How Accident-Prone Is America’s Housing Finance System? Assessing Its Stability Circa 2022 (Part 1 of 2)

Introduction

America’s housing finance system (HFS), which today funds approximately $13 trillion in first mortgages for almost 50 million homes, is a major component of the overall U.S. financial system and has long been a critical source of support for homeownership. Yet it has also been unusually prone to instability, as housing finance was at the heart of both of the two largest financial crises since World War II (WWII): the Savings & Loan (S&L) Crisis of 1989¹ and the Great Financial Crisis (GFC) of 2007-2009.²  

These two crises have proven how difficult it is for policymakers to spot and remediate potential HFS instability before it causes serious damage. Complexity has been one major driver of that historic instability, and the HFS has only grown more complex since the GFC, including due to the significant reforms adopted to address many weaknesses exposed at that time. Meanwhile, the HFS continues to support a homeownership rate of 65 to 66 percent since the end of the pandemic, a level that history shows is a strong performance. 

Three recent policy actions — two already implemented and one still being developed — have already begun to impact the HFS starting in about 2023. While none are intended to affect financial stability, the first two have already modestly weakened it as an unintended consequence.  

Part 1 of this two-part series will assess the HFS’s vulnerability to another “accident” as of 2022, before these policy changes began to take effect. The assessment is based both on the weaknesses revealed in previous historic stress episodes and on the extent to which post-GFC reforms reduced earlier levels of systemic risk. The conclusion is that the HFS circa 2022 was much less likely to experience an accident compared to the pre-GFC period, mainly due to the reforms made primarily via revised regulations and the Dodd-Frank Act. Simply put, together they were extensive and reasonably effective. However, some unresolved issues and key sources of potential instability absolutely still remain. 

Part 2 will then analyze the three ongoing changes to assess whether they will increase or decrease the HFS’s likelihood of accidents after they are fully implemented and adopted in the market. These changes involve (1) pricing adjustments at Fannie Mae, Freddie Mac, and theFederal Housing Administration (FHA), and (2) changed and reduced bank capital requirements related to mortgage activities.  

An Overview of America’s HFS Circa 2022

The HFS in place in 2022 was extremely complex. For purposes of this analysis, it can be summarized and understood via four main features.

1. It is government-dominated. The federal government designed almost all of the HFS, regulates virtually all aspects of it, significantly subsidizes it in various ways, and — unusually — acts as a major direct participant, especially as a credit risk guarantor.³ In 2022, about two-thirds of the funding for the $13 trillion in outstanding first-lien single-family mortgages in the U.S. came from two types of government-created secondary market organizations: (1) the government-sponsored enterprises (GSEs) of Fannie Mae and Freddie Mac, and (2) three government offices, most notably the Federal Housing Administration (FHA).⁴ One key aspect of the government design of the HFS is a focus on monolines — organizations designed to be solely or almost solely involved with residential mortgages. This supposedly makes policymaking easier to implement but also creates organizations with tremendous concentrations of risk, a vulnerability to stability discussed further below.  
2. The HFS is based on “mostly government-backed securitization.”  The GSEs and the FHA etc. all utilize pass-through securitization to provide funding for their mortgages.⁵ In other words, the mortgage loans and the liabilities funding them “match” each other, avoiding the twin mismatch risks of liquidity and interest rates that eventually crippled the thrifts and produced the S&L crisis of 1989.⁶ The GSEs plus FHA etc. also guarantee that investors in their mortgage-backed securities (MBS) are protected from credit losses. This means investors are only exposed to interest rate and liquidity risks, not to the risk of borrower default.⁷ The market for such MBS (called “agency MBS” because they are issued by the two GSEs and through Ginnie Mae) is extremely large. As a result, the GSEs plus FHA etc. are able to readily finance about two-thirds of the entire $13 trillion asset class of first-lien single-family residential mortgages. All of these mortgages are backed by government support. That level of market share results in unprecedented exposure to mortgage credit risk for the U.S. taxpayer.  
3. Many specialized firms dominate the HFS, adding to its complexity. Securitization, the dominant form of mortgage funding, has in turn led the HFS to be composed mostly of organizations — both private companies and government offices — with one or more major specialized roles. These roles include: (1) originating mortgages, (2) providing funding, (3) taking on credit risk, and (4) servicing loans. There are also additional smaller and more specialized roles, such as offering mortgage insurance or underwriting and trading mortgage-backed securities. This structure is vastly more complex than the simple “buy and hold” approach used by the thrifts that dominated the immediate post-WWII era. The organizations that now perform these specialized functions cover a broad spectrum.  In addition to the already-mentioned FHA etc. (which includes four different government offices) and the two GSEs, it includes independent mortgage banks (IMBs, which despite the name, are actually non-banks), commercial banks, the Federal Home Loan Bank System, private mortgage insurers (PMIs), securities firms, global bond investors, and others. The connections among these organizations, which are necessary for the system to work, are numerous and often involve subtle risks. 
4. Commercial banks play a limited role as holders of mortgages. In 2022, single-family mortgages held by commercial banks prudently amounted to about 10 percent of their aggregate assets,⁸ reflecting in part the difficulty they face in matching their deposit-based funding to the long-term fixed-rate nature of typical American mortgages – the mismatch that was at the heart of the S&L Crisis of 1989. As a result, commercial banks (along with some specialized depositories) held only about 20 percent of outstanding mortgages in 2022, a significant but clearly far from dominant market share.⁹  
     

