Dissecting the Federal Reserve’s Housing White Paper

Last week the Federal Reserve released its white paper outlining current conditions in the housing market as well as a framework for addressing a number of issues preventing market stabilization.housing-white-paper-20120104  After a media blitz by several senior Fed officials, the proposal garnered considerable attention both by the media as well as among policymakers and the industry.  The Fed white paper provides a number of tantalizing ideas regarding ways to reinvigorate the moribund housing market and while this renewed interest in housing is welcome, any significant short-term relief to markets is unlikely to occur.  In assessing the framework’s ability to address underlying problems in the market, I have categorized issues from the white paper as follows:

Reducing market uncertainty

The Fed references several examples of how uncertainty in government policy and the economic environment has up to this point dampened more robust participation by lenders, borrowers and investors in activities that would otherwise  stabilize home prices and the mortgage market.  Although a host of other structural problems have impeded meaningful housing recovery, uncertainty over policy and market outcomes created over a period of years since the crisis due to a host of reactive and disconnected policy actions is perhaps the greatest impediment to market stabilization.  Such is the case with repurchase uncertainty hanging over lenders these days as well as concerns over employment and the direction of home prices in the near-term for prospective borrowers.  The tip of the housing policy spear in the Fed’s view are Fannie Mae and Freddie Mac, the twin housing GSEs which remain in a state of suspended animation while the government figures out what it plans to do with them in the long-run.  Maintaining these two agencies in their current state is no longer in the best interest of achieving the goal of stabilizing housing in the next few years.

GSE Consolidation

It isn’t much of a stretch to wonder why so there remains so much tentativeness in housing by market participants when you consider that we lack of a comprehensive housing recovery plan.  So far housing policy in this area has been piecemeal and somewhat ad hoc in nature, with various loan modification programs and their limited effects epitomizing efforts to date.  Part of the problem lies in the fragmented accountability for housing that crosses multiple federal agencies, and state and local legal jurisdictions.  The Fed points out how raising Gfees for the GSEs may be hampering mortgage refinancing and yet we now have the new payroll extension bill adding another 10bps to GSE Gfees.  Here is yet another example of consensus-based policymaking that imposes adverse impacts on markets already under significant duress.   Additional uncertainty arises for prospective homebuyers worried about buying a home and then losing their job or part of their income and/or seeing their home’s value drop in price.  I will revisit this issue in the next section.  The GSEs themselves introduce a fair amount of uncertainty and unnecessary confusion at the moment to lender partners in terms of differences in policies and terms of business.  Although operating under FHFA conservatorship some general policy alignment between the GSEs has been taking place, now is the time to consider a radical strategy of combining the two with the intent of creating a GSE good bank/bad bank structure.  The retained portfolios of each firm should be combined into a “bad bank” operation charged with aggressively managing down the portfolio consistent with activities that maximize value for the taxpayer.  Likewise the guarantee businesses of both Fannie and Freddie should be consolidated into one organization (“good bank”)with the mission to enhance market liquidity and access to credit.  With the CEOs of both companies turning over and significant reductions in force taking place over the last year or more at both GSEs, now may be an opportune time to realign the organizations.  Separating the retained portfolios from the guarantee business into two distinct entities focused on front- and back-end activities improves the ability of the agencies to be more agile and responsive to these very different aspects of the housing market.  It also would introduce greater clarity and efficiency into the marketplace for lenders and investors to have to deal with one instead of two organizations.

Stimulating Mortgage Demand

The Fed white paper outlines the need to address tight credit lending standards by banks as well as financing mechanisms for bulk REO investment.  In the case of mortgage lending standards the Fed is largely without answers.  Nevertheless, I find it ironic that the Fed expresses such concern over tight credit standards now when during the housing boom the interagency task force on nontraditional mortgages issued its guidance well after that horse was out of the barn.   In fact, raising issues that “less than half” of 620 FICO borrowers putting 10% down on a home receive a mortgage offer seems a bit incongruous with the initial Qualified Residential Mortgage (QRM) proposal under the Dodd-Frank Act’s risk retention provisions defining QRM eligibility for purchase money mortgages that have at least 20% down.  The Fed paper places part of the blame for tight credit conditions on GSE repurchase activity and Basel III MSR provisions.  No question that limiting the percent of MSRs to Tier 1 capital to 10% incents holders of these assets to rethink their strategic contribution to the firm.  Moreover, aggressive GSE repurchase activity following the crisis perfectly illustrates the conflicts in policy viewpoints and agendas among federal agencies.  FHFA is appropriately focused on activities that minimize taxpayer exposure to the GSEs and robust repurchase processes serve that purpose but clearly create unintended consequences as a result.  The potential to use repurchase insurance products that exist today could be one way for lenders to expand lending consistent with GSE terms.  In the end, however, the economics of the transaction have to make sense for the lender and given alternative investments and balance sheet constraints, it may be some time before lenders find mortgages a strategic asset in growing their business.  Finally, the lack of borrower demand isn’t just due to tight lending practices but also the psychological damage prospective borrowers have suffered through prolonged economic weakness.  I’ve written about this before, specifically outlining new products that could entice borrowers back in the market if sufficient protections to their mortgage payment and home values are provided. HousingCrisis

