdom and a few others), it provoked a great increase in the world's
desire to hold U.S. Treasury bonds.
Evidently the world has more confidence in the ability of the U.S.
Government to collect the eventual taxes to refund its own bonds than
it has in the ability of individuals and businesses to repay their
debts. There is an element of irrationality in such beliefs, because
the very borrowers who are deemed less credit-worthy as individuals or
businesses are the same as those who will pay the taxes to refund the
bonds. It makes sense for the Government to use its superior standing
in the credit market to make credit flow to non-Government entities.
There are no structures more successful for doing this than the housing
credit institutions we created in the twentieth century. Mere
depositories would have done much less. Such a role was not
contemplated for them (with the exception of FHA, which was created in
a crisis specifically to make credit flow).
Nonetheless, they have served and made the crisis less painful than
it otherwise would have been. Thus, in deciding what to do about them
as we go forward, we should acknowledge another advantage to their
existence.
RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY FROM JANIS
BOWDLER
Q.1. In your testimony you state that pre-purchase counseling
has been shown to reduce the likelihood that a borrower will
default. You advocate increased funding from both the public
and private sectors to make financial counseling more available
to borrowers before they buy a home.
LGiven the benefits that you have found to borrowers
from this counseling, do you support mandatory
counseling for borrowers using Federal Government
programs, like FHA, prior to them receiving a mortgage?
A.1. Pre-purchase housing counseling from independent,
objective third-parties delivered in a timely manner and in a
one-on-one setting is highly effective. The model is based on
the commonsense notion that information is most effectively
absorbed during a ``teachable moment.'' That is, the critical
knowledge a family needs to navigate the mortgage market is
delivered at a point in time when 1) they are most receptive to
the information (because it is relevant to a near-term
decision) and 2) they have enough time to act on the
information. It is critical to distinguish between this kind of
high-impact housing counseling and less effective models, such
as a generic classes or online courses delivered moments before
signing mortgage papers. This kind of ``check the box'' model
does not empower consumers or inform their decisionmaking.
Housing counseling agencies approved by the Department of
Housing and Urban Development (HUD) are well-positioned to
offer timely advice to home seekers and to first-time
homebuyers. However, cuts to the HUD budget have endangered the
infrastructure of nonprofit housing counseling programs. HUD
funding is the backbone of the housing counseling program on
which nonprofits leverage other private funding. For example,
as a designated HUD Housing Counseling Intermediary, NCLR
matches HUD funds with private, philanthropic, and local
dollars 10 to one. Ideally, a well-rounded mix of funding
streams would support a robust and independent network of
private nonprofit housing counseling organizations. While many
banks support housing counseling providers with grant funds,
they have not put in place a fee-for-service model. Such a
model would ensure counselors are compensated for delivering a
mortgage-ready borrower that is less likely to default. Many
housing counseling organizations also support having their
clients pay a modest fee for receiving counseling. Most fees
are determined on a sliding scale based on income and cover the
cost of a credit report and materials. The housing counseling
industry is at a critical juncture. We urge Congress to
continue their long-standing support for a proven Federal
program, and we urge the banking industry to make a more formal
commitment to ensuring their clients have access to independent
housing counseling services.
Each year hundreds of thousands of first-time homebuyers
enter the market. While all first-time homebuyers can benefit
from a timely session with a certified housing counselor, HUD-
approved housing counseling agencies could not meet this demand
on the current resources and financial infrastructure. We would
support mandatory counseling for some mortgage programs so long
as they were paid for by the industry members that stand to
benefit and were supported by Federal funds. For example, we
would support mandatory housing counseling for first-time
homebuyers using Federal Housing Administration (FHA) mortgage
insurance if FHA paid nonprofit counseling groups for producing
a borrower less likely to default.\1\ Given FHA's high default
rates attributed to seller-financed downpayment scams,
counseling would have been a prudent investment for borrowers
and FHA. To be clear, we recommend that FHA fees be
administered separate from grant funding provided through the
HUD Housing Counseling Program. FHA, Fannie Mae, and Freddie
Mac should also consider incentives for borrowers to seek out
counseling, such as discounts on interest rates, fees, and
private mortgage insurance. NCLR made a similar recommendation
to Federal regulators on the risk retention rule.
