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St. Louis Fed president says it's time to reform housing finance

This article first appeared in the St. Louis Beacon, Nov. 17, 2010 - The current economic situation is an opportunity to reform U.S. housing finance according to best principles and sound lending practices, St. Louis Federal Reserve President James Bullard told participants at a conference Wednesday morning on government-sponsored enterprises -- troubled mortgage giants Fannie Mae and Freddie Mac.

"The extent of congressional meddling in this market has been astonishing to the point where one can barely identify what the private sector outcomes would be in the absence of intervention,'' said Bullard in his opening statement. "To the extent possible, we need to let the private sector provide the bulk of U.S. housing finance going forward, without the incentive-distorting set of government programs and taxpayer guarantees that caused our current system to collapse.''

Bullard said that those programs meant well but ended up costing everyone dearly.

"It makes little sense to try to design programs that subsidize everyone,'' he said. "If everyone is subsidized, then no one is subsidized."

The all-day conference at the St. Louis Fed is titled "Past, Present, and Future of the Government-Sponsored Enterprises" and includes research by academics, financial market experts and policymakers from across the country.

Government-sponsored enterprises are owned by shareholders but backed by the government. Although GSEs are complex financial arrangements, the bottom line is this: Shareholders benefit from profits when times are good; taxpayers pay for the losses when times are bad.

"We're in a critical moment now where we're thinking about how to reform these institutions and we're trying to do what we can to play a leadership role in that, as well,'' Bullard said during a news conference.

He told reporters that it is clear from the research being presented at the conference that reforming GSEs will be complicated.

"But I think it's important that the nation faces up to this and the Congress faces up to this and comes out with something better than let's continue the status quo, even though it created a disaster for the U.S. economy,'' he said.

Bullard noted that the St. Louis Fed has a tradition of expressing concerns about GSEs.

William Poole, Bullard's predecessor, warned in 2003 that Fannie Mae and Freddie Mac were under-capitalized -- that their assets didn't cover their liabilities.

"He warned repeatedly of the dangers of the GSEs. And if they tumbled then that would cause dramatic problems for the U.S. economy. He turned out to be exactly right about that,'' Bullard said.

In July 2008 -- the summer after the U.S. financial meltdown -- then-retired Poole caused another stir when he told a Bloomberg News reporter that Fannie and Freddie would be considered insolvent if normal accounting standards were applied to them.

Poole's warning was borne out two months later: In September 2008, regulators seized Fannie and Freddie. The administration of President George W. Bush pledged federal funds to keep them solvent under the Preferred Stock Purchase Agreements program administered by the Department of Treasury. That backing has continued during the administration of President Barack Obama.

In October, the Federal Housing Finance Agency reported that Fannie and Freddie had already drawn $148 billion from the program and estimated that the total cost could range from $221 billion to $363 billion through 2013, depending on how quickly the housing market recovers.

Bullard said that GSE reform won't come quickly and he doesn't see it as a risk to the housing market.

"The danger is probably that the reform won't get done or will get done in a poor way,'' he said. "We have to get clear in our heads what would be the best housing finance system for the country and then think about how can we move toward that system over time. You don't want to create problems during the transition. So there would be two parts: Decide what to do. Decide how to run the transition in a way that does the least damage in the meantime.''

Scheduled speakers include: Robert Van Order, professor of finance, George Washington University; John C. Weicher, director, Center for Housing and Financial Markets, Hudson Institute; Shawn Moulton, Ph.D. candidate in economics, University of Notre Dame; Dwight M. Jaffee, professor of finance and real estate, University of California-Berkeley; Lawrence White, professor of economics, New York University; and Alex J. Pollock, resident fellow, American Enterprise Institute.

Here is the complete text of Bullard's statement:

It is my pleasure to welcome you to the Federal Reserve Bank of St. Louis' research conference on the "Past, Present, and Future of the Government-Sponsored Enterprises."

The role of the housing market has been central in the recent financial crisis. Mortgage financing, in particular, turned out to be an exceptionally weak link as the crisis unfolded.

The U.S. government has often modified the structure of housing finance after a crisis. For example, before the Great Depression, a large fraction of mortgages was relatively short term (five to seven years). These loans were mostly non-amortizing balloon mortgages, with low loan-to-value ratios of 50-60 percent.