Identifying Potential Sources of HFS Instability Remaining in 2022

To pinpoint potential sources of instability in the HFS around 2022, I took these steps: 

• I segmented the housing finance system activities into the four main specialty roles: (1) funding, (2) assuming credit risk, (3) origination, and (4) servicing.  
• For each role, I identified the types of firms that account for the vast majority of activity (e.g., for credit risk, the GSEs are the largest, with FHA and banks also material).
• I identified the vulnerabilities for each of those types of firms for each role, relying heavily on the history of problems that developed in the past (e.g., using deposits to fund 30-year fixed-rate  mortgages), along with others discussed within the industry over the last decade or so.

First, and importantly, this analysis validated that all the reforms enacted post-GFC via legislation (mainly Dodd-Frank), regulation, and GSE conservatorship directives very significantly improved the HFS’s resilience and resistance to accidents. That is demonstrated by how many potential issues have been eliminated via reforms from that era. However, I also identified four areas where there was unfinished business circa 2022 to complete a comprehensive program to address HFS’s historic tendency to become unstable. Those areas are:  

1. Capitalization. An increase in capital requirements to improve the resiliency of the HFS, i.e., to reduce the likelihood that some loss becomes destabilizing, was broadly implemented post-GFC, but it was not fully comprehensive, with two areas still needing attention. First, the two GSEs were decapitalized during the Obama administration but have been building capital since 2019 by retaining earnings, with many years to go before they meet a post-GFC regulatory requirement for capital established in 2020.¹⁰ Second, private mortgage insurers (PMIs), monolines that effectively re-insure much of the riskiest mortgage credit risk taken on by the two GSEs,¹¹ have been required to have greater capital via revisions to the GSEs’ eligibility requirements¹² that apply to them. However, this level is still significantly below what the GSEs themselves need to carry the same risk, indicating further increases in PMI capital requirements are likely needed. As a complement to these two sets of companies needing increased capital, it is worth noting that capital requirements on bank activities in mortgages are right now being reformed and likely reduced somewhat (see Part 2), as it has been deemed by the regulators that the previous increases implemented in response to the GFC were sometimes too large.  
2. Risk concentration vs. diversification. Credit risk transfer (CRT) has reduced the extreme concentration of risk associated with mortgage monolines, but not by enough. As stated earlier, when the government designed the mortgage system, it created many monolines, which may be great for focused implementation of policy but is an unhealthy concentration of risk when it comes to stability and accident avoidance. Simply put, such concentrations increase the likelihood that some loss turns into a systemic problem. In 2022, the GSEs accounted for approximately 50 percent of the credit risk on mortgages, while their congressional charters mandate that they be monolines. To address this concentration, starting in 2013, the GSEs began credit risk transfer (CRT) transactions to distribute a significant share of the potential for large credit losses to a diversified group of global institutional investors and insurance companies. As this was successfully chipping away at the GSEs’ tremendous concentration of credit risk, in 2020 the program surprisingly began to be weakened by the Federal Housing Finance Agency (FHFA), the regulator and conservator of the two GSEs.¹³ The resulting hollowing out must be reversed, and the program needs to be restored to its previous vigor. This is entirely the FHFA’s responsibility. Also, the PMIs are similarly monolines and carry particularly high credit risk; they currently use CRT as well, but transparency is inadequate about whether the resulting risk diversification is sufficient.¹⁴
     
