| FHA Loan Programs |
The Role of the GSEs in Supporting the Housing
Recovery
Washington – Good afternoon. Thank you, David
and thanks to the Washington Economic Club for
this opportunity to provide my thoughts on long-
term reform of the housing Government
Sponsored Enterprises, the GSEs, Fannie Mae and
Freddie Mac.
Debate over the role and function of these
entities has raged for years. Congress
established Fannie and Freddie decades ago to
meet a public policy goal – to increase the
funding available for home mortgage financing.
The GSEs achieve this through providing liquidity
to the secondary market for a limited range of
home mortgages, either through credit
guarantees on mortgage-backed securities (MBS)
or by directly investing in mortgages and
mortgage-related securities through their
retained mortgage portfolios. To further this
mission, their congressional charters grant the
GSEs several benefits which together created a
perception that the GSEs were backed by the U.S.
government, even though this was not the case.
This "implicit" government guarantee provided
the GSEs with a funding advantage over other
mortgage market participants.
The inherent conflict in this structure is obvious –
the GSEs served both a public mission and
private shareholders – they received public
support but operated for private shareholder gain.
While policymakers of every ideological stripe
have acknowledged the risks created by this
conflict, entrenched debate, often with little
recognition of market realities, prevented reform.
Over time, the GSEs' advantages enabled them to
grow at a phenomenal pace, so that today they
have $5.4 trillion in obligations outstanding, held
by investors in the U.S. and around the world. As
a comparison, that is almost 40 percent the size
of the entire $14 trillion U.S. economy. The
systemic risk posed by such size was heightened
by the fact that investors assumed that GSE
securities were backed by the U.S. government
and therefore virtually risk-free, despite repeated
statements by consecutive U.S. administrations
to the contrary. These debt-holders would be the
largest, but not the only, conduits of systemic
impact should either GSE fail. Derivative
counterparties, for example, would also be
overwhelmed by a default of either GSE.
For some time market participants had
questioned whether the GSEs were adequately
capitalized for the risk they were taking, and
therefore able to withstand losses without
triggering a systemic event. Policymakers
acknowledged that the GSE regulator did not
have the authorities to address these risks, yet
they could not reach consensus to improve it, and
instead left a clearly inadequate regulatory
structure in place. When I came to Washington, I
saw an opportunity to improve the regulatory
structure, even if it wouldn't be perfect. I set to
work in the fall of 2006 to broker progress in the
House, and we did begin to solve some of the
seemingly intractable differences.
Even as Washington debated GSE oversight,
there was little debate over the extent to which
government should subsidize homeownership,
and whether such government support was
contributing to a housing bubble. The U.S.
government has many policies that subsidize
homeownership – it would be oversimplifying and
wrong to blame Fannie and Freddie for the
bubble, but they clearly are part of the public
policy bias that contributed to it.
In sum, the GSE reform debate was largely frozen
in place, or moving at glacial speed. Then
suddenly, the unprecedented housing correction
shifted the ground under that debate and forced
action.
Today I will review the actions we have taken
and their effect, and address two issues before
us. First, in the short-term, how do we use the
GSEs to mitigate the current credit crisis and
housing downturn? Second, given the temporary
nature of their current status, how might we
address the appropriate long-term structure?
Prelude to Recent Actions Regarding Fannie Mae
and Freddie Mac
As we progressed through the current housing
market downturn, investors fled mortgages that
carried any credit risk. But because the GSEs take
the credit risk on the mortgages they guarantee
and because investors believed there was implicit
government backing, the conforming loan market
continued to function relatively well. As a result,
the GSE share of new mortgage business rose
from 46 percent in the second quarter of 2007 to
84 percent in the second quarter of 2008.
Without the GSEs to finance mortgages, it was
very clear that mortgage finance would
essentially dry up.
However, as the extraordinary housing correction
deepened, weaknesses in these entities became
apparent. In July 2008, investors lost confidence
as they became increasingly uncertain about
Fannie and Freddie's capital position. The GSEs'
already depressed stock prices plummeted
further. Shareholder losses did not pose a public
policy concern, but the share price drop further
weakened confidence among the holders of the
$5.4 trillion of GSE debt and MBS. Investors at
home and abroad were reducing purchases and
even selling from their holdings of GSE debt. The
consequences of either GSE failing would be
catastrophic. We couldn't wait for a failure; we
had to act preemptively to shore up confidence in
these enterprises.
In July, I requested that Congress quickly
complete work on long-sought GSE regulatory
reform and also provide Treasury with expanded
authority to support Fannie, Freddie and the
Federal Home Loan Banks. Congress did so –
giving us enormous temporary authorities to
inject capital if the GSEs asked for it, and to
create a back up liquidity facility for GSE debt.
Immediately after passage of the legislation, in
coordination with the Federal Reserve, the newly-
constituted GSE regulator, FHFA, and our advisor
Morgan Stanley, we began a comprehensive
financial review of the GSEs. At the same time,
mortgage market conditions continued to
deteriorate. Negative earnings announcements by
Fannie and Freddie in August reflected those
worsening conditions, and further roiled markets.
Neither company appeared to have any
reasonable prospect of raising private capital to
allay those concerns in the foreseeable future,
and our examination found capital to be
inadequate – in terms of both the quality of
capital and the embedded losses stemming from
worsening mortgage market conditions.
