47

John C. Weicher

John C. Weictier is a senior fellow at the Hudson Institute anda visiting scholar at the Federal Reserve Bank of St. Louis.Heidi L. Beyerprovided research assistance.

J The New Structure of theHousing Finance System

FTER 25 YEARS OF ECONOMIC evolutionand 15 years of political turmoil, the U.S. housingfinance system has changed in fundamental ways,and the structure of the new system is becomingapparent. The system is still intended to allocatecredit to housing and hold mortgage rates belowtheir free-market level, but this subsidy is providedthrough different institutional arrangements. Thedominant institutions are now extremely largegovernment-sponsored enterprises (GSEs) whichoperate in the secondary mortgage market, issuingsecurities that are backed by mortgages aM buyingmortgages originated by other institutions, Theyhave taken the place of small local savings andloan associations which make loans directly tohomebuyers and hold the mortgages in their ownportfolios. The cost of the subsidy falls on tax-payers who bear the risk of failure by the GSEs.

The public purpose of government interventionin the housing finance system has always been topromote homeownership, giving force to a socialpreference that derives from a widely held butrarely analyzed belief that homeowners are bettercitizens, because they “have a stake in society.”Subsidies are appropriate because families willnot take this social benefit into account in decidingwhether to buy a home. The system also has twosubsidiary goals: (1) countercyclical support forhousing production; and (2) geographic equity(as defined by public policy) in the mortgage

market. The latter is more directly related to thepurpose of promoting homeownership.

Achieving these purposes is the responsibilitymainly of privately owned institutions which aresupposed to meet them while maximizing profitand avoiding direct cost to taxpayers. This is alsotrue of the major housing finance agencies withinthe federal government; they do not normallyreceive funds from the U.S. Treasury. The privateas well as public institutions operate understatutes which define their powers, limitationsand privileges, and delineate what they can holdas assets and liabilities. To some extent, theycompete against each other.

The home mortgage market consists of some$3 trillion of household debt, nearly all of itheld by private institutions, of which more than$1 trillion is explicitly or implicitly guaranteedby the federal government (not counting depositinsurance). There is continuing tension betweenthe public purposes of the system and the safetyand soundness—and profits—of the privatelyowned institutions that predominate in it.

This paper first describes the present structureof the housing finance system, contrasting it withthe traditional system and explaining why thesystem has changed. It concludes with a discus-sion of the major issues that will face public policyover the next few years.

48

THE CURRENT SYSTEM

Mortgage and Housing MarketsThe mortgage market has traditionally been

separate from other capital markets, becausemortgages differ in key respects from other debtinstruments. A home mortgage is a loan to anindividual or couple for the purpose of buyinga particular house, The amount the lender iswilling to loan depends on the value of the prop-efly. The mortgagor promises to repay the loanover time, If he or she fails to do so, thus default-ing on the mortgage, the lender can foreclose,take title to the property, and sell it to someoneelse. The default risk (also termed credit risk)depends on changes in the value of the propertyand in the circumstances of the owner, such asjob loss, divorce, or the death of a husband orwife. The extent of loss in the event of defaultdepends on changes iii property values. Realestate markets are local markets, so evaluatinga particular piece of property requires localexpertise. For these reasons, mortgages havetraditionally been illiquid; investors have beenwilling to buy them only if they have the know!-edge required to evaluate them.

The standard mortgage instrument—until the1980s, almost the oniy mortgage instrument—isa fixed-rate, level-payment, long-term, self-amor-tizing loan. The term usually runs for 30 years.Such mortgages carry prepayment risk as well asdefault risk. The term can he shortened only atthe option of the borrower, by prepaying the loan.Ifmarket interest rates fall, as happened mostrecently during 1993-94, mortgagors are likelyto prepay their loans and refinance their homesat a lower interest rate. If rates rise, mortgagorsare unlikely to prepay unless they are moving,and lenders will find themselves earning be1ow~market rates on their mortgage portfolios. Thus,lenders bear the risk of adverse movements ininterest rates. This was a particular problemduring the inflation of the late 1970s, As a result,mortgages with adjustable rates (ARMs) woreauthorized and became common in the earlylOBOs, A variety of other new instruments alsohave come into existence, such as balloon mort-gages, which are not fully amortized over theirterm, and graduated payment mortgages, whichcarry fixed interest rates but have lower paymentsin the early years, The traditional standardmortgage remains the most common, althoughits popularity relative to ARMs has varied asinterest rates have fluctuated. Fixed-rate mort-gages are more popular among borrowers when

the general level of interest rates is low andARMs are more popular when the level is high.

The dominant position of the standard mort-gage developed under the auspices of the federalgovernment, specifically the Federal HousingAdministration (FHA), which was created in the1930s to insure home mortgages. Buyers pay amortgage insurance premium to FHA, and inreturn FHA guarantees that lenders will receivepayment of the outstanding principal balance onthe mortgage in the event of default and foreclo-sure, FHA is required by law to operate on anactuarially sound basis; its insurance premiumsare supposed to cover its losses and operatingcosts. Once FHA demonstrated the viability andprofitability of such mortgages, the “FHA mort~gage” also became the norm for conventionalmortgages (those not insured or guaranteed by agovernment agency).

Primary Lenders

The local nature of real estate markets hasmeant that mortgage lenders have traditionallybeen local institutions. The most importanthave been the savings and loan associations(S&Ls), both in terms of their share of the mort-gage market and the share of mortgages in theirportfolios. The S&Ls started as local specializedmortgage portfolio lenders, obtaining depositsfrom “small savers” within their ‘ocality andmaking mortgage loans there also, Until 1983their lending areas were geographically limitedby statutes and regulation. Typically, theirdeposits have been locally generated as well,though there has been no geographic limitationon liabilities. Mutual savings banks, concentrat-ed in the Northeast, are similar to S&Ls as spe-cialized mortgage portfolio lenders, but theydeveloped independently and started with a dif-ferent purpose: to provide a range of financialservices to households. Savings banks and S&Lstogether are usually termed “thrifts.” They haveaccess to the national capitth markets throughthe Federal Home Loan Bank System, a set of 12regional Federal Home Loan Banks which theyown. Chartered and regulated by the federalgovernment, the Flame Loan Banks are able toborrow at preferential rates in the capital mar-kets. Commercial banks also hold a significantshare of home mortgages, but mortgages com-prise a minor fraction of their assets. Until 1989they could not belong to the Home Loan BankSystem; they now can if their mortgage holdingsare large enough.

rncn~~

49

S&Ls, mutual savings banks and commercialbanks are primary lenders; they originate mort-gages which they hold in their own portfolios.A large number of mortgages, however, are origi-nated by mortgage bankers, for immediate salein the secondary market to an investor whoexpects to hold them. Mortgage bankers maketheir money from fees for originating mortgagesand often for servicing them, collecting themonthly payments and transmitting them tothe investor. Mortgage banking developed asan important component of the housing financesystem when FHA began to insure mortgages.FHA insurance and its uniform national under-writing standards meant that specialized know!-edge of local housing markets was less importantfor investors. Mortgage bankers have sincedeveloped the skills necessary to originateconventional mortgages and now originatejust under half of all home mortgages.

Securitization and the Governrnent~Sponsored Enterprises

The limitations of mortgages as investmentvehicles led to the creation of mortgage-backedsecurities (MBSs) beginning in 1970, Mortgagesecuritization consists of combining a group ofmortgages into a pooi and selling shares in theponi to investors. This spreads the risk of defaultover a number of mortgages and allows investorsto calculate the probability of default for themortgages in the pooi with more accuracy thanfor any individual mortgage. The earliest andsimplest MBSs are known as pass-through secu-rities; the servicer collects principal and interestpayments and passes them through, withouttaxation, to the investor.

The pass-through security does not reduceprepayment risk. More recent forms, theCollateralized Mortgage Obligation (GMO) andthe Real Estate Moitgage Investment Conduit(REMIC), partition the principal cash flow froma pooi of mortgages or MBSs into maturity class-es, or tranches. Each investor receives a propor-tionate share of all interest payments. Principalpayments are allocated in full as they occur toeach tranche in turn, starting with the shortest-maturity tranche, Tranches are separatelypriced and sold to investors with different timehorizons. Investors in the longer-term tranches

incur greater interest rate risk, but have someprotection against prepayment. They are not,however, protected in the event of a protracteddecline in interest rates; if mortgagors prepay inlarge numbers, the securities will be redeemed.This type of security was developed in 1983 andit now accounts for about half of all mortgagesthat are securitized)

Securitization has broadened the mortgagemarket by creating instruments that appeal toinvestors without special knowledge of localhousing markets. The payment streams are sim-ilar to bonds, and the consequences of defaultand prepayment are minimized.

