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S. HRG. 112–341 

HOUSING FINANCE REFORM: SHOULD THERE BE 

A GOVERNMENT GUARANTEE? 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

FIRST SESSION 

ON 

EXAMINING A GOVERNMENT GUARANTEE IN HOUSING FINANCE 

REFORM 

SEPTEMBER 13, 2011 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.fdsys.gov/ 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

RICHARD C. SHELBY, Alabama 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

DWIGHT FETTIG, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

CHARLES YI, Chief Counsel 

ERIN BARRY, Professional Staff Member 

WILLIAM FIELDS, Legislative Assistant 

ANDREW OLMEM, Republican Chief Counsel 

CHAD DAVIS, Republican Professional Staff Member 

DAWN RATLIFF, Chief Clerk 

RIKER VERMILYE, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

(II)

C O N T E N T S 

TUESDAY, SEPTEMBER 13, 2011 

Page 

Opening statement of Chairman Johnson ............................................................. 1 

Opening statements, comments, or prepared statements of: 

Senator Shelby .................................................................................................. 2 

Senator Menendez 

Prepared statement ................................................................................... 19 

WITNESSES 

Richard K. Green, Director and Chair, USC Lusk Center for Real Estate, 

University of Southern California ...................................................................... 3 

Prepared statement .......................................................................................... 31 

Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise Institute ..................................................................................... 5 

Prepared statement .......................................................................................... 38 

Dwight M. Jaffee, Booth Professor of Banking, Finance, and Real Estate, 

University of California ....................................................................................... 6 

Prepared statement .......................................................................................... 47 

Adam J. Levitin, Professor of Law, Georgetown University Law Center ........... 8 

Prepared statement .......................................................................................... 51 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Prepared statement submitted by the Securities Industry and Financial Markets Association .................................................................................................... 58 

(III)

(1) 

HOUSING FINANCE REFORM: SHOULD THERE 

BE A GOVERNMENT GUARANTEE? 

TUESDAY, SEPTEMBER 13, 2011 

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. 

The Committee met at 10:03 a.m., in room SD–538, Dirksen Senate Office Building, Hon. Tim Johnson, Chairman of the Committee, presiding. 

OPENING STATEMENT OF CHAIRMAN TIM JOHNSON 

Chairman JOHNSON. I will call this hearing to order. I would like 

to thank our witnesses for joining us today. This will be the tenth 

housing finance reform hearing held by the Committee, and the 

need for a Government guarantee has been an undercurrent in 

nearly all the topics we have covered so far. 

Before the Great Depression, homeowners often had short-term 

or balloon mortgages they would roll over or renegotiate at the end 

of the term. But when there were runs on deposits and credit tightened, those homeowners had few opportunities for financing and 

were forced to sell their homes or enter foreclosure if they could not 

pay off the remainder of the underlying loan. 

Since the Great Depression, our housing market has been built 

around a structure that involves the Government. Entities such as 

the GSEs, FHA, and Ginnie Mae, the TPE market, which Senator 

Reed explored in his Subcommittee, and the widely available 30- 

year fixed-rate prepayable mortgage all rely on a Government role 

to some extent. I firmly believe that we need to reform our housing 

finance system, but I am concerned about the unintended consequences for our housing market and economy that could result if 

a Government role is eliminated completely. 

Returning to the housing system we had before the Great Depression would not be an optimal outcome. Rural States like South 

Dakota could suffer from a lack of credit and higher prices. With 

low population densities and housing turnover rates, access to a 

national mortgage market could be constrained depending on 

where investors were willing to put their money. 

Without a Government guarantee, interest rates would likely increase across the country, but it is unclear by how much. When I 

have asked financial analysts and academics about this, the answers range from a quarter of a percent to 3 percent. At the high 

end, using today’s rates, that would mean a monthly payment on 

a $200,000 mortgage would increase from about $975 to more than 

$1,350. 

2 

The 30-year fixed-rate mortgage would also likely take a different form and require substantial downpayments and higher interest rates, restricting the number of borrowers to a small number 

compared to today. If we use recently issued private label securities 

as a guide, the average downpayment was as high as 40 percent, 

according to testimony submitted for one of our previous hearings. 

Since there has been a Government role in the mortgage market 

for close to 80 years, completely eliminating a Government guarantee would result in significant changes to the current market. 

We have four witnesses who have written extensively on this 

topic, and I expect that they will help us navigate their arguments 

for and against a Government guarantee as well as the benefits 

and risks of a guarantee in good and bad economic times. 

While there is not a single-bullet answer to some of our housing 

problems, this discussion will help us better understand how individual families and communities might be impacted. 

With that, I will turn to Senator Shelby. 

STATEMENT OF SENATOR RICHARD C. SHELBY 

Senator SHELBY. Thank you, Mr. Chairman. 

Mr. Chairman, thank you for calling this hearing. Today’s hearing I believe will examine what is probably the most important 

question for housing finance reform. Can our mortgage market operate efficiently without a Government guarantee? How the Committee answers this question will, I think, dictate how we approach 

housing finance reform legislation. 

If the Committee decides that the housing market needs a Government guarantee, then it is likely that housing finance reform 

will be largely a debate over how to structure the guarantee. Reform will be easier but also less significant because we will essentially be preserving the status quo. 

However, if the Committee decides that the housing market can 

and should function without a Government guarantee, reform will 

then focus on how to transition to a private market. In that case, 

housing finance reform will be a bold undertaking that will fundamentally reshape how this Nation finances home ownership. 

While some say there is no need for bold reform, I believe that 

all options should and must be on the table. Misguided housing 

policies pursued by the Federal Government and implemented by 

the GSEs played a significant role in causing the financial crisis. 

Therefore, the Committee I believe should determine whether other 

models of housing finance are more efficient, more sustainability, 

and less likely to impose losses on taxpayers than the current system. 

It is my hope that today’s hearing will help the Committee begin 

to understand clearly the real benefit and cost of providing a Federal guarantee in housing finance. Regrettably, explicit and implicit 

Federal guarantees were often viewed as ways to subsidize home 

ownership without incurring a cost to the taxpayer. The implicit, 

so-called cost-free guarantee of Fannie Mae and Freddie Mac has 

already soaked the American taxpayer for over $170 billion, and it 

is climbing. The Federal Housing Finance Administration estimates that the total cost could more than double even over the 

next 2 years. 

3 

It is clear that the old way of doing things failed on a massive 

scale. Failed. The question now is whether we have learned anything from that experience. I look forward to the hearing. 

Chairman JOHNSON. Before we begin, I would like to briefly introduce the witnesses that are here with us today. 

Dr. Richard Green is the director and chair of the USC Lusk 

Center for Real Estate at the University of Southern California. 

The Honorable Peter J. Wallison is the Arthur F. Burns Fellow 

in Financial Policy Studies at the American Enterprise Institute. 

Mr. Wallison is also the former General Counsel for the U.S. Treasury Department. 

Dr. Dwight Jaffee is the Willis Booth Professor of Banking Finance and Real Estate at the University of California, Berkeley. 

And, finally, I would like to welcome Professor Adam Levitin, a 

professor of law at the Georgetown University Law Center. 

Thank you all for being here with us today. I will remind you to 

keep your statements to 5 minutes. Your entire written testimony 

will be entered into the record. 

Dr. Green, please proceed. 

STATEMENT OF RICHARD K. GREEN, DIRECTOR AND CHAIR, 

USC LUSK CENTER FOR REAL ESTATE, UNIVERSITY OF 

SOUTHERN CALIFORNIA 

Mr. GREEN. Thank you, Chairman Johnson and Senator Shelby, 

for allowing me to be part of this distinguished panel today. My 

name is Richard Green, and I am director of the Lusk Center for 

Real Estate at USC. 

As you know, I have been asked to discuss whether the U.S. 

mortgage market requires a Federal guarantee in order to best 

serve consumers, investors, and markets. My answer to that is yes. 

I will divide my remarks into four areas: 

First, I will argue that the United States has a history of providing guarantees, either implicit or explicit, regardless of its professed position on the matter. This phenomenon goes back to the 

origins of the republic. It is in the best interest of the country to 

acknowledge the existence of such guarantees and price them appropriately before, rather than after, they become necessary. 

Second, I will argue that in times of economic stress, such as 

now, the absence of Government guarantees would lead to the absence of mortgages. 

Third, I will argue that a purely private market would likely not 

provide a 30-year prepayable fixed-rate mortgage. I do not know 

that this is a particularly controversial statement. What is more 

controversial is whether such a mortgage is necessary, and I will 

argue that it is. 

And, finally, I will argue that in the absence of Federal guarantees, the price and quantity of mortgages will vary across geography. In particular, rural areas will have less access to mortgage 

credit that urban areas, and central cities will have less access 

than suburbs. 

Let me begin with the point that the U.S. has a long history of 

providing ex post—after the fact—guarantees as well as other guarantees. 

4 

One could reasonably argue that the United States was born 

from a bailout. One of the most famous compromises in U.S. history was the deal negotiated among Hamilton, Jefferson, and Madison for the new Federal Government of the United States to assume the Revolutionary War debts of the Continental Army and 

the individual States. This was followed by explicit guarantees for 

bonds that helped build the Transcontinental Railroad, and I could 

give other examples, but most recently, of course, we have many 

private institutions that have received Federal backing, including 

commercial banks who benefited from FDIC and TARP; the purely 

private investment banks who benefited from TARP; issuers of 

asset-backed securities who benefited from the Term Asset-Backed 

Securities Loan Facility, or TALF; and, of course, the Governmentsponsored enterprises. 

In light of the fact that the Government cannot credibly commit 

to no bailout policies, no matter what one thinks about the principle of Government guarantees, as a practical matter it makes 

sense to recognize them explicitly and to price them. 

The second point is that in times of economic stress, debt markets do not operate in the absence of Government guarantees. Beginning with the Great Depression, the United States has faced at 

least five periods when private debt markets largely shut down. Liquidity was so absent that spreads were not only wide, but they 

were difficult to measure because of the absence of transactions. 

These included the Great Depression, the double-dip recession of 

1979–81, the savings and loan crisis, the Long Term Capital Management crisis, and the Great Recession of 2008–09. Again, in each 

of these instances, it was Government coming in with a guarantee 

program of some form or another that allowed some restoration of 

liquidity and debt markets. Most recently, of course, we have had 

this with the fact that the Government-sponsored enterprises have 

become wards of the State and as such have been able to continue 

lending. It is frightening to think what might have happened to the 

housing market, already in very sick shape, had Government guarantees or had the GSEs not been there. As much as we might dislike them, one might argue that what they are doing currently is 

crowding out the private market. But if we look at parts of the private market where GSEs are not permitted to operate, we see an 

absence of lending in those markets, or at least it is very difficult 

to get a loan in those markets. 

The third point is that in the absence of guarantees, I do think 

it unlikely that we would see a 30-year fixed-rate mortgage. The 

reason this mortgage is important is because it allows households 

to hedge two things: it is allowed to hedge interest rate risk 

against a long-term assets—a house is a long-term asset—but also 

human capital risk. By being prepayable the U.S. mortgage allows 

people to move when they have job opportunities in one part of the 

country or another. This is a hedge that I do not think is sufficiently thought about and is particularly important. 

And the final point is that I think in the absence of Government 

guarantees, you would see the private sector cherry-pick certain 

markets over others. The problem with rural markets and central 

city markets is they are thin markets. There are not a lot of transactions. And it makes it very difficult to judge valuations in these 

5 

markets, which makes them relatively unattractive for lenders. As 

a consequence, what Government guarantees allow is for everybody 

to essentially pool insurance, and as such, for everybody to get access to mortgage credit. 

Thank you. 

Chairman JOHNSON. Thank you, Dr. Green. 

Mr. Wallison, please proceed. 

STATEMENT OF PETER J. WALLISON, ARTHUR F. BURNS FELLOW IN FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE 

Mr. WALLISON. Thank you, Mr. Chairman, Ranking Member 

Shelby, and Members of the Committee. The question is: Should 

there be a guarantee in our housing finance system? And my answer is no. 

I want to start with the question of the debt. We are all very 

worried here in the United States, and certainly in Congress, about 

the size of our debt. The CBO estimates that debt at about $14.3 

trillion now, to go to $23 trillion in 2021 under current policies. If 

we add to that the $7.5 trillion that is agency debt—that’s mostly 

Fannie Mae and Freddie Mac—we are talking about a $30 trillion 

debt for the United States in 2021. And if we guarantee mortgages 

or mortgage-backed securities under some plans that have been 

proposed, we will simply be increasing the debt even more. So this 

is a serious problem for us, and we have to consider whether it 

makes any sense to add to the debt by guaranteeing mortgages. 

The next thing I would like to talk about is how we protect the 

taxpayers. What we have found again and again is that every time 

the Government has some sort of guarantee program or some kind 

of program to stimulate housing through a guarantee, the taxpayers get it in the neck. The taxpayers ultimately have to pay for 

it because the Government has no way of pricing risk. And to the 

extent the Government did have a way of pricing risk, it is not able 

to do it because for political reasons. It is very difficult to impose 

these seemingly arbitrary costs on the various members of society. 

So what happens is that the politics prevents the Government from 

getting compensated for its risks, and as a result of that, whenever 

organizations like the S&Ls fail or when Fannie and Freddie— 

which were also running risks—fail, the taxpayers have to bail 

them out. 

And, finally, I ought to add—and this is also quite important in 

terms of the cost of the Government—when the Government guarantees anything it creates competition for Treasury securities, and 

that competition causes higher interest rates for Treasury securities—again costing the taxpayers. So there is no good reason to 

provide a guarantee, if once again we are going to be burdening the 

taxpayers. 

Actually, there was an interesting paper by some Federal Reserve scholars recently estimating that there was an interest rate 

increase of somewhere between 30 and 100 basis points in Treasury debt because of a Government guarantee elsewhere. 

The final thing I would like to mention is preventing bubbles. 

One of the arguments for guarantees is to provide for a steady flow 

of funds to the housing market, and yet when we do that we are 

6 

ignoring all kinds of other businesses—automobiles or consumer 

credit or whatever it is—and focusing on housing, and what we do 

there is we are taking away some of the risks in housing. That creates more speculation, overbuilding, overlending, and overborrowing. This creates bubbles, and when they collapse we have tremendous losses. 

Now, what are the reasons then for guarantees? One of them is 

that institutional investors will not buy mortgage-backed securities 

without a guarantee. This is not true. There are $13 trillion in 

fixed-income investments made by institutional investors. They are 

looking for more fixed-income investments of various kinds, and, of 

course, they take credit risk to do this. They are now investing in 

bonds and often junk bonds. What they need is more diversification. They want to be able to invest in mortgages. But they are not 

going to invest in Government-guaranteed mortgages because the 

yields are not sufficiently high. We need a private system, with 

market-rate mortgage-backed securities to attract institutional investors. 

Another point is that there will not be, we are told, a 30-year 

fixed-rate mortgage without a Government guarantee. That is also 

not true. If you go on to Google and you put in ‘‘jumbo 30-year 

fixed-rate mortgage,’’ you find that there are many, many offers out 

there, and a jumbo mortgage is not in any way guaranteed by the 

Government. So you can get a fixed-rate 30-year mortgage if you 

want one. You have to pay for it, but people ought to pay for that. 

There is no good reason to subsidize that mortgage. If we wanted 

to subsidize a mortgage, it probably should be a 15-year mortgage, 

which would actually allow people to accumulate some equity in 

their homes. 

Finally, I will make one further point, and that is that mortgage 

rates, we are told, will be lower if we have a guarantee, and of 

course they will be. That is because the taxpayers are taking the 

risk. If we price these things according to their full risk, then the 

Government’s rate would be exactly the same as the private sector 

rate. But we are not doing that. Instead, we are forcing the taxpayers to pay for the risks that the Government is taking. 

Thank you. 

Chairman JOHNSON. Thank you, Mr. Wallison. 

Dr. Jaffee, please proceed. 

STATEMENT OF DWIGHT M. JAFFEE, BOOTH PROFESSOR OF 

BANKING, FINANCE, AND REAL ESTATE, UNIVERSITY OF 

CALIFORNIA 

Mr. JAFFEE. Chairman Johnson, Ranking Member Shelby, and 

Members of the Committee, I welcome the opportunity to talk with 

you today about what is really the future form of the U.S. mortgage 

market. 

My comments compare what I believe are the two current and 

primary options for replacing the GSEs: private markets versus 

Government guarantees. 

My research leads me to strongly endorse the private market alternative. I recently carried out research that compared the mortgage and housing market performance of 15 Western European 

countries with that of the U.S. This comparison is relevant because 

7 

these countries systematically have very little Government intervention in their housing and mortgage markets compared to the 

United States. Indeed, none of them have any entities that correspond in any way to our GSEs. Nevertheless, on all statistical 

measures that I could find, the housing and mortgage markets of 

Western Europe have outperformed those of the U.S. over the last 

10 to 15 years. My written testimony has a detailed statistical 

table. Let me just point out the two key findings. 

First, the home ownership rate in the United States at year-end 

2009 was 67.2 percent, which is exactly the average of the 15 European countries. Indeed, seven of the European countries have higher home ownership rates than the United States, and I emphasize 

with very little Government intervention in those markets. 

Second, the average interest rate on mortgages in those countries 

is actually lower, in some cases by significant amounts, than the 

United States rates. Quite remarkable. Without any subsidies. 

It is important to understand the source of the superior performance in Europe, and I believe it is very simple. They have extremely safe mortgages. The default rates in Europe even today 

under, as we know, distressed conditions in those economies, the 

default rates are remarkably low, and, therefore, they do not have 

to have high premiums for default risk. 

I believe if the United States switched to an essentially private 

market system, we would obtain exactly the same benefits, and I 

would emphasize that having safe mortgages would save us what 

otherwise I fear will be a future replay of high default rates, high 

loan modifications costs, and high foreclosure rates. And it is my 

opinion that the U.S. housing markets would be much better without such costs facing us again. 

Let me now turn to the Government guarantee proposals, and I 

am skeptical of these for several reasons. First, it is commonly suggested that we currently have no private market activity and that 

the proponents of these proposals see no signs of recovery. To me 

this is Crowding Out 101. Of course, if there are highly subsidized 

Government programs offering the same service as the private sector, we will see no private sector activity. But this offers, in my 

opinion, no evidence that private markets would continue to fail if 

the Government programs were removed. 

A second common argument for the Government guarantees— 

and we heard it from Professor Green—is the 30-year fixed-rate 

mortgage. I strongly disagree. The 30-year fixed-rate mortgage does 

not require Government guarantees or GSE activity in any shape 

or form. The key point is that the risk an investor faces in buying 

a 30-year fixed-rate mortgage is interest rate risk, and neither the 

GSEs nor any of the Government guarantee programs have any actions to mitigate that risk. That risk is there in the marketplace, 

end of story. 

Second, if you actually think of credit risk, private market investors will think of a fixed-rate mortgage as safer than an adjustablerate mortgage. That is why we created the fixed-rate mortgage 

back in the 1930s, because it is a safer instrument. So there, again, 

the private markets will function just fine with fixed-rate long-term 

mortgages. As Dr. Wallison said, the markets are alive and well 

8 

both in Europe and in the United States where the private sector 

provides these mortgages. 

But most importantly, in terms of criticizing the Government 

guarantee proposals, my fear is that any proposal that actually 

gets enacted will put the Government in a first loss position, and 

that inevitably the Government and taxpayers and the borrowers 

will once again face the high costs of mortgage defaults and cumbersome losses associated with them. It is unfortunate, but the 

common experience with Government guarantee programs is that 

the political process inevitably leads to low underwriting standards, low premiums, subsidized costs, which cause taxpayers and 

borrowers to put themselves actually in harm’s way. 

Examples of this would include, for example, as you would know, 

the National Flood Insurance Program where Congress has recently had to make an appropriation for that. 

Let me just close by saying that I understand that we have a 

transition problem. How do we get to this nice private market from 

where we are? And the answer is: Reduce the conforming loan limits in a sequence of steps that will create an orderly transition. October 1st you have your first opportunity. The current temporary 

increase in the conforming loan limits are scheduled to step down 

by almost $100,000. I hope that happens. I believe it would be an 

excellent challenge to the private markets to carry on. 

Chairman JOHNSON. Thank you, Dr. Jaffee. 

Professor Levitin, please proceed. 

STATEMENT OF ADAM J. LEVITIN, PROFESSOR OF LAW, 

GEORGETOWN UNIVERSITY LAW CENTER 

Mr. LEVITIN. Mr. Chairman, Ranking Member Shelby, Members 

of the Committee, in the perfect world, there would be no Government guarantee of the housing finance system. It would be a totally 

private system. And I want to make clear, I do not disagree with 

Dr. Jaffee or Mr. Wallison on any of the problems of a guaranteed 

system. A guaranteed housing finance system has many concerns. 

But the truth is, there is no real alternative. 

The fundamental problem with housing finance privatization proposals is they do not work. Fully private housing finance systems 

simply do not exist in the developed world. The choice in housing 

finance is not a choice between Government guarantee and no 

guarantee. That is a false dichotomy. The Government inevitably 

bears the risk of catastrophic failure in the housing finance system. 