---------------------------------------------------------------------------
\1\ Congress has invested millions of public dollars into creating
a solid housing counseling infrastructure. Families that participate in
pre-purchase counseling sessions are less likely to default on their
mortgage, preventing foreclosures and future claims. However, since the
removal of the housing counseling requirement, fewer borrowers seek out
or are informed of this free service. For more information: Janis
Bowdler, The Role of Federal Housing Administration Mortgage Insurance
in Revitalizing Latino Homeownership, presented to 111th Cong, 1st.
sess., 2009, http://www.nclr.org/index.php/publications/
the_role_of_fha_mortgage_insurance_in_
revitalizing_latino_homeownership/ (accessed January 2012).
---------------------------------------------------------------------------
In summary, NCLR supports mandatory counseling with
adequate private and public resources to meet the demand. A
mandate without an infrastructure sufficient to meet demand
would create a vacuum that would quickly be filled by sham
operations looking to take advantage of borrowers required to
receive a service. The onslaught of foreclosure rescue scams
should serve as a cautionary tale in this regard. However, NCLR
is committed to working with Congress, HUD, and our partners in
the mortgage industry to establish funding streams that support
a robust, nonprofit pre-purchase housing counseling
infrastructure. Finally, we underscore that to be effective,
counseling must be delivered early in the home-shopping process
(at minimum prior to signing a contract). With this as the
foundation--timely, objective housing counseling readily
available and supported by a robust mix of income streams--NCLR
would support a combination of mandatory counseling and
incentives for obtaining counseling for first-time homebuyers.
------
RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY FROM ANTHONY B.
SANDERS
Q.1. The theory that the 30-year fixed-rate mortgage is always
the best product for American consumers presupposes that
Americans move into a home and live there for 30 years with one
mortgage. In reality, Americans move often, and they refinance
often. Other types of mortgage products offer lower interest
rates and the ability to build wealth in a home more quickly.
Even the adjustable rate products can be fixed for periods of
time greater than the average time that Americans typically
keep their mortgage.
LGiven these facts of American life, would many
consumers be worse off if they purchase a 30-year
fixed-rate mortgage?
A.1. Did not respond by publication deadline.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM PAUL S.
WILLEN
Q.1. In a recent speech, Eric Rosengran, President of the
Boston Fed, noted that ``the U.S. gets less effect from the
movement of short-term, monetary policy interest rates compared
to countries where the primary mortgage financing instruments
are floating-rate loans.'' This suggests that the 30-year fixed
has contributed to our weak economy because it has reduced the
effectiveness of Fed monetary policy.
LCould you provide us with some additional thoughts
as to how the effectiveness of U.S. monetary policy
might be enhanced if the United States were less
reliant on the 30-year fixed-rate mortgage?
A.1. Did not respond by publication deadline.
Q.2. The theory that the 30-year fixed-rate mortgage is always
the best product for American consumers presupposes that
Americans move into a home and live there for 30 years with one
mortgage. In reality, Americans move often, and they refinance
often. Other types of mortgage products offer lower interest
rates and the ability to build wealth in a home more quickly.
Even the adjustable rate products can be fixed for periods of
time greater than the average time that Americans typically
keep their mortgage.
LGiven these facts of American life, would many
consumers be worse off if they purchase a 30-year
fixed-rate mortgage?
A.2. Did not respond by publication deadline.
------
RESPONSE TO WRITTEN QUESTION OF SENATOR SHELBY FROM SUSAN E.
WOODWARD
Q.1. In your testimony you state that ``the 30-year fixed-rate
loan potentially has some cost to taxpayers, but since
taxpayers are virtually all homeowners too, there is nothing
unfair about this situation.'' Unfortunately, missing from your
analysis is the fact that when a mortgage is not repaid, the
guarantee is not paid by homeowners to homeowners, but rather
by taxpayers to the Wall Street banks and investors that hold
the mortgage.
Do you believe that such taxpayer bailouts of Wall Street
investors are ``fair'' to U.S. taxpayers?
A.1. Any holder of a mortgage security, whether it is a bank or
an individual investor, is just an intermediary. The only risk
borne by these intermediaries who buy Government-backed
mortgage securities is prepayment risk, and the returns they
earn over the long haul are commensurate with the prepayment
risk. All homeowners get the benefit of Government support to
the mortgage market in the form of superior alternatives for
home borrowing. The benefit is present at all times. The
taxpayers bear the default risk, and pay taxes to cover it in
increasing proportion to their incomes. I believe that nearly
all taxpayers and homeowners regard this as a socially
beneficial arrangement.