Until the last few years, the market for MBSshas generally required a government guaranteeon the mortgages, the securities, or both.Securitization was developed by a governmentagency, the Government National MortgageAssociation (GNMA or Ginnie Mae). GNMAissued pass-through securities based on poolsof FHA-insured mortgages, and added its ownguarantee of timely payment of principal andinterest to the FHA guarantee of principal pay-ment in case of default. (GNMA also issuessecurities backed by pools of mortgages guaran-teed by VA, originally the VeteransAdministration and now the Department ofVeterans Affairs, in a program created afterWorld War II and modeled on FHA.)

The other major MBS guaTantors are the housingGSEs: the Federal National Mortgage Association(FNMA or Fannie Mae) and the Federal HomeLoan Mortgage Corporation (FHLMC or FreddieMac).2 Both also buy and hold mortgages in theirown portfolios, financing them by issuing debtsecurities in the capital markets, and in fact theyhave the first- and fourth-largest mortgage port-folios, respectively, of all mortgage lenders in theUnited States. They are secondary market agen-cies; they do not originate mortgages but buyloans from primary lenders or mortgage bankers.

ENMA and FHLMC are privately owned insti-tutions with stockholders and private boards,but they are federally chartered corporationswith a variety of special privileges, and thePresident appoints five members out of is to theboard of each one. The most important of theprivileges are exemption from state and local

The collateral for CMOsand REMICs can be either wholemortgages or MBSs. Thus, the ratio of CMOs and REMICSto afi MBSs does not represent &ther their share of all MBSs

2 ONMA can also be considered a GSE, but R s fully owned

by the tedera} government and operates as an agency wfthinHOD, as is FHA.

or their share of all securitized mortgages.

50

income taxes, exemption from Securities andExchange Commission registration and statesecurities laws, the ability to borrow $2.25 bil-lion from the U.S. Treasury in an emergency,and the fact that their debt securities are ‘quali-fied investments” for regulated financial institu-tions. Their securities are also issuable andpayable through Federal Reserve Banks.3

These privileges give them ‘agency status” inthe capital markets, a general perception that thegovernment will stand behind them. This per-ception is reinforced by the fact that both arevery large financial institutions, “too big to fail.”Agency status allows them to borrow at relativelylow rates and to issue or guarantee payment onsecurities based on pools of conventional mort-gages. The market treats their guarantees oftimely payment of principal and interest asequivalent to a government guarantee.4

The Role ~fthe Federal GovernmentIt should be clear that the federal government

has a large role in the housing finance system. Itinsures some mortgages; it issues securitiesbacked by pools of those mortgages; and it haschartered corporations which are believed in thecapital markets to have an implicit governmentguarantee behind their debt securities and theirmortgage securities. In addition, it regulates andinsures the deposits of primary lenders, and haschartered institutions which provide them withaccess to the capital markets. The federal go~’-ernment is generally credited with conductingthree successful social experiments in the mort-gage market: demonstrating the feasibility oflong-term, self-amortizing loans; mortgage insur-ance; and securitization. In all three cases, theprivate sector has successfully copied the feder-al models. The FHA mortgage became the stan-dard for conventional mortgages, and a privatemortgage insurance industry has developed toinsure them. The private sector now accountsfor more business than the federal governmentin both instances. The demonstration that secu~ritization is feasible has been followed by a sub-

stantial volume of private MBS activity onlysince about 1990, however, and private securi-ties are still a small part of the total market.

The Dividing LinesThe federal government also demarcates the

market segments of the various institutions bymeans of two statutory numerical concepts: theFHA ceiling and the conforming loan limit.

The FHA ceiling is the maximum principalbalance on a mortgage that FHA can insure. Theceiling is set in law in nominth dollars; since1980 higher amounts have been allowed in areaswith higher housing costs. The present ceilingis $67,500, or 95 percent of the area medianhome price if that is higher, up to a maximum of$151,725. The maximum is still less than 95percent of the area median home price in a num-ber of large markets, among them New York andthe largest metropolitan areas on the \Vest Coast,

and it is raised every few years.

FHA insurance is intended for the first-timehomebuyer who can only afford a relativelysmall down payment, and who thus poses agreater risk of default to the lender, Most FHAbuyers make a down payment of five percent orIess,~Below the ceiling, nearly all low downpayment loans are insured by FHA and securi-tized by GNMA.

The conforming loan limit is the maximumprincipal amount of a mortgage that FNMA andFHLMC can buy. Before 1974, they wererestricted to mortgages with principal amountsbelow the FHA ceiling. A higher limit was setby statute in that year. In 1977 the limit was setat 25 percent above the maximum mortgage

amount for S&Ls, and both were raised in 1979.After the S&L maximum was abolished in 1980,the conforming loan limit was set by statute atits then-current value of $93,750, and indexed

on the basis of the annual percentage change inthe mean price of homes hough~with conven-tional mortgages. Since 1980, the limit has beenabout 37 percent above the mean price. In 1993

Most of these privUeges date back n some form to theFNMA Charter Act of 1954 or its nRial 1938 charter. In 1970the same prM~egeswere extended to FHLMC when ft wascreated.

The securfties may be issued directly by a GSE or alterna-fively by a subsidiary of a private entity such as a Wall Streetfirm, with the GSE guaranteeing the Umely payment of prin-cip& and interest.

These statements are based on unpublished tabu[aüons ofFHA-insured loans between 1989 and 1992. The tabula-

fans differ from published data because FHA aflows part(before 1991 aH) of the dosing costs to be financed n themortgage, as is discussed n Price Waterhouse (1990, pp.18-19). The published data do not adjust the oan-to-valueratios to reflect financing of dosing costs, and thereforeshow somewhat lower oan-to-value ratios. For example,Pñce Waterhouse (1990, p. 17), reports that n 1988-89shqhtly less than half of FHA-insured mortgagors had oan-to-va’ue ratios above 95 percent.

51

the conforming loan limit was $203,150, whilethe mean price was $144,000!’

Because of their agency status and the perceptionthat they are too big to fail, the GSEs can offerlower interest rates than the S&Ls and thereforedominate the market below the conforming loanlimit. Estimates of their cost advantage are inthe range of 20 to 35 basis points.7

The S&Ls remain as portfolio lenders above theconforming loan limit. Be’ow the limit, theyoperate largely as mortgage bankers. They origi-nate mortgages not for their own portfolios butfor sale to the GSEs, although they may buy backthe securities issued on a pool of the mortgagesthat they have sold. Regulations issued underthe Financial Institutions Reform, Recovery andEnforcement Act of 1089 (FIRREA) gave theS&Ls an incentive to move away from portfoliolending by setting capital requirements only 40

percent as high against MBSs issued by theGSEs as against whole mortgages. Other thriftsand commercial banks have a similar role.

The mortgage market, therefore, can be dividedinto the FHA/ GNMA submarket, for low downpayment loans below the FHA ceiling; the GSEsubmarket, for most other loans below the con-forming loan limit; and the “jumbo” submarket,occupied by S&Ls, other thrifts and commercialbanks, for loans above the conforming loan limit.

Actual market segmentation, however, is lessc1ear~cutthan the dollar demarcations suggest.The FHA ceiling oniy applies to FHA. TheGSEs, the S&Ls and any other lender can originatemortgages below the ceiling, and some such loansare made. To some extent, the private mortgageinsurers compete with FHA by offering insuranceon loans with low down payments, though theydo not insure a large share of these mortgages.

Similarly, the conforming loan limit appliesonly to the GSEs. The S&Ls and other primarylenders can make loans below the limit. But theconforming loan limit is much less restrictive onthe GSEs than the FHA ceiling is on FHA. Sincehouse prices in most years rise at least modestly,

mortgages that were above the limit when issuedmay be below it a few years later. Thus, theshare of the market open to the GSEs is largerwhen measured in terms of all outstandingmortgages than it is when measured in terms ofmortgages originated in the current year.Primary lenders do make loans be’ow the con-forming loan limit. Some are nonstandard loanswhich the GSEs do not choose to purchase, but

mortgages above as well as below the limit arelikely to be underwritten to the guidelines of theGSEs, to keep open the option of selling them inthe secondary market.

In addition, the conforming loan limit appar~ently only adjusts in one direction. Declininghouse prices during 1993 resulted in a reductionof $6,050 in the calculated conforming loanlimit for 1994, as reported by the FederalHousing Finance Board. FNMA and FHLMCannounced that they would not lower the limit,because the 1980 statute referred oniy to“increases,” and not to “decreases” or“changes”8 HUD Secretary Henry Cisneros, asGSE regulator, first challenged this action andthen accepted it.

THE GROWING DOMINANCE OF

THE GSEs

The GSEs have been the thriving and expand-ing institutions in the system. In 1992, the latestyear for which full data are available, FHA andVA loans were about 10 percent of the total dol-lar volume of all home mortgages issued, non-conforming loans about 20 percent, and conven-tional conforming loans about 70 percent. Thedominant role of FNMA and FHLMC in the con-forming loan market is reflected by the fact thatthey securitized over half of these loans andadded to their mortgage portfolios as well.

The growth of the GSEs is shown in Table 1,which depicts the mortgage market in terms ofthe total dollar volume of loans outstanding atvarious dates. The GSEs now hold or securitizeabout 30 percent of the total, compared to about7 percent in 1980. Since 1980 they have accounted

° The annua’ adjustment s based on the percentage changen prices of homes sold during the ast five business days inOctober.

