Joseph S Tracy: Testimony on Housing Finance Reform - essential
elements of a government guarantee for mortgage-backed securities
Testimony by Mr Joseph S Tracy, Executive Vice President of the Federal Reserve Bank of
New York, before the U.S. Senate Committee on Banking, Housing and Urban Affairs,
Washington DC, 31 October 2013.
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Chairman Johnson, Ranking Member Crapo and members of the Committee, thank you for
the opportunity to appear before you today. My name is Joe Tracy. I work at the Federal
Reserve Bank of New York. Today I will be discussing research1 in the area of government
support for housing finance that colleagues and I at the New York Fed have conducted. It is
important for me to emphasize that my remarks today, and the conclusions of the research
that I will share with you, represent my own views and are not official views of the New York
Fed or any other element of the Federal Reserve System.
I commend the Committee for focusing on the elements necessary to constitute a robust
housing finance system in the United States. By "robust" I mean that such a system must
provide for the uninterrupted flow of credit to housing markets even in periods of market
stress. In the wake of the financial crisis, significant progress is underway to improve the
resiliency of financial markets. Nevertheless, we must plan ahead for the risk of future market
stresses.
My co-authors and I have started with the observation that in the face of truly systemic
housing shocks, governments always intervene. It is not hard to imagine why: given the
importance of housing to Americans and our economy, at some level of housing market
stress, the government faces intense pressure to take action. We cannot eliminate the risk
that the government may have to intervene. So we need to acknowledge that risk and
establish a system to reduce and manage it, or we will recreate an implicit guarantee that
puts the taxpayer at unacceptable risk.
In my view, the private sector (and the borrower) must absorb all losses up to an agreed
point, with the government absorbing all further losses. The level at which the government
steps in must be well known in advance and credible to the market, meaning that there
should be no speculation as to when and how the government would intervene.
When should the government intervene? If markets believe that the government will
intervene sooner than it claims, then this will generate uncertainty, and financial markets will
speculate on the timing and nature of the intervention. This uncertainty could have a
destabilizing effect, leading to higher losses that the government would ultimately have to
absorb. A government guarantee that is unclear or not credible, even if it is explicit and
priced, will result in greater costs to the government and, ultimately, the taxpayer.
What should parties pay the government for its willingness to intervene? In my view,
the government must determine its exposure net of the loss absorption capacity provided by
the private sector. This includes evaluating the counterparty credit risks generated by any
risk-sharing transactions. Risk-sharing must require a payment of cash from the private
sector and oversight of the capital and overall risk profile of any participants in risk sharing.
Of course, the required private capital should be of high quality and should be determined
relative to the total risk associated with a given set of mortgage underwriting standards. This
may sound complicated, but it is not brain surgery. The government should bear only the
cost of extraordinary systemic risks and the private sector must bear losses associated with
the normal business cycle. If this can be arranged, then the largest portion of the overall
guarantee fee will be priced by the market and not by the government.
An important design decision for a housing finance system is whether the government
backstop will apply directly to mortgage-backed securities, their issuers, or some other legal
entity. An institution-based program could erode private sector discipline, while a
securitybased backstop would pick up the idiosyncratic and cyclical risks that are better left to the
private sector. Seeking to balance these concerns, I have explored the notion that
government support would be triggered by the total losses across an entire group or
"vintage" of mortgage-backed securities.
Vintage-based support would likely only be triggered by a true systemic shock. A vintage
approach would also provide a transparent and finite maximum loss for the private sector to
absorb, supporting robustness at the onset, during, and through the aftermath of a crisis. I
believe that the costs of the recent devastating economic downturn would have been far less
to the taxpayer, and the housing market would have rebounded far quicker, had a
vintagebased program containing adequate high-quality private capital been in effect.
Attracting private capital to finance residential real estate is another important consideration.
It is difficult for institutions that depend on short-term funding to take long-term interest-rate
risk - for example, the long-term interest-rate risk posed by 30-year fixed-rate mortgages. It
is also difficult for investors who do not do the underwriting themselves to take long-term
idiosyncratic credit risk. Securitization backed by a predictable level of government support
has a useful function in facilitating the allocation of these different risks to different sets of
investors through the To-Be-Announced or "TBA" market. I think the TBA market will be key
to ensuring Americans' continued widespread access to the 30-year fixed-rate mortgage.
The TBA market is also important to the role of small banks and lending institutions in a
competitive housing finance system. Ensuring an easy, predictable path to securitization of
standardized mortgage products is essential to making mortgage credit available throughout
our country - in traditionally underserved rural areas and urban areas, and to all sorts of
current and potential homeowners, provided by financial institutions of different sizes in
different locations. A strong regulator whose primary focus is the housing finance system can
also help ensure fair access to smaller institutions.
In summary, it is my personal belief that housing finance reform must incorporate an explicit
government backstop accompanied by significant sources of high-quality first-loss private
capital. Thank you for the opportunity to appear before you today. I look forward to your
questions.