There is not a housing finance system in the developed world that 

does not either contain an explicit guarantee, as in Canada, or an 

implicit guarantee, as in Germany and Denmark, which happen to 

be the only other two countries with widely available 30-year fixedrate mortgages. The real choice is not between a guarantee and no 

guarantee, but instead between an implicit guarantee and an explicit guarantee. 

Despite all our best intents and declarations, the reality is that 

if faced with the imminent collapse of the housing finance system, 

the U.S. Government will bail out the system. It is simply not credible that any Administration or Congress will permit the U.S. housing finance system to collapse. 

9 

Prior to 2008, remember, Fannie and Freddie’s obligations were 

explicitly not guaranteed by the U.S. Government, and yet they 

were bailed out. We simply have no ways of tying our hands 

against bailouts, and indeed, we may not even want to. Put differently, there is no way to guarantee against a guarantee. 

Once we accept that any housing finance system has a guarantee 

built into it, there should be little debate about whether the guarantee should be implicit or explicit. An implicit guarantee would result in a system that would guarantee moral hazard, as private 

parties would have all of the upside while the Government would 

bear the downside. An implicit guarantee means that if things get 

rough, the Government will bail out the system, but it will not 

have priced for it. 

An explicit guarantee has its problems, to be sure, as you have 

heard. But an explicit guarantee can be priced and structured to 

mitigate the risk. We may not get it perfect, but we can at least 

try and mitigate the risk that it will be used. That is not possible 

with an implicit guarantee. There is simply no thing as a nonguaranteed housing finance market other than in ideological fantasies. 

Moreover, attempting to privatize the U.S. housing finance system puts the entire economy at serious risk. Eliminate the Government guarantee risks the flight of over $6 trillion from the U.S. 

housing finance market, roughly half the dollars invested in U.S. 

mortgages. Such an occurrence would be catastrophic for the U.S. 

economy, as mortgages would become unavailable or unaffordable 

for even prime borrowers. 

Let me explain why privatization would result in a massive flight 

of U.S. mortgage capital. Mortgage investment involves two distinct risks, credit risk and interest rate risk. Most mortgage investors assume only interest rate risk. They are not credit risk investors. Investors in GSE and Ginnie Mae securities and MBS assume 

only interest rate risk, not credit risk. And investors in the nowdefunct private label securitization were functionally interest rate 

investors. Over 90 percent of private label mortgage-backed securities were rated AAA at issuance. So the investors who relied on 

these ratings understood the credit risk to be negligible. 

What this means is that the overwhelming majority of investors 

in the U.S. secondary market are not credit risk investors. They 

are solely interest rate investors, and they are unlikely to suddenly 

transform now, if ever, into credit risk investors, but that is precisely what a privatized housing finance system lacking a guarantee would do. It would require all the investors to become credit 

risk investors. 

To the extent that rate risk investors can be lured into assuming 

credit risk, it will entail much higher rates of return on the securities, which will mean much higher interest rates on mortgages. 

And even then, it is doubtful that there would be anywhere close 

to a sufficient volume of interest rate risk investors willing to assume U.S. mortgage credit risk. Theoretically, there could be as 

much as $6 trillion lost from the U.S. housing finance system. Following the siren song of privatization would put the entire U.S. 

economy in grave peril. 

10 

Now, it is true that the U.S. jumbo mortgage market operates 

without a Government guarantee, but the jumbo market is substantially smaller than the conventional conforming market and 

jumbo securitization rates are also much lower, which indicates 

that there is a limited supply of investment capital for credit risk, 

even on prime jumbo mortgages. Most of them are held on balance 

sheet by banks. 

The jumbo market also benefits from the existence of a guaranteed mortgage market in several ways. It is not a fully private market. It picks up benefits from having the Government guaranteed 

market. 

In short, the jumbo market does not provide evidence that there 

is sufficient private risk capital willing to take on credit risk on 

U.S. mortgages. The bottom line is that when we are considering 

a Government guarantee in the housing finance system, we need 

to accept that there really is no such thing as a nonguaranteed system. Every system that claims to be fully privatized has an implicit 

guarantee. We saw this in Germany and Denmark in 2008. Germany bailed out a number of its mortgage lending institutions that 

issued covered bonds. Denmark did the same thing. That means 

that even in those systems that were supposedly fully private, that 

are held up as paragons of private systems that produce 30-year 

fixed-rate mortgages, we actually had an implicit guarantee that 

became explicit. 

We just have never seen a fully privatized housing finance system and I think that we would be gambling with the U.S. economy 

if we tried to embark on such an experiment. 

Chairman JOHNSON. Thank you, Professor Levitin. 

Doctor Green, what are the economic risks associated with the 

absence of a Government guarantee for local communities from 

both an urban and rural perspective, and how would private investors decide to allocate their funds across the wide variety of housing markets in the country? 

Mr. GREEN. In my view, as I said in my testimony, the problem 

facing rural markets and central city markets is you do not see frequent transactions in these markets, and as a result of this, we 

have seen difficulty in these markets attracting capital in a wide 

range of areas. So, for example, it is very difficult for central cities 

to attract grocery stores, even though we see a high density of income in these places that could support the grocery stores. So it 

ranges from the commercial market to the residential market. 

And the problem is, when you are making a loan, you need to 

make a judgment about collateral, and the judgment about collateral comes from comparables, being able to see large numbers of 

sales. In suburban neighborhoods where you have homogeneity, 

where you have a large number of sales, it is pretty straightforward to determine what a house is worth and, as a result of 

that, to be comfortable with collateral when you are making a loan. 

In rural areas and in central cities where the transactions are 

rarer and where there is also more heterogeneity, so it is hard to 

know whether one farm town is really the same as another farm 

town or not, making judgments about valuations is very difficult, 

and this judgment about valuation makes people less prone to want 

to invest in a place. They consider it an informational risk. And so 

11 

if there is capital that flows to these places at all, it is in less favorable terms than it is in places where there is more homogeneity. 

And so in the absence of a Government which sort of puts a 

backstop on losses that one might find in these rural communities 

and these central cities in the event of catastrophic events, I think 

you would see substantial differences in how these places are treated. 

Chairman JOHNSON. Professor Levitin, both FHA and the GSEs 

lost market share to private market products during the housing 

boom. Why did the increase in private market participation not create a more stable market instead of the breakdown we experienced? 

Mr. LEVITIN. The problem with the growth of the private label 

securitization market in the 2000s was that it was essentially an 

unregulated market. There were no marketwide standards that applied on mortgage origination or securitization, and what happened 

then was essentially a race to the bottom, where private label 

securitizers competed to get market share based on having ever 

looser lending standards, and the GSEs found themselves in a losing market share and their private shareholders were not real 

pleased to see that and pushed the GSEs to try and compete more 

vigorously through laxer lending standards and the result was we 

got in a race to the bottom and we are all paying the price for that. 

Chairman JOHNSON. Dr. Jaffee, in the late months of 2008, the 

U.S. housing market was on the brink of collapse. Looking back, 

what would the housing crisis of 2008 have looked like if the Government had not taken over Fannie Mae and Freddie Mac? 

Mr. JAFFEE. I believe that by that time, there was probably no 

option about saving Fannie Mae and Freddie Mac. I had written 

as early as 2003 actually predicting exactly what would happen, 

which was to say that the institutions, if nothing else, were going 

to end with a liquidity crisis. They had unbalanced interest rate 

risk. They had a huge maturity imbalance in which a third of their 

liabilities came due every year, even though they had very longterm assets, and it was only going to require one morning in the 

financial markets in which the current holders of Fannie Mae and 

Freddie Mac debt said, we do not want to buy it any more, we do 

not want to roll it over, and they would be, in effect, in a liquidity 

crisis and have to be bailed out. So by that point, I think there was 

no way around it. 

Chairman JOHNSON. Mr. Wallison, your colleague Alex Pollock 

called for countercyclical measures to help prevent or at least protect against housing bubbles. Do you agree with his suggestion, 

and would the private market adopt these standards on its own? 

Mr. WALLISON. Yes, I agree generally with the idea that we 

ought to have some sort of countercyclical process for preventing 

the decline in mortgage standards. However, the important thing 

to keep in mind is that if we have a Government guarantee, we are 

assuring that there will be a decline in mortgage quality standards 

because investors will no longer be interested in whether the mortgages that are being guaranteed are of good quality or not. That 

creates the race to the bottom that Professor Levitin talked about. 

And we exacerbate that because we increase the likelihood that 

weak mortgages will be developed by having such programs as afVerDate Nov 24 2008 12:58 Apr 26, 2012 Jkt 048080 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\09-13 HOUSING FINANCE REFORM -- SHOULD THERE BE A GOVER
12 

fordable housing requirements for Fannie Mae and Freddie Mac, 

which caused them to buy very weak mortgages. That was one of 

the causes—probably the principal cause—of the financial crisis. 

Chairman JOHNSON. Professor Levitin, without a guarantee, 

could the private market pick up the remaining market volume? If 

not, what would happen to the availability of mortgage credit? 

Mr. LEVITIN. Without the guarantee, the private market simply 

would not pick up the volume of mortgage financing needed to sustain the U.S. housing finance market, and the result would be that 

a lot of people would be simply unable to get mortgages, or if they 

were able to get a mortgage, it would be at an extremely high interest rate. So we would really be gambling—if we tried to privatize the system, we would really be gambling with the entire 

housing finance system and taking on a risk that we would end up 

in a crisis that looks actually much worse than 2008. 

I think it is important, though, that I say a word about something that Mr. Wallison just said. Mr. Wallison just tried to blame 

the Government’s affordable housing programs for the financial crisis in 2008. I know that is the position he adopted in his FCIC dissent. I think it is important to state for the record that it is a position that has been thoroughly, thoroughly debunked and challenged 

by many other sources, and if you just want to see an example of 

a real estate market that tanked with no Federal involvement 

whatsoever, look at the commercial real estate market. 

The commercial real estate market had a bubble that tracked the 

residential market almost to a T. The Federal Government is not 

guaranteeing anything in the commercial real estate market. The 

Federal Government does not have affordable commercial real estate goals or any regulation thereof. That market also tanked. Unless Mr. Wallison can explain what happened in the commercial 

market, it is kind of hard to place the blame on the Government’s 

affordable housing programs for what happened in the residential 

market. 

Chairman JOHNSON. Mr. Wallison, do you have a response? 

Mr. WALLISON. Of course. 

[Laughter.] 

Mr. WALLISON. That followed what happened in the residential 

market. The residential market collapsed because of the affordable 

housing requirements. Quite apart from being debunked, as Dr. 

Levitin indicated, the data produced in my dissent from the FCIC 

report showed that the Government bought, through Fannie Mae 

and Freddie Mac and through other Government programs, twothirds of all the weak mortgages that were outstanding. Some of 

the arguments that have been made are that, well, Fannie Mae’s 

mortgages, Freddie Mac’s mortgages, were better quality than 

other mortgages. Yes, that is true, but Fannie Mae and Freddie 

Mac are insolvent. In other words, they bought terrible mortgages; 

they had the power to acquire good mortgages and they did not do 

it. They began this process in 1992 when the affordable housing requirements were first imposed. The numbers are very clear, if anyone were to read my dissent from the report of the Financial Crisis 

Inquiry Commission, Mr. Chairman. 

Chairman JOHNSON. Senator Shelby. 

Senator SHELBY. Thank you, Mr. Chairman. 

13 

Dr. Jaffee, according to economic research, how much of the benefit generated by a Federal guarantee would actually go to consumers in the form of lower interest rates and how much of the 

benefit would go to the housing and banking industry? Have you 

done some research in that area? 

Mr. JAFFEE. I have done some research—— 

Senator SHELBY. OK. 

Mr. JAFFEE. ——and many of my academic colleagues have done 

even more—— 

Senator SHELBY. Yes, sir. 

Mr. JAFFEE. ——and I think the numbers are—there is a broad 

consensus. Roughly speaking, the GSEs have probably been receiving a subsidy of approximately 50 basis points a year in terms of 

their ability to give guarantees that the markets basically assumed 

were Government guarantees as opposed to what they would have 

had to pay for, say, debt if they were private firms, 50 basis points. 

The available evidence on the loans at the margin between conforming GSE available and above it, not GSE available, is about 25 

basis points and it suggests that approximately half of the subsidy 

is going to the borrowers and half of the subsidy is going into the 

pockets of either the shareholders or the managers of the GSEs. 

And if you do the numbers, it comes out exactly right. That is why 

the GSEs over many years were able to report rates of return on 

equity at 30, 35 percent a year, which was double what any other 

bank in the world has been able to achieve. 

Senator SHELBY. Professor Jaffee, would you just comment a little bit—you alluded to this—the idea of socializing the risk and 

privatizing the profits—— 

Mr. JAFFEE. Well, what—— 

Senator SHELBY. ——what we do when we guarantee something 

by the taxpayer, do we not? 

Mr. JAFFEE. Well, for sure, we do. I would say the GSEs were 

the worst form of creating that because you created entities that 

had fiduciary responsibilities to their shareholders to maximize 

profits, and yet they quickly—in fact, it is interesting. The concept 

of an implicit guarantee was immediately adopted by the GSEs. If 

you go back and read the record and history, by 1969, 1 year after 

Fannie Mae became a GSE, and by 1971, 1 year after Freddie Mac 

became a GSE, they were telling the world, do not worry. We have 

an implicit guarantee. You can treat us as good as Government 

paper. And so they were adopting that immediately. 

Once you have an entity that has profit incentives and a Government guarantee, the economics are very clear. You maximize your 

size and you maximize your risk bearing as much as you can get 

away with. Their whole history from 1968 to the collapse was a 

progression of greater and greater risk taking. 

Senator SHELBY. Mr. Wallison, prominent bond trader Bill Gross 

recently stated, and I will quote him, ‘‘Without a Government guarantee, as a private investor, I would require borrowers to put at 

least 30 percent down and most first-time homebuyers cannot afford that.’’ Of course, I understand his motive. You know, he is in 

the marketplace and he is a big bond holder. Some have pointed 

to statements like this and argued that most private investors will 

not buy mortgage-backed securities without a Government guarVerDate Nov 24 2008 12:58 Apr 26, 2012 Jkt 048080 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\09-13 HOUSING FINANCE REFORM -- SHOULD THERE BE A GOVER
14 

antee. In your testimony, you state that this is a myth disproved 

by the data. Would you explain? 

Mr. WALLISON. Sure. 

Senator SHELBY. Yes, sir. 

Mr. WALLISON. The amount of fixed income investment by insti- tutional investors is $13 trillion. Of that sum—— 

Senator SHELBY. Thirteen trillion—— 

Mr. WALLISON. Thirteen trillion dollars. 

Senator SHELBY. That is not chump change, is it? 

Mr. WALLISON. That is not chump change. That is money that is 

available to the mortgage market here in the United States. 

Senator SHELBY. OK. 

Mr. WALLISON. This purchase of GSE securities, however, 

amount to $1.8 trillion, a very small portion of the $13 trillion, indicating—— 

Senator SHELBY. Explain what you mean by G-series. That is 

Government—— 

Mr. WALLISON. GSE the Government—— 

Senator SHELBY. GSE. 

Mr. WALLISON. That is Fannie Mae and Freddie Mac. Their debt, 

$1.8 trillion worth of their debt, was bought by these institutional 

investors, which indicates that these investors are not particularly 

interested in Government guaranteed debt. What they want is 

fixed-income securities that pay a market rate—— 

Senator SHELBY. Sure. 

Mr. WALLISON. ——and that is not what they have been able to 

get as long as we have a Government-backed program. So the idea 

should be to make privately insured mortgage-backed securities 

now. That would make as much as $13 trillion available to our 

housing market. 

Senator SHELBY. Dr. Jaffee, going back to you, if the Federal 

Government were to provide a broad explicit guarantee of mortgage-backed securities, then it would remove the need, some people 

argue, for investors to perform their own due diligence on the securities. Lack of due diligence, I think, is a problem here. Could any 

systemic risk to the U.S. economy arise if investors stopped doing 

their own due diligence on mortgage-backed securities? In other 

words, they say, well, the Government guarantees it. It is Fannie 

and Freddie. We are going to get paid regardless. Have you 

thought about that? 

Mr. JAFFEE. Indeed, I have. Indeed, I find it remarkable, given 

the distress that we are still going through, having had an episode 

of terrible risk taking in the mortgage market, that we are contemplating Government guarantee programs which, in my opinion, will 

inevitably have the Government providing insurance with low 

downpayment mortgages, with low premiums, and that will actually induce the borrowers to once again put themselves into risky 

positions and inevitably, just as it does with floods, as it does with 

earthquakes, as it does with hurricanes, we are going to find the 

Government has to bail out these folks, and then Government then 

has to admit, we induced them to do it and now we have to bail 

them out. 

A private market, in my opinion, will do just the opposite, and 

here I have to disagree with Professor Levitin, who suggested that 

15 

investors in these private label securities were only concerned 

about the interest rate risk and somehow they did not worry about 

the credit risk. Absolutely not true. The structured finance format 

that underlies all private label securitization has an equity 

tranche. It has a mezzanine tranche. It has a B-level tranche, all 

of which are the investors who have to put their money in the first 

loss position. 

In fact, it is quite remarkable. We never hear about those guys. 

They did not get bailed out. They all took their losses. These were 

hedge funds, they were mutual funds, they were pension funds, 

and they took their losses and that is where the equity losses were 

incurred. 

In a new system, those investors, just as we see in Europe, those 

investors are going to say, I am willing to take private market 

risks, but I want safe mortgages, and I think that is the transformation that we are going to have and that is why we will not 

see another similar episode under a private system but we would 

under a Government system. 

Senator SHELBY. Thank you. 

Mr. Wallison. 

Mr. WALLISON. Yes, I just want to add that of course these institutional investors will take credit risk. The idea that they will not 

take credit risk is mad. 

Senator SHELBY. They are taking them every day. 

Mr. WALLISON. Of course. Thirteen trillion dollars that is invested in bonds, including junk bonds—which is what they are buying now because they do not have other investments—is taking 

credit risk, and they would happily take credit risk on mortgages 

which are generally, if good quality, very safe investments. 

Senator SHELBY. Can I ask you a question, then, Professor—— 

Mr. LEVITIN. Of course, Senator. 

Senator SHELBY. I was getting to you. Thank you, though. 

Mr. LEVITIN. Thank you. 

Senator SHELBY. You are very patient. Bailouts after DoddFrank, and then you can get it. Professor Wallison, he was talking 

about the debt which is confronting all of us here in Congress right 

now and the American people. If we add the agency debt, if we add 

the continuing hemorrhaging of Fannie and Freddie, all this together, we are going to get up to $30 trillion worth of debt. Is the 

idea of a guarantee, which ultimately lays the groundwork for a 

bailout, you know, in other words, nothing is too big to fail, so to 

speak, is that smart in our economy today, in the world economy, 

with Europe reeling, we are reeling? Professor. 

Mr. LEVITIN. Well, I think it is important to frame this the right 

way, Senator. 

Senator SHELBY. Yes. 

Mr. LEVITIN. The question is not whether we would put this all 

on the U.S. balance sheet now or never. It is simply a question of 

whether it goes on the balance sheet now or at the time of the next 

crisis. 

Senator SHELBY. Wait a minute. It is either on the balance sheet 

or off the balance sheet, but the guarantee is there, you know, this 

whole idea—we sat here for years and talked about there is no real 

guarantee of Fannie and Freddie. We knew better than that. We 

16 

knew better. So there is either implicit or explicit. Right now, with 

Fannie and Freddie sitting in the lap of the Government, of the 

taxpayers, it is very explicit, is it not? 

Mr. LEVITIN. Oh, I think it is very explicit, but I do not think 

pretending that—if we did a privatization move and pretended that 

there was no guarantee, I am not sure that the market would be 

fooled. 

Senator SHELBY. OK. 

Mr. LEVITIN. I think that, you know, we look back at when we 

privatized Fannie Mae originally in 1968. That was to clear it off 

they Federal balance sheet in order to pay for the Great Society 

programs and the Vietnam war. 

Senator SHELBY. Wait a minute. You said we privatized it. You 

mean we basically created a hybrid, did we not, a Government 

Sponsored Enterprise. That is not privatizing. 

Mr. LEVITIN. Well, it is—there was no explicit guarantee. It 

was—— 

Senator SHELBY. But it was implicit. 

Mr. LEVITIN. It was implicit, which is exactly what would happen 

if we tried to privatize it again. We cannot get rid of an implicit 

guarantee. There is no way to do that. The nature of the implicit 

guarantee is it exists whether—— 

Senator SHELBY. As long as we have a Government Sponsored 

Enterprise, I agree with you. We cannot get rid of it. But if we 

were to spin off, period, and have the private markets working, 

even step by step, we could get rid of it. But we would have to 

have, one, the political will here to get rid of it—— 

Mr. LEVITIN. It would take—— 

Senator SHELBY. ——and I am not sure that is here yet, but—— 

Mr. LEVITIN. I think it would take more political will than we 

have ever seen from the U.S. Government. I think Professor Green 

detailed it pretty well, the history of the U.S. Government engaging 

in bailouts of nonguaranteed entities, including most recently private institutions or banking systems. 

