Thomas M Hoenig: Reforming US housing finance
Speech by Mr Thomas M Hoenig, President of the Federal Reserve Bank of Kansas City,
at the National Association of Realtors conference, New Orleans, 5 November 2010.
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The views expressed by the author are his own and do not necessarily reflect those of the Federal Reserve
System, its governors, officers or representatives.
Introduction
My position on the current stance of our nation's monetary policy is well known, especially to
those who closely follow the Federal Reserve. The Federal Open Market Committee has met
seven times this year, and at each of those meetings I have cast a dissenting vote against
the majority opinion of keeping the federal funds rate target at its current level near zero for
an "extended period."
I realize that advocating an interest rate increase is not the best applause line at a Realtors'
conference. However, I believe that moving rates modestly off of zero, where they have been
since December 2008, still represents highly accommodative monetary policy. More
importantly, such action is necessary if we are to ensure a more stable economy that can
thereby foster a more sustainable housing market.
How can we revive housing?
We have all suffered through the worst collapse in housing prices since the 1930s, and the
situation we face will not be easily corrected.
The housing collapse can be characterized as a classic asset-price bubble spurred by low
interest rates, easily accessible and often-unsound financing, over-optimism about housing
price trends, and a high - and difficult to control - level of subsidies that flowed into housing.
Although we may have experienced a few exceptional years of housing activity, those years
do not come close to making up for the economic recession, foreclosures, erased wealth and
slow recovery that we now are experiencing.
Given this experience, the question that now confronts us is, "What can we do to create more
stable housing markets and lessen the boom-bust cycles in housing?" These cycles have
unfortunately become all too familiar over the past few decades.
Some argue that our housing and mortgage markets will not recover in a timely fashion
without extensive public support. Among the suggested solutions are expanding Federal
Housing Administration lending and the role of the Federal Home Loan Banks and allocating
whatever funds are needed to bring the two housing agencies, Fannie Mae and Freddie Mac,
back to their pre-crisis role for housing. Other ideas include a renewal of tax credits for home
purchases and more extensive programs for mortgage restructurings. From the Federal
Reserve, some want a continuation of near-zero interest rates for an extended period and
greater investments in mortgage instruments.
In sharp contrast to that view, others suggest that the financial crisis has exposed a number
of critical flaws in our housing policies and mortgage finance system that call for a significant
"re-look" at how we finance this industry. For instance, Paul Volcker, who was chairman of
the Federal Reserve during a portion of the 1980s real estate crisis, recently described the
U.S. mortgage industry as "dysfunctional" and a "creature of the government" that needs
reform.
The options seem to fall out to either rebuilding a system backed by extensive public support,
subsidies and other protections, or build a new framework that returns housing finance to
greater reliance on private market forces.
I support a policy path that returns the housing industry toward greater market discipline and
greater long-run stability. This path requires a greatly reduced role for governmental
intervention and public subsidies that have distorted the market over recent decades. The
American public, including aspiring homeowners and those of you employed in the housing
industry, might be best served, over time, by reducing or removing these subsidies as part of
our national policy.
There are several factors that argue for making such a change in policy. First, the crisis
clearly shows that a mortgage finance system based on expanding the incentives and
opportunities to take on more debt with little equity places households at significant financial
risk and creates unsustainable trends in housing expansion.
Second, such policies create harmful distortions within the economy, and they are
enormously expensive in terms of both their explicit and implicit costs, to both taxpayers and
homeowners, especially when things go badly. Many of the subsidies directed toward
housing have been extremely inefficient, with other parties capturing most of the benefits
rather than homeowners.
Moreover, with the growing federal budget deficits and the many interests that will be
intensely competing for public funds, it is unrealistic to expect that all can be accommodated
or that housing can continue to command the same portion of public funds and levels of
taxpayer support and exposure. In brief, housing policy is badly flawed, and today's budget
environment requires reform.
Fix Freddie and Fannie
What specific steps should we take? The first and most obvious step is to reform the two
housing finance vehicles of Fannie Mae and Freddie Mac. These two institutions were
responsible for more than half of all U.S. mortgages passed through the system at the height
of the housing boom. These government-sponsored enterprises were assigned goals around
affordable housing that contributed dramatically to the growth in subprime credit and the
decline in lending standards that led to the crisis. Fannie and Freddie clearly fit the pattern of
what Paul Volcker said we must avoid: "Private when things are going well and public when
things are going badly."
