Debating How to Avoid Shocking the Market with GSE Reform

An important question in reform debate for Fannie Mae and Freddie Mac is how to balance the need for change and the need to avoid destabilizing shocks to the marketplace. Certain interest parties are terrified that a reform would derail the fragile movement of the housing market towards recovery. However, this recovery is being built on the very government subsidies that need to be reformed out of the system. So there will have to be some level of destabilization as we shift towards a more private market (assuming that is where reform takes us).

Nevertheless, even from a libertarian point of view, the potential losses of a transitional period are not be understated. There is an entire industry that has been build up on particular notions of how the credit markets interact with regulators. It would be unjust to simply change their system overnight without warning.

Thus the dilemma.

It is easier to begin with what we should avoid. Bill Berliner wrote a short piece in Asset Securitization Report recently that concludes: “Given the housing market’s dependency on GSE-backed financing, the efforts to reform Freddie and Fannie run the serious risk of inadvertently weakening the housing market. The need to preserve the continuity of [securitization] markets will limit the options available for fundamentally restructuring the GSEs.” Mr. Berliner’s argument is simply that the efficiencies build up in the securitization.

On the other hand, just because the private sector hasn’t developed similar efficiencies in the adjustable-rate mortgage market without the GSEs, according to Mr. Berliner, as the fixed-rate mortgage market has with the GSEs, doesn’t mean it can’t happen. In fact, to say that just because a market has been dominated by the government for so long that we can’t imagine operating without it is utterly ridiculous. Just because it is complex and difficult to see exactly what a more purely private sector market will look like, doesn’t mean we should discount it.

As one famous philosopher wrote, if it just so happened that the shoe market of America had been completely operated by the U.S. government for the past 100-years, and there was an attempt to privatize it all, would we really want to listen to those that say the private market would never want to provide for the poor and would not be able to efficiently make enough shoes to meet demand? Of course not, because we all know the shoe market in America works just fine. This is America—let the market free and we can figure it out.

Now, as to how we should proceed. My view is that the timing is flexible. I think it would be best to transition over a shorter-term period (5 to 10 years), but I am not opposed to plans that could take up to 20 years simply on the time scale aspect. For instance, I have argued that one of the first steps for the GSEs should be to wind down their portfolios by selling what they can over the next two to three years, and then sticking the rest in a bad bank and letting it run off. Mr. Berliner suggests that:

the “benefits that result from immediately liquidating the GSEs’ $1.6 trillion or so retained portfolios will not be worth the potential disruptions to the MBS market. A potential solution might be to allow the portfolios to run off over time, with only loans ineligible for securitization purchased through the cash window added to the portfolio.”

His argument stems from a recent FHFA report noting that nearly 3/4ths of the GSE losses stem from their guarantee program, not their portfolio. And while my plan cuts off GSE portfolio purchases after two years, I would accept a reform that dragged out the portfolio unwind over the next 20 to 25 years (roughly how long it would take to run off all those loans)—but only if it was part of a plan that did not include on going GSE securitization activities. I understand the desire to get the securitization market rolling again, but it shouldn’t be done with government subsidies (i.e. through the GSEs). I think ending all securitization activities of the GSEs in the next three to five years would give the market plenty of time to figure out where it wanted to go in this new frontier of housing finance.