Review of the Article:

Don't Reform Housing Finance - Reinvent It
by Richard Morris

Edward J. Dodson

[Comments posted Tuesday, 26 November 2013 at Knowledge at Wharton. The original article follows]

Richard Morris has been an officer in corporate strategy for two large corporations, including vice president of strategic initiatives with Fannie Mae from July 2006 through May 2011. He currently advises financial services companies on opportunities for growth through business and market innovation driven by insights emerging from the fields of behavioral economics and behavioral psychology. He is also a senior advisor to the Boston Consulting Group for two practice areas: financial institutions and regulatory institutions. I congratulate Richard Morris for expanding the debate over the nation's housing finance system. My own history included twenty years at Fannie Mae as manager of a team of review underwriters and later as a business manager performing market analyses in the Housing & Community Development group. Mr. Morris arrived the year after my retirement early in 2005. Prior to joining Fannie I spent several years managing the residential mortgage lending program for a large regional bank. So, many of the risks described in his article are those my colleagues and I grappled with on a daily basis.

What was most unique about Fannie Mae, from my perspective, was its charter as a shareholder owned company with a public mission and a very restrictive set of investment options. When I joined Fannie Mae at the end of 1984, the company was in serious financial trouble. It bought and held fixed rate mortgage loans at a time when the cost of funds was skyrocketing. Fannie was in the same situation as the thousands of thrifts scattered across the country -- bleeding red with no regulatory relief in sight.

Fannie's presence as part of the secondary mortgage market allowed mortgage originators to pass on interest rate and even credit default risk; when loan volumes were relatively low, Fannie's underwriters would look at each and every loan file before approving a purchase. However, as my own generation of "baby-boomers" reached adulthood and began to enter the work force and create new families, transaction volumes forced the industry to adjust. Delegated underwriting, shared risk structures and what were called "post-purchase reviews" by Fannie were introduced in response.

The same demographic shifts also added fuel to what had always been a speculation-driven part of the economy -- land markets. As new suburban developments went up around every major urban center, the asking price for still vacant land doubled and doubled again in only a few years time. A handful of city planners and economists who had some expertise in the operation of land markets offered warnings and advice to policymakers. Rarely did their input have an effect. And, as we know, the countryside everywhere retreated under the pressure of sprawling demand for land. Developers kept going further out from the regional center to find land at a reasonable cost. Local governments looked to the state and federal governments for funding to help shoulder the cost of putting in new roads, bridges, sewage treatment plants, sewer lines, utilities and water systems. Few gave much thought to the possibility that economic recession and "tax reform" would combine to bring an end to the era of revenue sharing initiated during the Presidency of Lyndon Johnson and continued on through Jimmy Carter.

What frustrated me as I began to work in the housing finance sector was the knowledge that most of problems we faced could have been avoided. I never forgot what a city planner in Central Pennsylvania had told me in the early 1970s. He explained the consequences of intense land specuation. More importantly, he explained how the way we taxed real estate caused land prices to skyrocket, imposing heavy stresses on the general economy so that about every 18 to 20 years we would experience a recessionary bust.

When I was given the responsibility at my bank for our CRA investments, this problem became quite evident. Infrequent and inaccurate property assessment actually penalized lower income households, whose property values had fallen but whose assessments remained fixed. With rare exceptions were property assessments in a community maintained at a consistent percentage of market value. For a long list of common sense reasons, the fairest and most economically efficient means of raising revenue from real estate was to tax the value of land only. I learned from the city planner that a handful of Pennsylvania city governments had actually moved moderately in this direction by applying a higher rate of taxation on land values than on houses and other buildings. I hoped that during my career I might be able to support this approach as I worked with distressed communities. Over the years, writing papers on the subject and even testifying before city councils, only the rare elected official could grasp how important this policy change could be.

The reason for telling the above story is that my desire to join Fannie Mae was, in part, based on an exchange of letters I had in 1982 or 1983 with the then Chairman and C.E.O., David Maxwell. Reaching out to Mr. Maxwell after viewing an interview of him with George Goodman (on Adam Smith's Money World), he informed me that he was quite familiar with the tax policy proposals I embraced and was in full agreement. If any company seemed to have good reason to work for such a change it was Fannie Mae. Non-inflationary economic expansion was just what a company required when borrowing short-term and lending long-term.

As it turned out, a combination of the Reagan recession and product innovation slowly brought Fannie out of its financial black hole. Cash was raised by selling off whole loans, but the losses were allowed to be amortized over the remaining live of the loans rather than immediately recorded. The adjustable rate mortgage was introduced, stimulating investor interest in mortgage-backed securities that offered protection against interest-rate risk. And, Paul Volcker's policies at the Fed gradually brought interest rates back down to single-digits. Deregulation did the rest, particularly the role played by money market funds and REITs providing the credit to anyone who showed the least bid of ability to act as a real estate developer.