Senator SHELBY. But I think you went back to the Hamilton era 

of where we—did not the Federal Government assume the States’ 

debts incurred? That is a little different thing. 

But you started to say something earlier. I want to be courteous 

to you, as long as the Chairman will indulge me. 

Mr. LEVITIN. That is very kind, Senator. Thank you. I think 

there are two important points to make about diligence. First of all, 

yes, Professor Jaffee is right. There were some credit risk investors. 

But it is important that we understand the scale of that because 

this is really an issue of scale. 

Of the private label mortgage-backed securities, something 

around 95 percent of them were rated AAA at issuance. That 

means only about 5 percent of them were being purchased by credit 

risk investors. Ninety-five percent of this market was not looking 

to take credit risk. And when you look at who those investors were, 

it is clear they have no ability to handle credit risk. Consider 

what—— 

Senator SHELBY. Like who, for instance? 

Mr. LEVITIN. Chinese investment funds, for example. How is it 

that—so Federal Reserve Chairman Ben Bernanke actually has an 

17 

article recently—he still publishes—pointing the extent of which 

the funding of the U.S. housing finance system was coming from 

foreign investors, particularly from East Asia. It is just not realistic 

to think that a Chinese investment fund—— 

Senator SHELBY. ——and why was it coming? Because they were 

led to believe that we would never let them fail, in other words, 

is that—— 

Mr. LEVITIN. That was part of it. They did not think there was 

going to be any credit risk, and had there been credit risk, they 

would not have invested because they have no way of doing diligence on U.S. mortgages in any meaningful capacity. They are at 

such an informational disadvantage that they simply would not invest in that. They are not looking for credit risk. They are looking—they can figure out what is going to happen on U.S. interest 

rates, they think, but they have no idea what is going on on the 

ground with U.S. mortgage lending and they make no pretense of 

it. 

Senator SHELBY. Professor Green, maybe I can get to you on the 

next round. Thank you. 

Chairman JOHNSON. Senator Menendez. 

Senator MENENDEZ. Thank you, Mr. Chairman. My thanks to the 

panel for their testimony, which I have read. 

Let me ask you, Professor Levitin, in the days before GSEs, loans 

were generally renewed every 3 to 5—or due every 3 to 5 years and 

had to be refinanced all the time because lenders were not willing 

to make 30-year commitments. So now we hear that once the Government gets out of the way, private capital will automatically 

enter the market and replace the Government’s position. 

What assurances are there of that, that it will occur in a timely 

fashion, considering that we have yet to see significant private capital participation in, for example, the jumbo mortgage market or 

significant private capital returning to the mobile home market? 

What if we eliminate, as some suggest, the GSEs and we turn out 

to be wrong about private capital coming back to fund 30-year 

loans? 

Mr. LEVITIN. There is absolutely no reason to believe that private 

capital would immediately step up, even if it would eventually step 

up. And there is really not good reason to believe that it would 

eventually step up in sufficient volume. If we are wrong about this, 

we have a financial crisis on our hands that far exceeds that in 

2008. 

Senator MENENDEZ. And one of the challenges I see is what if we 

completely eliminate the GSEs, as some are proposing? By how 

much do you think the cost of a mortgage would go up for the average middle-class family trying to buy a fairly modest home? 

Mr. LEVITIN. Actually, giving you a precise estimate is outside of 

my particular area of expertise, but I would expect—you heard a 

range of estimates. I have actually, I think, heard a higher estimate from Bill Gross, the head of PIMCO, which I think he said 

something around the range of 400 basis points. I do not want to 

quote him on that, though. But we would see that—we could potentially see a significant increase not just in interest rates but also 

in downpayment requirements. And you put those together, and we 

18 

could see a large number of American families simply shut out of 

the mortgage market. 

Senator MENENDEZ. And then—— 

Mr. LEVITIN. And I am sorry. I want to make one other point 

with that. If that happens, that causes a precipitous collapse in 

housing prices, which then triggers further defaults, and we can 

end up in something of a death spiral. 

Senator MENENDEZ. And, of course, those costs would be significant over the life of a loan. 

Dr. Green, do you have any views on this? 

Mr. GREEN. Well, it is not so much the cost as the availability 

of the product per se. So, again, it is really hard because making 

an apples-to-apples comparison is very difficult. 

Mr. Wallison discussed the fact that you can go on Google right 

now and get a jumbo loan, you will see a lot of people offering 

jumbo loans. But I am kind of wondering whether he has actually 

tried applying for one of them in the last 6 months. 

I did a refinance on my house on a 30-year jumbo, and it was 

very striking to me because when my wife and I got our first mortgage when we had our jobs for a year and all we had in the bank 

was a downpayment and that was it, it took like 2 days to get approved. It took us 4 months to get approved on our jumbo noncash-out refinance. And I do wonder about whether our housing 

market can actually transact if it takes 3 to 4 months in order for 

a loan to get approved. 

So there is a lot of stickiness in the process as well. How that 

exactly translates into a price I am not exactly sure. But if you say 

50 basis points plus it is going to take you another 2 to 3 months 

to get your mortgage, that is a very different kind of calculation 

than just saying 30 to 40 basis points. 

Senator MENENDEZ. Currently, small lenders such as community 

banks or mortgage brokers are able to participate in the mortgage 

market by selling loans to Fannie and Freddie without having to 

go through one of the big banks to accumulate enough loans to create a securitization pool. What would the various reform proposals 

do to the ability of small lenders such as community banks or mortgage brokers to compete in the mortgage market? Would this be a 

concentration of the market in the hands of a few players? Professor? 

Mr. LEVITIN. I think we would like—if we took the privatization, 

which I want to emphasize again is really an implicit guarantee 

route, I think that we would see concentration being the order of 

the day. And the reason I believe that is if you look at what happened in the private label securitization market, it did not have a 

long life during which it was, you know, a sizable market. But as 

that market grew in the 2000s, the move that happened was investment banks started to create integrated origination to distribution chains where they would purchase—they would have their own 

loan originators, and they would have their own securitization conduits. The move was to integration, and that integration move 

would really try and push out any other competitors on the origination front, your community banks, your credit unions, and I think 

that we would see them really losing business if we moved to a 

privatized or really implicitly guaranteed market. 

19 

Senator MENENDEZ. Thank you. 

Mr. Chairman, I would ask unanimous consent that my statement be entered into the record at the beginning of the hearing. 

Thank you Mr. Chairman for scheduling this hearing 

whose topic in my view goes straight to the heart not only 

of Government support of the housing market, but also to 

the question of what our values and priorities are as a Nation. I look forward to getting America’s housing finance 

system back on track, which is why I’m also looking forward to my Housing hearing tomorrow afternoon on New 

Ideas in Refinancing and Restructuring Mortgages. As 

families back in New Jersey, whether they own their 

homes or they are renting, are struggling through these 

tough times, we need to make sure that they have access 

to 30-year fixed-rate mortgages. I don’t think we should 

give up on the American Dream of home ownership because of the current housing market setbacks. As we consider various options for ensuring that taxpayers are protected, I hope we recognize that with the private 

securitization markets still badly broken, Government currently needs to play a role in ensuring that these affordable housing objectives are still met so that America’s wellqualified middle class families can still get mortgages 

when it comes time to buy a home and raise their families. 

Given that the housing market has not done as well as expected, I think now would be the wrong time to withdraw 

that Government crutch that has been one of the only 

things holding up the housing market. That’s why I believe 

allowing higher loan limits to expire would be a preventable mistake and why I hope this Committee will support 

the bipartisan Homeownership Affordability Act introduced by myself and Senator Johnny Isakson to maintain 

those limits temporarily. We extended them last year 

when the housing market was bad, and I don’t see why we 

wouldn’t extend them again given that the housing market 

has gotten worse since that time a year ago and 42 States 

would take a hit to their housing markets if we allow the 

limits to go down. So I look forward to addressing that, 

and I look forward to your testimony. 

Chairman JOHNSON. Yes, it will. 

Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman, and I thank each of 

you for your testimony. You know, a lot of people talk about gridlock here in Washington, rightfully so, and I was just thinking as 

I listened to the testimony of three professors that we are certainly 

creating another generation of gridlock among students in America. 

And in order to sort of bring maybe people together on a couple of 

issues, because we are probably going to have some housing legislation, I hope, during this Congress. 

Would it make some sense, to sort of bring the two bookends together with the middle, to at least look—at the end of this month 

we have got the qualified—the mortgages, the ceiling dropping 

from 729 down about a hundred grand. Would it at least make 

20 

some sense to allow that to go ahead and occur and see if we can 

backfill that with private demand instead of continuing the policy 

that we have right now? The two guys on the end. I know the guys 

in the middle say yes. 

Mr. GREEN. So as a Californian I should not say this, but I think 

it absolutely would be a worthwhile experiment, and it would test 

whether Professor Jaffee or I is correct about this, but yeah. You 

know, I have no disagreement with the idea that if you are going 

to have a guarantee, that it should be limited to middle-class mortgages. I do not know exactly how to define that, median price of 

a house plus some small increment. 

Senator CORKER. Professor Levitin. 

Mr. LEVITIN. I do not disagree. I think that is actually a reasonable approach today, and let us see what happens if we do this as 

a small scale and do not take away the guarantee altogether but 

see what happens if we ratchet it down. 

Now, I would emphasize, though, remember that the current 

level of the guarantee is much higher than it had been even a few 

years ago. 

Senator CORKER. Right. I think there is probably going to be an 

attempt to try to not let that drop, and I just appreciate the fact 

that even though both of you have advocated for keeping GSEs in 

place and that type of thing, you would at least agree that dropping that down and seeing if we can backfill that with private sector demand makes some sense at this moment. It seems to me that 

what has happened is people reacting to some very draconian 

bills—maybe they have been put forth in the House—instead of 

saying, well, you know, probably where we are today, we are way 

too dependent on Government, and we ought to reach a place that 

at least is less dependent. I think people could agree on that. And 

maybe some steps to try to backfill would make some sense, which 

brings me to a second point. 

A lot of people say the TBA market will not work without GSEs, 

but we have corn futures and oil futures and pork belly futures. I 

mean, is there any reason to believe that without a Government 

guarantee you could not still sell into the forward market as long 

as you had certain credit criteria? 

Mr. LEVITIN. Well, you do not need the Government guarantee 

per se to have a TBA market. What you need is standardization. 

A Government guarantee standardizes credit risk. It is—— 

Senator CORKER. Well, but it does not have to be that way, and 

I think what we have seen actually, because the private investors 

have been on strike, is a movement toward some standardization. 

So if we had some standardization in the marketplace, we had 

some industry criteria that people adopted, you are seeing the TBA 

market could function easily. 

Mr. LEVITIN. If everyone complied with that, and we have not 

seen that develop yet. 

Senator CORKER. But that is something that, again, I think much 

of what we do here is to try to create the environment and let the 

private sector generate the risk—or take the risk. Do you agree 

with that, Dr. Green? These other guys I know pretty well, so I 

know what they are going to say. 

21 

Mr. GREEN. I think you would have to somehow come up with 

a mechanism where investors would have confidence that people 

really are meeting the standards, and in light of the way that we 

are finding out about how mortgages not only were underwritten 

but the way documentation has been maintained and so on, I think 

the market is a very, very long way from having that kind of confidence. The standards have to stick in order for that to work. 

Senator CORKER. So if a Democrat and a Republican came forth 

with some legislation to step down over time the loan limits and 

to create a TBA market by actually creating some standards, some 

industry standards, our two bookends, for lack of a better word, 

would think that would be a methodical and thoughtful way to try 

to prime the market. 

Mr. LEVITIN. I want to be clear in the way I am supporting this 

and the way I want to have some caveats with it. I think yes, as 

a general matter, that is a very reasonable approach. We would 

want to see exactly what would happen if private capital would 

step up. But I think it is also—the devil is often in the details. 

Senator CORKER. Sure. 

Mr. LEVITIN. And what the standards are is, I think, going to be 

rather tricky. It is one thing if Congress imposes standards. It is 

another thing to have industry develop standards. And one thing 

we saw in the private label securitization market was incredible 

heterogeneity. They did not come up with homogenized products 

because they did not want them, because if you can compare apples 

to apples, you get better competition, and that means smaller margins. 

Senator CORKER. I appreciate it. I got the caveats, and I understand all of us keep those caveats. 

Let me ask one last question. I know my time is short here. 

There is no question that we subsidize the housing industry. Does 

anybody disagree with that? I mean, with the home mortgage deduction and—so here is—I actually spent a lot of my life trying to 

help lower-income citizens own housing as a civic endeavor, not as 

a business. And it seems to me that what we have done with our 

housing policy is we subsidize housing so much that we actually 

drive the price of it up. So, you know, it seems to me that as a social policy in our country, we would rather people have lesser 

amounts of indebtedness than more amounts of indebtedness. But 

what we do with our housing policy by subsidizing housing the way 

we do, we drive the price up; we lower the cost of loans, but we 

drive the loan amount up. And it seems to me that unintentionally, 

you know, with good intentions, we have actually done some pretty 

perverse things in our society as it relates to housing, and that we 

would be so much better off to actually price the risk as it really 

is and to not do what we do in our country by driving up prices. 

I wonder if you all might just comment on that briefly. And, Peter, 

I know you want to say something. 

Mr. WALLISON. I agree, of course. We do that. And, in fact, the 

30-year fixed-rate mortgage is a perfect example of that. We subsidize that mortgage because we think it is a good idea. What it 

does is reduce the monthly payment. The reduction in the monthly 

payment allows people to buy a bigger and more expensive house. 

Eventually, they have less equity in their homes. It is not good polVerDate Nov 24 2008 12:58 Apr 26, 2012 Jkt 048080 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\09-13 HOUSING FINANCE REFORM -- SHOULD THERE BE A GOVER
22 

icy. If a person wants to do it, that should be available. But the 

real cost of it should not be subsidized. 

Senator CORKER. Does anybody disagree with the fact that that 

is exactly what we have done in our country? Nobody disagrees. 

So, Mr. Chairman, I just think as we had one witness talk about 

the fact that those with good credit through the GSEs allow those 

people with bad credit to get loans at the same amount, I think 

that was a pretty interesting comment. 

I think to have people of such huge philosophical differences to 

say what has just been said is something that we should address 

and realize that as a country we have done some really perverse 

things as it relates to housing policy and really caused people to 

have more indebtedness than they otherwise would have. 

Chairman JOHNSON. Senator Merkley. 

Senator MERKLEY. Thank you very much. I am fascinated by this 

conversation because you all study the housing market and mortgages day in and day out, but you reach such dramatically different 

conclusions. 

Mr. Wallison, I think you stated several times that a guarantee 

induces a race to the bottom in terms of the quality of underwriting 

because investors no longer have a reason to be discriminating, if 

you will. Let me just test that against a couple items. 

The first is there was huge private money that was put into private label securities and into subprime pools, and done so by private investors, and yet it was extremely risky, incredibly poorly underwritten. Doesn’t this work against the argument that private investors are studying the quality of the mortgage investments and 

driving, if you will, the quality? 

Mr. WALLISON. Much of that investment was, as we know, rated 

AAA, and as Professor Levitin suggested, that for those buyers may 

have given them the idea that they were not going to be taking 

major credit risk. The problem with a Government guarantee, as 

we all know, is it creates moral hazard, and that means that you 

do not really worry about whether the mortgage that you are buying or the mortgage-backed security that you are buying is going 

to fail. That is the real danger. 

Now, what we know about what happened with the AAA securities, the private label securities, is that they were—when the bubble was growing—it was very easy for someone to look at those securities and say, ‘‘Gee, there are not many defaults going on here. 

These are not as risky as you would imagine subprime mortgages 

would be.’’ And the reason for that, of course, is when a bubble is 

growing, housing prices are going up, and people who cannot afford 

to pay their mortgages can simply refinance or sell the house and 

not suffer any losses. So investors thought they were really getting 

a good deal here—high yields, AAA securities. That is the sort of 

thing that was created by the Government having come in in the 

first place and pumped a lot of money into this bubble. 

Senator MERKLEY. Well, I think the first line of your answer was 

that the investors did not discriminate because they had a AAA 

rating. And indeed that points to a whole different issue and problem that none of you have raised up here on the panel, which is 

that even sophisticated investors used the rating system because 

they cannot get otherwise to the details. Unfortunately, our raters 

23 

could not get to the details either, and there are these terrible stories of individual employees going to their bosses and saying, ‘‘I 

cannot get loan level details, and you are asking me to rate this 

security.’’ And they are saying, ‘‘Well, too bad. This is what you 

have got, and this is how we make our money, and so rate it.’’ And 

we have not really addressed that yet in terms of our efforts on 

housing policy. 

I worry that we may be taking a few of the wrong lessons. My 

colleague has left—Senator Corker. He pointed out we did some 

terrible things. But I think the argument should not be about what 

we did from 2003 through 2008 in terms of the role of mortgages, 

but it should be about the model we had before 2003. In other 

words, before we allowed liar loans, teaser-rate exploding interest 

loans, prepayment penalties to lock people into this—all practices 

that we have now banned here, and it is good that we did ban 

them. They introduced a whole—talk about if you track the predatory practices and you track the influence on the bubble, that 

would have had a huge factor. But really what our argument is, we 

know those things were a mistake. What we should be looking at 

is that period from post-World War II up through 2003 and how 

the mortgage market worked then and keep the baby while we are 

throwing out the bath water, if you will. 

And so in that sense, are we, in fact, pulling the right pieces of 

the debate in terms of trying to design the mortgage market of the 

future? Or are we misusing the period of 2003 when these predatory practices were allowed as really an argument against the previous period? Mr. Levitin. 

Mr. LEVITIN. Sure. You have to ask what changed in 2003, what 

went wrong, and I think we can point at several things, but one 

of the factors that I think certainly deserves some attention is the 

erosion of consumer protection laws. Prior to the 2000s, we actually 

had a fairly robust web of consumer protection laws on the State 

level. You know, they were not standardized, they varied, their application varied, but they still existed. And that put some brakes 

on some of the more aggressive lending tactics. 

One thing that happened was that we had really an aggressive 

campaign of Federal preemption by the Office of the Comptroller 

of the Currency and the Office of Thrift Supervision to preempt the 

State consumer protection laws without substituting any equivalent Federal protections. Preemption makes a lot of sense if you are 

going to have a national standard. But when you preempt without 

having any standard, then you just end up with a regulatory vacuum. That opened the door for really having the race to the bottom. 

As long as those standards were in place across the whole market, 

it limited the ability for the GSEs really to get in and ensure a rate 

war. And I think it is important that we think of the GSEs as insurance companies, and a common problem in insurance regulation 

is that you can get a rate war where insurers start competing for 

market share by charging ever lower premia relative to risk. And 

when that happens, it leaves undercapitalized insurers. 

I just want to turn to one thing that Mr. Wallison said. He raised 

the moral hazard point, which exists in any insurance system, but 

the thing is we know ways to deal with moral hazard, that is, having deductibles and having copayments, the standard things that 

24 

you have on consumer insurance policies. We can have those kinds 

of features on a Government guarantee. But we can only do that 

if it is an explicit guarantee. If it is an implicit guarantee, we do 

not have any protection against moral hazard. If we are worried 

about moral hazard, we really actually have to have an explicit 

guarantee and then try and be smart about how we do it. 

Senator MERKLEY. Explicit guarantee with firm regulatory standards avoids the challenges that Mr. Wallison was speaking to. 

My time is up. I will just mention two things. I cannot ask for 

a response now, but one is we subsidize mortgages in so many different ways, with the home mortgage interest deduction, potentially with downpayment assistance to get people into loans, this 

informal guarantee of securities, and I would be very interested in 

following up afterwards with any data that compares the return on 

the investment in these different forms of subsidies. 

Thank you. 

Chairman JOHNSON. Senator Warner. 

Senator WARNER. Thank you, Mr. Chairman, and I wish I had 

been here for the beginning of the hearing, and I think as Senator 

Corker mentioned, this is a spirited area where we are going to 

have to find some common ground. 

I would concur with the basic notion that I imagine many of my 

colleagues have said. At this point we have got—whatever we think 

about GSEs, the percentage now is too high. How do we do this— 

how do we—whether we completely unwind or partially unwind— 

do it in a way that does not totally disrupt? 

I guess one of the questions I would start with, Dr. Jaffee—and 

it is good to see you again, Peter. We spent a lot of time together 

in discussions on Dodd-Frank. If we look at a nonguarantee system—and then, frankly, I would like to hear everybody on this. 

Some folks have pointed to the European covered bond approach. 

But aren’t we frankly seeing, somewhat to Professor Levitin’s position, that while there is no formal guarantee in the covered bond 

approach, you have this implicit guarantee with these large financial institutions that become too large to fail so you are back into 

a quasi-Government guarantee, whether explicit or implicit? 