Confidence in the GSE model was largely
shattered. It was clear to me that simply
injecting even a great deal of equity into their
business model would not create the market
confidence necessary to fund these enterprises
going forward and to bolster confidence in the
$5.4 trillion of extant GSE obligations, which
posed the greatest systemic risk. Market fragility
and the GSEs' deteriorating balance sheets
required that we take responsibility for the GSE
structural ambiguities that U.S. policymakers had
let fester for decades. If we had asked Congress
for, and received, the power to explicitly
guarantee the GSEs' obligations, we would have
done so. But without that authority, we had to be
creative and find a way to effectively guarantee
the GSEs' obligations.
We had to stabilize the situation immediately.
We knew that markets were exceptionally fragile
and would be further threatened in September
when we expected that a number of large
financial institutions, including Lehman Brothers,
would post disappointing earnings. Chairman
Bernanke, FHFA Director Lockhart and I met
almost daily, over a 10 day period, to work
toward a comprehensive action plan. As I made
clear at the time, we sought a temporary solution
that would achieve three goals: (1) stabilize
markets, (2) promote mortgage availability, and
(3) protect the taxpayer.
In comprehensive action taken on September 7th,
FHFA placed Fannie and Freddie into
conservatorship, enabling Treasury to take
creative steps to support their obligations. We
moved quickly to do what was necessary. Our
actions would have been impossible to implement
were it not for the GSE reform legislation that
gave FHFA the expanded power to make
qualitative and quantitative judgments about
capital and also gave Treasury the financial
authorities necessary to make conservatorship a
stabilizing, as opposed to a destabilizing, event.
We devised Preferred Stock Purchase Agreements
to effectively guarantee the GSEs' obligations by
ensuring Fannie and Freddie would maintain a
positive net worth. This commitment ensures that
they can fulfill their financial obligations, even
after the temporary authorities expire in
December 2009. Additionally, Treasury
established a new secured lending credit facility
intended to serve as an ultimate liquidity
backstop. To further support the availability of
mortgage financing, Treasury initiated a program
to purchase GSE MBS and has purchased over $50
billion thus far.
We took these actions first, to avert the financial
market meltdown that would ensue from the
collapse of these institutions and, second, to
allow the GSEs to continue, in the midst of
overall market stress, to perform their essential
role of providing mortgage finance. This
conservatorship, with the explicit backing of the
federal government, is temporary and must be
resolved for the long-term. In the meantime, the
GSEs must serve the taxpayers' interest by
assisting in turning the corner on the housing
correction, which is critical to return normalcy to
the capital markets and resume U.S. economic
growth. The GSEs can facilitate progress through
the housing correction by keeping mortgage rates
low and by mitigating foreclosures.
Keeping Mortgage Rates Low
Lower mortgage rates enable more potential
homebuyers to return to the market and help put
a floor under home prices. Initially, following our
September actions, mortgage rates did fall.
Market turmoil subsequently increased and
mortgage rates rose, but not nearly as much as
the cost of other forms of credit. Still, neither the
taxpayers nor the economy were getting the full
benefit of the agreements put in place to
effectively guarantee GSE debt. We could have
gone back to Congress to ask for authority to
directly guarantee GSE debt, however this would
have been difficult to achieve. While a simple,
direct government guarantee of GSE MBS might
have reduced rates further – given the
extraordinary strains in today's markets it
probably would still have failed to produce all of
the desired mortgage rate reductions. Therefore,
we examined other means of deploying our
authorities that could reduce mortgage rates.
We immediately noted that, given the effective
government guarantee and the spread between
Treasury rates and those of the GSEs, the
taxpayers would profit if the government simply
issued Treasuries to buy GSE securities. And in
fact, we have funded the purchase of GSE
securities with the issuance of Treasury bonds.
But to make an impact on mortgage rates, such
an initiative would have to be very large and
those Treasury issuances would count against the
debt limit.
On November 25, the Federal Reserve announced
a new program to purchase up to $100 billion in
GSE debt securities and $500 billion in GSE MBS.
This Federal Reserve program had a significant
impact. The 30-year fixed rate has fallen from an
average of 6.04 percent the week before the
policy was announced to a record low 5.10
percent last week, accomplishing a vitally
important step in addressing this housing
correction – lower mortgage rates that may bring
additional credit-worthy buyers into the housing
market.
Foreclosure Mitigation Efforts
While the GSEs are in this temporary form, we
have also worked to increase their impact on
foreclosure mitigation. In November, FHFA, the
GSEs, Treasury and the HOPE NOW Alliance
announced a major streamlined loan modification
program (SMP) to move struggling homeowners
into affordable mortgages. The new protocol
relies heavily on the "IndyMac model" developed
by the FDIC and creates sustainable monthly
mortgage payments by targeting a benchmark
ratio of housing payments to monthly gross
income. Together with the IndyMac/FDIC protocol,
the SMP creates a powerful new model that
should help ensure that no borrower who wants
to stay in their home and can make a reasonable
monthly payment will fall into foreclosure.
The SMP will directly and immediately apply to
the 50 percent of homeowners with loans
serviced under the GSEs' auspices. Fannie and
Freddie announced that they would suspend
foreclosure sales and cease evictions of owner-
occupied homes until January 9th to allow time
for implementation of the modification program.
The timing of this initiative is especially
important as prime loans now account for almost
50 percent of new delinquencies, and
delinquencies are increasingly the result of
overall economic factors rather than the loan
features and underwriting practices associated
with Alt-A and subprime products.
And the impact of the SMP will go much further.