Those of us in the trenches observed many warning signs. Year after year Fannie and Freddie increased maximum loan limits in order to sustain transaction volumes. This only added more fuel to the speculative character of the residential property markets. By the time of the 1989 crash property appraisals in some markets were reporting land-to-total value ratios greater than 50%. In short, consumers were paying as much or more for land as for the housing unit itself. And, then, of course, the S&L meltdown occurred. Delinquencies and REO climbed but these problems were kept manageable by a growing team of specialists in this part of the business.

By this time several economists had entered my circle of contacts, and they were warning that the next downturn would be far worse. The historical data indicated that the next crash would occur beginning in 2007 and continuing getting worse through 2010. I was not convinced for the simple reason that there was no one national property market in the U.S. Our recent history was one of boom in on region even as other regions were busting. Labor and capital moved from low growth or no growth regions where the prospects were brighter. For example, California's skyrocketing property prices and taxes opened the door for the economic diversification of Las Vegas and new growth in places such as Phoenix, Seattle and Portland. My attitude changed after the British economist Fred Harrison recruited me to provide research assistance for a book on the next crash that would be published in 2005. In one of the great ironies of modern social policy, the creation of a uniform secondary mortgage market that simultaneously took over a huge portion of the former jumbo market and funded the sub-prime business formerly the province of finance companies and second mortgage lenders brought on a nationwide crash. Fannie tried but failed to side-step the direction the market took by allowing Wall Street to build market share with private label MBS that increasingly ignored conventional creditworthiness standards and was often plagued by systemic fraud.

I remember hoping that the collapse of Wall Street's shell game would not bring down the GSEs. I knew, as Dan Mudd would later testify, that Fannie's Alt-A business was far less risky than the sub-prime loans Countrywide and other lenders had generated. But, investors almost immediately abandoned the entire MBS market. Fannie was forced (I surmise) to mark down assets to market value and book the losses and had no real hope of raising additional capital as the stock price collapsed. Before long the sub-prime collapse expanded to a general financial crisis, business contraction, layoffs, rising unemployment, eviction notices, and millions of foreclosures. Almost unanimously, economists and analysts said the "housing" market was in free fall. Actually, what was falling everywhere were the unsustainable land prices. In some markets (e.g., parts of Cleveland and Las Vegas and new condominiums scattered throughout Florida) demand collapsed which pulled property prices down well below the depreciated value of actual housing units.

At that point, the one measure regulators should have pushed through was to prohibit any financial institution that accepted government insured deposits from extending credit for the purchase of land or acceptance of land value as collateral for any borrowing. What this would have done is to deny the property markets of the fuel to reignite a return to land price escalation. Property prices had already fallen. With this one change in regulation, buyers would be required to accumulate savings sufficient to make a 20 percent cash down payment (as was once the case before the introduction of private mortgage insurance).

Instead of taking steps to keep the land markets from yet another destabilizing climb, our state and federal governments and the Federal Reserve combined forces to stimulate demand sufficient to pull property prices back up to levels that would protect banks for further losses and enable at least still employed homeowners to refinance out of high cost mortgage loans.

As I see the problems, the measures proposed by Mr. Morris do not in any meaningful way focus on the real causes. ** The debate over how to reform the U.S. housing finance system has heated up recently. President Obama has endorsed bipartisan legislation proposed in the Senate that would replace Fannie Mae and Freddie Mac with a government-run insurance fund. Republicans in the House Committee on Financial Services have introduced a series of bills that would eliminate Fannie and Freddie and replace them with private companies, while some investor groups have argued to recapitalize Fannie and Freddie and return them to private ownership. But instead of merely reforming our existing framework, now is the time to reinvent the country's housing finance system.


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Don't Reform Housing Finance - Reinvent It
by Richard Morris

For millions of Americans, the largest financial obligations they will ever have will come from owning a home and making mortgage payments. Mechanisms should be created that enable homeowners to manage the risks of home ownership and of their mortgage liabilities more effectively. The following article outlines how we can reinvent our housing finance system so that risks are reduced for borrowers, lenders, investors and taxpayers, it promotes the use of private capital, and it is more efficient, dynamic and responsive to our country's economic needs.

The Shortsighted Debate About Housing Finance Reform

The current debate about the future of the U.S. housing finance system has largely focused on two basic options. The first involves adjusting Fannie and Freddie's business practices and governance models, then recapitalizing and re-privatizing them. The second is to eliminate Fannie and Freddie and instead have privately funded entities take over their functions.