See, for example, CF (1990) and Henclershoti and ShiHing(1989). The former estimates a differential of 23 basispoints as of 1987, the Eatter 30 to 35 basis points as of 1986.Both apply to oans that are at east 15 percent above theconforming oan limit and! therefore, un~ikelyto be sold inthe secondary market when they are seasoned. These areapparently the most recent analyses.

o The staff director of the Senate Housing Subcommitteeas of

1980 has stated that the intent of the statute was that thelimit shou’d move in accord with house prices in both direc-fions, but prices had risen so long and so much by 1980 thatnobody remembered the possibility of a decrease when thebiU was written.

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FHA and VA insure or guarantee a graduallydeclining share of home mortgages, as Table 2shows. It is not feasible to calculate noncon-forming loans as a fraction of the outstandingstock of mortgages at any given time. The non-conforming market has been stable at about 20 to22 percent of all conventional mortgages origi-nated in a given year, measured in terms of dollarvolume, but there has been a fairly steadyshrinkage when measured in terms of the numberof mortgages, from 11,6 percent in 1984 to 6.4 per-

TabLe 1Single-Family Mortgage Debt Outstanding, 1968-92 (end~of-yearvalues)

Dollar Values (billions of currentdollars) Percent Shares

1968 1980 1989 199~ 1SSB 1980 1989 1992Portfolio lending Portfolio lenWngFF4MA portfolio 7 52 91 124 FNMA portfolio 26 54 3~8 4 2FHLMCportfolto 0 4 18 31 FHLMCparttoRG 00 04 07 tOS&Ls 110 411 512 375 S$eLs 413 426 213 127Commercial banks 39 160 33~ 452 C~nmeriat banks 141 166 *40 1$ aOthers 109 229 529 591 Others 4t1 237 221) 200Subtotal 265 85S 1486 1573 Subtotal 1000 887 61 7 533

SecuritY hOldin4V Security hotdtngt’S&Ls 0 27 200 159 S&Ls 00 ZG 83 54Commecc~a~banks 0 20 129 307 Commercra banks 00 1 G 54 i~4Others 1) 63 592 914 Others 00 65 246 SI 0SubtotS 0 110 921 1380 Subtota’ 00 114 382 487

Securtttes ~ssued Securities issuerFNAMAMBSs 0 0 220 436 ENMAMBSs 00 ca ai 14.8FHLMCPCs 0 14 268 402 FHLMCPCs 00 1 11.1 iaeGNMAMB$~ 0 92 358 411 00 9.5 149 13$Private paSs C) 4 77 132 Prwate pools 00 0.4 32 4.5Subtotaf C hG 921 1380 Subtotal 00 114 382 467Total 265 965 2408 2954

Others ~ncIudemutual savings banks We insurance companies finance companies the Farmers Home Adrn~nistrat~on,theFede a~Housnig AcJnitntstrafion the Veterans Administration (Department ofVeterans Affair tn 1989 and ater) mortgagecomparnes, re& e tate rwestment trusts state and ~acaIcretht agencies state andbeat retirement funds, noniMured pensionfunds cretht unions other U $ government agencies, andindividua’s

Security hetdtngs show the thstribution of securities~s tied Ether can be added tu porttoko ~endrngdata to obtain the totals,both cannot be added wfthout double counting Security holdings can be added to data on portfolio tenthng to showmortgagemarket activrty of thrifts banks and other institut oris seourthes issued canbe added to dataon portloho tending to show mortgage market activity of the GSEs

SOURCES’ Board of Governors U S Department of Housing and Urban Development Inside Mortgage Capital Markets, In ideMortgage Secunues Savings andLoan Fact Soak

for over 40 percent of the net increase; since 1989,over 70 percent This is nearly the entire conventional conforming loan market. The newinterpretation of the conforming loan limit allowsthem to further increase their market share.

cent in 1993. Even the stable dollar share ofannual originations implies a declining shareof all mortgages outstanding, as the conformingloan limit rises from year to year.

The housing finance system is an emergingduopoly, dominated by the two large GSEs.Other institutions are increasingly limited tosegments of the market which are effectivelybarred to the GSEs by statute, and which aredeclining in importance.

The dominant position of the GSEs is rein-forced by their relationship to other marketinstitutions. Thrifts and banks are both theircompetitors and their customers. They competeas portfolio lenders, but at the same time they sell

g~fl~A~ Q~JPV~t PA~JV fl~ crr

53

Table 2Government-Guaranteed andConventional Mortgages, 1968-92

1968 1980 1989 1992Dottar Values

(b000ns of currentdollars)A-IA 51 94 263 326VA 34 102 157 164

Conventional 180 770 1968 2464

Total 265 965 2408 295-4

Percent SharesFl-IA 1&2 97 11$ 110

VA 128 106 65 5.6CoriventionaF 679 79 8 81 7 834

Source- Oept. of Housing & Urban Development, Swvey ofMortgage Lending Activity.

mortgages to the GSEs and buy mortgage securitiesfrom them, and also buy the debt securities thatthe GSEs use to finance their portfolios.

THE TRADITIONAL SYSTEM:A COMPARISON

This is very different from the housing financesystem as it existed about 25 years ago. In 1968 itwas still recognizably the New Deal system. It wasdominated by the S&Ls, which gathered depositslocally, borrowed from the Home Loan Banksduring recessions or when rates were high, andmade long-term, fixed-rate loans (up to a maxi-mum of $40,000) on homes located within 50miles of their home offices (100 miles after 1964),The Federal Home Loan Bank Board (the BankBoard) regulated and supervised both the S&Lsand the Home Loan Banks, and insured the S&Lsthrough the Federal Savings and Loan InsuranceCorporation (the FSLIC).

FHA was losing business to the S&Ls, and atthe same time taking on greater credit risk,because of the growing private mortgage insur-ance industry. FHA had a single premium for

all loans; on the “principle of cross-subsidization,”profits on the less risky loans were supposed tosubsidize losses on those with higher loan-to-valueratios. The outcome was that FHA lost the betterloans to the conventional market, because privatemortgage insurers could charge a lower premiumon the less risky Ioans,°

The oniy secondary market agency was FNMA,established in 1938 as a fufly governmentalagency and limited to FHA and VA mortgages.Its purpose was to smooth out the flow of mort-gage credit, over time and between places.Securitization had not yet been invented; FNMAissued bonds and bought mortgages from primarylenders and mortgage bankers. It was supposedto be a dealer, selling as well as buying mortgages.It had begun to operate as a portfolio lender inthe post-war period, however, buying VA mort-gages in particular, until directed to liquidate itsportfolio by the 1954 FNMA Charter Act. Itsportfolio then fluctuated between $2 billion and$3 billion until 1965. At that point it againbegan to buy mortgages in large volume. Itsportfolio reached $7 billion in 1965, less than3 percent of the total market.

This system was considered a success in termsof its policy objectives. Housing productionreached unprecedented levels in the post-warperiod; the pre-war peak of 937,000 housingstarts in 1925 was eclipsed in 1946 and indeedin all later years. There was also a remarkableincrease in homeownership, from 44 percent ofall households in ‘1940 to 55 percent in 1950and 62 percent by 1960. Total home mortgagedebt doubled in the first five years after the warand doubled again in the next five years. Not allthe goals were met; regional differences in mort-gage rates probably did not diminish, but thiswas a secondary concern.10 Contemporary econ-omists were divided over whether the housingfinance system was a major contributor to theseoutcomes, or whether the same results couldhave been reached some other way, but as a policymatter the system was credited with the successesthat occurred)l

This paragraph is based on Kaserrnan (1977).10 See Fredrikson (1971) and the data and literature therein

cited on changes n regional differentials. Actual averagemortgage rates varied by about 1 percentage point betweenthe Northeast at the ow end and the South and West at thehigh end, and may have risen slightly between 1940 and1963. These rates are not risk-adjusted, but Fredriksonmakes adjustments for loan-to-value raUo and term, andfinds they have Uttle effect on the region& differentfals.

Grebler. Blank and Winnick (1956) argue that the changes inthe housing finance system were important; Saffinier,Ha~crowand Jacoby (1958) conc$ude they were not.

54

Several problems were inherent in this system,and by the late lOGOs it was already starting to

break down. The S&Ls were expected to incurinterest rate risk routinely. They borrowed shortand they had to lend long. If interest rates rose,their cost of funds would rise faster than theearnings on their long-term mortgage portfolios.Second, they operated under a kind of one-wayGlass-Steagall Act. They had no protection fromcompetition on either side of the balance sheet.They could issue only time deposits and had tospecialize in home mortgages. Commercialbanks could, however, also issue time depositsand make mortgage loans. Third, the geographiclending restrictions meant that S&Ls incurredcredit risk from local as well as national eco-nomic changes. This had already occurredon a large scale when the Florida land boomcollapsed in the late 1920s)2

CHANGES IN THE SYSTEM

All these potential problems became realones after 1965 and forced changes in the system.The disintegration that began with the onset ofinflation in the late lOGOs has been describedand analyzed by many economists:~ In this paperoniy a brief review of the process of change isnecessary. Table I traces its course. It showsthe importance of different institutions in themortgage market in 1968, as the New Deal systemwas starting to unravel: in 1980, when policy-makers were forced to recognize that the S&Lscould no longer function as portfolio senders inan inflationary world; in 1989, when FIRREAwas passed to address the losses of the S&Ls andthe insolvency of the FSLIC; and in 1992, thelatest year for which information is available.