The vast majority of servicing contracts for non-
GSE mortgages reference the GSEs' practices, and
we therefore expect the SMP to be widely
adopted and quickly move hundreds of thousands
of struggling borrowers into sustainable,
affordable mortgages. Further, this streamlined
protocol frees up servicing industry resources that
can be redirected to providing case-by-case
assistance to more difficult cases that fall
outside the SMP protocol.
Impact of Temporary Authorities to Stabilize the
GSEs
Given the authority granted by Congress last
summer, we have gone about as far as we can to
avert systemic risk and to use the GSEs to speed
progress through the housing correction that lies
at the heart of our economic downturn. Although
the effective guarantee of GSE debt and MBS has
brought some degree of stabilization, it is not
the most efficient way to remove the ambiguity
inherent in the GSE structure, even temporarily.
To the extent that the Congress and the next
Administration wish to use the GSEs as a tool to
further reduce mortgage rates, they could, under
existing authorities, make large purchases of
mortgages made at a target rate of, say, 4
percent – although very large volumes of Treasury
issuances would be required for such a program
to be effective. A targeted program such as one
that purchases only new mortgages made for
home purchases, as opposed to refinancing, for a
one year period would require less but still
substantial funding. Separately, the next
Administration could pursue legislative authority
to directly guarantee GSE debt for the remainder
of the conservatorship period.
Long-Term Policy Recommendations
The GSEs are playing a necessary role supporting
the mortgage availability which is essential to
eventually turning the corner on the housing
correction, reducing the stress in our capital
markets and returning to growth in our economy.
This must continue to be our first priority. But we
will make a grave error if we don't use this period
to decide what role government in general, and
these entities in particular, should play in the
housing market.
The public debate over the long-term structure of
the GSEs is dramatically changed today – no one
any longer doubts the systemic risk these
entities posed. It is clear to all conservatorship is
a temporary form, and that returning the GSEs to
their pre-conservatorship form is not an option.
The debate about the future of Fannie and
Freddie requires answering the much larger and
more important question of the federal
government's role in the mortgage market and in
housing policy, generally. Given the bubble we
have experienced, policymakers must ask what
amount of homeownership subsidies are
appropriate. Numerous long-standing indirect
subsidies already exist, including the mortgage
interest deduction, subsidized FHA mortgages,
and the variety of other HUD programs that
expand homeownership opportunities.
Is that enough? Or should government also
reduce mortgage rates for a larger group of
homebuyers? Policymakers must decide if the GSE
subsidy is a public policy priority. If the GSEs are
to play a role, then, the debate is clearly framed:
Government support needs to be either explicit or
non-existent, and structured to resolve the
conflict between public and private purposes. Any
middle ground is a recipe for another crisis.
Although there are strong differences of opinion
over the government's role in supporting housing,
under any course policymakers choose, there are
structures and choices that can resolve the long-
term conflict of purposes issues.
And it is clear that to protect against systemic
risk in the future, the GSEs should be constituted
with a portfolio no larger than what is minimally
necessary for warehousing purposes. Without
portfolios of significant size, the enterprises'
management of interest rate risk would remain a
vital function for the safety and soundness of the
enterprises, but would no longer present the
same potential systemic risk.
As a public policy tool to expand homeownership,
the GSEs, like FHA-Ginnie Mae, reduce mortgage
rates for borrowers by taking on the credit risk
that mortgage investors would otherwise bear
and guaranteeing that mortgage investors will be
paid in full should the mortgage borrower default.
As Congress considers the future role and
structure of the GSEs, it must consider how much
credit risk the Federal government should take.
Addressing Credit Risk
In today's stressed mortgage market, between
FHA-Ginnie Mae, Fannie Mae, and Freddie Mac,
almost all new mortgage market originations
have federal government credit support. This is
not sustainable over the long-run. It will lead to
inefficiency, less innovation and higher costs. It
also contradicts basic U.S. market principles. We
must have some degree of private sector
involvement in the evaluation of credit risk if we
are going to have a mortgage market that
allocates resources with efficiency.
In the mortgage market of the future, I clearly
see a role for the FHA and Ginnie Mae for first-
time and low income homebuyers. Beyond the
explicit guarantee provided to FHA and Ginnie
Mae policymakers must decide how much to
further subsidize mortgage credit risk, if at all,
and must decide the role of private capital in any
subsidy plan. Depending on the degree of subsidy
policymakers choose, there are a variety of
options for structures to replace the GSEs,
including:
(1) Expanded FHA/Ginnie Mae. Some advocate
that beyond the current credit crisis the U.S.
government's long-term policy should make the
implicit, explicit. Explicitly guaranteeing Fannie
and Freddie's obligations would essentially
nationalize this significant portion of the U.S.
housing finance market. Under this model, the
GSEs could become a government entity, or their
functions could be absorbed by FHA/Ginnie Mae .
In either case, the GSEs would no longer have
private shareholders. The size of the eligible
population of homebuyers would determine how
large a share of mortgage credit exposure the
government would own.
I view the permanent nationalization of the GSEs,
essentially expanding the role of FHA and Ginnie
Mae, as a less-than optimal model. While it
offers the perceived advantage of explicit
government support, it eliminates the necessary
private sector evaluations of credit risk and the
private market stimulus to innovation.
(2) Partial Guarantee. A hybrid of this would be
to create a Ginnie Mae-like entity for non-FHA
mortgages, structured as a partial guarantee
mechanism. The new entity could operate on a
similar basis as Ginnie Mae, but provide only
partial guarantees for MBS. Investors would then
have a floor under potential MBS losses, but
would still evaluate the credit risk associated
with individual issuers. While such a hybrid
program would clearly define the extent of the
government's guarantee, developing risk sharing
parameters compatible with profit incentives
would be as problematic, and potentially as
inefficient, as in the current GSE structure.