Several studies have found that the various subsidies received by Fannie and Freddie have
done little to lower mortgage rates. Instead, the vast majority of such benefits accrued to
Fannie and Freddie's stockholders or was used to gain political favor. For example, only two
months before Fannie Mae and Freddie Mac were put into conservatorship in September
2008, media accounts detailed how both had made the list of Washington's top 10 lobbying
spenders over the previous decade. Together, they had spent a total of $170 million.1 At that
time, Fannie employed 51 lobbyists and Freddie paid 91, with both counting former members
of Congress among their hired guns. This was only two years after the Federal Election
Commission levied a $3.8 million penalty against Freddie related to charges it was illegally
involved in 85 political fundraisers.
Considering the high level of political activism on the part of these GSEs, it should not
surprise you to learn that both Fannie and Freddie are considered "heavy hitters" on the
Center for Responsive Politics' website, OpenSecrets.org, which provides a wide range of
data on money's influence on U.S. elections and policy. That designation means that both
are among the biggest donors to federal-level politics since 1989.
So, while Fannie and Freddie have spent millions on lobbying and building influence in
Washington, their losses could cost taxpayers as much as $363 billion, according to recent
estimates - and those are just the direct losses. The overall losses that could be attributed to
the GSEs are likely to be several multiples higher when we consider that without their implied
"federal guarantee" and related incentives around risk, the markets might have been far more
cautious and the financial crisis far less prolific. More stunning perhaps, had these
institutions been held to stricter financial standards, far fewer households would have
suffered the tragedy of foreclosures, the lost home equity and the loss of personal savings
and wealth that today continues to hold back our economic recovery.
Given the costs and market distortions these government-supported institutions brought with
them, we should be confident that they should not be allowed to operate in the future as they
have in the past. We cannot afford to ignore that through their use of implicit government
funding guarantees, they held a significant competitive advantage in the marketplace, and
that this in turn encouraged excessive risk on their balance sheets, with tragic outcomes.
Given past errors, how might we approach the need for some modest support for future
financing within the housing industry? I see two basic options.
First, if we judge that some public support is needed, we could establish public entities that
focus solely on the securitization of conventional, conforming mortgages with strong
underwriting standards, tight public oversight and balance sheets limited to holding amounts
necessary for warehousing loans to be securitized. This makes the government a conduit
only, facilitating the flow of capital but not providing the implicit guarantees on funding and
assets held that contributed to this crisis. The market remains the final arbiter of standards
and funding.
A second option would be to give private entities sole authority to securitize pools of
conforming mortgages - similar to what is now done with jumbo mortgages. If the Congress
was disposed to provide some favor to housing, a federal guarantee could be given to certain
securities backed by mortgages meeting strict conforming loan standards. However, such
favored status should be based on some limiting factor, such as need or special purpose.
Either of these two options would address many of the problems associated with Fannie and
Freddie in this crisis and would create a more transparent and competitive marketplace. The
latter option involving privately owned entities would offer the additional benefits of greater
market discipline and insulation from political influence and control.
Enforce sound lending standards
Regardless of these actions, we must as a nation insist on the return to sound real estate
lending standards. We know today that countries that avoided the worst of this most recent
real estate meltdown did a better and more consistent job in maintaining an effective and
consistent set of standards for loan-to-value and debt-to-income ratios. Some countries, such
as Canada, even tightened mortgage lending requirements when real estate markets heated
up. In the United States, the opposite occurred.
While sound credit standards are a key responsibility of individual lenders, public policy also
played an important role in the deterioration of loan quality in the United States. This
occurred largely through public efforts to promote and subsidize homeownership and
increase access to housing credit. During the crisis, politicians, regulators and market
participants were singled out for blame. In reality, it was a group effort.
In the years leading to this most recent crisis, a common theme emerged at all levels:
Households can accommodate more debt relative to income. A report titled The 1994
National Homeownership Strategy: Partners in the American Dream
stated: "Financing
strategies fueled by the creativity and resources of the private and public sectors should
address ... financial barriers to homeownership [and] ... reduce downpayment requirements
and interest costs by making terms more flexible." In other words, the key to homeownership
from a political perspective is to promote more creative and flexible lending standards, or
what, in hindsight, we might more correctly call high leverage.
