The Government Is Preventing Private Housing Finance

A major investor explains that the market wants to return to mortgage securitization and won't demand very high interest rates

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If changing the status quo was easy, it wouldn't be the status quo. This explains the challenge facing housing finance policy reform. Currently, the government backs around 90% of new mortgages. The only way for this to change is for the government to actively step back and allow the private market into the game. This was an important takeaway from a Senate Banking Committee hearing on Thursday that focused on housing finance.

As always, there was a cross section of experts testifying at the hearing. Real estate industry lobbyists and affordable housing advocates made up four out of the six witnesses. Unfortunately, it's hard to treat them as credible witnesses, since they are hopelessly biased in favor of keeping the government's huge role in housing left intact. That way, as many mortgages as possible can be issued, no matter the consequence to taxpayers. The other two witnesses, however, represented the market. One, in particular, explained that the private sector can and would return to housing finance if the government allows it to do so.

Margin S. Hughes is the President and CEO of Redwood Trust, a firm that sponsors and invests in residential mortgage securitizations. Why should we listen to what he has to say? In April 2010, his firm sponsored the first and only private residential mortgage securitization deal since the financial crisis wrecked the market in 2008. They sponsored another deal in March and are planning two more this year. While academics and policy wonks can debate the pros and cons of government intervention in the mortgage market, Hughes has seen its effect firsthand and lays out the necessary steps to bring back the private market.

The Fallacy of Investor Distaste for Mortgage Risk

Some commentators assert that investors are no longer interested in mortgage bonds, having been injured by the housing bubble's pop. Hughes disagrees. In his prepared testimony (.pdf), he said:

Today, there is a vast amount of global investment capital from bank balance sheets, insurance companies, and mutual funds to non-U.S. financial institutions, hedge funds, and even real estate investment trusts searching for ways to generate safe, attractive risk-adjusted returns.

Based in part on the success of our two recent mortgage securitizations and on-going discussions with triple-A investors, we have confidence that the private market will invest in safe, well-structured, prime securitizations that are backed by "good" mortgage loans. We consider "good" loans as loans on properties where borrowers have real down payments, capacity to repay, and good credit.

So sensible loan underwriting paired with strong disclosure and transparency can produce private housing finance. Again, this is according to someone who actually works in this industry as a market participant, not a fringe libertarian type.

Those who want to maintain the government's role in the market often dream up scary consequences from asking the private market to step in. They will frown and tell you that the 30-year mortgage will go away or that interest rates will jump by 3%. Hughes rejects those possibilities too. He believes that interest rates would rise, but modestly -- probably by something like 0.5%. Historically, he says investors have demanded an interest rate premium of around 0.31% on mortgages that lack government backing. In Redwood's recent deals, that premium was 0.46%.

So What's the Problem?

If investors want to take on mortgage risk again, then why aren't they more aggressively doing so? The government is stifling competition. It's keeping private capital out of the real estate market in several different ways.

Crowding Out the Private Sector

Let's say there's a product of some sort that you really want being sold at two places: a private firm and the government. However, the government will sell the product for cheaper because it's subsidized by taxpayers. Which do you buy? That's a no-brainer: you buy it from the government.

For our purposes, that product is real estate financing. The government's prices are so good that it has about 90% share of the market. It is able to provide such a great deal, says Hughes, because its pricing doesn't accurately reflect the risk of the loans, meaning that a taxpayer subsidy is implicitly present.

No Urgency to Change the Status Quo

Because the government is willing to fund most mortgages, banks see no urgency in trying to jumpstart the private securitization market. Why would they fund cheap financing stamped with a government guarantee? Although such aggressive support might have been necessary during the financial crisis, Hughes says that on-going taxpayer support of "90% of a $10 trillion market is simply untenable."

The government needs to take off the training wheels. Hughes suggests doing this slowly, by gradually reducing the size of the loans the government will back and by increasing its guarantee fee to be more in-line with the market.

Regulatory Burdens

Unfortunately, some of the government's efforts to make the market safer are counterproductive. Hughes sees several ways in which the government needs to alleviate the regulatory challenges holding back the mortgage securitization market:

  • More flexible rules to accommodate complex products, instead of one-size fits all regulation
  • Reducing the risk-retention options to one in which the sponsor must hold the first-loss piece
  • Loosening proposed underwriting requirements to allow banks to take "common sense" approaches, without getting caught up trying to satisfy specific rules
  • Providing uniform standards for mortgage servicer responsibilities, so to avoid the problems that arose last year with processing foreclosures

Stricter Limitations on Second Mortgages

In order for investors in first mortgage to become comfortable with the assets again, they must see limits in place to second mortgages. As Hughes explains, second mortgages reduce a borrower's equity, which makes the first mortgage riskier.

Congress needs to listen to this kind of testimony, because it clearly and transparently shows the direction that policy reform should take. Having someone who is on the ground telling you how things actually are is far more valuable than other so-called experts theorizing on how things might be. Clearly, Hughes has a reason for wanting mortgage financing to become private again: so he can invest in it. That isn't the kind of bias that skews the truth in what he's saying, it's the kind of bias that confirms it.

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