Response to the Treasury GSE Report

We can work with this. I read the Treasury/HUD housing reform report last Friday and mulled it over Saturday and Sunday (between glossy Dayquil induced afternoon naps—not exactly nondrowsy). It starts from a pretty solid premise: Fannie Mae and Freddie Mac must be eliminated. This can certainly be the starting point for a bipartisan approach to fixing the mortgage finance system and making affordable housing more narrow and efficient.

Seriously, Secretaries Geithner and Donovan should be applauded for taking this bold step. (Though with the suggested guarantee options it isn’t completely in defiance of the mortgage industry, more on that further down).

Whether or not you believe these government-sponsored enterprises were the primary cause of the financial crisis, they played a significant role. Even the FCIC majority report and the Center for American Progress say so. The GSEs represent the confluence of mortgage finance policy and affordable housing policy, which led to a inefficient and maligned housing finance system that yielded such a spectacular boom and bust. Secretaries Geithner and Donovan should be applauded for this bold and necessary first step.

However, the next strides in the report are little more than a drunken stumble that leaves the paper sprawled in every direction by the end. Treasury outlines “three options” for long-term reform of the system, two of which would establish a federal guarantee of mortgages (or “backstop”), but with little more detail than might exist in a long blog post like this. There are no serious details about how each idea would work, and what the outcome would be.

By far the first option is the best: “Privatized system of housing finance with the government insurance role limited to FHA, USDA and Department of Veterans’ Affairs’ assistance for narrowly targeted groups of borrowers.” The concept of this mirrors my suggested approach to having mortgage finance be fully private with separated narrow, direct, on budget subsidies for affordable housing.

However, their critiques of the approach are a bit off base. To begin, they suggest that “While mortgage rates are likely to rise somewhat under any responsible reform proposal, including the three outlined here, the effect could be larger under this option.” This is likely true. But the reason the cost of mortgages would be higher in a fully private system is that there would be less subsidy distorting prices. And the more distortion, the higher the potential for a soul-crushing, wallet-wiping boom and bust. The report even suggest so, arguing that a private option “would minimize distortions in capital allocation across sectors, reduce moral hazard in mortgage lending and drastically reduce direct taxpayer exposure to private lenders’ losses.” Who is to say how high is too high?

The administration also argues that with a fully private market, “it may be more difficult for many Americans to afford the traditional pre-payable, 30-year fixed-rate mortgage.” Though as David Reilly wrote in the Journal this weekend, “While ensuring continued availability of 30-year mortgages, [a federal guarantee] would suck capital back into housing at the expense of other, more productive parts of the economy. It also may lead to renewed housing bubbles in the future. Avoiding that outcome is clearly important.” And again, Treasury defeats themselves by acknowledging earlier in the paper that in a private system, “more capital will flow into other areas of the economy, potentially leading to more long-run economic growth and reducing the inflationary pressure on housing assets.” The fundamental question is: is the 30-year FRM worth another asset bubble and financial crisis? Treasury skirts this question but I argue, that it is not worth it. There are plenty of other proven methods of financing mortgages. A private system would not get rid of 30-yr FRMs, but even if it did we don’t need them.

The administration also frets that “smaller lenders and community banks could have a difficult time competing for business outside of the FHA segment of the market, which may in turn impact access to lending in the communities they have traditionally served more effectively than larger institutions.” While the anti-trust notion is admirable, it is unlikely that local mortgage originators would be driven out of business in a fully private market. There will always exist a desire in many communities for doing business with a local dealer. But where larger banks are able to offer better rates, this should not necessarily be a concern of policymakers. Keeping smaller lenders in business when market prices are lower than they can offer would put upward pressure on mortgage rates, thus requiring a guarantee that drives down interest rates to compensate for that manipulation. It is a net zero gain.

Treasury is also concerned that without a guarantee the wouldn’t be able to “play the countercyclical role that they have played in the recent downturn,” and that Congress, FHA and the Fed would be unlikely to “play a still more robust role as might be needed in the absence of broader government support in the market.” Pardon me while I get out my celebration hat! I am all for the government not having the capasity for a robust countercyclical role, since it was that ability which caused the cyclical problem in the first place. It’s like saying that you can’t win a draw without a gun. But if you don’t have a gun, then no one can challenge you to a draw and the fight doesn’t happen.