(3) Privatization. A third alternative would be to
remove all direct or indirect government support,
completely privatizing these companies while
breaking them up to minimize systemic risk. As
appealing as this alternative sounds, it is difficult
to envision a sound, practical, private sector
mortgage insurance business of any significant
size that does not require large amounts of
capital, and consequently generates only a
modest return on capital. The recent problems
encountered by monoline insurers, which ventured
into guaranteeing mortgage product as well as
the experience of the GSEs, underscores this
point. Moreover, a break up scenario does not
look particularly promising, as reverse economies
of scale would take hold. It is also worth noting
that a regional mortgage insurer would lack
diversity as a risk mitigant. Perhaps a consortium
of banks would find it advantageous to own a
national mortgage insurer to wrap their product,
or some other good private sector business model
may emerge. But I am skeptical that the "break it
up and privatize it" option will prove to be a
robust or even viable model of any substantial
scale, without some sort of government support
or protection. However, should policymakers
choose to scale back public policy bias toward
homeownership, we will eventually find out what
business model the free market would support.
(4) Housing Utility. Finally, given traditional U.S.
public policy support for marshalling private
capital to expand homeownership, establishing a
public utility-like mortgage credit guarantor could
be the best way to resolve the inherent conflict
between public purpose and private gain. Under a
utility model, Congress would replace Fannie Mae
and Freddie Mac with one or two private sector
entities. The entities would purchase and
securitize mortgages with a credit guarantee
backed by the federal government, and would not
have investment portfolios. These entities would
be privately-owned, but governed by a rate
setting commission that would establish a
targeted rate of return, thereby addressing the
inherent conflicts between private ownership and
public purpose that are unresolved in the current
GSE structure. This commission would also
approve mortgage product and underwriting
innovations to continually improve the availability
of mortgage finance for a population to be
defined by the Congress. In this model, continued
safety and soundness regulation would be
essential.
Need to Support Vibrant Private Market
If we are to maintain a private-sector secondary
mortgage market – which I believe serves the
taxpayer and the homebuyer equally well – then
we must enhance the ability of depository
institutions to fund mortgages, either as
competitors to a newly-established government
structure or as a substitute for government
funding. One way to do this is for the government
to receive some compensation for its guarantee.
The current GSE Preferred Stock Purchase
Agreements take a small step in this direction, in
that as of 2010 the GSEs must pay the
government a fee for the taxpayer backstop on
their guarantees. Of course, if this rate perfectly
reflected the risk versus the cost of the
guarantee, there would be no subsidy to
mortgage availability. It is obviously inherently
difficult to reach an exactly correct price, yet a
long-term fee-like structure in exchange for
explicit government backing would help to reduce
advantages over private institutions. Over time,
another approach might be to offer other financial
institutions the opportunity to pay a fee for
government backing on securitized, conforming
loans, a structural transformation that would
lower entry barriers, and increase competition
and innovation in housing finance.
Covered bonds are another private sector
alternative worth exploring. The FDIC has made
regulatory changes to support the emergence of
covered bonds, which could provide enhanced
opportunities for depository institutions to fund
and manage mortgage credit risk. There is strong
interest in developing a U.S. covered bond
market, but we will have to work through the
credit crisis before a new market is likely to take
hold. Some have advocated dedicated covered
bond legislation, which could be helpful to
establishing this market, and should be
considered in the context of broader housing
finance reforms.
Additionally, the President's Working Group on
Financial Markets has recommended extensive
reforms in the mortgage securitization process by
investors, ratings agencies, underwriters and
regulators, especially with respect to mortgage
origination oversight. When these reforms are in
place, we expect private label securitization to
return with greater oversight and market
discipline.
Conclusion
My thoughts today are intended to inform the
necessary debate over the future structure of the
housing GSEs. By allowing the GSE structural
ambiguities to persist for too long, U.S.
policymakers have created an untenable
situation. Today, Fannie Mae and Freddie Mac are
in a temporary form that, while stable, cannot
efficiently serve their Congressionally-chartered
mission and protect the taxpayers' investment
over the long-term. We took the right actions to
meet a specific need at a specific time.
The GSEs are critical to getting us through this
current period, and this is our first priority. More
may need to be done to clarify and simplify their
structure and to increase their effectiveness in
curbing further housing price correction. But we
cannot look only at this short-term need;
policymakers must resolve the question of long-
term structure because the pre-conservatorship
model has been disproven.
The first step must be for policymakers to decide
– in light of the recent housing bubble and the
severe financial and economic penalty it has
imposed on our nation – the role government
should play in supporting home ownership. We
cannot allow a repeat of the devastation this
housing correction has wreaked on families and
communities across the United States. Once that
decision is made, the GSEs should be
restructured to meet that public policy choice and
satisfy three objectives: First, there must be no
ambiguity as to government backing. It must be
explicit or non-existent. Second, there must be a
clear means of managing the conflict between
public support and private profit. Third, there
must be strong regulatory oversight of the
resulting institutions.
As I have outlined, whatever role the U.S.
government chooses to play in subsidizing
mortgage finance, there is a structure that can
meet the objectives. With the knowledge of
recent experience, we have a responsibility to
begin work now on a long-term GSE structure
which avoids the dangerous mix of policy and
market distortions created by the former flawed
Remarks by Treasury Secretary Henry M. Paulson, Jr.