Mr. JAFFEE. Well, I am very pleased you asked that because I 

was hoping to have an opportunity to indicate how much I disagree 

with Professor Levitin’s position on that. I believe there is no evidence of any implicit guarantees or bailouts of any European banks 

relating to their covered bond issues. Those bonds are all rated 

AAA. They have been rated AAA from the day they were issued. 

I know of no down-rating of any of them. 

At the key point of the crisis, there was a temporary liquidity 

blip where some investors simply got worried, and so the spreads 

on these bonds are typically 20 basis points above the sovereign 

debt of those countries. I suspect today they are below the sovereign debt of some of those countries. But those 20 basis points 

blipped up to 75 basis points. Not a huge amount. The European 

central bank said this is wrong, the bonds are completely safe. 

They bought a few of them, and the spreads went right back down 

to the 20 basis points. 

The system worked with very safe mortgages, and the whole system agrees on that. The borrowers understand that you have to 

25 

have downpayments, you have to have the income, and you cannot 

expect to default. It is not a system in which you hand off the key 

if the prices do not go your way. The bankers understand that they 

are going to be the—they are going to be holding these bonds on 

their balance sheet, but issuing them with covered bonds, with 

dedicated debt. And the Government understands that the system 

is going to work because they do not want the costs of foreclosure 

and default as we have just faced here. And the system does work. 

It has worked perfectly throughout this period, and I know of no 

problems. 

The problem here in the United States, I will just quickly say, 

is that agencies like the FDIC have stood in the way of American 

banks creating these, and the FDIC’s position is if we get a bank 

in trouble, we do not want them to have issued a lot of covered 

bonds because the mortgage assets are then dedicated to those 

bond holders, and we, the FDIC, think that is going to make our 

life tougher. That assumes that those mortgages would have been 

there in any case. That is not what happens in Europe. The mortgages that we securitize are actually held on the balance sheet. 

They are very safe, and the covered bond system works. And I hope 

we move—— 

Senator WARNER. Thank you. Other comments on this, please? 

Yes, everybody, if we could. 

Mr. WALLISON. Well, I will just make a comment. 

Senator WARNER. Relatively quickly, because I would love to get 

in one more question before my time is up. 

Mr. WALLISON. I have heard the same argument that you made, 

Senator, and I do think it is a significant argument in the sense 

that if the largest banks in the United States are implicitly guaranteed in some way, then you might be creating a system with covered bonds that, in fact, results in some sort of Government backing. 

However, the securitization system in the United States does not 

involve that, and one of the really interesting and valuable things 

about the securitization system is that anyone can participate. You 

do not need a lot of capital to do it. So the small banks can participate in securitizations as well as the large banks, and they do not 

have to sell to the large banks. They can also form cooperatives of 

their own in order to take advantage of the high-quality mortgages 

that they are creating. 

So this is a complicated issue, and I would love to spend some 

further time on it. 

Senator WARNER. Please. 

Mr. LEVITIN. Very briefly, I just want to respond to what Professor Jaffee said. If you look at page 8 of my written testimony, 

I detail what happened in Germany and what happened in Denmark where the implicit guarantee actually became explicit, that 

Germany and Denmark both guaranteed the liabilities of some of 

their covered bond issuers. And in Denmark, yes, it was—— 

Senator WARNER. That was at the beginning of the crisis, wasn’t 

it? 

Mr. LEVITIN. That was in October 2008. And you can say, well, 

that was just a response to liquidity. Well, whatever it was, it 

showed that the Government would intervene to hold up this marVerDate Nov 24 2008 12:58 Apr 26, 2012 Jkt 048080 PO 00000 Frm 00029 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\09-13 HOUSING FINANCE REFORM -- SHOULD THERE BE A GOVER
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ket, whether because of credit risk or liquidity. Now, it may be a 

guarantee only for catastrophic risk, but that is a guarantee right 

there. And, you know, in Denmark, it was not formally a guarantee 

of the covered bonds. It was a guarantee of the issuers. But because there is recourse to the issuers, that means that it functions 

as a guarantee of the covered bonds. 

Mr. GREEN. To some extent I was going to say what Professor 

Levitin just said, but the other point is that Germany and Denmark are heavily regulated mortgage markets, and, you know, Government intervention could take many forms, and one of them in 

that if the Government says you may only do mortgages that have 

certain features to them, I would call that pretty serious Government intervention. So the idea that there is a mortgage market 

that does not have Government involvement is a statement I have 

a problem with. 

The other thing is the Danish mortgage bonds have a feature 

that is very friendly to consumers, and I think it is worth thinking 

about. But, again, it means that the default rates are going to be 

low, which is that consumers can basically buy their mortgage back 

at the market value of the mortgage at any time. That is one of 

the attractive things about it. 

In the U.S. context, what that would mean is if you are in Corona, California, where house prices have fallen 70 percent and the 

market judges that, therefore, your mortgage’s value is only worth 

30 percent of the par value, you as the borrower can buy it back 

and sell your house and actually be at least at water if not above 

water. And that is an attractive feature, but that is a very consumer-friendly feature that, again, is the result of Government decisions about how these things were designed. 

Senator WARNER. Thank you, Mr. Chairman. The only thing I 

would just ask, I hope as we explore this area—and I know today 

was about Government guarantees, and I would look forward to 

kind of continuing and trying to get educated on this. I would love 

to see us look not only at the European model, but I would also 

like us to see what has become an article of faith and something 

I would like to make sure there is still a product in terms of a 30- 

year loan. I do think there are a lot of lessons that we can learn 

from our neighbors to the north in Canada where we did not have 

the kind of expectation around the Canadian market, the pricing 

around mortgages, the motion more that they were 15-year rather 

than 30-year. I really hope we will kind of get a chance to dig into 

all these things because I do think, whether we like it or not, this 

crisis’ overhang continues to be with us. I do not think we have 

sorted through it well, and I think we ought to look at all the options on the table. Thank you for giving me this question. 

Chairman JOHNSON. Senator Vitter. 

Senator VITTER. Thank you, Mr. Chairman, and thanks to all of 

our witnesses. 

Let me ask you all this question: It seems to me in the last decade the implicit guarantee by Fannie and Freddie was certainly 

closely related, a major or a significant cause of the decline in underwriting standards. They are not a coincidence, I do not think. 

If that is the case, how would we move to an explicit guarantee and 

27 

somehow move in the opposite direction regarding real underwriting standards? That seems pretty uphill, pretty unnatural. 

Mr. GREEN. Sure, well, I think it is worth thinking about how 

Fannie and Freddie behaved, again, before the crisis. If you look 

at how they did underwriting through, let us just say, the late 

1990s, it was pretty robust underwriting. They had models that related FICO score, loan-to-value ratio, income, reserves, time in job, 

et cetera, to default probability. And they came up with cutoffs as 

a result of that, and they stuck to that quite well for a very long 

period through their existence. 

I think there was a long period of time when they had the implicit guarantee where they had robust underwriting. 

What seemed to happen is roughly in 2003 or 2004 they were losing market share to the private market. If you look at Federal flow 

of funds reports, this is pretty clear. And shareholders were 

screaming, and this is the problem, and so they followed the market in in having their underwriting standards deteriorate. 

But that said, one of the mechanisms they used was buying AAA 

tranches of subprime mortgages, and they should not have done 

that, and somebody should have stopped them from doing that. 

But, on the other hand, there was also somebody buying lower 

tranches of these things as well, and these somebodies were people 

like Lehman Brothers. And there was an understanding—you 

know, I think Professor Jaffee is correct, that we said, OK, you 

make these risky bets and you lose and you are done, OK. But 

after Lehman Brothers collapsed, what we had is other investors 

in these lower tranched securities, and we did not let them fail because we decided the systemic risk for doing so would be too great. 

So I think to pin it all on the implicit guarantee is very difficult 

because we went for so many years having it with pretty good underwriting. 

Mr. WALLISON. Let me contradict what I just heard because it is 

not true at all that their underwriting was good, after 1992, especially after the affordable housing requirements were imposed on 

them. If you look at the data, you can see Fannie Mae and Freddie 

Mac were buying subprime and other low-quality loans right 

through the 1990s, and by the year 2000, in fact, Fannie Mae was 

offering a no-downpayment loan. Large proportions of their loans 

were 3-percent downpayment or less. In other words, they were already the cause of the decline in underwriting standards, and that 

eventually infected the private markets. But in the end, we had 27 

million subprime or other low-quality loans in our financial system; 

that was half of all mortgages and two-thirds of those weak mortgages were on the books of Fannie Mae and Freddie Mac and other 

Government agencies, all of which, of course, were backed by the 

Government. 

So it is a very important relationship that you have pointed out 

between a Government guarantee and poor-quality mortgages because the investors in those mortgages do not care about the quality of the mortgages as long as they have a Government guarantee. 

Senator VITTER. And before the rest answer, let me just insert, 

I think another factor is the CRA-type mandate Congress has put 

out there, which also has not changed. So I am just wondering how 

we do not change that mandate, we move from implicit guarantee 

28 

to explicit guarantee, and all of a sudden we expect underwriting 

standards to move in the opposite direction. It does not strike me 

as very natural. 

Dr. Jaffee. 

Mr. JAFFEE. Yes, well, that is exactly what I would have wanted 

to say. I think it is inevitable that a switch to a Government guarantee program is going to lead to lower underwriting standards. I 

mean, the proposals that are available publicly now usually start 

off with the right words. They say, ‘‘These are going to be prime 

mortgages, 20-percent downpayment, very suitable income-to-debt 

ratios.’’ And, of course, then you could ask the question: Well, if 

they are so good, why do we need a Government guarantee at all? 

But the true answer—and if you now look in the details of these 

proposals—is, well, no, we are also going to have a 10-percent 

downpayment loan, and we will have a 5-percent downpayment 

loan, but we are going to charge actuarial premiums. Well, that is 

going to last for 2 minutes because as soon as the borrowers say, 

‘‘Well, wait a minute. This is a Government program, and I only 

have 10 percent down, and you are telling me that I have to pay 

more on my mortgage than my fat cat friend. No way.’’ In all of 

the experience—I mean, the National Flood Insurance Program is 

a classic example. Congress passed legislation that on the surface 

of the words was perfect. There would be risk-based premiums, it 

would be self-funding, all the right things. And what do you discover? As soon as there is a big flood, Katrina, they are $20 billion 

in the hole, and what you discover is the premiums that—the agency now admits the premiums were half of what they should have 

been. They had just the opposite of risk-based premiums. They actually gave benefits to people that had the most risk because they 

lived on the Mississippi River. And I believe it is inevitable that 

that is going to happen again. 

Mr. LEVITIN. First, I would disagree about the statement that the 

implicit guarantee was causing the underwriting decline. The market leader in weak underwriting was the nonguaranteed private 

label securitization market. Now, Mr. Wallison points out that the 

GSEs were buying what he calls ‘‘weak loans.’’ I think we need to 

be careful about exactly what we are calling weak loans because 

not every weak loan is the same. My understanding of how Mr. 

Wallison kind of reaches his figure is he is looking at loans that 

lack some—let us say loan-to-value ratio, documentation, FICO 

score, or some category like that, do not look like a perfect prime 

loan. That is perfectly fine if he wants to count them that way. But 

there is a difference between a loan that has, you know, a low LTV 

and a high FICO score and limited documentation and a loan that 

has high LTV, low FICO score, and limited documentation. Three 

dings is much worse than one ding. And the GSEs were not buying 

the three-ding loans. They were buying the one-ding loans. So 

those were the three-ding loans, and that is where we really saw 

the market go off the cliff. That was in the private label 

securitization market. 

Two other comments. I think it is important that we remember 

the example of the FHA. There are plenty of problems with FHA 

and how it is run, but FHA has an explicit guarantee, it prices for 

it—not perfectly—but, you know, that market has not tanked. And 

29 

FHA ceded market share because it did not have private shareholders trying to get in competing for market share. That is what 

saved FHA. 

Finally, on the Community Reinvestment Act, there is a Federal 

Reserve study about the impact of the Community Reinvestment 

Act on mortgage lending. I think it is probably the best thing out 

there on this. And what it shows is pretty clearly the most aggressive lenders were either not subject to the CRA or the aggressive 

loans they were making were not—they were not getting CRA credit for them because they were making them outside of their CRA 

assessment area. 

So, you know, I think it is a little difficult to pin the blame on 

the CRA for the excesses of the private label securitization market 

in particular. 

Senator SHELBY. Mr. Chairman. 

Chairman JOHNSON. Senator Shelby has a closing observation. 

Senator SHELBY. Thank you, Mr. Chairman. 

First of all, Professor, it is my understanding that the Congressional Budget Office’s recent estimates show that when market 

risks are incorporated, FHA guarantees are underpriced by almost 

$8 billion, for the record. 

Now, where are we today? I think this has been a good hearing, 

Mr. Chairman. I think that we have got some different voices here, 

which we need. What is all this about and where are we? We have 

got a horror movie. And what is a horror movie? It is the GSEs, 

it is sitting in the lap of the taxpayers and growing. By conservative estimates, I understand, the taxpayers are going to eat a 

third of a trillion dollar, maybe a half a trillion dollars. Are we 

going to repeat this again? Are we going down that same road? 

Have we learned anything? I do not know. You know, I think this 

is a healthy discussion. I hope we have. But the CRA—I want to 

pick up on Senator Vitter. I tried to repeal the CRA right here in 

this Committee, because what we are doing, we are telling the 

market to make these loans for political reasons. Loans should be 

made on risk. I mean, it is nice to have a home. You know, we 

pushed the home ownership to the limit. We pushed the deal 

where, oh, they had equity in their home because prices were rising 

and they were borrowing second mortgages on this, home equity 

loans. It helped the economy temporarily. 

So we got that horror movie where we are, and I hope we will 

not repeat it. Is it going to be tough political answers? I do not see 

any quick answer to this. But I hope we do not go down that same 

road. God, I hope and pray. 

Thank you, Mr. Chairman. 

Chairman JOHNSON. Before I close, I would like to correct a 

statement made early in this hearing. Congress did not appropriate 

$20 billion to the Flood Insurance Program. This may be the confusion of the Flood Insurance Program with the supplemental appropriations for FEMA. 

I would like to thank the witnesses for joining us today. This 

issue of the Government guarantee is one that will continue to 

weave itself into all our discussions about the future of the housing 

finance system. It is clear that our priorities for market access, liVerDate Nov 24 2008 12:58 Apr 26, 2012 Jkt 048080 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\09-13 HOUSING FINANCE REFORM -- SHOULD THERE BE A GOVER
30 

quidity levels, and the types of mortgage products available will 

help our options going forward. 

The hearing record will remain open for 7 days if Senators would 

like to submit statements or additional questions for the record. 

This hearing is adjourned. 

[Whereupon, at 11:37 a.m., the hearing was adjourned.] 

[Prepared statements and additional material supplied for the 

record follow:] 

31 

1 Ron Chernow, Alexander Hamilton, The Penguin Press: New York. Ch. 16. 

PREPARED STATEMENT OF RICHARD K. GREEN 

DIRECTOR AND CHAIR, USC LUSK CENTER FOR REAL ESTATE, UNIVERSITY OF

SOUTHERN CALIFORNIA

SEPTEMBER 13, 2011 

Chairman Johnson and Senator Shelby, thank you for allowing me to be part of 

this distinguished panel today. My name is Richard Green, and I am the Lusk Chair 

in Real Estate and the Director of the Lusk Center for Real Estate at the University 

of Southern California, where I am also Professor of Policy, Planning and Development and Professor of Finance and Business Economics. 

As you know, I have been asked to discuss whether the U.S. mortgage market 

requires a Federal guarantee in order to best serve consumers, investors and markets. I will divide my remarks into four areas: 

(1) I will argue that the United States has had a history of providing guarantees, 

either implicit or explicit, regardless of its professed position on the matter. This 

phenomenon goes back to the origins of the republic. It is in the best interest of 

the country to acknowledge the existence of such guarantees, and to price them appropriately before, rather than after, they become necessary. 

(2) I will argue that in times of economic stress, such as now, the absence of Government guarantees would lead to an absence of mortgages. 

(3) I will argue that a purely ‘‘private’’ market would likely not provide a 30-year 

fixed-rate prepayable mortgage. I think this is no longer a particularly controversial 

statement; what is more controversial is whether such a mortgage is necessary— 

I will argue that it is. 

(4) I will argue that in the absence of a Federal guarantee, the price and quantity 

of mortgages will vary across geography. In particular, rural areas will have less 

access to mortgage credit that urban areas, central cities will have less access than 

suburbs. Condominiums already are treated less favorably than detached houses, 

and this difference is likely to get larger in the absence of a guarantee. 

Before discussing the substance of my remarks, I should make some disclosures. 

First, I worked as a Principal Economist and then Director of Policy Strategy for 

Freddie Mac between September of 2002 and January of 2004. Part of my compensation for that work was restricted shares in the company. I never sold my 

shares in Freddie Mac, and I have no expectation of ever seeing them have material 

value. I think it appropriate that common shareholders were substantially wiped 

out by the Government conservatorship of the company. Second, I have performed 

research with two Fannie Mae employees, Eric Rosenblatt and Vincent Yun, for an 

academic paper. The only compensation I received for this was intellectual satisfaction. Finally, when the Fannie Mae Foundation was publishing Housing Policy Debate, I received compensation for reviews I wrote for the publication. 

I. The United States Has a Long History of Providing Ex Post (After the 

Fact) Guarantees, As Well As Other Guarantees 

One could reasonably argue that the United States was born from a bailout. One 

of the most famous compromises in U.S. history was a deal negotiated among Hamilton, Jefferson, and Madison for the new Federal Government of the United States 

to assume the Revolutionary War Debts of the Continental Army and the individual 

States. While Jefferson would later write that he regretted the compromise (probably because he saw Virginia as a net loser on the deal), it helped bind the States 

together. Moreover, because of Hamilton’s financial acumen, Assumption probably 

allowed States and the Continental Army to pay less in interest costs than they otherwise might, and so allowed the country to begin on a strong financial footing. 1

The Transcontinental Railroad also received financing at least in part because of 

Government guarantees (as well as direct subsidies). While the railroads were built 

by private companies (the Central Pacific and the Union Pacific), capital costs were 

financed by bonds that were explicitly backed by the Federal Government. While the 

backing was explicit, the equity investors in the railroads were not required to pay 

guarantee fees; profits were privatized while risk was socialized. In the end, the 

shareholders of both railroads lost their investments, but somehow the managers, 

including Coliss P. Huntington and Charles Francis Adams, obtained and retained 

great wealth. 

More recently, of course, we have had many ‘‘private’’ institutions receive Federal 

backing, including commercial banks (who benefited from the Troubled Asset Relief 

32 

2Franco Modigliani and Merton Miller’s eponymous and famous theorem predicts that the 

total cost of capital to a firm should be invariant to capital structure. F. Modigliani and M. Miller (1958) ‘‘The Cost of Capital, Corporation Finance and the Theory of Investment’’, American 

Economic Review 48(3): 261–297. 3 Ben S. Bernanke, ‘‘Nonmonetary Effects of the Financial Crisis on the Propagation of the 

Great Depression’’ (1983). American Economic Review, 73(3): 257–276. 4 Jin Son and Keun Lee (2010), ‘‘Financial Crisis and Asset Market Instability in the 1930s 

and 2000s: Flow of Funds Analysis’’. http://apebhconference.files.wordpress.com/2009/08/sonn-lee.pdf 5 Raymond W. Goldmith (1955), A Study of Savings in the United States. Princeton University 

Press: Princeton. 

Program (TARP) as well as the Federal Deposit Insurance Corporation (FDIC)), the 

‘‘purely private’’ investment banks (who benefited from TARP), issuers of Asset 

Backed Securities (who benefited from the Term Asset Backed Securities Loan Facility (TALF)) and, of course, the Government Sponsored Enterprises. While one 

might argue that the GSEs have received more largess than the other private institutions, the fact is the Federal Government has shown, again, that it will intervene 

when large, systemically dangerous institutions are on the verge of collapse. 

Furthermore, we still don’t know the full extent of Government largess, because 

we don’t yet know the potential cost of off-balance sheet assets that commercial 

banks may be forced to repurchase because of alleged misrepresentations. 

In light of the fact the Federal Government cannot credibly commit to no-bailout 

policies (after all, TARP was the creation of a Republican administration), no matter 

what one thinks about the principle of Government guarantees, as a practical matter it makes sense to recognize them explicitly and to price them. 

Recent evidence suggests that neither the public nor private sectors is particularly 

good at pricing risk (although the FHA program, which has performed remarkably 

well through the crisis, might be an exception). The Government should thus begin 

by pricing risk cautiously; perhaps more important, it should require institutions 

that might benefit from guarantees to hold capital. While market participants fear 

that higher capital requirements would raise costs to consumers, (1) such costs may 

be appropriate and (2) they may be actually be small. As financial institutions become less levered, their required return on equity should fall. 2 Indeed, because 

bankruptcy is costly, a policy that reduces the probability of bankruptcy, such as 

strong capital standards, could actually lower the total cost of capital for lenders. 

As we unfortunately know too well now, though, measuring capital is difficult, so 

guaranteed mortgage finance in future should require both fees and robust capital 

standards. 