Inflation and the Decline of the S&LsThe S&Ls remained the dominant institutions

in the mortgage market during the 1070s. Theyheld over 40 percent of all home mortgages in

1980 as they did in 1968, and they accountedfor almost half of the net increase in mortgagesoutstanding over the period. But this wasincreasingly against their will. Once inflationbegan to accelerate, they could not finance theirportfolios of fixed-rate long-term mortgages withshort-term deposits, unless depositors wouldaccept below-market rates. The small saverproved unwilling to subsidize the homebuyer,if alternative investments paying market rateswere available. Money market mutual funds(MMMFs) were such an investment. Beginningin 1972 the S&Ls’ cost of funds began to riserelative to short-term Treasury rates.14 By 1980the net income of the S&Ls as a whole wasapproaching zero, tangible net worth was start-ing to fall, and the industry had a net worth inmarket value terms variously calculated to bebetween -8 and -19 percent of its assets)5

Major legislation was enacted in 1980 and1982 that liberalized both the asset and liabilitysides of S&L balance sheets. The goal of savingthem as institutions took precedence over thegoal of promoting housing. They were allowedto make loans and direct investments outside ofhousing altogether, up to 40 percent of theirassets. Between 1980 and 1989, they accountedfor less than a quarter of the increase in out-standing mortgages, and more than half of theirgrowth took the form of security purchasesrather than portfolio lending. By 1989 they heldonly about 30 percent of outstanding mortgageseither in portfolio or as securities. Since thepassage of FIRREA, closure of failed S&Ls hasreduced the total poflfolio of the industry byover $175 billion, and their share of the marketis iiiow under 20 percent.

The Evolution of theSecondary MarketThe dates in Table 1 a’so represent stages in

the evolution of the secondary market. Between

12 Between 1927 and 1929,40 percent of the S&Ls in Florida.with almost ha’f of the assets, went out of business, whileS&Ls n the rest of the country were expanding. SeeBodfish (1931) for these data.

‘~ For analyses of the prob}ems of the S&Ls during the 1970sand 1980s, see Barth (1991) and White (1991); White was amember of the Federal Home Loan Bank Board and Barthwas chief economist there during the late 1980s. Jones(1979) describes the policy process during the 1970s. Themost extensive analysis of the secondary market is US.Department of Housing and Urban Development (1987).Weicher (1988) describes the changes in the system as awhole and the devebp~ngproblems that ed to the passageof FIRREA.

14 The ELeventh District Cost of Funds rose from 9 basis pointsbelow the three-month Treasury rate in 1972 to 61 basispoints above it in 1987, (The E’eventh D~str~ctFederaLHome Loan Bank s located in San Francisco and the districtindudes the states of Arizona! California and Nevada. ItsCost of Funds, measuring the interest rate on deposits pakiby S&Ls in the district, is one of the common indices forARMs.)

~ See, for example, Brewer (1989), Brumbaugh (1988) and

Kane (1985). Brewer’s estimate is the lowest, Kane’s thehighest. Brunibaugh’s is -12.5 percent.

~fl~flA~ D~C~DW~ ~A~dV nc Ct fl~UC

55

1968 and 1980, the secondary market took on itspresent institutional structure, securitizationwas invented, and the first mortgage securitieswon market acceptance.

Two legislative changes—one in 1954 requir-ing FNMA to buy mortgages on privately ownedlow-income housing projects subsidized by thegovernment, and the other in 1967 treating thepurchases as a federal budget outlay—resultedin splitting FNMA into two agencies in 1968and changing its role.16 GNMA was created totake responsibility for the low-income mort-gages, and FNMA went off-budget as a federallychartered corporation with agency status in thecapital markets.

In 1970, amid concerns about rising interestrates and a new “credit crunch” in the primarymortgage market as a result of Reg Q, policymakersresponded by turning to the secondary market.In the Emergency Home Finance Act of 1970,FNMA was given authority to buy conventionalmortgages as well as those guaranteed or insuredby the federal government. At the same time,the S&Ls acquired their own federally charteredsecondary market facility, the Federal HomeLoan Mortgage Corporation (FHLMC). FHLMCwas supposed to buy the S&Ls’ current conven-tional mortgage portfolios to “free up” funds fornew loans—in effect trying to shift the conse-quences of monetary policy to other sectorsof the economy. Like the Home Loan Banks,FHLMC was wholly owned by the S&Ls”

Thus, where there had been one secondarymarket agency in 1967, there were three in 1970.They had different ownership and they acted indifferent ways.

GNMA operated as a secondary market agencyvery much in the original intent of the New Dealsystem. It did not buy and sell mortgages, but itachieved the same result by issuing securities.

It created the first MBSs in 1970; by 1980 it wassecuritizing virtually all new FHA and VA loans,and its MBSs accounted for almost 10 percent ofall outstanding mortgages. FHLMC followedGNMA into the securities business on a muchsmaller scale and became primarily an issuerof MI3Ss backed by conventional mortgages.FNMA took a different route. During the 1970s,it turned itself into the largest conventionalmortgage portfolio lender and thus, in effect, thelargest S&L in the country, albeit with differentsources of hinds. Its experience paralleled thatof the S&Ls. It did not foresee the inflation ofthe 1970s, so that its net worth also turned nega-tive in the late 1970s: its 1980 value of -16 per-

cent was similar to the S&L industry,bB

During the lQBOs, securitization accountedfor over half the growth in the total volumeof mortgage credit. In 1981 both FNMA andFHLMC initiated mortgage swap programs,buying S&L portfolios and issuing pass-throughsecurities on exactly the same mortgages in return.This brought FNMA into the business of issuingsecurities, rather belatedly. Since then, bothits portfolio and its MBS volume have grownrapidly. Its outstanding MBSs are now 3.5times the size of its portfolio, but it remainsthe largest portfolio lender. Besides issuingpass-throughs to S&Ls, FHLMC created theCMO in 1983 and expanded its securitiesbusiness almost twentyfold.

FIRREA marks a further stage in the evolutionof the secondary market. It turned FHLMC intonearly a carbon copy of FNMA, giving it exactlythe same kind of board of directors and a verysimilar charter. After FIRREA, the secondarymarket institutions assumed a dominant positionin the mortgage market. Between 1968 and 1980,about 80 percent of the net increase in mortgageswas held in portfolio and 20 percent was securi—tized; since 1989 the proportions have been

IS Under the 1967 federa’ budget reform, purchases of subs~-dized mortgages were raising ouflays on a doUar-for~doliarbasis, even though part of the principal and nterest on themortgage would be paid to the government by the borrower.Subsequent budget reforms have changed this accourmngpractice. Under current law, the entire principal amount of amortgage purchased or nsured by the federal government iscounted in the credit budget, but only the anticipated subsidyis included as a ouflay in the administrative budget.

17 Opposition to aflowing FNMA to buy conventiona’ mortgageswas stated by Federa~Reserve Chairman Martin n 1969and opposition to creating FHLMC was stated by FederalReserve Chairman Burns in 1970. Martin expressed con-cern that FNMA’s convenfional mortgage portfolio would beilliquid and, therefore, might ult~mat&ydisp’ace FNMA’s

holdings of FHA and VA mortgages, and also that FNMA’sdebt issuances would drive up merest rates and raise thecost of funds to the S&Ls and other primary mortgageenders. Burns raised the issue of ilhquidity and expressedconcern that FHLMC would drive up interest rates on FHAand VA mortgages. See U.S. Department of Housing andUrban Development (1987).

18 U.S. Department of Housing and Urban Development(1987), based on Kane and Foster (1986).

56

reversed. GSE portfolios also continued to growas a share of the market.

Did the System “Work” After 1965?Housing advocates opposed many of the policy

changes for fear they would weaken the abilityof the system to allocate credit to housing,regardless of the consequences for the financialsystem or the economy. This was the key concernpreventing financial reform in the 1970s: If theS&Ls were allowed to diversify, who would “fillthe gap” in the mortgage market? This concernproved to be unfounded. The secondary marketagencies filled the gap, as Table 1 shows, andthe volume of outstanding mortgages almosttripled between 1980 and 1989.

A second concern was the cost of mortgage credit.This too has proved to be largely unfounded. Thespreads between mortgage and bond rates mayhave widened during the 1970s and early 1980s,but by the late 1980s the conventional mortgagemarket may have become fufly integrated withthe capital markets)° Here also, the growingrole of the GSEs offset the declining presence ofthe S&Ls, holding down the mortgage rate in theconforming loan market.