Supply-side Remedies

The Fed’s discussion of how to address stubbornly high REO levels through REO rental programs may have some potential, but understanding the needs of both holders of REO assets and prospective investors is instructive.  The Fed may be first understating the amount of REO inventory that would be attractive to investors.  Recent figures suggest that 14-15% of distressed properties are damaged.  The costs of rehabilitating such properties is costly and cannot be understated.  The Fed offers some calculations suggesting that REO cap rates estimated at around 8% may be attractive to investors given rent and home price trends.  Behind such numbers are assumptions on vacancy rates of single family properties as well as costs with maintaining these properties.  And while cap rates for multifamily investments compressed in 2011 (ranging between 6.5% and 9+%) reflecting interest rates and competition in the market for high quality properties, large differences in managing a pool of single family versus multifamily properties remain.  For example, a 50-unit multifamily property enjoys geospatial efficiencies in maintenance that a pool of single family properties does not enjoy.  Another metric, the debt-service coverage ratio for a typical multifamily deal needs to be at least above 1.25 to be attractive to investors and so differences between what bulk REO investors are willing to pay and what REO holders are willing to give up create pricing discrepancies that have thus far precluded market clearing on a significant scale notwithstanding a host of other contributing factors to this problem.  Further, with a quarter of REO held by banks, until some mechanism is created to mitigate the hit to banks for REO haircuts that would allow for market clearing, the impasse will continue.  Compounding the problem as the Fed rightly calls out is a lack of debt financing structures to accommodate bulk REO purchases.  Both issues are addressed in an earlier policy briefing I provided on stabilizing housing by development of a private-public financing structure that imposes no additional costs onto the taxpayer (See link above).

Homeowner Fairness and Loss Mitigation Efforts

We have struggled since the crisis to find an effective program to help maintain homeownership that balances fairness and economic realities.  Various incarnations of loan modification programs have been spectacular failures – for some reason thinking that we could create a set of standard rules that explain the unique circumstances of each and every borrower is another great example of the lack of creativity allowed in shaping such programs.  I recall my astonishment not all that long ago as Chief Risk Officer at a major bank at being told by one regulator that the custom loan modification program my risk management group had developed had to be replaced with a “Mod-in-the-Box” one size fits all program.  With a standard 31% debt-to-income ratio rule applied to all borrowers is there any wonder why we’ve had so little improvement in modifications?  The Fed brings up principal reduction programs as a possible solution to negative equity problems but proceeding along this path without appropriate incentives behind such a program is fraught with danger.  Surprisingly, Mr. Dudley at the New York Fed downplayed the impact of moral hazard used in such cases, and I’m wondering if he may have seen the statistics on strategic defaults.  In any event, principal forgiveness even if earned poses significant incentive issues for borrowers and equity issues as well.  What exactly will the 30% or so of all homeowners that own their house outright think about principal reduction?  As he states, “We either assist everyone or assist nobody.”

Summary Thoughts

While this vivisection of the Fed white paper might have readers thinking that it has little to cheer about, the glass is half full view suggests something very different. Surprisingly it represents the real first attempt to put an issues and policy framework together for housing and thus raises the stakes for other policy participants to participate and react.  However, it severely misses the mark to provide a comprehensive strategy for addressing housing policy by not offering any tangible solutions to act on.  We are now in the 5th year of the housing downturn and it is disappointing that for all of that time the best we have to show for it is a summary framework recommending more analysis.  Between Treasury’s white paper on GSE reform and this effort, a great deal of uncertainty remains over the fortunes of the housing market.  Political rhetoric and turf issues aside, a coherent strategy for housing needs to be established that goes beyond the incrementalist approach taken so far and introduces creative structural solutions addressing market uncertainty, financing and equity.