This political desire for creative and flexible lending was hardly new in 1994, though. It was
also a central fixture in the real estate collapse of the 1980s. A Senate report on a 1982
legislative provision to remove national bank loan-to-value limits on real estate lending
provides a powerful insight into the causes of financial crises. According to this report, the
purpose of the legislative change was "to provide national banks with the ability to engage in
more creative and flexible financing, and to become stronger participants in the home
financing market."
Although creative and flexible financing might remain a goal in housing, sound lending
standards cannot be ignored if we are to have sustainable housing growth. With this in mind,
the Federal Reserve in 2008 revised rules implementing the Home Ownership and Equity
Protection Act. These rules simply prohibit lenders from making loans without considering a
borrower's ability to repay the loan from income and assets other than a home's value. Who
would have thought it necessary to write rules that are otherwise nothing but common
sense?
We should also take a closer look at the loan-to-value guidelines that depository institutions
are required to follow in making real estate loans. We should review guidelines to ensure
they are adequate, and we should apply them equitably to other lenders. Other lending
provisions, subsidies and public policies directed toward the housing sector and home
financing also need to be examined. These would include the risk weights for mortgage loans
and mortgage-backed securities under the Basel capital requirements, state and federal tax
deductions for mortgage interest, reliance on credit rating agencies' assessments of
mortgage-backed securities, and the wide variety of other public policies related to housing.
Given current housing conditions and the way a number of subsidies have become
embedded in our housing system, some policy reforms would have to be phased in gradually
and after markets have recovered.
A key point in reviewing U.S. housing finance policies should be to consider whether they
encourage homeownership in a cost-effective manner without putting homeowners at
unacceptably high financial risk. The 2005 President's Advisory Panel on Federal Tax
Reform, for instance, concluded that the federal tax deduction for mortgage interest provided
an "incentive to take on more debt," involved large subsidies that encouraged
"overinvestment in housing" and was "not shared equally among all taxpayers," with
higherincome households receiving "a disproportionate benefit." Accordingly, the panel
recommended replacing the deductions with tax credits and placing a cap on the benefits as
a means of distributing the benefits more evenly and limiting the incentives to take on
excessive amounts of debt.
With regard to promoting housing through interest rate policies, I have many times publicly
expressed my views about the dangers of using monetary tools and the Federal Reserve's
balance sheet to pursue low interest rates and fund mortgage-backed securities. The only
additional point that I would repeat is that for home financing to follow a path that is
sustainable over time, the Federal Open Market Committee must begin taking steps to
normalize monetary policy.
Conclusion
Economists Hyman Minsky, Charles Kindleberger, and, more recently, Carmen Reinhart and
Kenneth Rogoff have all written extensively about how high credit growth and the financial
imbalances that develop during economic upturns sow the seeds for future financial
instability. In a similar manner, a Norwegian economist looked at banking and financial crises
in Norway going all the way back to the early 1800s. She found that every major crisis was
preceded by a rapid run-up in real housing prices. Consequently, it is apparent that
unsustainable trends in housing prices and home financing have been a major contributor to
financial crises.
The United States stands virtually alone in its use of GSEs and significant subsidies to
promote homeownership. Fannie Mae, Freddie Mac and their political supporters have long
attempted to justify this system by saying that "American housing finance is the envy of the
world." Few would believe that today.
It is time for a significant change. We must move toward a system with fewer subsidies and
misdirected incentives. Furthermore, to ensure accountability, any housing subsidies that we
decide to keep should be made explicit, voted on transparently and carefully targeted to the
intended beneficiaries: potential homeowners most in need and for whom such support will
bring success.
Many of you might question whether a system with greatly reduced subsidies will work. A
partial answer to this question can be found in international comparisons. A recent study, for
instance, found that in terms of homeownership rates, the United States ranked only 17th out
26 economically advanced countries. Many countries have achieved higher homeownership
rates without - and perhaps because they don't have - many of the special privileges of U.S.
housing finance, such as GSEs, minimal down payments, 30-year fixed-rate loans and
mortgage interest tax deductions. To this list, we could also add non-recourse debt
instruments, government promotion of "creative and flexible financing," the ability to prepay
loans, affordable housing goals and similar government housing programs.
In making these remarks, I am not suggesting we do away with all support for housing. I am
saying it is time for change.