3. Procyclicality. While the HFS did not appear unusually procyclical in 2022, there was nothing to stop it from heading in that direction. In addition, it is not clear that any particular government unit is watching this issue or has the tools to prevent it. One long-noted positive feature of heavy government participation in the HFS as a credit guarantor is that it has significantly dampened the usual private-sector procyclicality.¹⁵ Many consider retaining this counterweight to typical procyclicality as a high policy priority to help dampen economic downturns, which in turn reduces the likelihood of stresses that could turn systemic. As of 2022, the HFS’s mix of funding sources was not overly procyclical, but this was largely because the GSEs — which are the only source of mortgage credit with demonstrated countercyclicality in recent years¹⁶— accounted for about 50 percent of the entire $13 trillion market. However, that mix of funding sources could easily become much more procyclical for a variety of reasons. The HFS’s weakness is that there is nothing to stop such changes in market share from happening, even if the result is dramatically increased procyclicality. This will be discussed further in Part 2, especially since the degree of countercyclicality has been eroded in recent years. 
4. Mortgage servicing reliance on independent mortgage banks (IMBs). Independent mortgage banks, which were the dominant providers of mortgage servicing circa 2022, are poorly positioned to take on some of the financial obligations that can arise during times of stress. IMBs have dramatically risen from providing a very small percentage of mortgage servicing, growing market share from 4 percent in 2008 to being the dominant providers, with over 50 percent share, in 2022 (and strong momentum for their share to grow). With this growth, they are replacing the banks for which the servicer role was originally designed. What is not commonly understood is that the role of servicer goes beyond providing an operational service, at times requiring servicers to take on certain financial obligations that may, in particular, require massive amounts of liquidity.¹⁷ Such access to large amounts of liquidity is not something they are inherently strong at, while the banks they replaced are. During COVID-19, circumstances occurred that exacerbated this weakness. Specifically, when forbearance¹⁸ became mandated by legislation during the pandemic, it created a risk of collapse in the servicing industry. By 2022, the industry had handled this threat by “muddling through,” without implementing a strong long-term solution.¹⁹ As a result, this weakness and related problems were identified as a systemic risk issue by none other than the Financial Stability Oversight Council (FSOC), which undertook to issue a report on the topic (which was not completed and published until two years later, as I will discuss more in Part 2). In other words, in 2022, IMBs still faced the risk of liquidity problems during a period of liquidity drain.  
   

Conclusion

Overall, in 2022, the HFS’s accident proneness had clearly been significantly reduced from what it had been going into the GFC. But the four areas of unfinished business listed above are not minor in their potential impact, so they also need to be addressed to complete a comprehensive program to improve the stability of the HFS. 

Part 2 will examine how this stability is being impacted by three changes now underway in the structure of the HFS. So far, the impact on stability has been modestly negative, with more potential impacts expected as the changes become fully implemented.