Recovery
Washington – Good afternoon. Thank you, David
and thanks to the Washington Economic Club for
this opportunity to provide my thoughts on long-
term reform of the housing Government
Sponsored Enterprises, the GSEs, Fannie Mae and
Freddie Mac.
Debate over the role and function of these
entities has raged for years. Congress
established Fannie and Freddie decades ago to
meet a public policy goal – to increase the
funding available for home mortgage financing.
The GSEs achieve this through providing liquidity
to the secondary market for a limited range of
home mortgages, either through credit
guarantees on mortgage-backed securities (MBS)
or by directly investing in mortgages and
mortgage-related securities through their
retained mortgage portfolios. To further this
mission, their congressional charters grant the
GSEs several benefits which together created a
perception that the GSEs were backed by the U.S.
government, even though this was not the case.
This "implicit" government guarantee provided
the GSEs with a funding advantage over other
mortgage market participants.
The inherent conflict in this structure is obvious –
the GSEs served both a public mission and
private shareholders – they received public
support but operated for private shareholder gain.
While policymakers of every ideological stripe
have acknowledged the risks created by this
conflict, entrenched debate, often with little
recognition of market realities, prevented reform.
Over time, the GSEs' advantages enabled them to
grow at a phenomenal pace, so that today they
have $5.4 trillion in obligations outstanding, held
by investors in the U.S. and around the world. As
a comparison, that is almost 40 percent the size
of the entire $14 trillion U.S. economy. The
systemic risk posed by such size was heightened
by the fact that investors assumed that GSE
securities were backed by the U.S. government
and therefore virtually risk-free, despite repeated
statements by consecutive U.S. administrations
to the contrary. These debt-holders would be the
largest, but not the only, conduits of systemic
impact should either GSE fail. Derivative
counterparties, for example, would also be
overwhelmed by a default of either GSE.
For some time market participants had
questioned whether the GSEs were adequately
capitalized for the risk they were taking, and
therefore able to withstand losses without
triggering a systemic event. Policymakers
acknowledged that the GSE regulator did not
have the authorities to address these risks, yet
they could not reach consensus to improve it, and
instead left a clearly inadequate regulatory
structure in place. When I came to Washington, I
saw an opportunity to improve the regulatory
structure, even if it wouldn't be perfect. I set to
work in the fall of 2006 to broker progress in the
House, and we did begin to solve some of the
seemingly intractable differences.
Even as Washington debated GSE oversight,
there was little debate over the extent to which
government should subsidize homeownership,
and whether such government support was
contributing to a housing bubble. The U.S.
government has many policies that subsidize
homeownership – it would be oversimplifying and
wrong to blame Fannie and Freddie for the
bubble, but they clearly are part of the public
policy bias that contributed to it.
In sum, the GSE reform debate was largely frozen
in place, or moving at glacial speed. Then
suddenly, the unprecedented housing correction
shifted the ground under that debate and forced
action.
Today I will review the actions we have taken
and their effect, and address two issues before
us. First, in the short-term, how do we use the
GSEs to mitigate the current credit crisis and
housing downturn? Second, given the temporary
nature of their current status, how might we
address the appropriate long-term structure?
Prelude to Recent Actions Regarding Fannie Mae
and Freddie Mac
As we progressed through the current housing
market downturn, investors fled mortgages that
carried any credit risk. But because the GSEs take
the credit risk on the mortgages they guarantee
and because investors believed there was implicit
government backing, the conforming loan market
continued to function relatively well. As a result,
the GSE share of new mortgage business rose
from 46 percent in the second quarter of 2007 to
84 percent in the second quarter of 2008.
Without the GSEs to finance mortgages, it was
very clear that mortgage finance would
essentially dry up.
However, as the extraordinary housing correction
deepened, weaknesses in these entities became
apparent. In July 2008, investors lost confidence
as they became increasingly uncertain about
Fannie and Freddie's capital position. The GSEs'
already depressed stock prices plummeted
further. Shareholder losses did not pose a public
policy concern, but the share price drop further
weakened confidence among the holders of the
$5.4 trillion of GSE debt and MBS. Investors at
home and abroad were reducing purchases and
even selling from their holdings of GSE debt. The
consequences of either GSE failing would be
catastrophic. We couldn't wait for a failure; we
had to act preemptively to shore up confidence in
these enterprises.
In July, I requested that Congress quickly
complete work on long-sought GSE regulatory
reform and also provide Treasury with expanded
authority to support Fannie, Freddie and the
Federal Home Loan Banks. Congress did so –
giving us enormous temporary authorities to
inject capital if the GSEs asked for it, and to
create a back up liquidity facility for GSE debt.
Immediately after passage of the legislation, in
coordination with the Federal Reserve, the newly-
constituted GSE regulator, FHFA, and our advisor
Morgan Stanley, we began a comprehensive
financial review of the GSEs. At the same time,
mortgage market conditions continued to
deteriorate. Negative earnings announcements by
Fannie and Freddie in August reflected those
worsening conditions, and further roiled markets.
Neither company appeared to have any
reasonable prospect of raising private capital to
allay those concerns in the foreseeable future,
and our examination found capital to be
inadequate – in terms of both the quality of
capital and the embedded losses stemming from
worsening mortgage market conditions.