II. In Times of Economic Stress, Debt Markets Do not Operate in the Absence of Government Guarantees 

Beginning with the Great Depression, the United States has faced at least four 

periods when private debt markets largely shut down—liquidity was so absent that 

spreads were not only wide, they were impossible to measure owing to the absence 

of transactions: the Great Depression; the double-dip recession of 1979–81; the 

Long-Term-Capital financial crisis; and the Great Recession of 2008–09. 

In the aftermath of the banking crisis of 1930–33, mortgage lending shut down. 

As Ben Bernanke wrote in his classic paper 3: 

because markets for financial claims are incomplete, intermediation between some classes of borrowers and lenders requires nontrivial marketmaking and information gathering services. The disruptions of 1930–1933 

(as I shall try to show) reduced the effectiveness of the financial sector as 

a whole in performing these services. 

In other words, the banking crisis was principally a liquidity crisis; lenders had 

a reluctance to make even good loans to each other. The passage also underscores 

the more ubiquitous problem with financial institutions: they are rife with incomplete markets. Even in the absence of Government guarantees, financial institutions 

have principal-agent problems, adverse selection problems, lemons problems, and 

pooling problems. 

The Hoover administration created the Federal Home Loan Bank System and the 

Roosevelt administration created the Federal Housing Administration, the Federal 

Deposit Insurance Corporation, the Home Owners Loan Corporation and, later, the 

Federal National Mortgage Association to restore liquidity. 

And restore liquidity they did. Figure 13 in Son and Lee 4 (which graphs data 

from Goldsmith 1955 5) shows the sharp drop in liquidity between 1930 and 1933, 

and how it is restored in 1934. The Federal Home Loan Bank system was established in 1932, FDIC in 1933 and the Federal Housing Administration in 1934. 

33 

6See, Flow of Funds Accounts of the United States, Table F.1, line 40. 

While one does not want to make post-hoc ergo prompter-hoc arguments, one could 

argue that the new Federal Institutions allowed for the possibility of price discovery, 

which in turn brought about some restoration of liquidity. 

More recently, the double-dip recession of 1979–1981 led to a diminution of liquidity in the mortgage market. Between 1977 and 1982, net lending from savings institutions, the primary source of mortgage finance, dropped by 67 percent. 6 At about 

this time, and not coincidentally, Government Sponsored Enterprise lending expanded by a factor by 3. GSE-backed Mortgage Backed Security lending quadrupled 

during this time, and GSE portfolio lending more than doubled. Both Savings and 

Loans and Fannie Mae were technically insolvent over this period, but the Federal 

Government exercised forbearance, which could be looked at as a whispered guarantee. 

We should note that mortgage institutions were troubled less by credit risk than 

interest rate risk: Savings and Loans as well as Fannie Mae had long-term mortgages on their balance sheets; they funded these mortgages with short-term debt. 

The yield curve between 1979 and 1981 was highly inverted (in fact, short term 

rates were higher than long-term mortgages by an unprecedented amount). One 

might take the view that while financial institutions have control of credit risk, they 

have no control over the short-term interest rate set by the Federal Reserve System. 

In any event, investors were apparently more comfortable with Freddie Mac and 

Fannie Mae’s credit risk guarantees than depositors were with Savings and Loans. 

Most dramatic was the Long-Term Capital Management Crisis, which was something of a rehearsal for the most recent crisis. When conduits for commercial mortgages shut down, Fannie Mae and Freddie Mac continued to lend. Anthony Sanders 

(no fan of GSEs) shows in a graph that the spread between Jumbo and Conforming 

Mortgage widened from 10 to 40 basis points in the aftermath of the Long-term 

Capital Financial Crisis. 

Of course, in the current environment, the Government sponsored enterprises, 

which are wards of the State, are the dominant sources of mortgage lending. It is 

frightening to think where housing markets, already at their weakest point since 

the Great Depression, would be in the absence of the GSEs. While one might argue 

that the lack of other lending arises from a private sector being crowding out by 

the public sector, the segments of the housing market which are not eligible for GSE 

34 

purchases have very nearly shut down. According to Inside Mortgage Finance, the 

prime jumbo mortgage originations have dropped by more than 5⁄6 since the peak, 

and in 2010 were at about 1⁄3 the level of any year before 2008. 

Home equity lines of credit, which are an important mechanism for the elderly 

to use housing wealth to smooth consumption, have seen similarly dramatic drops. 

35 

7Thanks to Tsur Somerville of the University of British Columbia for making this point to 

me about Canadian mortgages. 8See, http://www.americanprogress.org/issues/2010/11/housinglreform.html. 

III. The 30-Year Fixed-Rate Mortgage Might Go Away in the Absence of 

Government Guarantees 

There are two issues here: whether the U.S. long-term self-amortizing mortgage 

requires some sort of Government support, and whether it is important. 

Counterfactuals are impossible to prove, but we do have some evidence that the 

GSEs mattered to making the long-term mortgage common. While such loans existed before the Home Owners Loan Corporate made them the standard instrument 

in the United States, they were not common. Moreover, as we look at other countries, we find that long-term fixed-rate prepayable mortgages are rare. So far as I 

can tell, Denmark is the only other country that has such mortgages, and while that 

market appears ‘‘private,’’ it has heavily regulated, specialized institutions that 

issue that bonds that fund mortgages. When these institutions faced problems in 

2009, the Danish government injected liquidity into them. And while there is much 

to praise about the Canadian mortgage systems, it too has Government involvement 

(most low-downpayment loans are supported by Government mortgage insurance) 

and is vulnerable to a particular type of risk: borrowers must roll over their debt 

every 5 years or so. 7 The current state of the commercial real estate Market underscores that maturity defaults—defaults that arise because borrowers cannot roll 

over debt when capital markets are troubled—are just as bedeviling as payment defaults. 

David Min has a nice explanation of why the 30-year mortgage is good for con- sumers 8: 

There are three major arguments in favor of continuing to emphasize the 

30-year fixed-rate loan in the United States: 

• First, the 30-year fixed-rate mortgage provides cost certainty to borrowers, 

which means they default far less on these loans than for other products, particularly during periods of high interest rate volatility. 

• Second, the 30-year fixed-rate mortgage leads to greater stability in the financial markets because it places the interest rate risk with more sophisticated financial institutions and investors who can plan for and hedge against interest 

36 

9See, Brent Ambrose and Richard Buttimer (2005), ‘‘GSE Impact on Rural Mortgage Markets’’, Regional Science and Urban Economics, 35(4): 417–443. 10See, W. Lang and L. Nakamura (1993), ‘‘A Model of Redlining’’, Journal of Urban Economics, 33(2): 223–234. 

rate fluctuations, rather than with unsophisticated households who have no 

such capacity to deal with this risk and who are already saddled with an enormous amount of financial burden and economic uncertainty. 

• Third, the 30-year fixed-rate mortgage leads to greater stability in the economy 

because short-term mortgages are much more sensitive to interest rate fluctuations and thus much more likely to trigger a bubble-bust cycle in the housing 

markets. Indeed, there may be reason to believe that a primary cause of the 

recent housing bubble-and-bust cycle was the rapid growth of short-duration 

mortgages during the 2000s, which caused U.S. home prices to become more 

sensitive to the low interest rate environment created by Alan Greenspan’s Federal Reserve. 

I would add that the prepayable 30-year mortgage allows households to duration 

match assets and liabilities. Most households have two principal assets—their house 

and their human capital. Houses are long-term capital assets—and as such their 

values are sensitive to real interest rates. The 30-year mortgage allows households 

to hedge interest rate risk. This hedge isn’t free—long-term interest rates are usually higher than short-term rates for a reason. But having the option of the hedge 

helps household mitigate risk. 

On the other hand, the ability to freely repay a mortgage allows households to 

be mobile. If one needs to move from one State to another to take a new job, free 

prepayment reduces the cost of such a move. Once again, this option is not free— 

investors need to be compensated for the risk they take—but it helps households 

better manage risk. 

We at business schools teach the importance of hedging duration risk. It is no less 

important for households than it is for financial institutions. The 30-year fixed-rate 

prepayable mortgage is the instrument that allows households to do so. 

IV. In the Absence of a Guarantee, We Would Observe Differences in the 

Price and Availability of Mortgage Credit Across Communities 

Some housing markets have many fewer transactions than others. It can be difficult to infer house prices, and therefore to assess mortgage risk in these markets. 

Brent Ambrose and Richard Buttimer 9 write about how rural markets, where 

houses trade infrequently, might be ill-served in the absence of a guarantee: 

our analysis confirm[s] that the conforming rural market is closely tied to 

the conforming urban market, while the jumbo rural market is less closely 

tied to the jumbo urban market. We interpret this as evidence that GSE 

involvement in the rural market, while a relatively small portion of the 

overall GSE business, is, nevertheless, serving to provide rural conforming 

mortgage borrowers with improved access to credit, especially when compared to rural jumbo borrowers. 

The problem rural markets face applies to central urban markets as well. Lang 

and Nakamura show how thin markets in urban centers make valuation more difficult and undermine liquidity in the lending market 10

A ruthless economist might argue that this simply means that rural areas and 

central cities are obsolete places that ‘‘deserve’’ their second class status for borrowing or lending. But when lending is underprovided because of information problems, resources are being wasted, and a well-tuned policy that allows for lending 

on favorable terms can provide a more efficient outcome than the market alone. 

There are times, moreover, when even the most attractive neighborhoods for lending find themselves without easy access to credit. We find ourselves at this such a 

time right now. Even though lenders are advertising jumbo mortgages, borrowers 

are currently finding it very difficult to obtain one. 

To begin, the process is long—loan approvals are taking as long as 4 months, 

which essentially eliminates a spot market in housing. Second, as with the case of 

rural and inner-city markets, appraisals are an impediment to lending, because the 

thinness of markets is making it difficult to determine appraised values. Third, the 

underwriting standards have swung from being too lenient to being considerably 

harsher than they were in the 1990s or even the late 1980s, which, based on performance, was a period in which underwriting was strong. For example, lenders are 

often looking for reserves equal to 10 percent of the value of the house along with 

a 20 percent downpayment. 

37 

11P. Linneman and S. Wachter (1989), ‘‘The Impacts of Borrowing Constraints on Home Ownership’’, AREUEA Journal 17, 389–402. 12See, Dwight Jaffe (2010), ‘‘Reforming the U.S. Mortgage Market Through Private Incentives’’, http://research.stlouisfed.org/conferences/gse/Jaffee.pdf. 13The Government itself discriminated against certain neighborhoods based on racial characteristics for many years. The Home Owners Loan Corporation and the Federal Housing Administration had maps that green-lined neighborhoods that were considered desirable and red-lined 

those that were not. Neighborhood ‘‘desirability’’ was determined in part by its ethnic and racial 

make-up. In a recent law review article, Thomas Mitchell, Stephen Malpezzi, and I (‘‘Forced Sale 

Risk: Class, Race, and the ‘Double Discount’ ’’, Florida State University Law Review, Vol. 37: 

589-68 (2010)) moreover found that many African Americans had their home equity stripped 

through partition sales and sheriff’s sales. 14See, http://www.aei.org/article/23974. 

Perhaps such underwriting standards would be fine, were it not for the fact that 

they would prevent a substantial number of households from obtaining mortgage 

credit. As Peter Linneman and Susan Wachter 11 showed many years ago, the largest impediment to obtaining credit is not so much the ability to make monthly payments as it is to obtain a downpayment. 

Professor Jaffee has argued that other countries (including Canada, Australia, 

and many European Countries) have home ownership rates as high as the United 

States despite having more onerous terms for borrowers, and that therefore the 

United States need not worry about making mortgage funds more difficult to obtain. 12

The problem with this line of reasoning is that the income and wealth distributions in these countries are substantially more even than in the U.S. For example, 

according to the OECD, the top half of the income distribution in the U.S. has higher income than all but two other countries (the Netherlands and Luxembourg), the 

bottom quintiles income ranks 19th. The wealth distribution in the U.S. is even 

more skewed than the income distribution. 

If these differences in wealth and income reflected differences in effort and talent, 

this would not be a source of concern, at least to me personally. But we know that 

intergenerational wealth is an important determinant of the income distribution, 

and we are a country where for many generations not all of us had equal access 

to capital. 

According to the Federal Reserve’s Survey of Consumer Finances, median wealth 

among non-Hispanic white families was $171,000 in 2007; among nonwhite and Hispanic families it was $28,000. It is not a coincidence that the home ownership rate 

for white households is more than 20 percentage points higher than for the remainder of the country—easier access to mortgage credit over the years allowed white 

Americans to build wealth more easily than nonwhite and Hispanic Americans. 13

Differences in wealth—particularly home-owning wealth—from past generations 

had an impact on successor generations. Dalton Conley has used Panel Survey of 

Income Dynamics Data to show that the probability of a child attending college can 

be largely predicted by two things: whether her parents went to colleges, and whether her parents had home equity. 

It is doubtful that the private market on its own can redress this inequality of 

wealth that arises not because of differences in effort across people, but because of 

differences in how previous generations were treated. 

There are those who argue that it was the attempt to advance mortgage credit 

to minorities that led to our current condition—I do not accept that argument. The 

loans that have performed most poorly were originated by institutions that were not 

covered by the Community Reinvestment Act or the Affordable Housing Goals. 

Moreover, as Mr. Wallison 14 himself once noted, Fannie Mae and Freddie Mac did 

not do a good job of advancing credit to minorities or low-income neighborhoods. 

While this is to their discredit, it undermines that argument that their troubles 

arose because they made too many loans to underserved borrowers. 

Indeed, part of the problem is that institutions that received no guarantee made 

no effort to assure their loans were suitable, and often steered borrowers away from 

vanilla 30-year fixed-rate products toward more dangerous products that were 

larded with fees. These were more profitable in the short-term, but exploded in the 

slightly longer-term. Such recent past behavior does not support the conclusion that 

Government guaranteed loans are more menacing than those produced in the purely 

‘‘private’’ sector. 

38 

* The views expressed in this testimony are those of the author alone and do not necessarily 

represent those of the American Enterprise Institute. 1 Alex J. Pollock, ‘‘The Government’s Four-Decade Financial Experiment’’, The American.com, 

July 13, 2011, http://www.american.com/archive/2011/july/the-government2019s-four-decadefinancial-experiment. 

PREPARED STATEMENT OF PETER J. WALLISON 

ARTHUR F. BURNS FELLOW IN FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE

INSTITUTE

SEPTEMBER 13, 2011 

This testimony is in three parts.* First, I address a Government guarantee for 

housing finance in the context of its adverse effects on the U.S. debt picture, on U.S. 

taxpayers, and on the overall health of the U.S. economy. In the second section, I 

address the arguments that are generally made in support of a Government-backed 

system and show that they are without merit. In the third section, I briefly discuss 

how a fully private system for housing finance should be structured. 

I. Problems Associated With a Government Guarantee of the Housing Finance Market Effect on U.S. Debt 

Although the Government’s overall debt position is not an issue that is usually 

part of the debate on housing finance policy, the fiscal position of the United States 

has deteriorated so seriously in recent years that the question whether to increase 

the national debt in order to support the U.S. housing market has now become highly germane. 

The CBO recently estimated—even after the recent debt extension agreement— that if current policies are pursued the national debt will balloon from $14.3 trillion 

today to $23 trillion in 2021. Virtually all proposals for U.S. Government assistance 

to the housing finance market assume that it will involve an explicit Government 

guarantee, but even if this guarantee is only implicit—as it was with the Government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—it will make no 

significant difference except in the budget numbers. As my AEI colleague Alex Pollock has pointed out, 1 the off-budget debt of the various Government agencies—pri- marily Fannie Mae and Freddie Mac—currently totals $7.5 trillion, but the bailout 

of Fannie and Freddie proved beyond question that this debt is every bit a part of 

the Nation’s debt as the securities are issued by the Treasury. 

So, without any change in policies and without any further increase in the GSEs’ debt, the national debt will reach $30 trillion in 10 years. With this background, 

it is hard to believe that there is actually a viable campaign to have the Government support the housing market once again. At a time when Congress is having 

great difficulty trying to reduce the debt by finding places where spending can be 

cut, it is astonishing that some in the private sector can appear before Congress to 

ask for yet more debt in support of the housing market, a sector of the economy 

that could function perfectly well without any Government backing. 

Accordingly, in considering whether the Government should back housing finance, 

the first consideration this Committee should have in mind is whether it would be 

good policy at this time to add to the U.S. Government’s financial obligations. 

Effect on the Taxpayers 

There is no doubt that this campaign for Government backing, if successful, will 

benefit certain groups—primarily the ones who are doing the campaigning. However, there is one group—U.S. taxpayers—who never seem to get a second thought 

when these campaigns are run. Nevertheless, it is the taxpayers who inevitably 

have to bear the burden of the subsidies that the Government hands out through 

its support for housing finance. 

The history here is consistent; the taxpayers are always left holding the bag. 

There’s an explanation for this: the Government is never fully compensated for its 

risks. In the 1930s, for example, Congress set up the Federal savings and loan system (S&Ls), insuring their deposits—and giving them advantages over banks in attracting funds—so that they could finance mortgages at low rates. In adopting this 

program, the Government took substantial risks for the taxpayers’ account. S&Ls 

were expected to borrow money through short-term deposits but make long-term 

mortgage loans, an obvious prescription for disaster that only worked as long as interest rates were controlled by the Government. When the capital markets were 

freed of controls, so that funds could flow where they were most useful, the Government could no longer maintain controls on interest rates, and the higher rates they 

had to pay for funds drove many S&Ls into insolvency. The Government could have 

been compensated for the risk it was taking on the S&Ls by raising the premium 

39 

2Departments of Treasury and HUD, Reforming America’s Housing Finance Market, 26. 

for their deposit insurance. But this would have raised the cost of their mortgage 

loans, defeating the purpose of the S&Ls. So when the consequences of the Government’s risks unfolded in the 1980s the taxpayers had to pick up a $150 billion tab. 

Parenthetically, it should be noted that even the interest rate controls that made 

the S&L system work were another way of assessing the taxpayers. The deposit rate 

ceilings limited what depositors could earn on their savings, and penalized them 

even more directly when inflation caused prices and market interest rates to rise 

in the 1970s. 

Now the taxpayers are being assessed to bail out Fannie and Freddie. These two 

Government sponsored enterprises (GSEs) became insolvent because Congress materially increased their risks in 1992 by requiring them to acquire what were called 

affordable housing loans. These loans were to be made to borrowers at or below the 

median income in the places where they lived. Initially, 30 percent of the mortgages 

Fannie and Freddie were required to buy had to meet the affordable housing goals. 

However, the Department of Housing and Urban Development was given authority 

to administer the program, and by 2007 it had increased the goals so that 55 percent of all mortgages the GSEs bought had to be affordable housing loans. HUD also 

added subgoals that required the purchase of mortgages made to borrowers who 

were 80 percent and in some cases 60 percent of the median income in their communities. 

It is of course possible to find prime mortgages among borrowers who are at or 

below the median income where they live—and maybe even borrowers who are at 

80 percent or 60 percent of the median income—but not when more than half of the 

GSEs’ loans had to be made to borrowers who frequently had blemished credit, 

lacked funds for downpayments and did not have the steady incomes necessary to 

maintain home ownership. Accordingly, in order to meet the affordable housing 

goals, Fannie and Freddie had to take significant risks on mortgage quality, and 

those risks—which turned into losses when the housing bubble deflated—eventually 

caused their insolvency. Here is a quote from Fannie Mae’s 2006 10-K that makes 

exactly this point: 

[W]e have made, and continue to make, significant adjustments to our 

mortgage loan sourcing and purchase strategies in an effort to meet HUD’s 

increased housing goals and new subgoals. These strategies include entering into some purchase and securitization transactions with lower expected 

economic returns than our typical transactions. We have also relaxed some 

of our underwriting criteria to obtain goals-qualifying mortgage loans and 

increased our investments in higher-risk mortgage loan products that are 

more likely to serve the borrowers targeted by HUD’s goals and subgoals, 

which could increase our credit losses. [emphasis supplied.] 

The GSEs’ regulator, the Federal Housing Finance Agency (FHFA) estimated several months ago that the losses these two firms will eventually suffer will range 

from $221 billion to $363 billion, but the continued deterioration of the mortgage 

market since that estimate was made suggests that the taxpayers will eventually 

have to pay more than $400 billion to make up the GSEs’ losses. 