The intervention of the government changed those terms in favor of fixed-rate mortgages with longer maturities (20-30 years) and higher loan-to-value ratios (80 percent and above). In 1938, Fannie Mae was established to create a secondary market to provide liquidity by buying primarily FHA-insured loans. In 1968, Fannie Mae split into a private corporation (Fannie Mae) and a publicly financed institution (Ginnie Mae). To provide competition for the newly private Fannie Mae, Congress established Freddie Mac in 1970.

The extent of congressional meddling in this market has been astonishing to the point where one can barely identify what the private sector outcomes would be in the absence of intervention.

To the extent possible, we need to let the private sector provide the bulk of U.S. housing finance going forward, without the incentive-distorting set of government programs and taxpayer guarantees that caused our current system to collapse. Those programs meant well, but ended up costing everyone dearly.

It makes little sense to try to design programs that subsidize everyone. If everyone is subsidized, then no one is subsidized.

We should perceive the current situation as an opportunity to reform housing finance according to best principles and sound lending practices. The future of Fannie Mae and Freddie Mac will depend on the nature and structure of the new mortgage finance system. Here are a few principles that may be used to guide the reform process, and which may be discussed during the conference today:

  • Housing affordability: To the extent possible, government subsidies to lower-income and first-time buyers should be disentangled from housing finance more broadly defined. Subsidies should be regularly reviewed and subject to congressional approval and appropriation of funds. These functions could be merged into the structure of the Department of Housing and Urban Development along with the government mortgage programs of the FHA and Ginnie Mae.
  • Mortgage loan origination: One of the rationales for the GSEs is to enhance the flow of credit to specific sectors of the economy. A key question we need to ask is whether the private market will allocate credit more efficiently. In most developed countries, mortgage finance is provided by the private sector. Ideally, in a well-functioning private system, taxpayers can be sheltered so they are not exposed to insolvency risk.
  • Leverage: Home equity is the best insurance against default. Loan-to-value ratios of 80 percent or below should be adequate to insure against most house price movements. Homeowners who choose higher loan-to-value ratios could be required to purchase default insurance or to increase the amortization component of their mortgage payments.
  • Recourse: Many European countries had housing booms and busts of a similar magnitude to the one in the U.S., but they experienced a different pattern of default rates. For example, in Spain mortgage debt cannot be discharged in the event of default, and as a result, the default rate is much lower than in the United States. A possible reform of recourse regulation along European lines may improve the pattern of default in the U.S., which is currently regulated at the state level.
  • Transparency, risk, and insurance: The pooling of mortgages into mortgage-backed securities could be constrained to pool loans with similar characteristics (i.e., $150,000 to $200,000 with a loan-to-value ratio of 80 percent). To avoid one-sided bets, financial intermediaries could be required to purchase insurance or otherwise appropriately hedge their MBS portfolios.

The research presented at this conference addresses these important issues and is thus particularly timely. The range of issues we will study today ranges from the evaluation of the role of the GSEs in the expansion of the home ownership rate to their role in the purchase of subprime agency debt, as well as several proposals to reform their structure and regulation. The Federal Reserve Bank of St. Louis has long supported fundamental research in economic policy. Our goal has long been to provide perspectives on whether the policies adopted in the past still serve us well today, and on how recent developments at the frontier of research can be applied to improve policy. That is what the St. Louis Fed has aimed to do for the past four decades.
With that in mind, I welcome the speakers who have agreed to share their insights with us today. I trust that we will all learn quite a lot. Thank you for being here, and have a great conference.

Mary Delach Leonard is a veteran journalist who joined the St. Louis Beacon staff in April 2008 after a 17-year career at the St. Louis Post-Dispatch, where she was a reporter and an editor in the features section. Her work has been cited for awards by the Missouri Associated Press Managing Editors, the Missouri Press Association and the Illinois Press Association. In 2010, the Bar Association of Metropolitan St. Louis honored her with a Spirit of Justice Award in recognition of her work on the housing crisis. Leonard began her newspaper career at the Belleville News-Democrat after earning a degree in mass communications from Southern Illinois University-Edwardsville, where she now serves as an adjunct faculty member. She is partial to pomeranians and Cardinals.

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