Regional differences in mortgages rates probablydisappeared by the mid-1980s, as a result ofsecuritization and deregulation. Available dataon interregional flows of mortgage funds suggestthat securitization resulted in transfers from theNortheast and Midwest to the South and West,where population and housing demand weregrowing, and, as already noted, in 1983 the S&Lswere allowed to make mortgage loans anywhere

in the country.2° The developing S&L crisis inthe 1980s also helped create a national mortgagemarket. One way in which the Bank Board

handled failing S&Ls was to sell them for theirfr~mchisevalue to other S&Ls—at first in the samemarket, then in the same state, then in other states,as the number and severity of failures rose andthe financial resources of the FSLJC wereincreasingly inadequate.

The system had less success in achieving itsother purposes. Since 1965 the homeownershiprate has fluctuated in a fairly narrow range,between 62 and 66 percent of all households 21

There was a notable increase among youngfamilies during the 1970s, but this was simplya result of inflation. Young families boughthomes as soon as they could because owninga home was the best inflation hedge available,especially as inflation pushed them into highermarginal tax brackets. In the 1980s disinflationand reductions in marginal tax rates causedtheir homeownership rate to drop quickly backto its 1970 level.

Housing cycles, like economic cycles in general,became more pronounced. Record years of over2 million housing starts annually in 1971-73were followed by a postwar low in 1975; anotheryear of 2 million in 1978 was followed by newlows in 1981 and 1982. The housing financesystem could not have been expected to offsetcompletely the effects of the oil shocks andother macroeconomic changes, but it is doubtfulif it achieved its stated more modest objective ofmitigating their impact on housing and shiftingpart of the consequences to other sectors. TheS&Ls used advances from the Home Loan Banksto offset deposit outflows, and this may havehad some effect. FNMA may also have mitigatedthe cycles to a lesser extent through the late 1970s,but it was not aggressively countercyclical, and itmay have had no effect in the recessions of 1980

19 Hendershott and Van Order (1989) conclude that the interestrate on conventional, fixed-rate mortgages rose by about100 basis points between the late 1970s and the mid-1980s,compared to the rate that would have prevailed in a perfectmarket; then II fefi by about 50 basis points between 1986and 1988 to the market rate. Other studies coveñng a shorterpehod and compahng the mortgage and bond rates also findthat the conventiona’ mortgage rate began r~s~ngfl r&ativeterms sometime in the 1 970s, before deregu~ationot the S&Ls.See, for exarnp~e.Kaufman (1981), Tucdllo, Van Order andVillani (1982) and Hendershott, Shilling and ViMan~(1983).The Hendershoti and Van Order study ends in 1988, andthere does not appear to be any more recent ana~ys~sof thespread; given the year4o-year fiuctuat~onsn the spreadwhich they calculate, t wou’d be desirab~eto see morerecent data before conduding that the actua! conventionalconforming oan rate is the same as the rate in a pertecflycompetitive market. Cotterman (1994) notes that the spreadbetween the MBS and Treasury rates fluctuated between1984 and 1990, and was at ts lowest evel in 1988 and 1990.

20 Rudolph. Zumpano and Karson (1982) find that interregionalinterest rate differences still existed in the mid-1970s, whileKarson, Rudolph and Zumpano (1986) conclude that theydid not exist by the mid-i 980s. King and Andrukonis (1984)report that FHLMC securities generated a gross transfer ofover $5 billion during their first decade. Informauon on netinterregional flows of mortgage funds is not availabre, butthe existence of substanfial gross flows suggests that securi-tization played a significant role in ePimiriating regional ratedifferentia’s.

21 The difference in the trend after 1960 may be parily aftribut-able to demographic changes, especially the increasing pro-portion of households in categories n which homeownerships less common, such as single ndividuajs and sing’e parents.

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and 198F82.22 FNMA’s purchases of conven-tional mortgages dropped by about one4hirdfrom 1979 to 1981, which does not suggest thatit tried to act countercyclically.

Thus, even during this period of institutionalchange and upheaval, the system continued toallocate credit to housing, albeit at somewhathigher mortgage rates, and a fully national mort-gage market developed. But cyclical fluctuationsin housing were severe and the homeownershiprate stopped rising, raising the question of whetherthe system was still achieving its basic purpose.

POLICY ISSUES: SAFETY AND

SOUNDNESS VS. PUBLIC PURPOSE

The housing finance system continues toevolve. Congress has enacted three major lawsin the last five years, affecting every institutionin the system, and may consider further legisla-tion for the Federal Home Loan Bank System.23

Some important provisions of these laws havenot yet been implemented; when they are, theymay in turn provoke further changes. The lawshave addressed two kinds of issues: policy mat-ters—what purposes the system will genie andhow it will achieve them; and regulatory mat-ters—what powers different institutions willhave and how they will be regulated.

In the policy area, all three new laws representa balancing of public purpose against “safety andsoundness,” the implicit objective that the systemnot impose direct costs on taxpayers that must bemet by legislated appropriations. In the wake ofthe S&Ls’ problems, there has been a much strongeremphasis on safety and soundness; new capitalrequirements have been imposed on most insti-tutions within the system. But there are elementsin each law that concern the public purposes, andthere is some evidence that the pendulum may beswinging back toward a renewed emphasis on

these purposes. At the same time, some provi-sions of the new laws may make it more difficultto achieve them.

Safety and Soundness

The new laws raise capital standards andtake account of risk differentials among assetsfor virtually all institutions within the housingfinance system. FIRREA imposed more stringentcapital requirements on the S&Ls. They must have1.5 percent tangible capital relative to assets andmust meet the same risk-based capital standardsas national banks. The tangible net worth of theS&Ls as a whole was only 0,7 percent in 1989.

Both FHA and the GSEs are required to holdmore capital than they had when the laws werepassed. The existing standards were not raisedso much as they were changed conceptually.FHA had no specific capital standard, beyondthe legislative requirement that it be actuariallysound, which was undefined. FNMA’s capitalrequirement, established in its Charter Act, wascalculated as a debt-to-capital ratio. This meantthat it was only required to hold capital againstits portfolio. Because it did not need to issuedebt to finance its MESs, FNMA’s capital-to-assetratio (including MBSs) was 1.1 percent in 1990.Prior to FIRREA, FHLMC had no statutory capitalrequirement; the Bank Board determined it as apolicy matter. FIRREA gave FHLMC the samedebt-to-capital standard as FNMA. With its largerproportion of MBSs, its capital-to-asset ratio was0.8 percent in 1990. These are quite low levelsof capital; had the GSEs been required to meetthe risk~basedcapital standards set for the S&Lsin FIRREA, FNMA would have needed 2.5 timesas much capital as it actually had in 1990, andFHLMC more than three times as much.24

Both the FHA and GSE standards are establishedby “stress tests.” In other words, the entity must

22 See Grebler (1977) and Jaffee and Rosen (1979) for theearlier cydes, and Kaufman (1985) for the 1980-82 reces-sions. Greb~eranalyzes both Home Loan Bank advancesand FNMA purchases.

‘~ The three laws are~FIRALA, concerning the S&Ls, theFederal Home Loan Bank Board (which it abolished),FHLMC, and to a easer extent the Federal Home LoanBanks: Title Sot the National Affordable Houshig Act of1990, concerning FHA; and the Federal Housing EnterprisesFinancial Safety and Soundness Act of 1992, enacted asTitle 13 of the Housing and Community Development Act of1992, concerning FNMA and FHLMC. In addition, Congressin 1992 required five separate studies of the Federal HomeLoan Bank System as the precursor to future legislation.Four of these studies appeared during 1993, and the fifth inApril 1994. (The GSE legisIat~onin 1992 was enacted after

Congress required and received nine separate reports fromvarious federa~government agencies.)

24 The calculations of these various capital ratios are reportedin U.S. Department of Housing and Urban Development(1990a, 1990b). The published debt-to-capital ratios in thereports include only stockholders’ equity; on that basis, theratios are 0.8 percent for FNMA and 0.6 percent for FHLMC.Regulatory capital is defined in the Charter Acts to includeretained earnings arid subordinated debt. Subordinateddebt is not counted as equity under Generally AcceptedAccounting Princip’es because it takes precedence duringbankruptcy over ownership riterests. The subordinated debtof the GSEs is due and payabfe in the event of bankruptcyor insolvency, which appears to Umit the government’s abHityto r&y on it as capital.

58

have enough capital to survive a recession, withthe amount determined in advance by econo-metric analysis. Both are risk-adjusted capitalstandards; riskier loans are more likely to defaultand more capital is required against them.

