In a two-part series, experts will tackle fundamental questions left over from the housing bubble crash: What should we do with Fannie Mae and Freddie Mac? How should we reform the market so that it is fair and risk-free? In the second part, David Min, Associate Director for Financial Markets Policy at the think tank Center for American Progress, argues for keeping the government involved in the housing market by creating an FDIC-inspired backstop. **Read part one here.
1. What went wrong with the GSEs?
Starting in the early 2000s, "private-label securitization," which was essentially unregulated, began to grow astronomically. This growth came primarily at the expense of the GSEs, whose market share dropped by a roughly equivalent amount. In an effort to regain their market share, the GSEs took on more risk, both in terms of the loans they guaranteed and also as far as the securities they acquired for their own account.
As we now know, the extraordinary growth in PLS was based on a fundamental mispricing of risk and structural problems in the process, including shoddy underwriting, misaligned servicing incentives, and bad credit ratings. This led to two distinct sets of problems for the GSEs. First, it created a housing bubble, which disproportionately impacted them, as they are entirely focused on housing finance. Second, the riskier products they acquired or guaranteed in their "race to the bottom" defaulted at rates much higher than expected.
2. What is wrong with simply privatizing the mortgage market?
First, we would be providing an enormous taxpayer-funded windfall to the big financial institutions that caused the financial crisis. Second, we would be effectively punishing many Americans by eliminating the New Deal legacy of broad availability of consumer-friendly mortgages to working- and middle-class households.
As we learned from the Great Depression, banking poses an enormous amount of systemic risk. Exacerbating this risk is the contemporary problem of "too big to fail" banks, which means that effectively, large financial institutions are believed to enjoy an implicit government guarantee on their obligations. It appears that this guarantee is already benefiting them, providing them with significantly lower funding costs than smaller financial institutions.
It is these largest financial institutions that would benefit the most if we adopted either of the Obama administration's privatization proposals. The $5.5 trillion in mortgage financing for the working- and middle-class that is currently provided by the GSEs would need to be replaced by either lenders willing to buy and hold loans on their balance sheet or by private-label securitization. The six largest U.S. financial institutions-Bank of America, Wells Fargo, JP Morgan Chase, Citigroup, Goldman Sachs, and Morgan Stanley-account for over $1.2 trillion in balance sheet-funded mortgage lending, over a third of all such loans. Moreover, these firms, which currently hold about $9.275 trillion in assets, have even greater market power in the investment banking sector, particularly given the consolidation that has occurred in the aftermath of the financial crisis. Thus, they are likely to dominate a private-label mortgage securitization market, when and if this returns to becoming a major financing channel.
If these large financial institutions (and other very large or systemically significant firms) held or guaranteed any significant portion of the $5.5 trillion in mortgage loans currently financed through Fannie and Freddie, it would clearly escalate the problem of "too big to fail", particularly given the importance of residential mortgage debt both for the financial markets and the broader economy.
Privatization would also be bad for consumers. There is limited evidence of what a privatized mortgage market would look like. Since the New Deal, the U.S. government has supported a large segment of the mortgage market either through federal deposit insurance or guarantees on securitization. And there is no developed economy in the world that does not provide significant amounts of government support. (For example, in Canada the government explicitly guarantees up to 70% of outstanding mortgages; in western European countries, governments implicitly guarantee 100% of their mortgage markets.)
The pre-New Deal era illustrates why privatized residential mortgage systems are so rare. Mortgages were only available to higher income and higher wealth borrowers, and even then only on terms that would be considered predatory today: short-term, interest-only, high rates, and high down payments (typically 50%). While this is obviously a very dated example, it is striking that in some important ways, it resembles the current market for commercial real estate finance. As Elizabeth Warren has noted, commercial real estate loans today generally have terms that closely resemble pre-New Deal residential mortgages: short-term, interest-only, high interest rates, and high (often 50%) down payments. And of course these loans are generally reserved for higher wealth borrowers.
All of this points to the same conclusion: privatization would lead to a sharp reduction in mortgage liquidity and a transition away from consumer-friendly products.
3. What does the experience of the jumbo mortgage market tell us about whether a privatized mortgage market can well serve the broader mortgage needs of America?
Nothing. The jumbo market serves higher wealth, higher income Americans, and no one disputes that private capital, absent a guarantee, can provide mortgages to this class of homebuyers as it has always done. It is also clear that since the New Deal, private capital has provided jumbo loans with consumer-friendly terms and prices that are reasonably competitive. But to simply note these facts misses the point.
The questions at issue are these: 1) will private lenders continue to provide affordable and consumer-friendly loans if we get rid of the government-guaranteed portion of the market; and 2) in the absence of a government guarantee, will the private markets make such products broadly available to all Americans (including working- and middle-class households)? As I noted above, the limited historical evidence suggests that the answer to both of these questions is no. This finding is reinforced by our experience in the 2000s, as private non-guaranteed capital exhibited a strong bias towards high cost, predatory products when it gained significant market share. Moreover, it is important to note that the availability of competitively priced jumbo 30-year fixed-rate loans is based in large part on the existence of deep and liquid markets for Fannie and Freddie securities, which allows private securitizers to finance, rate-lock, and hedge their own securities backed by jumbo 30-year fixed-rate loans.