Confidence in the GSE model was largely
shattered. It was clear to me that simply
injecting even a great deal of equity into their
business model would not create the market
confidence necessary to fund these enterprises
going forward and to bolster confidence in the
$5.4 trillion of extant GSE obligations, which
posed the greatest systemic risk. Market fragility
and the GSEs' deteriorating balance sheets
required that we take responsibility for the GSE
structural ambiguities that U.S. policymakers had
let fester for decades. If we had asked Congress
for, and received, the power to explicitly
guarantee the GSEs' obligations, we would have
done so. But without that authority, we had to be
creative and find a way to effectively guarantee
the GSEs' obligations.
We had to stabilize the situation immediately.
We knew that markets were exceptionally fragile
and would be further threatened in September
when we expected that a number of large
financial institutions, including Lehman Brothers,
would post disappointing earnings. Chairman
Bernanke, FHFA Director Lockhart and I met
almost daily, over a 10 day period, to work
toward a comprehensive action plan. As I made
clear at the time, we sought a temporary solution
that would achieve three goals: (1) stabilize
markets, (2) promote mortgage availability, and
(3) protect the taxpayer.
In comprehensive action taken on September 7th,
FHFA placed Fannie and Freddie into
conservatorship, enabling Treasury to take
creative steps to support their obligations. We
moved quickly to do what was necessary. Our
actions would have been impossible to implement
were it not for the GSE reform legislation that
gave FHFA the expanded power to make
qualitative and quantitative judgments about
capital and also gave Treasury the financial
authorities necessary to make conservatorship a
stabilizing, as opposed to a destabilizing, event.
We devised Preferred Stock Purchase Agreements
to effectively guarantee the GSEs' obligations by
ensuring Fannie and Freddie would maintain a
positive net worth. This commitment ensures that
they can fulfill their financial obligations, even
after the temporary authorities expire in
December 2009. Additionally, Treasury
established a new secured lending credit facility
intended to serve as an ultimate liquidity
backstop. To further support the availability of
mortgage financing, Treasury initiated a program
to purchase GSE MBS and has purchased over $50
billion thus far.
We took these actions first, to avert the financial
market meltdown that would ensue from the
collapse of these institutions and, second, to
allow the GSEs to continue, in the midst of
overall market stress, to perform their essential
role of providing mortgage finance. This
conservatorship, with the explicit backing of the
federal government, is temporary and must be
resolved for the long-term. In the meantime, the
GSEs must serve the taxpayers' interest by
assisting in turning the corner on the housing
correction, which is critical to return normalcy to
the capital markets and resume U.S. economic
growth. The GSEs can facilitate progress through
the housing correction by keeping mortgage rates
low and by mitigating foreclosures.
Keeping Mortgage Rates Low
Lower mortgage rates enable more potential
homebuyers to return to the market and help put
a floor under home prices. Initially, following our
September actions, mortgage rates did fall.
Market turmoil subsequently increased and
mortgage rates rose, but not nearly as much as
the cost of other forms of credit. Still, neither the
taxpayers nor the economy were getting the full
benefit of the agreements put in place to
effectively guarantee GSE debt. We could have
gone back to Congress to ask for authority to
directly guarantee GSE debt, however this would
have been difficult to achieve. While a simple,
direct government guarantee of GSE MBS might
have reduced rates further – given the
extraordinary strains in today's markets it
probably would still have failed to produce all of
the desired mortgage rate reductions. Therefore,
we examined other means of deploying our
authorities that could reduce mortgage rates.
We immediately noted that, given the effective
government guarantee and the spread between
Treasury rates and those of the GSEs, the
taxpayers would profit if the government simply
issued Treasuries to buy GSE securities. And in
fact, we have funded the purchase of GSE
securities with the issuance of Treasury bonds.
But to make an impact on mortgage rates, such
an initiative would have to be very large and
those Treasury issuances would count against the
debt limit.
On November 25, the Federal Reserve announced
a new program to purchase up to $100 billion in
GSE debt securities and $500 billion in GSE MBS.
This Federal Reserve program had a significant
impact. The 30-year fixed rate has fallen from an
average of 6.04 percent the week before the
policy was announced to a record low 5.10
percent last week, accomplishing a vitally
important step in addressing this housing
correction – lower mortgage rates that may bring
additional credit-worthy buyers into the housing
market.
Foreclosure Mitigation Efforts
While the GSEs are in this temporary form, we
have also worked to increase their impact on
foreclosure mitigation. In November, FHFA, the
GSEs, Treasury and the HOPE NOW Alliance
announced a major streamlined loan modification
program (SMP) to move struggling homeowners
into affordable mortgages. The new protocol
relies heavily on the "IndyMac model" developed
by the FDIC and creates sustainable monthly
mortgage payments by targeting a benchmark
ratio of housing payments to monthly gross
income. Together with the IndyMac/FDIC protocol,
the SMP creates a powerful new model that
should help ensure that no borrower who wants
to stay in their home and can make a reasonable
monthly payment will fall into foreclosure.
The SMP will directly and immediately apply to
the 50 percent of homeowners with loans
serviced under the GSEs' auspices. Fannie and
Freddie announced that they would suspend
foreclosure sales and cease evictions of owner-
occupied homes until January 9th to allow time
for implementation of the modification program.
The timing of this initiative is especially
important as prime loans now account for almost
50 percent of new delinquencies, and
delinquencies are increasingly the result of
overall economic factors rather than the loan
features and underwriting practices associated
with Alt-A and subprime products.
And the impact of the SMP will go much further.