But by centering the debate on these narrow choices - and their various hybrids - the country is missing an enormous opportunity. Rather than simply address who should perform the functions of the existing housing finance system, we should take this chance to rethink and restructure the system in innovative ways. This is best framed by posing a fundamental question: "If we were to design a housing finance system to best address the needs of the country today and in the future, would it be the one we already have?" I believe we would want a system that differs in meaningful ways.

Our housing finance framework has spanned many generations but has centered on an inherently risky financial transaction: individuals buying homes - which are expensive and illiquid assets - by making relatively small down payments and borrowing very large amounts of money over a long time, usually 30 years. This transaction's risk profile was tolerable years ago when job and income security were high and people stayed in their homes for many years. But unlike in prior generations, job and income security in today's economy are much lower, and people need flexibility so they can move for work opportunities. Buying a home on such a long-term and highly-leveraged basis has become a riskier proposition. Indeed, when our economic downturn combined with a reversal in home prices, we saw how this risk can become greatly magnified systemically. In short, our current housing finance system is outdated and too risky for our modern economy.

We should work to change the system. There are straightforward ways to reinvent our housing finance system so risks are reduced, the system becomes more responsive to our economic needs, and it promotes the use of private capital as the dominant source of financing.

Reducing Homeownership Risk: 'Shared Equity' Financing

When financing a major asset, such as a new factory or an acquisition, a company typically has a great deal of flexibility. In addition to using its own capital, it also can issue debt and/or sell stock. This allows the company to create a suitable financing structure for the asset's risk and longevity. The key is having the ability, if desired, to share equity risk with third parties by selling shares. But this option does not exist for homeowners in the current system.

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To finance their purchases, homebuyers must use 100% equity (their down payments) along with third-party debt (their mortgages). Unlike companies, homebuyers alone face the risk that their home equity declines or possibly disappears altogether, as was true for the millions who found themselves "underwater" on their mortgages during the housing crisis.

But we can create greater financing flexibility for homebuyers, and lower the risks associated with house price declines, by establishing a legal framework that easily enables institutional investors to co-invest in homes alongside occupying homeowners. I call this "shared equity" financing. This involves a transaction where less than 50% of home equity is purchased by an institutional investor. In a sense, this makes owning a home a joint-venture type of activity, with the occupying homeowner being the "majority partner" (with more than 50% of the home equity) while the institutional investor is the "minority partner". The "partners'" interests would be aligned, and any funds due to the institutional investor would be paid upon the sale of the home when all home equity is available to both "partners". Meanwhile, the traditional economic incentives of home ownership would be maintained for the occupying homeowner. For example, shared equity contracts would stipulate that improvements made to the home accrue to the equity account of the occupier.

This kind of financing is distinctly different from other "equity-like" home financing techniques, such as the shared-appreciation mortgage, which allows for sharing in house price appreciation but remains a debt obligation for the homeowner. In a shared equity structure, the institutional investor only get its share of home equity - if there is no home equity (as would be the case for "underwater" homes), the investor gets nothing with the occupying homeowner having no further obligation to the investor.

Homebuyers could use shared equity financing to reduce equity risk and also potentially to lower mortgage amounts. Many underwater homeowners probably wish they had this option when they bought their homes. The technique, however, also could be used by homeowners with a great deal of equity in their homes who want to diversify their wealth by selling a portion of their home equity to invest in other assets. From a macro standpoint, this type of financing would distribute home price risk more broadly and enable institutional investors to get exposure to residential home prices and to use it to create diversification benefits.

A New Kind of Insurance: House Price Risk

A private market should be developed which provides homeowners with insurance against severe declines in home prices. There are a number of potential frameworks for providing this kind of insurance. The most straightforward would involve basing the insurance on changes in home price indices, which would be developed for a range of different regions. House price insurance then would be a matter of measuring changes in a given index's value from the date an insurance policy goes into effect to the date of an insurable event, such as the sale of a home.

Although premiums for such insurance may be high initially, they should become more reasonable as the housing market normalizes and insurers develop increasingly effective ways to hedge house price risk. (Shared equity financing could help in this regard by providing liquidity for institutions to trade house price risk exposures systematically.) Again, by shifting risk away from individual homeowners to institutions, home price insurance would help make the overall housing finance system less risky, more flexible and dynamic, and better suited to meeting the challenges posed by our modern economy.

A Better Way to Manage Mortgage Debt: Refinancing at Less than Par Value

Another way to reinvent the housing finance system would be to introduce a mechanism that allows mortgages to be refinanced for less than par value (i.e., 100 cents per dollar of debt).