Again, the Government could have been compensated for the risks it was creating 

for Fannie and Freddie. It was well-known that they were regarded in the capital 

markets as Government-backed, and for that reason were the beneficiaries of low 

borrowing costs. Accordingly, there were many proposals that the Government 

charge Fannie and Freddie a guarantee fee, so in the event of their failure the Government could have been compensated for the costs it would have to bear. But as 

in the case of the S&Ls these proposals to compensate the Government and protect 

the taxpayers were strongly opposed in Congress (and by the GSEs themselves) because they would increase the cost of mortgages. So in a very direct way the taxpayers are now paying for the risks that the Government required Fannie and 

Freddie to take. The Administration itself recognizes this problem. As it noted in 

its February 11 statement on housing finance policy, ‘‘Political pressure to lower the 

price of Government support increases the odds that the Government will misprice 

risk and put taxpayers at risk.’’ 2

The Government also imposes costs on the taxpayers because of its lack of discipline in maintaining the necessary reserves for insurance funds that are intended 

to pay for contingent losses when they occur. Government loves to describe its policies as insurance—insurance sounds so stable and sensible—but it doesn’t do the 

one thing that private insurers do to cover their risks: it does not maintain adequate 

contingency funds. As the Government’s funds accumulate, the argument is made 

40 

3 ‘‘FEMA Administrator Craig Fugate says the debt results partly from Congress restraining 

insurance rates to encourage the purchase of coverage, which is required for property owners 

with a federally backed mortgage. . . . ‘It is not run as a business,’ Fugate said. Congress’ Government Accountability Office said in April that the program is ‘by design, not actuarially sound’ 

because it has no cash reserves to pay for catastrophes such as Katrina and sets rates that ‘do 

not reflect actual flood risk.’ Raising insurance rates or limiting coverage is hard. ‘The board 

of directors of this program is Congress,’ Fugate said. ‘They are very responsive to individuals 

who are being adversely affected.’ ’’ (Thomas Fink, ‘‘Huge Losses Put Federal Flood Insurance 

Plan in the Red’’, USA Today, August 26, 2010.) 4 As of the end of FY2010, the Pension Benefit Guaranty Corporation (PBGC) reported a def- icit of $23 billion. ‘‘In part, it is a result of the fact that the premiums PBGC charges are insufficient to pay for all the benefits that PBGC insures, and other factors.’’ Pension Benefit Guaranty 

Corporation, ‘‘2010 PBGC Annual Report,’’ www.pbgc.gov/about/ar2010.html (accessed January 

14, 2011). 5 Barclays Capital estimates that the FHA has drastically underpriced the risk of its guarantees and could face losses of up to $128 billion. Barclays, ‘‘U.S. Housing Finance: No Silver Bullet’’, December 13, 2010. 6 Center on Federal Financial Institutions, ‘‘Federal Deposit Insurance Corporation’’, August 

10, 2005, www.coffi.org/pubs/Summaries/FDIC%20Summary.pdf (accessed January 14, 2011). 

See also, Congressional Budget Office, ‘‘Modifying Federal Deposit Insurance’’, May 9, 2005, 

‘‘Currently, 93 percent of FDIC-insured institutions, which hold 98 percent of insured deposits, 

pay nothing for deposit insurance.’’ 7 Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack, ‘‘Large-Scale Asset Purchases by the Federal Reserve: Did They Work?’’, FRBNY Economic Policy Review, May 2011, 

p. 41 

that times are different, that the fund is large enough, or even that the industry 

paying the premium is strapped for cash or investment capital. These pressures 

cause the Government to let it ride, to refrain from collecting the necessary fees or 

premiums. This has occurred with the National Flood Insurance Program, 3 the Pension Benefit Guaranty Corporation, 4 the FHA, 5 and the Federal Deposit Insurance 

Corporation (FDIC). 

Recent FDIC experience is fully consistent with Congress’s reluctance to collect 

the necessary premiums in any insurance program. When the deposit-insurance system was reformed in 1991 in response to the failure of the FSLIC, Congress placed 

a limit on the size of the fund that the FDIC could accumulate to meet the demands 

of a future crisis. Since 1996, the FDIC has been prohibited by law from charging 

premiums to well-capitalized and stable institutions. As a result, between 1996 and 

2006, institutions representing 98 percent of deposits paid no deposit-insurance premiums. In 2009, FDIC chair Sheila Bair observed: ‘‘An important lesson going forward is we need to be building up these funds in good times so you can draw down 

upon them in bad times.’’ 6 Instead, once the bad times hit, the FDIC became insolvent and was forced to raise its premiums at the worst possible moment, thereby 

reinforcing the impact of the down cycle. 

Finally, it should be noted that to the extent that Government guaranteed mortgage-backed securities (MBS) are available they compete with Treasury securities. 

Many investors prefer them to treasuries because they represent virtually the same 

risk but offer a higher yield. Under these circumstances, the Treasury must pay a 

higher rate of interest than it would otherwise have to pay if there were no competition in the market. A recent Fed paper suggested that by purchasing GSE MBS 

(and thus taking those securities out of competition with the Treasury 10-year note) 

the Fed had reduced the interest rate on the 10-year note by as much as 30 to 100 

basis points. 7 If correct, this is an enormous amount and in effect another cost of 

a Government housing finance guarantee that will have to be paid by the taxpayers. 

Effect on the Economy as Whole 

Bubbles are a familiar phenomenon in any economy. They occur in the prices of 

many commodities from time to time, and even occur in the stock market, but they 

are particularly pervasive and long-lived in housing. In the last 30 years, there were 

housing price bubbles in 1979 and 1989—each of which lasted about 3 or 4 years— 

and a gigantic 10 year bubble between 1997 and 2007. There is good reason to believe that these housing bubbles are the result of Government involvement in housing finance. 

Among the purposes of past Government support for the housing market was to 

assure a steady flow of funds for housing. There is no particular reason why housing—as opposed to any other area of the economy—might require a steady flow of 

funds. Automobiles, food and other retailing, mining, high tech, and corporate finance generally do not require steady flows of funds and have survived and prospered quite well. 

However, one of the effects of Government support for a steady flow of funds to 

housing is that it lowers the financing risks for the homebuilders and others in the 

41 

8See, Peter J. Wallison, ‘‘Dissent From the Majority Report of the Financial Crisis Inquiry 

Commission’’, January 2011, http://www.aei.org/docLib/Wallisondissent.pdf. 

business of producing housing. Lowered risks encourage more homebuilding activity, 

because it reduces the likelihood of loss in the event of a market downturn. This, 

in turn, encourages speculation and increases the likelihood that housing bubbles 

will develop. When these bubbles eventually deflate, the losses they create represent 

a misallocation of capital that could have been used more efficiently elsewhere. Occasionally, as in 2008, the losses that occur as a result of a bubble’s collapse can 

cause a financial crisis. 8

The Government’s role in housing finance also has a negative effect on competition and thus reduces innovation and raises costs. The fact that the Government 

cannot or will not price for risk should be an important clue about the distorting 

effect its guarantee will have on competition. For the reasons outlined above, the 

Government’s charge for supporting the housing market will be lower than the actual risk would demand, so its backing operates as a subsidy. 

This happened with Fannie and Freddie. Because they were seen as Governmentbacked, they were beneficiaries of lower funding costs in the market, and this allowed them to drive all competition from the secondary mortgage market. As a result, until they were felled by the affordable housing requirements, the GSEs’ profits were extraordinarily high and their efficiencies and innovations low. In addition, 

they were not subject to market discipline because lenders did not believe that as 

Government-backed enterprises they represented any significant risk. 

Thus were Fannie and Freddie enabled to take the risks required by the affordable housing requirements without any scrutiny by the private market. The real 

costs to society appeared later. The same thing will happen with any Government 

program that backs housing finance with a guarantee of any kind, whether it covers 

the issuers of mortgage-backed securities (MBS) or only the MBS. In both cases, 

competition will be reduced and market discipline impaired. 

Accordingly, apart from its adverse effects on the debt and the taxpayers, Government support for housing finance also tends to increase speculation in homebuilding 

and related activities, causing housing bubbles, waste of capital resources, and impairment of the benefits of competition. This reduces, rather than increases economic growth and employment. 

II. The Arguments Advanced in Support of Government Guarantees Have 

no Merit 

Having shown that Government guarantees for housing are affirmatively harmful 

for the country’s fiscal position, for taxpayers and for the U.S. economy, I will now 

discuss the likely form that any such guarantees will take, and the various reasons 

that the proponents of Government guarantees advance to support of their position. 

These, I will show, are without merit. 

The Likely Form of a Government Guarantee Program 

The spectacular failure of Fannie and Freddie has caused many proponents of 

Government guarantees in housing finance to revise the structure of their proposals. 

Instead of guaranteeing the issuers of MBS like Fannie and Freddie, the new more 

sophisticated idea—including Option 3 in the Administration’s February 11 policy 

statement—is to have the Government’s guarantee attach only to the MBS and not 

to the issuers. These plans would obligate the Government to pick up losses only 

after the capital of an MBS issuer has been exhausted and would require the issuer 

to pay a fee to the Government to cover the Government’s risks. This idea is presented as though it will prevent losses similar to those that resulted from the operations of Fannie and Freddie; the implicit suggestion is that if only the MBS are 

guaranteed the Government’s risks will be reduced and the likelihood of taxpayer 

losses will be minimized. 

This is an illusion, for several reasons. First, as noted above, the Government cannot effectively set a fee to cover the taxpayers’ risks on the Government’s program. 

Even if Government had the incentives and capabilities to assess a proper fee, the 

assessment would be seen and attacked as an unfair tax on housing or on the borrowers who would have to pay higher interest rates. For example, when the Office 

of Management and Budget suggested near the end of the Clinton administration 

that Fannie and Freddie pay a fee for the Government’s risk on its implicit backing 

of their obligations, the idea was immediately derided as a tax on home ownership, 

the Administration was inundated with protests from the housing industry, and the 

proposal was promptly abandoned. 

Apart from whether the appropriate fee can be credibly established, history shows 

that Congress does not have the political fortitude to impose a fee that burdens 

42 

homeowners or the housing industry. In addition, it is fanciful to believe that the 

companies set up by the Government to perform a Government mission will not be 

viewed in the market as Government-backed. It is necessary only to point out that 

the GSEs’ charter says explicitly that they and their obligations are not guaranteed 

by the Government, but when they became insolvent the Administration immediately took them over and assured creditors that they would be fully paid. 

Similarly, as discussed above, even if the Government were to impose a fee of 

some kind, the political process would—as it has in the case of the FDIC and other 

‘‘insurance’’ programs—soon stop the accumulation of a reserve fund to cover eventual losses. So when the losses actually occur, the taxpayers would be the ones to 

bear the costs. 

Nor is the problem solved—as many of the supporters of these guarantee plans 

suggest—if the Government is liable for losses on guaranteed MBS only after the 

issuer of the MBS has absorbed the first losses and exhausted its capital. It is true 

that in this case issuers will have an incentive to be cautious about risk taking, but 

the Government guarantee eliminates an important element of market discipline— 

the risk aversion of investors. The existence of a Government guarantee will mean 

that no MBS buyer needs to be concerned about the quality of the underlying loans 

or the financial stability of the issuer. This is exactly analogous to the effect of deposit insurance on risk taking by banks. As is well known, deposit insurance permits bank depositors to ignore the risks a bank is taking—the principal reason that 

so many banks fail. As in the case of deposit insurance, Government backing of 

MBS will eliminate investor concerns about both the financial stability of the issuer 

and the quality of the mortgages underlying the MBS. The effect of this moral hazard is certainly one of the lessons of the GSEs’ failure. 

The GSE experience also shows how difficult it will be to limit the scope of any 

Government support program. The GSEs were seen as providing advantages to the 

middle class, mostly in the form of lower mortgage costs, and it was a natural impulse for Congress to want to extend those benefits to other constituents. The affordable housing goals were one example of such an extension, but so were the higher conforming loan limits, adopted in 2008, which allowed Fannie and Freddie to 

extend the benefits of their Government-backed low-cost financing to borrowers who 

were not at all low income or in any way economically disadvantaged. This is the 

way a legislature will work in a democracy, and there is no reason to assume that 

any limitations Congress might put on Government support of the mortgage market 

will continue for very long. Government-conferred benefits provide subsidies to certain favored groups, and Congress will always be attentive to extending these subsidies to others. 

Where moral hazard is present, regulation is imposed to protect the Government 

and the taxpayers, and regulation of the issuers of the guaranteed MBS is another 

prescription of the advocates of Government guarantees. They argue that regulation 

will ensure that the issuers have sufficient capital to cover the risks they will be 

taking and thus to protect the Government and the taxpayers from loss. But experience with bank regulation has shown that regulation does not prevent excessive risk 

taking and does not ensure sufficient capital to cover risks. Its effect, indeed, is almost the opposite. By increasing moral hazard, it encourages risk-taking. Moreover, 

as shown by the recent experience of the FDIC, which (despite prompt corrective 

action) has suffered losses in the great majority of banks it has closed in the last 

3 years, regulators are frequently unable to determine the financial condition of a 

regulated entity until it is too late. In these cases, the taxpayers will once again 

end up taking the losses. 

Accordingly, the structure of most proposals for Government housing market 

guarantees will not provide any protection for the taxpayers. As with Fannie and 

Freddie and the S&Ls, when the losses come in the taxpayers will eventually have 

to pay the bill. 

Nevertheless, the proponents of Government guarantees and their congressional 

supporters argue that there cannot be a functioning housing finance market without 

Government guarantees, and in the discussion below I show that these arguments 

have no merit. 

Institutional Investors 

One of the most frequently heard arguments in favor of Government guarantees 

is that institutional investors will only buy U.S. mortgages, or MBS based U.S. 

mortgages, if they are backed by the Government. On its face, this seems absurd, 

since in most advanced economies the housing finance market operates effectively 

without Government guarantees. Of course, if it were true that institutional investors will not buy MBS without a Government guarantee, it would be a weighty arVerDate Nov 24 2008 12:58 Apr 26, 2012 Jkt 048080 PO 00000 Frm 00046 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\09-13 HOUSING FINANCE REFORM -- SHOULD THERE BE A GOVER
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gument. However, it’s a myth, disproved by the data, which shows that institutional 

investors are not major buyers of GSE securities. 

According to the Federal Reserve’s flow of funds data, nonbank institutional investors had assets of $28 trillion in the fourth quarter of 2010. About $13 trillion 

of this amount was invested in fixed-income or debt securities—but only $1.8 trillion 

was invested in U.S. Government-backed securities issued by Government agencies 

or by Fannie and Freddie. Thus, even at a time when private housing finance has 

not yet revived—and most of the investment in housing is flowing through Fannie 

and Freddie or the Federal Housing Administration (FHA)—less than one-seventh 

of the funds invested in debt securities by institutional investors were invested in 

Government-backed GSE mortgage securities. 

Most likely, even these investments are only for liquidity purposes—made by 

money managers who want some small amount of Government securities that can 

be sold at any time in order to raise cash, no matter what the conditions in the market. These investors hold GSE securities because their yield is slightly higher than 

treasuries of equivalent maturity. As discussed above, it should be noted that by 

providing these investors with a security that carries a Government guarantee—an 

alternative to a Treasury security—Congress is raising the Treasury’s interest costs, 

another cost levied on the taxpayers. 

By contrast, at the end of 2010, nonbank institutional investors had assets consisting of $2.6 trillion in both residential and commercial whole mortgages. Whole 

mortgages are not guaranteed by Fannie and Freddie or the FHA. This means that 

even after the financial crisis, institutional investors held a larger dollar amount of 

mortgages that are not backed by the Government than the mortgages that are perceived as Government-guaranteed. 

The Fed’s flow of funds data also includes a $4.6 trillion category called ‘‘corporate 

and foreign bonds,’’ which includes privately issued mortgage-backed securities. Although this category is not further broken down, the mortgage-backed securities 

within it would add to the total of mortgage assets not guaranteed by the Government. 

This data should have a profound effect on the question of whether to replace 

Fannie and Freddie with another Government-backed system. They show that 

nonbank institutional investors are not investors in Government guaranteed debt 

(except for liquidity purposes) and prefer private mortgages and mortgage-backed 

securities to Government-backed instruments. 

Who are these institutional investors, and why do they prefer whole mortgages 

and private mortgage-backed securities over U.S. Government-backed mortgage securities? The biggest members of this class fall into three categories—life insurers 

($5.1 trillion in assets), private pension funds ($6 trillion) and mutual funds ($8 trillion). What these institutional investors have in common is a desire for yield. Life 

insurers and pension funds have long-term liabilities they have to cover, and mutual 

funds function in a competitive environment in which yield is important to retaining 

their investors. Privately issued instruments provide market rates of return that 

allow these institutions to meet their long-term obligations. U.S. Government agencies, by contrast, don’t pass this test. Their yields are low because their interest 

rates, subsidized by the taxpayers, are lower. 

That doesn’t mean they have figured out how to escape from market risk. Instead, 

as we know from experience, the taxpayers eventually have to compensate for this 

risk through bailouts of Fannie and Freddie and other Government housing finance 

ventures. This analysis is confirmed by looking at who the buyers of Governmentbacked securities actually are. In 2006, before the financial crisis, 11 percent of the 

holders were foreign central banks, 23 percent were Federal, State, and local governments and enterprises and their pension funds, and 21 percent were insured depository institutions. Thus more than 50 percent of the demand for Fannie and 

Freddie mortgage-backed securities came from U.S. and foreign governments, or 

from organizations the Government controls or regulates. In other words, Government-backed mortgage securities are primarily attractive to risk-averse institutions 

or those with regulated capital requirements. 

Thus, if we want U.S. and foreign institutional investors to invest in our mortgage 

market, we should be looking to a private system of mortgage finance, and not one 

run or backed by the Government. Private U.S. institutional investors have $13 trillion invested in fixed income or other debt securities. Much of this investment is 

going into corporate debt, including junk bonds, because mortgages or mortgagebacked securities yielding market rates are not available—and were not available 

even in 2006. If there were good private mortgage-backed securities available, institutional investors would be eagerly investing in the U.S. housing market. 

44 

9See, for example, Peter J. Wallison, ‘‘What’s So Special About the 30-Year Mortgage?’’ Wall 

Street Journal, February 1, 2011, www.aei.org/article/103092. 

Increase in Mortgage Rates 

Another argument in favor of a Government-backed system is that the interest 

rates on mortgages will be lower than in a private system. There is little question 

that a Government backed housing finance system can deliver mortgages at lower 

rates than private systems, but that’s because the Government is taking risks for 

which it will not be compensated. Instead, when the Government’s losses show up, 

the taxpayers are handed the bill. If the taxpayers were not the ultimate insurer 

of the Government’s risks, the rate on Government-backed mortgages would be the 

same as private mortgages, because the Government-backed loans would then reflect all the risks inherent in the structure. Those who support a Governmentbacked system must concede that it only provides lower rates because it puts the 

taxpayers at risk. 

The 30-Year Fixed-Rate Mortgage 

Many proponents of Government guarantees in housing finance argue that without a Government role in the housing market the 30-year fixed-rate mortgage will 

not be available to American homebuyers. On its face, this is not true, since anyone 

can go to the Internet and find lenders offering jumbo fixed-rate 30-year loans— 

which, by definition, have no Government backing. It is true that, at this point, a 

30-year fixed-rate mortgage is somewhat more expensive than a Government-backed 

30-year fixed-rate mortgage, but the lower cost of the Government mortgage simply 

means that the taxpayers are providing a subsidy to the person who wants a Government-backed mortgage with these terms. 

Anyway, history has shown—and simple economics would anticipate—that a Government subsidy for a 30-year fixed-rate mortgage is not good policy. The subsidy 

causes most borrowers to choose the 30-year loan, since in general it offers a fixed, 

low monthly payment with a Government-subsidized ‘‘free’’ prepayment option. Supporters, including the Administration in its Option 3, point to the apparent stability 

it provides to borrowers. This ‘‘stability,’’ however, carries with it several serious deficiencies. A 30-year loan amortizes slowly, keeping the homeowner’s equity low and 

debt level high for a good portion of the loan period. In other words, it increases 

the homeowner’s leverage. If the home is sold after 7 years (the average duration 

of occupancy), the homeowner has not accumulated much equity. 9 In addition, the 

‘‘free’’ prepayment option encourages equity withdrawal through serial refinancing. 

For these reasons, it is peculiar that the proponents of Government backing are 

never asked to explain why the taxpayers should be subsidizing a 30-year fixed-rate 

mortgage. This is not to say that this mortgage should not be available, but only 

that homeowners who want such a loan should not expect the taxpayers to subsidize 

its availability. In today’s market, it is available at a slightly higher cost without 

a taxpayer subsidy. 

The TBA market 

Another frequently heard argument from the supporters of Government backing 

for residential mortgage finance is that only with Government backing can the ToBe-Announced (TBA) market exist. This is another myth. First, however, it is important to put the TBA issue in perspective. Just as commodity futures markets enable 

farmers to hedge the price risk of their commodities, the agency TBA forward market allows mortgage originators to mitigate their interest rate risk. Today, originators of both agency and nonagency mortgages use the agency market to hedge the 

risk of a change in interest rates between the time that a mortgage rate is ‘‘locked 

in’’ and the time the mortgage is actually closed and securitized. Reducing that risk 

has a positive effect on mortgage rates, but it is only one of the elements that go 

into the full cost of a mortgage. It would be dwarfed, for example, by a 1⁄4 point 

increase in overall interest rates. The mortgage market could function effectively 

without a TBA market, but total mortgage costs—the principal component of which 

is the interest rate—would be slightly higher. Nevertheless, Government backing is 

not a requirement for the TBA market, just as it is not a requirement for a 30-year 

fixed-rate mortgage. 