The jumbo market argument also fails to appreciate the important differences between jumbo financing and the rest of the market. Jumbo mortgages are financed either by lenders who originate and hold loans or through private-label securitization. Most all other mortgages are financed by investors in government-guaranteed MBS. These investors include foreign central banks, fixed income investors and regulated financial institutions, which purchase government-guaranteed securities either because of investment objectives or regulatory incentives. The attraction is that they have essentially no credit risk, don't require due diligence, and are very liquid.
In the absence of a government guarantee, these investors would be looking at securities that carry significant credit risk, require high levels of independent due diligence, and are highly illiquid (particularly after the PLS debacle of the last decade)-in other words, exactly the opposite of their preferences. It seems implausible that these investors would purchase such securities in the amounts necessary to make up the $5.5 trillion in mortgage financing currently provided by the GSEs.
4. Will there be 30-year fixed-rate mortgages in the future? What are the consequences of this?
Under privatization proposals, 30-year fixed-rate mortgages would clearly not be widely available. Some advocates of privatization dispute this claim, primarily based on their availability in the jumbo markets. As I noted in the previous section, that argument is flawed, even more so when it comes to this particular product. The long 30-year duration gives significant interest rate and liquidity risk to lenders. As a result, banks and thrifts have dedicated an increasingly small amount of their balance sheet lending to 30-year mortgages since the high interest rate increases of the late 1970s and 80s. And as explained above, there is likely to be a lack of investor capital for this product from securitization.
Only one other country in the world, Denmark, provides broadly available 30-year fixed-rate mortgages, and the Danish government implicitly guarantees 100% of the market (most recently evidenced in a series of sweeping bailouts, including a blanket guarantee for its entire banking system.)
But why should we want the 30-year fixed-rate mortgage? I have made the argument more thoroughly in a brief I wrote last year, but here are two reasons. First, it provides borrowers with cost certainty in housing, the largest single monthly expense for most families. This is increasingly important in a world where working households are taking on greater amounts of risk and uncertainty. Its value is at its highest during periods of housing market distress-when interest rates are rising and the availability of refinancing options has decreased. Given the high near- to medium-term likelihood of interest rate and house price volatility, this cost certainty will be ever more important to household stability. Second, the 30-year FRM places interest rate risk and others with parties that are better suited to handle them-sophisticated investors who can plan for, capitalize against, and sometimes hedge against them.
5. What does your plan do to fix the problems?
Our plan tries to essentially keep the significant benefits created by the New Deal while reining in systemic risk and protecting the taxpayer from loss. In addition to specific measures designed to encourage mortgage liquidity to underserved communities and borrowers, including for rental housing, what we have essentially proposed is a replication of the FDIC model of regulation, insurance, and resolution around an explicit, very limited government guarantee for certain conforming MBS. We would require firms that receive this guarantee to put up significant amounts of capital (somewhere between 4-9 times the levels currently put up by the GSEs), which would stand against non-catastrophic credit losses. Should these amounts be insufficient, and the CMI effectively insolvent, resolution authority would be exercised and a Catastrophic Risk Insurance Fund, modeled after the FDIC's Deposit Insurance Fund and funded by assessments on the industry, would step in to make timely payment of interest and principal to guaranteed MBS investors.
To be clear, under our proposal investors in government-guaranteed MBS would first be paid from the underlying mortgages that collaterize the MBS. If these were insufficient, they would be paid by the CMI's assets. Only if the CMI's assets were insufficient and it had to be taken over by regulators would the industry-funded Catastrophic Risk Insurance Fund be tapped. And only if this Fund, which would have the ability to tax the industry on a going forward basis to make up shortfalls, went insolvent would taxpayers be on the hook for a single dollar. We think these various firewalls against taxpayer loss, coupled with strong regulatory oversight, are sufficient to ensure that such a loss never occurs.
Conversely, if we privatized the mortgage finance system and handed it over to the largest financial institutions, there would be no protections against taxpayer losses.
6. What happens if we misprice the fee or let regulation go lax?
First, the private sector hasn't shown itself to be particularly good at pricing risk either, as evidenced most recently in the PLS debacle, and we've seen that its losses in today's "too big to fail" era can cause taxpayer losses.
Second, the government doesn't need to price risk perfectly, but to ensure it doesn't underprice risk (and expose taxpayers to losses). Moreover, in the event that a CMI failure caused the Fund level to dip excessively low, it would have the ability to levy prospective fees on surviving CMIs to replenish itself.
Finally, it is worth noting that the government actually has successfully provided similar forms of catastrophic risk insurance in the past, including with the FDIC, the Federal Housing Administration, and the Terrorism Risk Insurance program.
David Min is Associate Director for Financial Markets Policy at the think tank Center for American Progress.