Obama Housing Policy Plan Stronger Than Anticipated

The Treasury released its long-awaited housing finance policy report Friday morning. Leaks suggested that the Obama administration would essentially punt on the question of what to do about the government's role in the mortgage market. That assessment was a little too strong. Instead, the plan did provide three options, but all were variations on a clear theme: the government's role in the housing market will be sharply reduced once a new policy is adopted.

The report (.pdf) begins with a narrative of how the government's involvement in the housing market played a role in the financial crisis. It stressed how the public-private nature of government-sponsored enterprises Fannie Mae and Freddie Mac was intrinsically flawed. It then asserted that these GSEs should be wound down over the next decade or so. This much is clear: under every option the Treasury outlines, Fannie and Freddie will eventually cease to exist.

With that said, however, the government's presence in the housing market will not disappear entirely. In fact, it would certainly remain intact for the affordable housing initiatives through the Federal Housing Authority and other targeted programs, as it had in the past. The big change would be how mortgage funding would be provided for the vast majority of mortgages in the U.S., which have heavily relied on Fannie and Freddie for decades. The Treasury wants the private market to step in and take on most of that funding responsibility and relieve taxpayers of some or almost all of the mortgage market's risk.

Before getting into the three alternative policy possibilities that it offers, the plan explains how the mortgage market would be weaned off of Fannie and Freddie over a period of time. One change would be to gradually increase the guarantee fees that the GSEs charge, so that private guarantors would be able to better compete. Another change would be to require Fannie and Freddie to obtain more private capital to cover subsequent credit losses. The Treasury also intends to reduce the size of mortgages that qualify for Fannie and Freddie guarantees. Finally, the administration intends to wind down Fannie's and Freddie's mortgage portfolios, by at least 10% per year.

The Treasury also provides some guidance on mortgage underwriting and measures to crack down on predatory lending. Perhaps the most surprising assertion was that loans that obtain government backing going forward -- excluding those in designated programs specifically targeting lower-income borrowers -- should eventually be required to "have at least a ten percent down payment." The Treasury also stressed the importance of ensuring borrowers have the ability to pay the mortgages they obtain.

Finally, the plan provided three alternatives to how the government's role in housing finance policy should proceed going forward. The three proposals would all provide government support for programs to help to lower-income borrowers secure housing, as has traditionally been done through the FHA, USDA, and Veterans' Affairs assistance program. These would make up about 10-15% of the mortgage market. So the three alternatives would impact the other 85% of mortgages.

Here's the big surprise: under all three alternatives, the government would have a much smaller presence than it did through Fannie and Freddie prior to the financial crisis. Here's a brief description of each summary:

Option 1: Go Private

The first possibility the Treasury offers is simply the free market model. While the FHA and other such programs would remain in place, the vast, vast majority of mortgages would not benefit from government assistance. For some 85% of the market, there would be no government guarantee in place. Instead, other funding mechanisms like securitization and potentially a covered bond market would be in place for lenders to obtain mortgage financing.

Option 2: Crisis Funding Mechanism

The second alternative would provide the option of a government guarantee, but at a price that isn't normally competitive with the private market. As a result, when the economy is in good health, this framework would look a lot like the fully private market, because the government's guarantee pricing would be too high to be competitive. But the plan's impact would be felt when a credit crunch hits and mortgage funding becomes scarce. The guarantee would then provide the opportunity to obtain funding, despite market instability. The fee that wasn't competitive during normal times might also be reduced appropriately to facilitate credit in times of great economic stress.

Option 3: The Catastrophic Guarantee

Finally, there's the alternative that would provide the most, but still limited, government involvement. This plan actually looks an awful lot like one proposed earlier this week by Moody's Chief Economist Mark Zandi. It would essentially create a market where the government would provide an insurance backstop (through reinsurance) that would only be utilized when catastrophe hits -- as it did over the past few years. Mortgages would pay a premium to obtain this insurance, but the first losses (up to some specified percentage) would hit whoever held the mortgage asset, whether it be a bank or investor. If losses exceed that first loss piece, then the government would cover the remainder. The government would use the guarantee fees it obtained to do so. That way, theoretically, taxpayers would not be harmed. Think of this as a little like depository insurance, where there's a fund in place paid for by insurance premiums that the government uses to cover losses.

From the standpoint of someone who has been closely following the housing finance policy debate for some time, this report is surprisingly aggressive. Even though the Obama administration doesn't take a firm stance on the best specific housing policy framework, it clearly sets the tone for the debate going forward. Any hope that the government would still maintain a full mortgage guarantee for most of the mortgage market may be dead. This will likely frustrate the real estate industry, banking lobbyists, and mortgage bond investors. But it's ultimately pretty good news for taxpayers. Even in the third option, where the government has the biggest role, taxpayers should have far less risk than they did through the system in place prior to the financial crisis.

So really, the Treasury has taken a pretty firm stand against heavy government involvement in the housing finance. Going forward, the debate won't focus on how much government support the mortgage market will enjoy, but how little.