It is perfectly possible for a TBA market to develop for private MBS. This is because the TBA market function does not exist because of a Government guarantee 

but because of a high level of liquidity in the market—a large number of MBS that 

are regularly bought and sold. That liquidity is created by a convention—an agreement—among market participants about what they will accept as sufficient information about a particular pool of MBS. That convention, embodied in the Uniform 

Practices for the Clearance and Settlement of Mortgage-Backed Securities—adminisVerDate Nov 24 2008 12:58 Apr 26, 2012 Jkt 048080 PO 00000 Frm 00048 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\09-13 HOUSING FINANCE REFORM -- SHOULD THERE BE A GOVER
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10 James Vickrey and Joshua Wright, ‘‘TBA Trading and Liquidity in the Agency MBS Market’’, Federal Reserve Bank of New York Staff Reports, Staff report no. 468, August 2010, p. 

7 11 Ibid. 12 Id., p. 12 13Departments of Treasury and HUD, ‘‘Reforming America’s Housing Finance Market’’, 28. 14Peter J. Wallison, Alex J. Pollock, and Edward J. Pinto, ‘‘Taking the Government Out of 

the Housing Finance: Principles for Reforming the Housing Finance Market’’, AEI, March 2011, 

http://www.aei.org/paper/100206. 

tered by the Securities Industry Financial Markets Association (SIFMA) and otherwise known as the ‘‘Good Delivery Guidelines’’—establishes that a seller and buyer 

in the TBA market need only agree on six factors to confirm a trade: issuer, maturity, coupon, price, par amount, and settlement date. 10 For example, as described 

in a recent paper by the Federal reserve Bank of New York, ‘‘a TBA contract agreed 

in July will be settled in August, for a security issued by Freddie Mac with a 30- 

year maturity, a 6 percent annual coupon, and a par amount of $200 million at a 

price of $102 per $100 of par amount, for a total price of $204 million.’’ 11

The limitation on the information available to the buyer makes the agency MBS, 

in effect, ‘‘fungible’’ with other agency MBS already outstanding and thus adds significantly to the liquidity in the market. As also explained in the Federal Reserve 

paper: ‘‘Paradoxically, the limits on information disclosure inherent in the TBA market actually increase this market’s liquidity, by creating fungibility across securities, 

and reducing information acquisition costs for buyers of [agency] MBS.’’ 12

The existence of GSEs makes it easier for a TBA market to exist, because it removes credit risk as one of the risks that market participants must consider, but 

that is not essential for the TBA market to function. If the mortgages on which MBS 

are based are all relatively similar in quality—as they would be if certain minimum 

standards existed—that, combined with mortgage insurance, would create a private 

sector product not far off from an agency MBS. Then, all that would be necessary 

for a private TBA market would be a large number of MBS issuances and agreement on the same terms—issuer, maturity, coupon, price, par amount, and settlement date—as the current convention outlines for the agency TBA market. 

Access to Capital in a Crisis 

Finally, supporters of a Government-backed system argue that the Government’s 

involvement will keep the market functioning in the event of another financial crisis. The Administration’s February 11 report expresses concern about whether—in 

a fully private market—there will be sufficient access to mortgage credit during a 

crisis. The Administration notes, ‘‘absent sufficient Government support to mitigate 

a credit crisis, there would be greater risk of a more severe downturn, and thus the 

risk of greater cost to the taxpayer.’’ 13 This idea gave rise to the Administration’s 

Option 2, which is a private market with a Government backstop that would be invoked only in the event of a financial crisis that makes credit unavailable for housing. 

However, if one assumes that some backstop is necessary, the Federal Reserve 

has already demonstrated that it can liquefy the housing market by purchasing 

MBS. The only question is whether the MBS are of good quality. If the underlying 

mortgages meet the quality tests outlined below, and include mortgage insurance, 

they would be of sufficient quality so that the Fed could purchase them without taking significant risks. 

III. How a Private Market Would Be Structured 

This testimony is not the place to describe in detail how a private MBS market 

would work. However, in March 2011, my AEI colleagues, Alex Pollock and Ed 

Pinto, and I issued a white paper 14 in which we responded to the Administration’s 

February 11 statement and showed how Option 1 in that Administration report— 

which discussed a private market for MBS—would work. The white paper was 

based on four principles: 

I. The housing finance market—like other U.S. industries and housing finance systems in most other developed countries—can and should principally function 

without any direct Government financial support 

Under this principle, we note that the huge losses associated with the savings and 

loan (S&L) debacle of the 1980s and Fannie and Freddie today did not come about 

in spite of Government support for housing finance but because of that Government 

backing. Government involvement not only creates moral hazard but also sets in 

motion political pressures for increasingly risky lending such as ‘‘affordable loans’’ 

to constituent groups. 

46 

Although many schemes for Government guarantees of housing finance in various 

forms have been circulating in Washington since last year, they are not fundamentally different from the policies that caused the failures of the past. The fundamental flaw in all these ideas is the notion that the Government can successfully 

establish an accurate risk-based price or other compensatory fee for its guarantees. 

Many examples show that this is beyond the capacity of Government and is in any 

case politically infeasible. The problem is not solved by limiting the Government’s 

risks to MBS, as in some proposals. The Government’s guarantee eliminates an essential element of market discipline—the risk aversion of investors—so the outcome 

will be the same: underwriting standards will deteriorate, regulation of issuers will 

fail, and taxpayers will take losses once again. 

II. Ensuring mortgage quality, and fostering the accumulation of adequate capital 

behind housing risk, can create a robust housing investment market without a 

Government guarantee 

This principle is based on the fact that high-quality mortgages are good investments and have a long history of minimal losses. Instead of relying on a Government guarantee to reassure investors in MBS, we should simply ensure that the 

mortgages originated and distributed are predominantly of prime quality. We know 

the characteristics of a prime mortgage, which are defined in the white paper. They 

do not have to be invented; they are well known from many decades of experience. 

Experience has also shown that some regulation of credit quality can prevent the 

deterioration in underwriting standards, although in the last cycle regulation promoted lower credit standards. The natural human tendency to believe that good 

times will continue—and that ‘‘this time is different’’—will continue to create price 

booms in housing, as in other assets. Housing bubbles in turn—by suppressing delinquencies and defaults—spawn subprime and other risky lending; investors see 

high yields and few defaults, while other market participants come to believe that 

housing prices will continue to rise, making good loans out of weak ones. Future 

bubbles and the losses suffered when they deflate can be minimized by interrupting 

this process—by focusing regulation on the maintenance of high credit quality. 

III. All programs for assisting low-income families to become homeowners should be 

on-budget and should limit risks to both homeowners and taxpayers 

The third principle recognizes that there is an important place for social policies 

that assist low-income families to become homeowners, but these policies must balance the interest in low-income lending against the risks to the borrowers and the 

interests of the taxpayers. In the past, ‘‘affordable housing’’ and similar policies 

have sought to produce certain outcomes—such as an increase in home ownership— 

which turned out to escalate the risks for both borrowers and taxpayers. The quality 

of the mortgages made in pursuance of social policies can be lower than prime quality—taxpayers may be willing to take risks to attain some social goods—but there 

must be quality and budgetary limits placed on riskier lending to keep taxpayer 

losses within known and reasonable bounds. 

IV. Fannie Mae and Freddie Mac should be eliminated as Government-sponsored enterprises (GSEs) over time 

Finally, Fannie and Freddie should be eliminated as GSEs and privatized—but 

gradually, so the private sector can take on more of the secondary market as the 

GSEs withdraw. The progressive withdrawal of the GSEs from the housing finance 

market should be accomplished in several ways, leading to the sunset of the GSE 

charters at the end of the transition. One way would be successive reductions in the 

GSEs’ conforming loan limits by 20 percent of the previous year’s limits each year. 

These reductions would apply to conforming loan limits for both regular and highcost areas. This should be done according to a published schedule so the private sector can plan for the investment of the necessary capital and create the necessary 

operational capacity. The private mortgage market would include banks, S&Ls, insurance companies, pension funds, other portfolio lenders and investors, mortgage 

bankers, mortgage insurance (MI) companies, and private securitization. Congress 

should make sure that it facilitates opportunities for additional financing alternatives, such as covered bonds. 

How a Private Market Will Attract Capital 

The most important question for purposes of this testimony is how a private market would attract capital. I have already discussed the size of the institutional investor market, and shown that these investors are not attracted by Governmentguaranteed MBS, except for liquidity purposes. Without any question, institutional 

investors will buy mortgages that have attractive risk-adjusted yields. However, if 

we want mortgage interest rates to remain low, we have to reduce the risks associVerDate Nov 24 2008 12:58 Apr 26, 2012 Jkt 048080 PO 00000 Frm 00050 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\09-13 HOUSING FINANCE REFORM -- SHOULD THERE BE A GOVER
47 

ated with these loans. In that case, institutional investors will not build in a large 

risk premium, which will add to mortgage costs. 

One of the most effective ways to do this would be to specify certain minimum 

terms for all securitized mortgages. These would include a minimum downpayment 

of 10 percent, a borrower’s FICO credit score of at least 660 and a borrower’s debt 

to income ratio in the upper 30s. Even when these minimum criteria are specified, 

however, institutional investors will want assurance about the overall quality of the 

mortgages in the pool. One way to accomplish this is to create a contractual structure in which the top tiers do not take losses on the pool until the lower tiers are 

wiped out. This is the structure used in many securitizations before the financial 

crisis and in the securitizations that take place today. 

In these offerings, the risk is mitigated by creating subordinated tranches (or 

tiers) that take the first losses. Only if the losses are greater than the size of those 

subordinate tranches will the top tiers (normally rated AA or AAA) suffer losses. 

This is an effective system, and could be attractive to institutional investors, but 

it has two problems: first, if the quality of the mortgages in the pool is poor, the 

subordinate tranches have to be thick (to absorb more expected losses) and this will 

raise interest rates on the mortgages in the pool; second, institutional investors do 

not have the facilities or capabilities to underwrite mortgage pools, and because of 

the failure of the rating agencies during the financial crisis institutional investors 

are now reluctant to rely on rating agencies for assurance about the quality of the 

mortgages in the pools. Therefore, another assurance mechanism is necessary. 

The best and most efficient system for this is mortgage insurance. Under current 

state regulation of mortgage insurers, they are required to hold at least half of their 

revenues in a reserve fund for 10 years, an amount more than sufficient to deal with 

any foreseeable housing downturn. In addition, they have the facilities and ability 

to do the underwriting that institutional investors lack. It appears that if mortgage 

quality is controlled so that only prime mortgages are securitized, mortgage insurers 

can write insurance that covers losses down to a loan-to-value ratio of 60 percent 

without increases in mortgage costs that significantly exceed what Fannie and 

Freddie are now charging. A system that provides for a minimum set of mortgage 

standards, combined with mortgage insurance, could reduce the risk for institutional investor substantially. This would permit interest rates on the mortgages underlying the MBS to be competitive with any Government backed system where the 

taxpayers are not compelled to subsidize the risk. 

A complete copy of the white paper, and its plan for a private housing finance 

market, may be found at http://www.aei.org/paper/100206. 

This concludes my testimony. 

PREPARED STATEMENT OF DWIGHT M. JAFFEE 

BOOTH PROFESSOR OF BANKING, FINANCE, AND REAL ESTATE, UNIVERSITY OF

CALIFORNIA

SEPTEMBER 13, 2011 

Mr. Chairman and Members of the Committee, I welcome the opportunity to discuss with you today the future role of the Government in the U.S. mortgage market. 

There is now a widespread consensus that Fannie Mae and Freddie Mac—I will 

refer to them as the GSEs—should be closed as soon as practical. It is thus timely 

to consider the best means for replacing the mortgage market functions that have 

been carried out by the GSEs. 

Current discussions focus on two primary alternatives for replacing the GSEs. The 

first alternative is to allow the private markets to replace the existing GSE functions, with the possible addition of expanding the FHA or a similar Government program with the goal to augment the supply of mortgage funding for lower-income 

borrowers and multifamily housing. The second alternative is to create a new Government program that will provide investors in conforming mortgages with an explicit Government guarantee against losses due to default. 

My research leads me to a strong endorsement of the private markets as the preferred alternative for two reasons. First, there is strong evidence that the private 

markets are fully capable of carrying out all mortgage market functions to a standard substantially higher than actually experienced under the GSE regime. Second, 

experience indicates that a program of Government guarantees of conforming residential mortgages is highly likely to leave taxpayers, once again, to pay the high 

costs of defaulting mortgages. I will now briefly explain the basis for these conclusions. 

48 

I have recently carried out research that compares the mortgage and housing 

market performance of the U.S. with that of 15 major Western Europe countries. 

This is relevant because none of these European countries provides an amount of 

Government assistance to their housing and mortgage markets close to that provided in the U.S., and, in particular, none of them has any institution comparable 

to our GSEs. Nevertheless, the mortgage and housing markets of these countries 

have significantly outperformed the U.S. markets on all available measures. 

The attached Table 1 provides the full data from my research. The first important 

fact is that the U.S. home ownership rate, 67.2 percent at year-end 2009, is exactly 

equal to the average rate of the 15 European countries, with the home ownership 

rates of 7 European countries actually exceeding that of the U.S. This is all the 

more remarkable because the population density of these countries far exceeds the 

U.S. and some of these countries—Austria and Germany for example—have longstanding social traditions to postpone the date of first home purchase. 

Second, the average of U.S. mortgage interest rates has significantly exceeded the 

corresponding average for the 15 European the countries. The lower European mortgage rates are mainly the result of the much lower default rates for European mortgages. Even with the current financial distress in Europe, their mortgage default 

rates have remained very low. The financial distress currently facing many European banks is mainly the result of losses on construction loans and sovereign debt, 

and not from home mortgages. 

I expect private markets will deliver lower mortgage rates in the U.S. for the 

same reason as in Europe. That is, private investors will require the mortgage loans 

they purchase to be originated under high underwriting standards. The decline in 

U.S. mortgage rates that will result from greater safety will offset the pressure toward higher mortgage rates that will result as the GSE subsidies are eliminated. 

Equally importantly, the switch to safer mortgages will preclude any future replay 

of the huge economic and social costs we are currently facing from high foreclosure 

rates on risky mortgages. 

As to the second alternative, proponents of new Government guarantees for U.S. 

home mortgages often start by pointing out that the private mortgage markets are 

currently moribund, and that they see no mechanism through which the private 

markets can displace the current dominant role of the GSEs. In contrast, I believe 

the current dominant position of the GSEs is simply the result of crowding out, 

whereby any entity with a Government guarantee will always displace comparable 

private market activity. In my view, a private market revival will follow rapidly 

once we remove the current GSE subsidies. 

I would also like to shed light on two further issues—I would say myths—raised 

by the proponents of expanded Government guarantees of residential mortgages. 

The first issue is their contention that the 30-year, fixed-rate, mortgage can exist 

only with a Government guarantee program. This is in error for two reasons. First, 

the primary risk on long-term, fixed-rate, mortgages is interest rate risk, and neither the GSEs nor the proposed Government guarantees provide any protection 

against this risk. Second, without even considering Government guarantees, the 

credit risk on long-term mortgages is actually lower than on, say, adjustable rate 

mortgages. The proof is that private markets in the U.S. and Europe have long provided long-term, fixed-rate, mortgages and at accessible interest rates. 

The second issue raised by advocates of new Government guarantee is that the 

guarantees are essential to the continuing existing of the so-called TBA forward 

market for mortgage securitization. This is also in error for two reasons. First, as 

long as the existing FHA and GNMA programs exist, and most likely they will expand, the TBA market will continue to exist. Second, and more fundamentally, the 

private markets for hedging interest rate risk have proven highly satisfactory for 

controlling the pipeline risk that arises in private label securitization in the U.S. 

and covered bond issuance in Europe. I have to add that the arguments to protect 

the existing TBA market primarily reflect the wish of the vested interests in these 

markets to continue to earn fees from running the market, while transferring the 

risk of mortgage defaults to U.S. taxpayers. 

I recognize, of course, that the U.S. housing and mortgage markets are currently 

in a highly distressed state, and rapidly closing down the GSEs would be inadvisable. There is, however, a very safe and dependable mechanism to close down the 

GSEs, namely to reduce the conforming loan limits in a steady sequence. For example, a reduction in the conforming loan limits by $100,000 annually would basically 

close down the GSEs in 7 years. This also has several additional desirable features: 

• The GSE subsidies would remain on the smaller sized mortgages for as long as 

possible. 

49 

• The private market would anticipate the annual opening of each new tier of the 

market. 

• The process could be stopped if it appeared the private markets were not responding. 

A very important first step would be to allow the recent temporary increase in 

the conforming loan limits to expire as scheduled on October 1 of this year. 

I also recognize that other researchers and market participants do not share my 

confidence in the private markets and they have proposed a variety of Government 

guarantee plans to replace the GSEs. The least intrusive of these plans proposes 

a temporary Government program of catastrophe insurance, to allow the markets 

more time to stabilize, before reverting to a fully private system. As it happens, catastrophe insurance is a second area of my research focus and I am therefore familiar with the successes and failures of the various Government insurance programs. 

In my opinion, the Terrorism Risk Reinsurance Act (TRIA) is arguably the most 

successful of all the current Government insurance programs. As you may recall, 

TRIA provides reinsurance against the catastrophic losses that an insurer may suffer from providing terrorism insurance on commercial buildings. It was enacted, following 9/11, to provide insurers with the reinsurance that would allow them to provide building owners coverage against losses from a terrorist attack. TRIA has been 

successful in that the private market for terrorism insurance is now active and efficient, with private insurers taking the first-loss position for all events. Furthermore, 

taxpayer payments arise only for the most extreme events where the insured losses 

would substantially exceed the insured losses realized from 9/11. If a catastrophe 

back-stop for the U.S. mortgage market is considered critical, a TRIA-like plan could 

work well. 

Unfortunately, I believe the actual plans for new Government mortgage guarantee 

programs are likely to require the U.S. Government itself to take the first-loss position, quite the opposite of providing reinsurance against only catastrophic losses. 

This is the experience with the National Flood Insurance Program on the Federal 

level and with the California Earthquake Authority and the Florida Hurricane Fund 

on the State level. While the authorizations for these programs all used the right 

words—no subsidies, risk-based premium, sound capital, etc.—in practice, they have 

all proven costly or ineffective. Specifically, you will recall that, following Katrina, 

the National Flood Insurance Program needed a $20 billion plus Federal appropriation to cover its losses. The Florida Hurricane fund is similarly a ward of the State 

of Florida. The California Earthquake Authority has had the good luck of no major 

earthquakes, but it also has reached remarkably few customers. 

The common problem for these Government insurance programs is the inability 

to maintain premiums at a true actuarial level. Instead, inevitably, the underwriting standards and the premiums are reduced, sooner or later leading to taxpayer costs. I fear a new Government mortgage guarantee plan will follow this path, 

ultimately leading to further taxpayer losses. 

Not to end on such a somber note, let me say again I believe that private markets 

can efficiently provide all the required mortgage market functions, and that steady 

reductions in the conforming loan limits is a safe and dependable means to make 

the transition. 

50 

51 

1Federal Reserve Statistical Release Z.1, Table. L.217, June 9, 2011. 

PREPARED STATEMENT OF ADAM J. LEVITIN 

PROFESSOR OF LAW, GEORGETOWN UNIVERSITY LAW CENTER

SEPTEMBER 13, 2011 

Mr. Chairman, Ranking Member Shelby, Members of the Subcommittee: 

My name is Adam Levitin, and I am a Professor of Law at the Georgetown University Law Center in Washington, DC, where I teach courses in structured finance, 

bankruptcy, and commercial law. I am also a member of the Mortgage Finance 

Working Group sponsored by the Center for American Progress, which has put forth 

a proposal for GSE reform. I am here today, however, as an academic who has written extensively on housing finance and am not testifying on behalf of the Mortgage 

Finance Working Group. 

As an initial matter, I want to be clear where I stand ideologically on housing 

finance reform. In the ideal world, I would unequivocally prefer to see the U.S. 

housing finance system financed entirely with private capital. The Government’s involvement in the U.S. housing finance system carries with it serious concerns of 

moral hazard and politicized underwriting. 

I am nonetheless opposed to proposals to eliminate any Government guarantee 

from the housing finance system. My opposition is based on practical realities, not 

ideological grounds. It is important that we not allow our ideological predilections 

get in the way of common sense. Despite privatization’s ideological appeal, there is 

a fundamental problem with privatization proposals for the housing finance system: 

they don’t work. Indeed, fully private housing finance systems simply do not exist 

in the developed world. 

Following the siren’s song of privatization would put the entire U.S. economy in 

grave peril, as there is simply nowhere close to the sufficient private risk capital 

willing to assume credit risk on U.S. mortgages, even prime ones. The housing finance market is barely stabilized with massive Government life support; it is no 

longer on the operating table, but is in the financial equivalent of the intensive care 

unit. Pulling the plug on the Government guarantee will kill the housing market, 

not resurrect it. Eliminating the Government guarantee risks the flight of over $6 

trillion dollars from the U.S. housing finance market—roughly half the dollars invested in U.S. mortgages. 1 Such an occurrence would be catastrophic for the U.S. 

economy. 

