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If the US government continues to underwrite the mortgage market, then the one thing it should not do is pad banks' profits
The administration took its first step toward resolving the final status of Fannie Mae and Freddie Mac with a big conference at the White House last week. In keeping with its housing policy to date, it seems intent on taking the worst possible course.
These mortgage giants have played an important role in making housing more affordable in the United States. Fannie Mae created the secondary market in mortgages when it was established as a government-owned company during the New Deal. Its willingness to buy mortgages from banks essentially created the basis for the 30-year fixed rate mortgage that is the standard today.
The virtue of the original Fannie Mae was that it was simple and cheap. It bought and held 30-year mortgages. It did not securitise them. This avoided the costs and risks associated with securitisation. At every step in the securitisation process, the financial industry expects to make money, and often lots of it, since salaries are so bloated. In addition to saving these costs, a public Fannie also had no incentive to engage in risky gambles to inflate profits. Its senior management was paid civil servant wages, not the tens of millions that go each year to top Wall Street executives.
Holding the mortgage on its books meant that Fannie Mae, and therefore the government, was bearing the interest rate risk associated with the mortgage, in addition to the risk that the mortgage would go bad. Interest rate risk is the risk that interest rates will rise. If the standard interest rate for a 30-year mortgage rises from 5.0% to 6.0%, then a newly issued 30-year mortgage will lose more than 12% of its value. Sharper rises in interest rates, as we saw in the inflation-wracked 1970s, led to large losses on mortgages for Fannie and Freddie, as well as banks and savings and loans institutions that held 30-year mortgages.
While this risk is raised as a danger if these government-owned mortgage giants are allowed to hold their mortgages, it really does not pose a problem for the government. The government is a massive issuer of long-term debt. In the event that the government-owned Fannie and Freddie are taking a big hit due to a rise in inflation rates, then the government is simultaneously getting a bonanza from the reduction in the real value of the debt it owes.
In other words, insofar as a sudden burst of inflation erodes the value of the mortgages held by Fannie and Freddie, it will likely be offset by the reduction in the value of the debt the government owes the public. In short, we are hedged against this risk.
If we are interested in a cheap and efficient way to sustain the secondary mortgage market, it would be hard to beat the old government-owned Fannie model. It may make sense to keep Freddie as a source of competition and to ensure some dynamism, but if efficiency is the goal, then the keeping Fannie and Freddie as government-owned companies would be the way to go.
But this approach seems to be off the agenda "“ since it makes too much sense. Instead, the consensus seems to be to design some hybrid model in which private profit-making banks will decide which mortgages will get a government guarantee.
We are assured by the housing finance wizards that the government regulators will effectively police the private banks. The basic issue is the problem of moral hazard: private banks have an incentive to issue the guarantee to the worst junk around, since they will make money on the process and the risk goes to the government. It is difficult to believe that anyone who has lived through the crisis of the last three years would want to re-establish this sort of situation.
The third alternative to the hybrid or the government-owned Fannie/Freddie route is simply to let them die over a period of 5-10 years and leave mortgages to the private sector. We know that the private sector can and does issue mortgages without government support. This is demonstrated by the existence of the jumbo mortgage market. Jumbo mortgages exceed the size limits set for a loan to be purchased by Fannie and Freddie. Even in the current environment, the spread is only 90 basis points (9/10ths of a percentage point) compared with the Fannie/Freddie-backed conformable mortgages, and it is typically much less.
If ideological and political considerations prevent us from establishing the most efficient mortgage system, relying on a purely private model is almost certainly better than trying to construct a convoluted hybrid. The potential benefits from this mixed system are fairly modest "“ a slight reduction in mortgage interest rates. While the risks from not doing it right are large.
If we want to have the government subsidise the mortgages of moderate- and middle- income homeowners, it can be easily done through the tax code or other mechanisms. There is no reason to set up a whole new system of finance to accomplish this purpose.
Unfortunately, the smart money is on the convoluted route because the big money stands to gain this way. The waste in such a system is income for folks like Citigroup and Bank of America. And we all know that the most dangerous place to stand in modern America is between the financial industry and a policy that will enhance its profits. So, look for more bad housing policy coming out of Washington.
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23 Aug 2010, 2:31PM
In the old days, banks were happy to give mortgages to credit-worthy buyers, then sit back and collect, 5%, 6%, whatever, interest over the next decade or two. It seems like a good business, I would take that amount of return on my money. But of course, banks don't want that now - they want to churn the money rapidly, taking in big fees every time they do it, paying for big profits and bonuses.What we have now is a banking industry that looks out for itself, not for the economy as a whole. I agree that if the US is backstopping the business, the US should be getting the mortgage interest. When will we get politicians with the courage to do this? Obama and the Dems haven't stepped up, and of course the GOP would be even worse. Sad, sad, sad.
23 Aug 2010, 2:42PM
I'd go for the third option, stop meddaling in the mortgage market. You just get the feeling the more they fiddle with it and the more people get involved with reforming it, the worse the final outcome will be.
The third alternative to the hybrid or the government-owned Fannie/Freddie route is simply to let them die over a period of 5-10 years and leave mortgages to the private sector. We know that the private sector can and does issue mortgages without government support. This is demonstrated by the existence of the jumbo mortgage market. Jumbo mortgages exceed the size limits set for a loan to be purchased by Fannie and Freddie. Even in the current environment, the spread is only 90 basis points (9/10ths of a percentage point) compared with the Fannie/Freddie-backed conformable mortgages, and it is typically much less.
So they don't even make martgages that much cheaper!
23 Aug 2010, 2:59PM
Something has to change drastically about the system. They gave mortgages to anyone with a pulse, just like they did with credit cards. Now it's all blowing up. Check out this story about a bank actually lying to a guy about his mortgage so he would refinance with them:
http://onthefrontlinesofamericanswarwithdebt.wordpress.com/
23 Aug 2010, 5:39PM
thereverent:
The killer flaw in your argument is the existence of the FDIC, insuring the banks against failure. (Actually, insuring their depositors.) That transfers at least some of the risk of flaky banking to the government, e.g. all the rest of us. So, the 'let the free market run free' argument does not apply; if the public is insuring at least some of the risk, we cannot fully privatize the decisions of the banks. We've been down that road just recently.
The FDIC is essential to the stability of our banking system.
I like the simple option best: go back to insuring mortgages without creating secondary securitization markets. That secondary marketing was the root of the bubble that burst, which almost ruined our entire economy.
But Mr. Baker still overlooks the lingering effects of that bursting bubble. The resulting wave of foreclosures is actually growing larger again this year, as the five-year option-ARM's from 2004 and 2005 uptick, and the many borrowers who cannot afford the new full payments are defaulting.
The banks are now resorting to more 'short sales', which are becoming a booming business in the four major Foreclosures States (CA, AZ, NV and FL). The reason is, the banks cannot absorb many more homes onto their books. They are choking on several million already foreclosed, but not yet dumped back onto the market. And they can't dump those quickly, without destroying what is left of equity value in many areas.
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