The FHA standard was set on the basis of anactuarial study by Price Waterhouse during1989-90. Price Waterhouse recommended thatFHA should at a minimum have a net worth of1.25 percent against insurance in force, insteadof the then-current level of about 1.0 percent.The purpose was to ensure that FHA wouldhave positive net worth in the event of a typicalpost-war recession. This standard was enactedin 1990, to be effective in 1992, with a higherstandard of 2.0 percent in the year 2000. Toreach these targets, the insurance premium wasraised by about 70 percent, in present valueterms, and risk-related premiums were estab-lished for the first time. Minimum equityrequirements for FHA homebuyers were alsoraised, to reduce defaults and strengthen theinsurance hind; this increase, however, waspartly rolled back in 1992.25

The GSE stress test is based on their worstactual regional experience, which for both hasbeen Texas in the mid-1980s. They are supposedto have enough capital to withstand such arecession if it occurred on the national level,and also to survive large (600 basis points)upward or downward changes in interest ratesoccurring within a period of one year and lastingfor 10 years. Both mortgages held in portfolioand MBSs are included.

The GSE capital standard includes more thanthe stress test. It also defines two lower levelsof capital, in the form of ratios against mortgagesheld in portfolio and MBSs. The authority of theregulator varies depending on the GSE’s actualcapital relative to the levels defined in the statute.The “minimum” capital level is 2,5 percentagainst mortgages held in portfolio and 0.45 per-cent against MESs, which matched FNMA’s

actual capital position as of 1991, and was slightlymore than FHLMC’s capital. (FHLMC was given18 months to meet the minimum level withoutincurring any regulatory sanctions, and it nowdoes.) The “critical” capital level is half of theminimum level; if capital falls below it, theregulator can immediately put the GSE intoreceivership.

The GSEs’ risk-based capital standard is almostcertainly less stringent than the standard forthrifts and banks, and the minimum standardclearly is lower. Depository institutions musthave 4 percent capital against a mortgage intheir portfolio, while the GSEs must only have2.5 percent. If a mortgage is securitized by theGSEs and the security is held by a thrift or bank,total capital is still less: 2.05 percent, consistingof 1.6 percent for the depository institution toprotect against interest rate risk and 0.45 percentfor the GSE to protect against credit risk.

The FHA and GSE standards were establishedin very different ways. In the case of FHA, aneconometric analysis was conducted and theresults were known before legislation was passed.The law set new parameters for FHA insurancepartly on the basis of whether they would enableFHA to achieve the standard. In the case of theGSEs, the stress test is prescribed as much aspossible in the statute, but it was not performedbefore the bill was passed. Instead, it was nego-tiated between the Bush Administration and theGSEs and written into law by Congress withoutanalysis of how much capital will be required tomeet it. The test must be formally stated in reg-ulations by November 1994, and does notbecome effective for another year.

Capital standards for the Federal Home LoanBanks may be the subject of legislation in thenear future. Their capital now consists only ofthe stock that S&Ls and other institutions havehad to buy in order to be members of the HomeLoan Bank System and to obtain advances.Members can withdraw from the System and sell

25 The 1990 egis~ationrequired FHA mortgagors to have ateast 2.25 percent equity in their home when they bought it(1.25 percent for mortgages under $50,000). Previously, itwas possib’e to buy a home with no real equfty, becausebuyers were allowed to finance the closing costs n theirmortgage. On loans betow $50,000, the minimum downpayment is 3 percent; on loans over $50,000, it s 3 percentof the first $25,000 and 5 percent over $25,000. C’osingcosts average 2 to 3 percent, ranging up to 6 percent n afew states. The down payment n effect paid the closingcosts for a substanflal number of FHA-insured homebuyers.For analysis of the r&ationship between defaults and initial

loan-to-value rafios, showing a strong positive corretation,see Price Waterhouse (1990) and Hendershott and Schultz(1993), and the hterature cited therein. For a more detailedd~scuss~onof the 1990 FHA egislaUon, see Weicher (1992).

59

their stock back to their Home Loan Bank, subjectto an advance notice requirement of six months.Thus, it is problematic whether the capital wonidbe available if individual Home Loan Banks begaxito incur losses. The members have an incentive,and a right, to withdraw their capital just whenit is most needed.

But the Home Loan Banks have so little capitalbecause of public policy. They had $2 billion inretained earnings until FIRREA took that moneyto cover part of the cost of S&L failures. FIRREAalso required them to contribute $300 millionper year out of their future earnings. That iswhy the oniy capital they now have is the stockowned by the members. It is going to be difficultto build capita’ through new retained earnings.Even if Congress were to repeal the $300 millionannual contribution, the S&Ls and probably thenewer members are likely to prefer having thismoney passed through as dividends rather thanremaining as retained earnings, which could betaken away again. In their studies of the Home

Loan Banks, both the General Accounting Officeand the Clinton Administration have argued thatthey need more capital, but neither has offered aspecific proposal for raising it.

Countercyclical Support for

Housing ConstructionThe emphasis on safety and soundness creates

a clear potential conflict with the traditionalcountercyclical objective of the housing financesystem. This is most obvious with respect to theGSEs, where it was explicitly discussed in eva!-uating the adequacy of their present capital. Inits annual reports as regulator of FNMA andFHLMC prior to legislative consideration of anew capital standard, HUD used a Depressionscenario to assess capital adequacy, based onone used by Moody’s to rate private mortgageinsurers. HUD concluded that neither GSE couldsurvive 10 years of the Depression scenario, but

both could last six years.25 This analysisassumed that they continued to be active in themortgage market during the Depression to thesame extent as previously; FNMA and FHLMCcould survive a full 10 years of the Depressionscenario, if they immediately suspended opera-tions at the beginning of the Depression. Inresponse, the GSEs stated that they would infact cease buying mortgages immediately.27This, of course, raises the question of whetherthey could recognize the onset of a depressionimmediately (a delay of two years would beenough to cut the period of survival from 10 tosix years for both GSEs). The 1992 legislationaccepted the GSE position on at least an interimbasis. The stress test must assume that the GSEsaccept no new business until the GeneralAccounting Office and Congressional BudgetOffice complete studies of the appropriate newbusiness assumptions. The studies are due inNovember 1995. The GSEs have also said theywould increase their guarantee fees if necessaryto remain solvent, but it is not easy to raiseprices during a recession.

It should be possible fora GSE to buy mortgagesin periods of high interest rates, earn a profit ifrates decline, and perhaps moderate fluctuationsin housing production in the process. Theopportunity to profit from interest rate declinesis limited, but not eliminated, by the prepaymentoption. On the other hand, countercyclicalbehavior may result in credit risk. If the qualitydistribution of loans offered in a recession is thesame as during an expansion, then it is necessaryto buy lower quality mortgages in order to beactively countercyclical.

The potential conflict has been discussed inevery downturn. The legislative changes probablyheighten it. The GSEs still have Charter Actresponsibilities to “provide ongoing support tothe mortgage market,” but a capital standard that

assumes they do not.

28 These results are for 1991 as reported in U.S. Departmentof Housing and Urban Development (1992a, 1992b). Similartests for 1990 show that FHLMC could survive six years andFNMA seven (U.S. Department of Housing and UrbanDevetopment, 1991b). The 1991 test is more detailed andsophisticated. The test is stringent: It includes a 10 percentdecline in house prices for four straight years, for example.It is necessary to survive 10 years of the Moody’sDepression scenario to qualify for an AAA rating; very fewfinancial institutions are rated AAA. The HUD stress test isnol identicat to the Moody’s scenario, aithough ft is clos&ymodeled on the scenario. Thus, ft cannot be said that theGSEs wou’d or woufd not receive an AAA rating fromMoody’s, or conversely that any other financial insfitutionwould or would not survive 10 years of the HIJD stress test.

An AAA rating is not Ukely, however. In 1991 Standard andPoor’s evaluated both GSEs at the request of the Treasury,rating FHLMC as A+ and FNMA as A~on the assumption thatthe GSEs did not have agency status. which in fact they do.

27 The reaction of the GSEs appears in U.S. Department ofHousing and Urban Development (1991b).

60

At present these issues are hypothetical, butin a severe downturn they would become real.They would then attract policymakers’ attentionand perhaps result in further changes.

“Underserved” Areas and GroupsThe traditional goal of making mortgage credit

equally available across the country has takennew forms in FIRREA and the GSE legislation.The focus of concern has shifted from regions tocommunities, particularly low-income urbanneighborhoods and those with predominantlyminority residents, arid also to individuals.

Explicit subsidies through the housing financesystem are being provided and proposed to meetthis goal. FIRREA required the Home LoanBanks to subsidize low-income housing directlyby allocating 20 percent of their profits to a newAffordable Housing Program, with a minimumannual amount starting at $50 million andincreasing to $100 million by 1995. This isessentially another tax on the Home Loan Banksand through them the S&Ls. The ClintonAdministration’s report on the Home Loan BankSystem goes further and proposes a specificmandate to facilitate mortgage lending to lower-income families and targeted populations. Thiswould he a new role for the Home Loan Banks.