The vast majority of servicing contracts for non-
GSE mortgages reference the GSEs' practices, and
we therefore expect the SMP to be widely
adopted and quickly move hundreds of thousands
of struggling borrowers into sustainable,
affordable mortgages. Further, this streamlined
protocol frees up servicing industry resources that
can be redirected to providing case-by-case
assistance to more difficult cases that fall
outside the SMP protocol.
Impact of Temporary Authorities to Stabilize the
GSEs
Given the authority granted by Congress last
summer, we have gone about as far as we can to
avert systemic risk and to use the GSEs to speed
progress through the housing correction that lies
at the heart of our economic downturn. Although
the effective guarantee of GSE debt and MBS has
brought some degree of stabilization, it is not
the most efficient way to remove the ambiguity
inherent in the GSE structure, even temporarily.
To the extent that the Congress and the next
Administration wish to use the GSEs as a tool to
further reduce mortgage rates, they could, under
existing authorities, make large purchases of
mortgages made at a target rate of, say, 4
percent – although very large volumes of Treasury
issuances would be required for such a program
to be effective. A targeted program such as one
that purchases only new mortgages made for
home purchases, as opposed to refinancing, for a
one year period would require less but still
substantial funding. Separately, the next
Administration could pursue legislative authority
to directly guarantee GSE debt for the remainder
of the conservatorship period.
Long-Term Policy Recommendations
The GSEs are playing a necessary role supporting
the mortgage availability which is essential to
eventually turning the corner on the housing
correction, reducing the stress in our capital
markets and returning to growth in our economy.
This must continue to be our first priority. But we
will make a grave error if we don't use this period
to decide what role government in general, and
these entities in particular, should play in the
housing market.
The public debate over the long-term structure of
the GSEs is dramatically changed today – no one
any longer doubts the systemic risk these
entities posed. It is clear to all conservatorship is
a temporary form, and that returning the GSEs to
their pre-conservatorship form is not an option.
The debate about the future of Fannie and
Freddie requires answering the much larger and
more important question of the federal
government's role in the mortgage market and in
housing policy, generally. Given the bubble we
have experienced, policymakers must ask what
amount of homeownership subsidies are
appropriate. Numerous long-standing indirect
subsidies already exist, including the mortgage
interest deduction, subsidized FHA mortgages,
and the variety of other HUD programs that
expand homeownership opportunities.
Is that enough? Or should government also
reduce mortgage rates for a larger group of
homebuyers? Policymakers must decide if the GSE
subsidy is a public policy priority. If the GSEs are
to play a role, then, the debate is clearly framed:
Government support needs to be either explicit or
non-existent, and structured to resolve the
conflict between public and private purposes. Any
middle ground is a recipe for another crisis.
Although there are strong differences of opinion
over the government's role in supporting housing,
under any course policymakers choose, there are
structures and choices that can resolve the long-
term conflict of purposes issues.
And it is clear that to protect against systemic
risk in the future, the GSEs should be constituted
with a portfolio no larger than what is minimally
necessary for warehousing purposes. Without
portfolios of significant size, the enterprises'
management of interest rate risk would remain a
vital function for the safety and soundness of the
enterprises, but would no longer present the
same potential systemic risk.
As a public policy tool to expand homeownership,
the GSEs, like FHA-Ginnie Mae, reduce mortgage
rates for borrowers by taking on the credit risk
that mortgage investors would otherwise bear
and guaranteeing that mortgage investors will be
paid in full should the mortgage borrower default.
As Congress considers the future role and
structure of the GSEs, it must consider how much
credit risk the Federal government should take.
Addressing Credit Risk
In today's stressed mortgage market, between
FHA-Ginnie Mae, Fannie Mae, and Freddie Mac,
almost all new mortgage market originations
have federal government credit support. This is
not sustainable over the long-run. It will lead to
inefficiency, less innovation and higher costs. It
also contradicts basic U.S. market principles. We
must have some degree of private sector
involvement in the evaluation of credit risk if we
are going to have a mortgage market that
allocates resources with efficiency.
In the mortgage market of the future, I clearly
see a role for the FHA and Ginnie Mae for first-
time and low income homebuyers. Beyond the
explicit guarantee provided to FHA and Ginnie
Mae policymakers must decide how much to
further subsidize mortgage credit risk, if at all,
and must decide the role of private capital in any
subsidy plan. Depending on the degree of subsidy
policymakers choose, there are a variety of
options for structures to replace the GSEs,
including:
(1) Expanded FHA/Ginnie Mae. Some advocate
that beyond the current credit crisis the U.S.
government's long-term policy should make the
implicit, explicit. Explicitly guaranteeing Fannie
and Freddie's obligations would essentially
nationalize this significant portion of the U.S.
housing finance market. Under this model, the
GSEs could become a government entity, or their
functions could be absorbed by FHA/Ginnie Mae .
In either case, the GSEs would no longer have
private shareholders. The size of the eligible
population of homebuyers would determine how
large a share of mortgage credit exposure the
government would own.
I view the permanent nationalization of the GSEs,
essentially expanding the role of FHA and Ginnie
Mae, as a less-than optimal model. While it
offers the perceived advantage of explicit
government support, it eliminates the necessary
private sector evaluations of credit risk and the
private market stimulus to innovation.
(2) Partial Guarantee. A hybrid of this would be
to create a Ginnie Mae-like entity for non-FHA
mortgages, structured as a partial guarantee
mechanism. The new entity could operate on a
similar basis as Ginnie Mae, but provide only
partial guarantees for MBS. Investors would then
have a floor under potential MBS losses, but
would still evaluate the credit risk associated
with individual issuers. While such a hybrid
program would clearly define the extent of the
government's guarantee, developing risk sharing
parameters compatible with profit incentives
would be as problematic, and potentially as
inefficient, as in the current GSE structure.