Our current system allows 30-year fixed-rate mortgages to be paid off early without penalty, enabling homeowners to refinance their mortgages at par value when interest rates fall. This has allowed millions to lower their home mortgage payments - and, consequently, their financial risk - as the Federal Reserve has eased monetary policy. A mechanism allowing borrowers to manage their mortgage balances when interest rates rise also should be developed. Doing so will reduce risk in the housing finance system.

An example is Denmark's system, in which a standardized type of mortgage-backed bond (a "covered bond") is created whenever a fixed-rate mortgage is issued. These covered bonds are widely traded and their prices are broadly publicized. As with all fixed-rate debt securities, the traded prices of these bonds rise above par value when mortgage interest rates decline and fall below par value when rates rise.

As in the U.S., the Danish system allows borrowers to refinance their mortgage principal balances at par value without penalty when interest rates decline, and thereby lower their monthly mortgage payments. Importantly, however, and unlike in the U.S., the Danish system also enables borrowers to maintain their monthly payments, but to reduce their mortgage principal balances when rates rise. This involves having a borrower buy a covered bond in the open market at a price below par when interest rates rise and then relinquish it to extinguish their outstanding mortgage debt at par value.

For example, a covered bond with $100,000 of principal paying a 6.0% coupon rate of interest will have a market value of about $90,000 if mortgage interest rates rise to 7.0%. Therefore, a borrower with a $100,000 6.0% mortgage can borrow $90,000 at a rate of 7.0%, buy a 6.0% covered bond in the market, and then immediately relinquish it to extinguish the 6.0% mortgage obligation. The result: The borrower has replaced the $100,000, 6.0% mortgage with a new $90,000, 7.0% mortgage. The lowered principal balance combines with the higher interest rate to leave the borrower's monthly mortgage payments unchanged at $600, but $10,000 of principal has been permanently extinguished via this mechanism. Then, this lowered principal amount can be refinanced again without penalty when interest rates fall, thereby permanently lowering the borrower's monthly mortgage payment.

This framework has enabled Danish homeowners to dynamically manage their mortgage debts and minimize their financial risks in a manner that otherwise is available only to large companies. This model could be applied in the U.S. with relative ease, since the country is dominated by fixed-rate mortgages that are securitized by Fannie, Freddie and Ginnie Mae. This would lower the overall risks in our housing finance system and improve the responsiveness of the housing finance sector to changes in monetary policy. It would create a stimulative effect by decreasing mortgage payments when the economy is soft and interest rates fall, and it would also lower financial leverage when rates rise as the Fed tightens monetary policy in order to rein in an overheating economy.

Removing Complexity from the System

The U.S. housing finance system is very complex. As such, it is ripe for streamlining, taking out both costs and "complexity risk" - the risk that things fail because they are too complex to handle in times of stress. An overhaul will require great political skill and leadership because our complex system has many varied economic interests. Reinventing the system, however, will pay enormous dividends by lowering costs, enhancing flexibility and minimizing operational risk.

There are many things policymakers could do to streamline the housing finance system. For example, the country should consider establishing a "uniform commercial code" for housing finance and, in the process, set national standards and practices as opposed to continuing with the patchwork of state and local laws and regulations, which hinders efficiency. A holistic electronic mortgage finance system could be developed, providing more efficient forms for clearing property titles, as well as for underwriting, settling, securitizing and trading mortgages. Mortgage servicing policies, protocols and compensation are being rethought, but appropriate standardized frameworks should be established for relevant real estate asset classes, such as performing mortgage loans, non-performing loans, and modified loans. These should be re-examined on a regular basis. There are many more areas that should be reviewed, and I invite others to suggest how to reinvent key operational aspects of the country's housing finance system.

Implementation

Our current housing finance system is governed by a complex web of federal, state and local laws and regulations. Individual aspects of my proposal likely could be implemented under existing rules, but certainly not all. A fundamental reinvention of the housing finance system requires legislation that allows for new products, services and operational functions to be developed seamlessly while also clearing away legal and regulatory complexity. This can be done by expanding current legislative proposals to include the legal frameworks needed to establish the desired transformational changes. We should seize the opportunity to adjust the country's legal and regulatory framework for housing finance, ensuring complexity is reduced and flexibility is increased.

The debate on reforming the U.S. housing finance system is too narrowly focused. Rather than simply deciding the futures of Fannie and Freddie and outlining the role of the federal government, we should reinvent how housing is financed and its risks are distributed. The goal should be to establish a system that is less risky for all - homeowners, financial institutions and U.S. taxpayers - and that is more dynamic, flexible and suitable for our present-day economy. There are clear routes to accomplish this objective, and policymakers in the Administration and Congress should make it a priority to find ways to move responsibly beyond the outdated framework that contributed to the country's devastating housing crisis.