Last week Congressmen Campbell (R-CA) and Peters (D-MI) introduced a bill that would overhaul the mortgage finance market by replacing Fannie and Freddie with five private companies that would issue federally guaranteed mortgage-backed securities. The legislation is being pitched as a compromise between the left and the right, but is more a compromise between being devoured by a bear and jumping into a lava pit.
In short, it is a terrible idea.
Before you write off that summary as ideological, anti-GSE religious furor, I propose to argue that is a terrible idea from both a right and left perspective. Here is the rough plan as reported by The Wall Street Journal:
"Like Fannie and Freddie, the new entities would be restricted to buying loans that meet certain standards, including size caps. But the firms would have to hold much more capital than Fannie and Freddie. And only the mortgage-backed securities that they issue—not the companies themselves—would enjoy federal guarantees. The companies would operate more as public utilities and likely wouldn't have exchange-listed shares… Advocates say taxpayers will be less exposed to losses because borrowers would be required to make significant down payments and the new firms would be required to hold more capital. The firms will also pay a fee for government backing to finance a catastrophic insurance fund, much as the Federal Deposit Insurance Corp. levies fees and handles bank failures."
The bill also would require FHFA to “issue charters to the mortgage ‘guaranty associations,’ and would be charged with setting guarantee fees and ensuring appropriate capital levels.”
Let’s start at the top—
Guarantees: A federal subsidy is a federal subsidy and the problems of the GSEs will be the problems of this similar semi-private, semi-government set up. Rep. Gary Miller doesn't believe the GSEs were that problematic so he wouldn't see the problems with this idea, but guarantees are the root source of today's housing problem and this plan doesn't get rid of them—it makes it worse.
Conforming loan problems: One of the problems that led to the housing crisis was that the conforming loan standards set by the GSEs created an underwriting floor for mortgages, and as those standards dropped so too did the quality of mortgages. (Investors were also looking for higher yield MBS and needed subprime to give them that, but that does not negate the GSE problem.) Giving these new entities conforming loan standards, including mortgage size caps, may sound promising at first because the underwriting standards would certainly be strong.
But like Fannie and Freddie, eventually those will cave in. Whether by political desire to promote “affordable housing goals” or to stabilize a housing down turn, those standards are a political minefield that will be triggered. Why? It is not just because it has happened before. It is because the whole point of creating a government guarantee is to provide some subsidy for housing prices in the first place. The political assumption is that housing prices would be unaffordable without the government help—otherwise, why have the government help? Or the idea is that the guarantee is needed to stabilize the market in market down turns—but that is also about making sure the price stays affordable. So if prices ever got politically high, then standards would change so the guarantee could serve its purpose. And since subsidies create demand, they drive up prices, eventually requiring more subsidy to account for the added lack of affordability. And so the cycle grows until a bubble collapses.
Capital ratios: This certainly addresses a core problem in the GSE structure: capital requirement arbitrage. But how much capital is right? We thought the GSEs had enough before, who is to say we’ll get it right this time? Is setting requirements “higher” the answer? Why not let private companies without a guarantee issue securities and be forced to conduct their own due diligence in figuring out what the right amount of capital relative to their risk should be, given that their own skin is on the line. As long as the company can be liquidated if it fails and the executives held responsible, they company should have properly aligned incentives. If really smart people failed with Basel I and Basel II—and by many accounts have set requirements too low with Basel III—then why should we trust a regulator or Congress to get this right now?
MBS-wrap vs. company guarantee: Five federally chartered companies that are being used by the federal government to subsidize mortgages will not be allowed to fail. The law may say they don’t have a guarantee, but if the whole logic of setting up this system is that these companies are needed to provide some service that the private sector cannot, then they will almost certainly be seen as having an implicit guarantee. Fannie and Freddie printed on every one of their documents that they were not guaranteed—it was in their charters—but the market ignored it. The same will happen again. Causing similar problems with business activity.
On the flip side, if one of the firms was allowed to fail, then the government would just compensate for it by putting fees on the remaining four firms, creating incentives for the firms to collude and keep themselves afloat as a group. This very well could mean that a problem hitting one firm would be a problem hitting all of the firms. And the system would either sink or float as a whole, depending on the government's TBTF policy at the time.
Public utility faux-panacea: an argument for mortgage companies set up as public utilities is that their profit motive can be strictly regulated and it removes a misaligned incentive of trying to please shareholders while fulfilling a public mission. But just take a look at some of the shenanigans pulled by public utilities such as local water and electric companies and you’ll find that they are not void of political gamesmanship to improve profitability at the expense of the taxpayer. This would be inviting a political rent seeking typhoon.
Downpayments: having higher downpayments would be fantastic. It was certainly a contributing factor to the crisis and remains a cause of our current malaise. There is just no logical reason FHA should be backstopping mortgages with just 3.5% down. But this then begs the question—why is the guarantee system needed? We can assume that the private sector will demand more downpayments without a government guarantee—thus making home buying an unaffordable expense until a family can save up enough. That is the “problem” inspiring politicians to save the day by subsidizing the American Dream in exchange for votes. But if they follow that up with high underwriting standards, what is the point of the guarantee? Either the guarantee serves little purpose other than to distort capital allocation, or the downpayment requirements will eventually come down.
From the left: I said at the outset that this wasn’t just going to be about free market housing finance reform concerns. Consider the policy goals of progressives (and this will be giving them the benefit of the doubt): housing should be affordable for all income levels, mortgage prices should be low and the 30-year fixed rate mortgage should be available at a reasonable rate, and homeownership rates should be high. Arguably, there are plenty on the political right that would favor these policy goals as well.
But how does this kind of a plan help them? Mortgage prices would be kept lower with a group of private companies issuing MBS. The guarantee for the investor would pump capital into mortgage markets making 30-yr FRM financing at a low cost, but this would spark demand and push up housing prices. And prices going up means homeownership becomes more unaffordable. Plus, low rates have historically not really been much of an impact on the homeownership rate—see a graph on that here.
So the plan hits one out of three goals. Batting .333 may be solid performance in baseball (especially if you’re a Washington National), but it sucks when considering the trade-off of setting up a new regulator and finance apparatus for housing reform. There certainly are more critiques of this plan, but I’ll stop here and just point to my policy brief on the 10 arguments against a government guarantee that we published a few months ago.