Support for low- and moderate-income housinghas been one of the purposes of FNMA andFHLMC, as stated in their Charter Acts.28 Thisbecame the major Congressional concern in1992, once the Administration and the GSEsagreed on a capital standard. The law sets twogeneral goals that certain percentages (to bedetermined by the HUB Secretary) should be forunits occupied by families with incomes belowmedian, and for housing in central cities. Bothgoals include rental housing as well as homes.29The law allows a number of acceptable reasonsfor not meeting any goal in a given year, and amulti-year regulatory process before any sanc-tions could be imposed for falling short.

The law also sets transition goals. Each GSEis to have at least 30 percent of its purchases forhousing occupied by families below medianincome by 1994, rising in two steps from their1992 levels. This is about the share of the con-ventional conforming loan market consisting ofbuyers in this income range. The GSEs have notcome very close to this percentage in the past forsingle-family houses; both were below 25 percentin 1991. Nearly all apartments, however, areaffordable by families of median income by therules of thumb set forth in the legislation. BothGSEs met the 1993 targets established by HUD.

Similar transition goals were established forcentral cities, and in this case neither GSE metthe 1993 goal. Under HUD’s regulations theyare now required to file housing plans to describehow they will meet them in the future.

These housing goals pose another potentialconflict between the safety and soundness of thehousing finance system (and also the financialinterests of the private and quasi-private housingfinance institutions) and a public purpose whichis becoming increasingly prominent. Both theGSEs and the Home Loan Banks have pointedout the conflict. The issue is more serious forthe Home Loan Banks because they must fundthe Affordable Housing Program. This require~mont, like the $300 million contribution to thecost of S&L resolutions, has been used by theHome Loan Banks to justify making investmentswith the funds that they borrow on the capitalmarkets as the demand for advances has fallen,and thus perhaps to undertake new types of risk.

FNMA and FHLMC are required only to buyloans for moderate-income housing, not to pro-vide subsidies, and they need not lower theirunderwriting standards. The general conclusionof the mortgage default literature is that defaultis largely a function of the loan-to-value ratio onthe mortgage and not closely related to eitherthe value of a home or the income of the buyer.~°But even if moderate-income housing turned out

28 Both GSEs are required “to provide ongoing assistance tothe secondary market for residentia’ mortgages (includingactivities relating to mortgages on housing for ow- andmoderate-income tandies invofving a reasonabie economtreturn that may be less than the return earned on otheractMties) See 12 U.S.C. § 1716.

20 The law a~sosets a special affordable housing go& that1 percent of each GSE’s purchases should be for housingaffordab~eto low-income families or ocated in ow-incomeneighborhoods, with allocated shares for s~ngIe-famiIyandmultifamily housing.

~° See Hendershott and Schultz (1993) and the literature citedtherein. Hendershott and Schultz do find that foreclosureson FHA-insured loans are irlvers&y related to loan size,which they attribute to differential underwrfting standards orhouse price appreciation rates. The latter explanation mightndicate greater risk for small loans.

ctfltC*~ nCt~t~~tnrt~nMt( flt CT fl~OC

61

to be riskier, it would be possible for the GSEs totake more risk than the S&Ls, given their lowercost of funds. The charter acts and the legislationseem to expect that the GSEs will use their agencystatus to make loans to moderate-income buyers,

without jeopardizing their safety and soundness.The Administration’s proposed lower-incomemandate for the Home Loan Banks takes a similarview, stating that collateral requirements shouldnot be relaxed to meet the mandate.

REGULATORY ISSUES

The Struclvre of RegulationAt the same time that capital standards were

being raised for most entities within the system,all of the private institutions were given newregulators. The Bank Board was abolished andits duties parcelled out among several agencies.

Some of the potential conflicts between publicpurpose and safety and soundness are reflectedin the new regulatory structure. The 1992 GSElegislation divided authority between the Secretaryof HUll) and the Director of a new Office ofFederal Housing Enterprise Oversight (OFHEO),which is formally part of HUD but is effectivelyindependent of the Secretary. The Director reg-ulates for safety and soundness; the Secretaryestablishes, monitors, and enforces the housinggoals and regulates the GSEs in all areas otherthan safety and soundness. For example, theSecretary rather than the Director approves newprograms, and the Secretary rather than theDirector raised the issue of whether the GSEshad to reduce their maximum mortgage amountwhen the conforming loan limit declined lastyear. The effectiveness of this relationship hasnot yet been tested, since the Office is still in theformative stage and has not yet had to issue anyof the regulations required by the law.

Both the GAO and the Administration studiesof the Home Loan Banks have recommended

that they be regulated by OFHEO. At presentthey are regulated by the Federal HousingFinance Board, created in FIRREA as an after-thought for that sole purpose. The ostensiblereason for abolishing the Bank Board was that itacted as an advocate for the industry it was sup-posed to regulate. The risk that the regulatedentities would capture the regulator would seemto be still greater for the Federal HousingFinance Board, with nothing to do but regulatethe 12 Home Loan Banks, and for OFHEO, regu-lating only the two GSEs. It is probably prefer-able to have one regulator for all 14 institutions,rather than two, although FNMA and FHLMC donot favor sharing their regulator. Whether thatproposal is adopted, it seems likely that the reg-ulatory structure of the system will be revisedagain.

Is There A Future for SpecializedPortfolio Lenders?Public policy has wrestled for two decades

with the question of whether specialized mort-gage portfolio lenders can exist. In the 1970spolicymakers decided they could and tried tokeep the S&Ls operating as they always had inthe face of inflation and new competition. Inthe 1980s policy reversed itself, and S&Ls weregiven broad new asset powers. In the 1990spolicy has reversed itself again. FIRREA adoptedthe premise that deregulation caused the S&Lfailures, a view not shared by most economists.3’It explicitly took away some of the powers gnmtedin 1980-82 and required S&Ls to put a higherpercentage of their assets in mortgages andhousing investments to keep their tax advantages,although the latter restriction was somewhatrelaxed in 1991.32 S&Ls are not forced to be sp&-cialized housing portfolio lenders, however; thenew capital rules give them an incentive tomove away from portfolio lending by requiringonly 40 percent as much capital against MBSsissued by the GSEs as against whole mortgages.

31 White (1991) favors deregulation, but says it came 15 yearstoo ate and should have been accompanied by strongersafety and soundness regulation, and by risk-adjusteddeposit insurance premiums. He reviews the Oteratureshowing that losses were posillvSy related to use of the newpowers. Barth (1991) favors deregulation but says that itcontributed to the problems of some S&Ls. Kane (1989)argues that deregufation did not cause the problems of S&Lsand re-regulation would not solve them, but goes on to saythat deregulation expanded opportunities for poor’y man-aged S&ls to fail, as well as allowkig weD-managed ones torebuild their net worth. Rudolph (1989) analyzed the subse-quent behavior of S&Ls that were insolvent in 1982 andfound that trathtional hous~ngenders were more likely to be

insolvent in 1982-83, but less ikely fl 1986, which suggeststhat among insolvent S&Ls, at least, those taking advantageof the new powers were ess successfu~than those whichstayed in housing.”

32 White (1991) notes, however, that at the same fime theseprovisions were enacted, many members of Congress weresaying that S&Ls should be more like commercial banks.

62

Meanwhile, the GSEs are thriving in partbecause they are specialized lenders—very largeS&Ls, in that sense—as well as secondary marketagencies. Their portfolio operations are quiteprofitable: Almost three-quarters of FNMA’srevenue, and almost half of FHLMC’s, camefrom their portfolios in 1992. FHLMC has recog-nized this since FIRREA gave it the same powersand incentives as FNMA; it is behaving similarly,expanding its portfolio by 70 percent and an-nouncing a business objective of further rapidgrowth. FHLMC was already the fourth largestportfolio lender in the United States, althoughits portfolio always has been small relative to itssecurities volume. The specialized portfoliolender is alive and functioning to a greaterextent than is generally recognized.

Several factors contribute to the GSEs’ successas portfolio lenders. A number of recent studiesconclude that the 20 to 35 basis point differencebetween the conforming market and the jumbomarket is the margin between profit and loss forS&Ls, on average. The cost advantage of theGSEs is attributed to the lower capital require-ments they face, the tax exemptions and smallerregulatory burdens granted them by their federalcharters, the fact that they do not have to paydeposit insurance premiums or help to fund theresolution of failed S&Ls, and economies of sca1e.~The first two factors are benefits conferredexplicitly by act of Congress.

Macroeconomic conditions may also con-tribute to the GSEs’ recent success. If inflationis erratic and unanticipated, it is probably notpossible to survive as a specialized portfoliolender, as ENMA and the S&Ls showed duringthe 1970s and early lOBOs. If inflation is lowand stable, it is apparently still possible to be aspecialized portfolio lender, as the same institu-tions showed when inflation receded after 1982and both FNMA and a large number of S&Lsbecame profitable once again. FNMA especiallywas saved by disinflation. It gambled on adecline in interest rates (there was not much tolose from such a gamble, from the stockholders’point of view), buying mortgages in large vol-ume, and it benefitted greatly when rates fell.Its net worth became positive in 1985. It hastried to prevent a similar problem in the future.A HUD analysis in 1991 concluded that it has

~ See Cotterman (1994) and McNulty and Pearce (1994) fordiscussions of the literature. Goodman and Passmore (1992)caIcu~atethat the difference in capit& requirements aloneowers the OSEs’ costs by about 35 basis points.

effectively hedged against interest rate risk bychanging the duration of its liabilities, eventhough most of its portfolio consists of fixed-ratemortgages.