Along these lines, I wish to make five major points in my testimony: 

1. There is insufficient market demand for U.S. mortgage credit risk to support 

the U.S. housing market absent some form of Government guarantee. 

2. The prime jumbo securitization market does not provide evidence of the viability of a large-scale private securitization market. 

3. All five previous attempts at private mortgage securitization in the United 

States failed because of the inability of investors to manage credit risk in 

securitization. 

4. There is no housing finance market anywhere in the developed world in which 

there is neither an explicit nor an implicit Government guarantee of at least 

catastrophic risk. 

5. The choice we face is not guarantee versus no guarantee. It is between an implicit and an explicit guarantee. A Government guarantee is inevitable in the 

housing finance market, so it is best to make the guarantee explicit and wellstructured and priced. 

I. Lack of Market Demand for Mortgage Credit Risk 

A mortgage carries two types of risks for investors: credit risk and interest rate 

risk. Credit risk is the risk that the borrower will default on the mortgage. Interest 

rate risk is the risk that interest rates will either rise—in which case the interest 

rate the investor earns on the mortgage will be below market—or that interest rates 

will fall—in which case the mortgage will now be at an above market rate, but with 

the borrower likely to refinance. 

GSE and Ginnie Mae securitization divides the credit risk from the interest rate 

risk. Investors in Fannie, Freddie, and Ginnie mortgage-backed securities assume 

interest rate risk, but not credit risk. The credit risk is retained by Fannie, Freddie, 

or Ginnie, which often are insured for part or all of that risk, either through private 

mortgage insurers or through FHA insurance and VA guarantees. 

In contrast with the GSEs and Ginnie Mae, investors in private-label mortgagebacked securities (PLS) assume both interest rate risk and credit risk. Over 90 perVerDate Nov 24 2008 12:58 Apr 26, 2012 Jkt 048080 PO 00000 Frm 00055 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\09-13 HOUSING FINANCE REFORM -- SHOULD THERE BE A GOVER
52 

2 Notably some proponents of privatization would have a Government regulatory role in the 

market. It is hard to fathom the Government as regulating the market, but taking no responsibility then, if the market collapses. 3 Inside Mortgage Finance, Mortgage Market Statistical Annual. 

cent of PLS were rated AAA at issuance by credit rating agencies. Investors who 

relied on these ratings understood the credit risk on these PLS to be negligible because of the quality of the underlying mortgages and various credit enhancements 

to the PLS, such as senior-subordinate credit structures, overcollateralization, excess spread accounts, and various types of insurance. 

What this means is that the overwhelming majority of investors in the U.S. secondary mortgage market are not credit risk investors. Investors in Fannie, Freddie, 

and Ginnie MBS are not credit risk investors, and most investors in PLS did not 

perceive themselves as assuming credit risk. Instead, U.S. mortgage investors are 

interest rate risk investors. 

Interest rate risk investors are very different types of investors than credit risk 

investors. Investing in credit risk successfully requires a different kind of diligence 

and expertise than interest rate risk investment. A large portion of the investment 

in U.S. mortgages is from by foreign investors. Chinese investment funds and Norwegian pension plans, for example, are unlikely to seek to assume credit risk on 

mortgages in a consumer credit market they do not know intimately. But interest 

rate risk is something that foreign investors are far better positioned to assume because it is highly correlated with expectations about U.S. Federal Reserve discount 

rates. 

Proponents of secondary mortgage market privatization would have the Government guarantee completely eliminated, meaning that investors would bear both interest rate risk and credit risk. 2 There is no evidence that there is a substantial 

body of capital eager to assume credit risk on U.S. mortgages at any rate, much 

less at mortgage rates that would not be prohibitively expensive for borrowers. Even 

if PLS were structured to remove most credit risk from some securities, few investors are likely to trust credit ratings on MBS in the foreseeable future. What all 

of this means is that if the secondary mortgage market were completely privatized, 

as much as $6 trillion in housing finance investment—roughly half of the investment in the U.S. housing finance market—would leave the U.S. market. The result 

would be a collapse on a scale far worse than in 2008. 

II. The Jumbo Market Does not Provide Evidence of the Viability of a 

Large Scale Private Market 

Mortgages that are too large to qualify for purchase by the GSEs because of the 

statutory conforming loan limit are known as ‘‘jumbo’’ mortgages. There is a private 

securitization market in jumbo mortgages. In the jumbo market, investors assume 

both interest risk and credit risk. Advocates of privatization have suggested that the 

existence of the jumbo market is proof that a securitization market can function 

without a Government guarantee. 

The existence of the private jumbo mortgage securitization market is does not 

demonstrate that there is sufficient private risk capital to support the entire U.S. 

housing market. The jumbo market is smaller and benefits from the existence of the 

Government supported market. The shape of the jumbo market in fact indicates 

that there is a quite limited demand of credit risk on U.S. mortgages, and certainly 

not enough to sustain the entire market absent a Government guarantee. 

The jumbo market overall is substantially smaller than the conforming market. 

From 2001–2007, there were roughly two times as many dollars of conforming loans 

originated as jumbo loans, and in sheer origination dollars, the jumbo market has 

never comprised more than a quarter of the U.S. market. 3 Jumbo loans are more 

expensive than conforming loans; currently there is around a 60 basis point spread 

between jumbo and conforming rates, despite jumbos often being of higher credit 

quality. While some of that spread (which at times has been as small as 20 basis 

points) is a function of the GSE guarantee, it is also a reflection of limited demand 

for U.S. jumbo mortgages—meaning a limited demand for credit risk. If all U.S. 

mortgage investors were willing to assume credit risk, we should tighter credit 

spreads between prime jumbos and conventional conforming loans, and investors 

would be willing to assume the credit risk on jumbos for the additional return. 

What’s more, the securitization rate for jumbo loans is substantially lower, which 

has resulted in a much smaller amount of jumbo mortgage-backed securities issued 

than GSE MBS. (See Figures 1 and 2). Jumbos lower securitization rate is itself 

strong evidence of limited investor demand of credit risk on U.S. mortgages—at 

least at interest rates less than those borne on subprime loans. 

53 

54 

4This section of the testimony derives from Adam J. Levitin and Susan M. Wachter, ‘‘The 

Rise, Fall, and Return of the Public Option in Housing Finance’’, in Regulatory Breakdown? The 

Crisis of Confidence in U.S. Regulation, Cary Coglianese, ed. (University of Pennsylvania Press, 

forthcoming 2012). 5Kenneth A. Snowden, ‘‘Mortgage Securitization in the United States: Twentieth Century Developments in Historical Perspective’’, in Anglo-American Financial Systems: Institutions and 

Markets in the Twentieth Century, Michael D. Bordo and Richard Sylla, Eds. 261, 270 (1995). 

Proponents of privatization also ignore that the jumbo market does benefit from 

a Government guarantee indirectly in multiple ways. The jumbo market has long 

aped the standards set by the GSEs in the conforming market, including amortization, maturity lengths, and appraisal standards. Indeed, the real benefit of the 

GSEs was not in terms of cost savings through efficiency or the Government guarantee but in standard setting; but for the GSEs, the 30-year fixed-rate mortgage 

would likely not exist. The standardization achieved by the conforming market has 

enabled the jumbo To Be Announced (TBA) market, which lets borrowers lock in 

their interest rates months before closing. The jumbo TBA market piggybacks on 

the existence of the highly liquid conforming TBA market. Whether this would continue absent a Government guaranteed TBA market is questionable. 

Finally, the stability of housing prices in the jumbo market benefits from the Government guarantee in the conforming market. Housing prices of nearby properties 

are highly correlated. The ability for buyers or owners to obtain financing or refinancing significantly affects property values, so to the extent that the Government 

guarantee has stabilized the conforming market and thus bolstered the property values of properties with conforming mortgages, there is a spill-over that benefits properties with jumbo mortgages. The systemic stability that comes from the Government guarantee has benefited the jumbo market. Indeed, the virtual disappearance 

of the jumbo market following the financial collapse in 2008 draws into question 

whether this market is in fact viable; the spill-over benefits from the guarantee in 

the conforming market have not been enough to resuscitate the jumbo market. 

The jumbo market demonstrates that there are some investors who are willing 

to assume credit risk on U.S. mortgages. But investors in the vast majority of the 

$6 trillion plus in U.S. mortgage securities outstanding are interest rate investors, 

and it is difficult to imagine them transforming into credit risk investors over several years, much less immediately. Sufficiently high yields will no doubt lure some 

of them into accepting credit risk-but that translates into much higher mortgage interest rates, which in turn increases the credit risk on the mortgages. And even 

higher yields will not be sufficient to induce investors who have no interest in assuming credit risk to buy into the U.S. mortgage market. The fundamental problem 

with any housing finance privatization proposal is that there just isn’t sufficient 

capital interested in credit risk on U.S. mortgages. Ideology cannot substitute for 

market demand. 

III. We’ve Tried This Five Times Before Without Success4

Privatization advocates pay little attention to the history of housing finance in the 

United States, but it holds a cautionary tale. The United States has had four previous experiences with private mortgage securitization. These experiences have been 

long-forgotten, but it is important to note that every time it ended in disaster, as 

did the fifth experiment, that of private label mortgage securitization in the 2000s. 

There is little reason to believe that a sixth charge of the Light Brigade will be more 

successful. 

The U.S. did not develop a national secondary mortgage market until the New 

Deal. By the mid-nineteenth century, however, deep secondary mortgage markets 

were well-established in both France (the State-chartered joint-stock monopoly 

Cre ́dit Foncier) and the German states (cooperative borrowers’ associations called 

Landschaften and private joint-stock banks in Prussia and Bavaria), and ‘‘[b]y 1900 

the French and German market for mortgage-backed securities was larger than the 

corporate bond market and comparable in size to markets for Government debt.’’ 5

Although there were significant design differences in the European systems, they 

all operated on a basic principle-securities were issued by dedicated mortgage origination entities. Investors therefore assumed the credit risk of the origination entities. Because these entities’ assets were primarily mortgages, the real credit risk assumed by the investors was that on the mortgages. 

The European systems were successful because they ensured that investors perceived them as free of default risk. This was done through two mechanisms. First, 

there were close links between the mortgage origination entities and the state. 

Mortgage investors thus believed there to be an implicit state guarantee of payment 

on the securities they held. Second, and relatedly, the state required heavy regulation of the mortgage market entities, including underwriting standards, 

55 

6 Id. at 271–273 7 Id. at 278. 8 Id. at 279. 9 James Graaskamp, ‘‘Development and Structure of Mortgage Loan Guarantee Insurance in 

the United States’’, 34 J. Risk and Ins. 47, 49 (1967). 10 Id. at 49–50; Snowden, supra note 5, at 284. 11Graaskamp, supra note 9, at 51; Snowden, supra note 5, at 285. 12Snowden, supra note 5, at 286. 13 Regarding the causes of the housing bubble and its collapse, see, Adam J. Levitin and 

Susan M. Wachter, ‘‘Explaining the Housing Bubble’’, 100 Georgetown Law Journal (forthcoming 

2012), available at http://papers.ssrn.com/sol3/papers.cfm?abstractlid=1669401. 14Snowden, supra note 5, at 263. 

overcollateralization of securities, capital requirements, dedicated sinking funds, auditing, and management qualifications. 6

There were attempts to import the Cre ́dit Foncier model to the U.S. in both the 

1870s and 1880s. Mortgage companies that originated and serviced the loans, pledging them against ‘‘debentures . . . issued in series backed by specific mortgage 

pools.’’ 7 These attempts failed as the originators often violated their stated underwriting standards and securitized only the lowest quality collateral. 8

A third attempt at establishing a private secondary market was undertaken in the 

1900s by New York title guarantee companies, which expanded beyond title insurance into mortgage and bond credit insurance. 9 The title companies originated 

mortgages, insured them, and then sold debt securities backed by the mortgages. 

The favored form were participation certificates that allocated the cash flow from 

the underlying mortgage pool in proportionate shares, much like later Fannie Mae/ 

Freddie Mac Pass-Thru Certificates. 10 These participation certificates thus created 

a secondary market in mortgages. The purchasers of the participation certificates 

believed that they were assuming the credit risk of the title company that insured 

the mortgages, rather than the borrower, so they were not particularly concerned 

with the quality of the mortgage underwriting. 

As defaults in the housing market rose in 1928–1934, the guaranteed participation certificate market collapsed. Poor regulation and malfeasance by the title companies made it impossible to weather a market downturn. The title companies were 

thinly capitalized and routinely violated their underwriting standards, and engaged 

in assorted other shenanigans that resonate of the excesses of the 2000s market. 11

In addition to the guaranteed participation certificates, another type of secondary 

market instrument emerged in the 1920s, the single-property real estate bond. 

Whereas participation certificates were issued against a pool of mortgages, singleproperty real estate bonds were backed by a single building, a distinction roughly 

analogous to that between securitization and project finance. Single-property real 

estate bonds were used to finance large construction projects, such as the skyscrapers of New York and Chicago. 12 This system too collapsed in a series of scandals in the 1920s and ’30s that made clear that underwriting standards had long 

been ignored. Their enduring legacy of the single-property real estate bonds is the 

Trust Indenture Act of 1939, the preamble to which is an indictment of the industry’s practices. 

Finally, in the 2000s we saw an explosive growth of private-label mortgage 

securitization. PLS great from 21 percent of MBS issuance in 2003 to 56 percent— 

a majority of the market—in 2006. PLS operated in a largely unregulated space and 

underwriting standards quickly collapsed. The growth in PLS ate away at the GSEs’ 

market share, which encouraged the GSEs to be more aggressive in their underwriting. This competition between the GSEs and the unregulated PLS market 

proved fatal to the entire financial system. 13 Early American secondary mortgage 

markets share two critical commonalities with each other and with the PLS market 

in the 2000s. First, they were virtually unregulated, and what regulation existed 

was wholly inadequate to ensuring prudent operations. And second, they all suffered 

from an inability to maintain underwriting standards, as the loan originators had 

no capital at risk in the mortgages themselves, regulation was scant, and investors 

in the mortgage-backed bonds lacked the ability to monitor the origination process 

or the collateral. In contrast, successful European structures, ‘‘were either publicly 

financed or sponsored and were subject to intense regulatory scrutiny.’’ 14 The historical evidence strongly indicates that both a Government guarantee and a robust, 

market-wide regulatory system is necessary to ensure a stable, liquid secondary 

market. 

56 

15 E.g., Peter J. Wallison, ‘‘A New Housing Finance System for the United States’’, Mercatus 

Center Working Paper No. 11-08, at http://mercatus.org/sites/default/files/publication/ 

wp1108-a-new-housing-finance-system-for-the-united-statesl0.pdf, at 10 (‘‘Neither Denmark nor 

Germany backs any part of the mortgage financing system, which seems to work well because 

of the regulatory assurances of mortgage quality.’’). 16See, Bundesanstalt fu ̈ r Finanzdienstleistunsaufsicht, ‘‘Annual Report of the Federal Financial Supervisory Authority’’, (2008), available at http://www.bafin.de/clnl152/nnl720486/ 

SharedDocs/Downloads/EN/Service/Jahresberichte/2008/ 

annualreportl08lcomplete,templateId=raw,property=publicationFile.pdf/ 

annualreportl08lcomplete.pdf. 17See, Neelie Kroes, ‘‘Guarantee Scheme for Banks in Denmark’’, European Commission 

Memorandum, State Aid NN51/2008—Denmark, available at http://ec.europa.eu/communityllaw/statelaids/comp-2008/nn051-08.pdf. 

IV. All Developed Countries Implicitly or Explicitly Guarantee Their Housing Financed Systems 

A truly private housing finance system is a pipedream. It simply does not exist 

in any developed country and never has. Every developed country either explicitly 

or implicitly guarantees some part of its housing finance system. In some countries, 

like Canada, the guarantee is explicit—and priced—and the market is regulated to 

protect the Government from excessive risk exposure. In other countries, the guarantee is implicit. It is difficult to prove an implicit guarantee; the very nature of 

it is that there is no clear proof. One can look at spreads between mortgage debt 

and Government debt, for example, but that is not necessarily conclusive. Indeed, 

in the United States, GSE debt was explicitly not guaranteed by the Federal Government . . . until it was. 

Proponents of privatizing the housing finance system and eliminating the Government guarantee will generally point to Germany and Denmark as examples of housing finance systems without a guarantee that have widely available long-term, 

fixed-rate mortgages. 15 Unfortunately, this view of the German and Danish housing 

finance systems is incorrect. Germany and Denmark both turn out to have been latent implicit guarantee cases prior to October 2010, at which point they became examples of explicit guarantees. 

In October 2008, Germany created a Teutonic TARP known as the ‘‘Special Fund 

Financial Market Stabilization,’’ or SoFFin (its German acronym) to bail out its 

banks. SoFFin provided nearly ÷150 billion to support ten financial institutions’ liabilities, including those of one issuer of covered mortgage bonds and of three 

Landesbanks (another type of German mortgage lender). 16 Germany was not prepared to allow even one of its numerous covered bond issuers to fail, even though 

any single issuer was arguably not a systemically important financial institution. 

Denmark also announced a broad guarantee of all deposits and senior debt issued 

by its banks in October 2008. 17 Denmark has a robust mortgage lending system financed by covered bonds—bonds issued by banks against mortgage collateral held 

on balance sheet. Formally, the Danish guarantee did not apply covered bonds, only 

to the deposits and senior debts of the banks that issued them. The functional reality of this arrangement, however, was to guarantee the covered bonds by guaranteeing that the issuers would have sufficient assets and liquidity to meet their covered bond payment obligations so that the covered bondholders would never have 

to look to their cover pools of collateral for recovery. 

There is no housing finance system in the developed world in which there is neither an implicit nor explicit guarantee, much less one which ensures the widespread 

availability of long-term, fixed-rate mortgages. 

V. The Inevitability of a Guarantee Means It Should Be Explicit and Priced 

The lack of a formal guarantee in good times is no guarantee against the application of a formal guarantee in bad times. Housing finance is simply too central to 

the economies of developed countries and to their social stability to permit market 

collapse. Put differently, there’s no way to guarantee against a guarantee. 

Therefore, it’s better to accept that we are going to be living with a guarantee 

sooner or later—whenever the next crisis occurs—and to design a system that properly prices for it now. In 2008, the market saw that when threatened with collapse, 

the U.S. Government blinked. And despite Congress’s best efforts and Dodd-Frank’s 

no-bailout provisions (which still leave the door open for sub rosa bailouts), it’s hard 

to believe that if threatened with massive economic collapse, the U.S. Government 

wouldn’t bail out the financial system again. As distasteful as bailouts are, we as 

a society are simply too scared of the potential consequences of not bailing out the 

system to find out what would happen. 

What this means is that if we are really serious about avoiding moral hazard, we 

actually have to have an explicit guarantee and price for it. Counterintuitively, an 

57 

explicit and properly priced guarantee is the best protection against moral hazard. 

Otherwise, we will find ourselves in the next crisis with a private system that is 

suddenly guaranteed by the Government, and which has never had to pay for it, 

despite everyone in the market knowing that if things get really bad, Uncle Sam 

will come bail them out. 

It is thus important to recognize, however, that the Government is not assuming 

more risk with an explicit guarantee. Instead, an explicit guarantee is just formalizing what the market assumes and hopefully pricing for it. 

Conclusion 

Try as we may, we cannot escape either history or the reality that the U.S. Government will always bail out its housing finance system if it gets into trouble. We 

did that in 1932–34. We did it with the S&Ls in the 1980s. We did it again in 2008. 

Catastrophic risk in housing finance is inevitably socialized, so it is best to recognized that truism and adapt our regulatory system to mitigate the risk. Pretending 

that it won’t happen again is hardly a solution. 

We do not have to like the existence of a Government guarantee in housing finance. But the choice we face is between an implicit and an explicit guarantee, not 

between a guarantee and no guarantee. All Government guarantees have clear problems—moral hazard because the Government holds the credit risk, while private 

parties hold the upside, and the danger of politicized underwriting. There are ways 

to try to guard against both problems. For example, moral hazard can be alleviated 

through use of deductibles and copayments—have first-loss private risk capital or 

loss splitting between the Government and private capital. Administrative structures can guard against politicized underwriting. Those risk mitigants, however, require an explicit guarantee. 

For better or worse, though, we need to accept that some form of a Government 

guarantee, even if only for catastrophic losses, is required in our housing finance 

system. The unique nature of housing finance as an enormous asset class that affects a wide swath of citizens and economic and social stability means that no U.S. 

Government will permit the market’s collapse: it would be economic and political 

suicide. The question then is not whether there should be a guarantee—we have one 

whether we want it or not—but how it should be structured. 

58 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

PREPARED STATEMENT SUBMITTED BY THE SECURITIES INDUSTRY 

AND FINANCIAL MARKETS ASSOCIATION 

59 

60 

61 

62 

63 

64 

65 

66 

67 

68 

69 

70 

71 

72 

73 

74 

75 

76 

77