(3) Privatization. A third alternative would be to
remove all direct or indirect government support,
completely privatizing these companies while
breaking them up to minimize systemic risk. As
appealing as this alternative sounds, it is difficult
to envision a sound, practical, private sector
mortgage insurance business of any significant
size that does not require large amounts of
capital, and consequently generates only a
modest return on capital. The recent problems
encountered by monoline insurers, which ventured
into guaranteeing mortgage product as well as
the experience of the GSEs, underscores this
point. Moreover, a break up scenario does not
look particularly promising, as reverse economies
of scale would take hold. It is also worth noting
that a regional mortgage insurer would lack
diversity as a risk mitigant. Perhaps a consortium
of banks would find it advantageous to own a
national mortgage insurer to wrap their product,
or some other good private sector business model
may emerge. But I am skeptical that the "break it
up and privatize it" option will prove to be a
robust or even viable model of any substantial
scale, without some sort of government support
or protection. However, should policymakers
choose to scale back public policy bias toward
homeownership, we will eventually find out what
business model the free market would support.
(4) Housing Utility. Finally, given traditional U.S.
public policy support for marshalling private
capital to expand homeownership, establishing a
public utility-like mortgage credit guarantor could
be the best way to resolve the inherent conflict
between public purpose and private gain. Under a
utility model, Congress would replace Fannie Mae
and Freddie Mac with one or two private sector
entities. The entities would purchase and
securitize mortgages with a credit guarantee
backed by the federal government, and would not
have investment portfolios. These entities would
be privately-owned, but governed by a rate
setting commission that would establish a
targeted rate of return, thereby addressing the
inherent conflicts between private ownership and
public purpose that are unresolved in the current
GSE structure. This commission would also
approve mortgage product and underwriting
innovations to continually improve the availability
of mortgage finance for a population to be
defined by the Congress. In this model, continued
safety and soundness regulation would be
essential.
Need to Support Vibrant Private Market
If we are to maintain a private-sector secondary
mortgage market – which I believe serves the
taxpayer and the homebuyer equally well – then
we must enhance the ability of depository
institutions to fund mortgages, either as
competitors to a newly-established government
structure or as a substitute for government
funding. One way to do this is for the government
to receive some compensation for its guarantee.
The current GSE Preferred Stock Purchase
Agreements take a small step in this direction, in
that as of 2010 the GSEs must pay the
government a fee for the taxpayer backstop on
their guarantees. Of course, if this rate perfectly
reflected the risk versus the cost of the
guarantee, there would be no subsidy to
mortgage availability. It is obviously inherently
difficult to reach an exactly correct price, yet a
long-term fee-like structure in exchange for
explicit government backing would help to reduce
advantages over private institutions. Over time,
another approach might be to offer other financial
institutions the opportunity to pay a fee for
government backing on securitized, conforming
loans, a structural transformation that would
lower entry barriers, and increase competition
and innovation in housing finance.
Covered bonds are another private sector
alternative worth exploring. The FDIC has made
regulatory changes to support the emergence of
covered bonds, which could provide enhanced
opportunities for depository institutions to fund
and manage mortgage credit risk. There is strong
interest in developing a U.S. covered bond
market, but we will have to work through the
credit crisis before a new market is likely to take
hold. Some have advocated dedicated covered
bond legislation, which could be helpful to
establishing this market, and should be
considered in the context of broader housing
finance reforms.
Additionally, the President's Working Group on
Financial Markets has recommended extensive
reforms in the mortgage securitization process by
investors, ratings agencies, underwriters and
regulators, especially with respect to mortgage
origination oversight. When these reforms are in
place, we expect private label securitization to
return with greater oversight and market
discipline.
Conclusion
My thoughts today are intended to inform the
necessary debate over the future structure of the
housing GSEs. By allowing the GSE structural
ambiguities to persist for too long, U.S.
policymakers have created an untenable
situation. Today, Fannie Mae and Freddie Mac are
in a temporary form that, while stable, cannot
efficiently serve their Congressionally-chartered
mission and protect the taxpayers' investment
over the long-term. We took the right actions to
meet a specific need at a specific time.
The GSEs are critical to getting us through this
current period, and this is our first priority. More
may need to be done to clarify and simplify their
structure and to increase their effectiveness in
curbing further housing price correction. But we
cannot look only at this short-term need;
policymakers must resolve the question of long-
term structure because the pre-conservatorship
model has been disproven.
The first step must be for policymakers to decide
– in light of the recent housing bubble and the
severe financial and economic penalty it has
imposed on our nation – the role government
should play in supporting home ownership. We
cannot allow a repeat of the devastation this
housing correction has wreaked on families and
communities across the United States. Once that
decision is made, the GSEs should be
restructured to meet that public policy choice and
satisfy three objectives: First, there must be no
ambiguity as to government backing. It must be
explicit or non-existent. Second, there must be a
clear means of managing the conflict between
public support and private profit. Third, there
must be strong regulatory oversight of the
resulting institutions.
As I have outlined, whatever role the U.S.
government chooses to play in subsidizing
mortgage finance, there is a structure that can
meet the objectives. With the knowledge of
recent experience, we have a responsibility to
begin work now on a long-term GSE structure
which avoids the dangerous mix of policy and
market distortions created by the former flawed
Remarks by Treasury Secretary Henry M. Paulson, Jr.
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