It is doubtful if S&Ls could do the same thing,given their higher costs. They may be able toprosper as portfolio lenders specializing to someextent in fixed-rate mortgages by accepting inter.est rate risk, if inflation remains low and if theyield curve remains upward sloping. They mayalso survive as ARM lenders.

The broader geographic authority of the GSEsmay have been important in the 1980s. S&L fail-ures since deregulation have been concentratedin states which suffered severe recessions,notably Texas but also other energy and farmstates. The decline in domestic crude oil pricesbetween 1982 and 1989 precipitated a regionalrecession in which commercial real estate val-ues in the Southwest fell by one-third. (Overthe same period, they rose nationally by about10 percent.) Defaults on home mortgages andother real estate rose rapidly. The geographicrestrictions on S&L portfolios meant that the badinvestments and loans were held in the portfo-has of institutions in those states. One-fifth ofthe S&Ls which failed during the lOSOs werelocated in Texas and they accounted for half ofthe losses. Deposit insurance turned the region-al failures into a national problem.

It is now possible for an S&L, like a GSE, tomake or buy loans anywhere in the country.This may be significant. Both FNMA and FHAsurvived the Texas recession and other regionalproblems during the mid-lQBOs. Both sustainedlosses, but neither was driven to a negative networth position. Their experience suggests thatnational portfolio lenders—in effect, nationalS&Ls—could be viable. But the cost advantagesof the GSEs would remain.

GSE PowersThe competitive advantages conferred on the

GSEs by agency status raise the question of theirrole as potential competitors in markets beyondtheir current activities. This has been a recurringissue for FNMA since it was privatized, when theSecretary of FEUD was given new program approvalauthority. It has become an issue for FHLMC

trfl~ZO~ c~~owc ~AMW fl~ CT fl~OC

63

since FIRREA. Typically, FNMA has soughtlegislative authority from Congress if the Secretaryhas denied or deferred approval. Usually, butnot always, Congress has given approval.

The most contentious instance is REMICs. TheTax Reform Act of 1986 created these securitiesand authorized FNMA and FHLMC to issueREMICs backed by conventional mortgages,subject to the approval of their regu1ators.~Both agencies sought approval, over the strongobjections of Wall Street securities issuers, whoargued that they could enter this market if theagencies did not, but could not compete withthem. The Federal Home Loan Bank Boardoriginally decided not to allow FHLMC to issueREMICS, but HUD (under pressure fromCongress) eventually allowed FNMA to issuethem on a temporary basis, which became per-manent in 1988, and FHLMC was allowed toissue them in 1988.

FNMA has also sought to move beyond mortgagepurchase and securitization, with less success.In 1985 it proposed to buy bonds collateralizedby mortgages that would be issued by financingsubsidiaries of financial institutions. In 1990 itrequested approval of a program to buy debtobligations secured by conventional mortgages,or securities hacked by such mortgages. Theformer proposal brought objections from invest-ment bankers and the Senate Banking Committeechairman and ranking minority member, as beingfinancing transactions rather than mortgage pur-chases, and HUD did not approve it. The latterwould have placed FNMA in competition withthe Home Loan Banks by ‘etting it issue advancesagainst mortgage collateral, and HUD againdenied approva1.~~

FNMA has also undertaken or consideredactivities that are ancillary to its secondary marketoperations but that are already provided by privatefirms. In the mid-1980s, it raised the possibilityof establishing a mortgage insurance subsidiary,in competition with the private mortgage insur-ance industry. In 1985 it acquired a computersoftware firm with the intent of producing andselling a loan origination and servicing program.3°

The GSEs have strongly opposed any regulatorylimitation on their powers. This was a major issuein the 1992 legislation. Ultimately, the HUDSecretary retained the authority to deny approvalfor a new program if he or she determines thatthe program is “not in the public interest,” butthe Secretary has to act within 45 days, and thelaw prescribes an appeals process which isheavily weighted toward the GSEs. The lawalso gives the GSEs broad authority to buy anykind of home mortgage, limiting the Secretary’sregulatory discretion.~~There is no reason tothink that the GSEs will not attempt to extendtheir activities in the future, so the demarcationof authority between different institutions willprobably continue to be a recurring issue.

CONCLUSIONOne public policy issue which appears to be

resolved is the desirability of a housing financesystem to allocate credit to housing. This is achange from recent years. For about a decadebeginning in the late 1970s, there was extensivepublic discussion about dismantling the systemon the grounds that it was becoming too expen-sive for society to continue allocating credit tohousing, in two senses. Household investmentin housing was growing rapidly in response to

REMICs have tax advantages over CMOs and were expectedto be a major innovafion in mortgage securWes.

~ HUD also denied approva’ on grounds that the programnvo$ved significant risks to all parUes, nclud~ngthe federalgovernment, and could adversely affect FNMA’s safety andsoundness since it could affect FNMAs needs for capitaLThe transactions would have allowed financial institutionsto defer recognition of economic losses and encourageeveraging, possibly ncreas~ngthe risk of bankruptcy bythe instituUon. Deniaf of new programs on safety andsoundness grounds has been relativ&y infrequent.

36 The regulatory issues raised by new acUv~t~esbetween 1980and 1985 are described in U.S. Department of Housing andUrban Development (1987), the propos& to purchase debtobligations secured by convention& mortgages in U.S.Department of Housing and Urban Dev&opment (1991a).

~ In 1970 FNMA sought and received regulatory approval fromSecretary George Romney to begin a program of buyingconvenflon& first mortgages on s~ng~e-familyhomes. At the

time, virtuafly the only conventiona’ mortgages ssued werestandard mortgages. As new nstruments were developedin the 1980s, FNMA claimed the authority to buy any kindof conventiona’ first mortgage under the “Romney letter”such as ARMs and bafloon mortgages with different hskcharacteristics than the standard mortgage. Proposed HUDregulations ssued in 1990 would have revoked this broadnterpretation. FNMA objected to the regu~aflons,and theywere superseded by the 1992 legislation.

64

inflation in the late 1970s, with concomitant Cotterrnan, Robert F. “The Effects of FHLMC’s and FNMA’sunderinvestment in productive capacity, and the Mortgage Activities,” n U.S. Department of Housing and

Urban Development, Report to Congress on the Federalgrowing problems of the S&Ls were threatening Home Loan Bank System, vol. 2: Analytical Studies. U.S.to impose direct costs on taxpayers. Department of Housing and Urban Deve’opment, 1994.

A number of proposals were offered to address Fredrikson, E. Bruce. “The Geographic Structureof Residentialthese concerns. The Financial Reform Act con- Mortgage Yields,” in Jack M. Guttentag, ed., Essays on

Interest Rates, vol.11. Columbia University Press, 1971.sidered by the House of Representatives in 1976

would have turned the S&Ls into commercial Goodman, John L., Jr., and S. Wayne Passmore. MarketPower and the Pricing of Mortgage Securitization.” Federalbanks. The Reagan Administration offered budget Reserve Board Finance and Economics Discussion Paperproposals to levy fees on the GSEs, which could No. 187(March 1992).have been set at a level to cover the market value

Grebler, Leo. “An Assessment of the Performance of the Publicof agency status. There were several studies of Sector in the Residential Housing Market: 1955-1974,” inprivatizing one or both of them in the mid-lOBOs. Robed M. Buckley, John A. Tuccillo, and Kevin E. Viflani, eds.,

Capital Markets and the Housing Sector. Ballinger, 1977.But interest has faded since then. During con~

sideration of FHA reform, no one (including its David M. Blank, and Louis Winnick. Capital Formationin Residential Real Estate. Princeton University Press, 1956.competitors) made any suggestion to close FHAdown or turn it over to the private sector. Most Hendershott, Patric H., and Wilharn R. Schultz. ‘Equity andimportantly, there was no real interest in priva~ Nonequfty Determinants of FHA Sing~ePamilyMortgageForeclosures in the 1980s.” fournaloftheAmerican Realtizing either GSE in the extended process of Estate and Urban Economics Association (winter 1993).writing the 1992 legislation. The closest thing pp. 405-30.to it was an amendment offered by Rep. Jim and James 0. Shilling. ~TheImpact of the Agencies onLeach (R.-Iowa) on the floor of the House of Conventional Fixed-Rate Mortgage Yields,” Journal of RealRepresentatives, which would have set higher Estate Finance and Economics (June, 1989), pp. 101-15.capital standards and eliminated some of the and Kevin E. Villarii. “Measurementof theGSEs’ privileges. The amendment lost on a ~Th7~i~een YIe~dson Various Mortgage Contracts and298-119 vote. No comparable proposal was Treasury Securities,” AREUEA Joumal(winter 1983), pp.

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