The one legitimate concern Treasury has for a private solution is that “investors believe that the government would inevitably step in to save whatever private financial institutions or banks have become necessary to maintain the flow of mortgage credit. If so, this option will potentially fail to eliminate the risk of moral hazard.” We can not simply transfer the implicit guarantee of Fannie and Freddie to the banks. If Dodd-Frank has not ended too-big-to-fail (which I do question whether it has), then Congress will have to consider carefully how to ensure there is no implicit guarantee. This will likely require some changes to Dodd-Frank that accompany GSE reform.

Option 2 would create a “guarantee mechanism to scale up during times of crisis.” Either a federal guarantee would be offered, but priced ” at a sufficiently high level that it would only be competitive in the absence of private capital” or public insurance would be restricted in “normal times” but allowed to expand in “times of stress.”

This kind of guarantee would be preferable to a direct MBS-wrap offered by a public-private hybrid, but it still leaves the question of pricing in play. How high should the rate be set? And relative to what measure of the “absense” of private capital? At any time Congress or FHFA could argue there was not enough capital in the system, based off their arbitrary notion of what should be available. And policymakers would certainly be tempted to lower that rate in the future—they have in the past. Furthermore, it would be problematic to restrict private companies from offering insurance based on an arbitrarily determined “normal time” or “time of stress.” See my paper on guarantee risks for more on this.

The third option is by far the worst. As the Journal put it, this would be “like Fannie in a new suit.” The proposal is basically this: One, have “a group of private mortgage guarantor companies that meet stringent capital and oversight requirements would provide guarantees for securities backed by mortgages that meet strict underwriting standards.” Such standards would certainly be established like conforming loan limits today—politically, and with the confluence of mortgage finance and affordable housing in full effect.

Two, have a government reinsurer “provide reinsurance to the holders of these securities, which would be paid out only if shareholders of the private mortgage guarantors have been entirely wiped out. The government reinsurer would charge a premium for this reinsurance.” This is essentially like and FDIC coverage of deposits in the case of a run on the bank.

Basically this means privatized profits and socialized risk. The private companies can take all the gains from their business. But if they happen to fail, then the taxpayer is there to pick up the pieces. Again, see this one-pager for more on the dangers of this idea.

The trouble Treasury ran into is that they did not ensure their suggestions aligned well with the negative outcomes they alluded to existing with government intervention in the mortgage market. And they ignored this reality for the political benefit of “ensuring liquidity.”

Here is what Treasury should have done. First, determine some objective, short-term actions that can be executed by the Federal Housing Finance Agency or enacted by Congress to protect taxpayers in the near-term and get the ball rolling on enabling private capital to flow back in to the system, since everyone seems to be on board with that goal.

Some easy steps would be to reduce the maximum loan amounts eligible for purchase by the housing agencies by 20 percent across the board, start the process of raising down payment requirements on mortgage backed by government agencies now, have FHFA begin raising the GSE’s guarantee fee by 3 basis points a month, and have Congress move forward with enacting a legal framework for covered bonds.

These steps would leave conforming loan limits above national average and median housing prices, so the jumbo market could be expanded without middle class America feeling the full effects of an unsubsidized market in the near term, while also reducing taxpayer risk and making business deals with Fannie and Freddie more expensive.

Each of these steps are based off ideas championed in the Treasury report and several presented at a House financial services subcommittee hearing last week. They are moderate steps that would make the transition whatever long-term system is established easier since even the Treasury report acknowledges that responsible reform is going to increase mortgage prices at least a little bit.

Second, Treasury should have taken a step back to ask some fundamental questions about housing policy, including a deep look into how the government’s role in the mortgage market directs outcomes in the financial. When taking this 30,000-foot view, it is clear that there are some contradictions in the Treasury report.

Treasury makes clear from the outset that the private sector should be the “primary source” of capital for the mortgage market. And in the introduction, the Treasury report admits “the government’s financial and tax policies encouraged housing purchases [that] ultimately left taxpayers responsible for much of the risk.” Yet, the report goes on to suggest its goal in establishing a federal guarantee would be to ensuring access to mortgage credit and making investment in housing attractive.

This is once again conflating mortgage finance policy with affordable housing policy. The Treasury report acknowledges on the one hand that pushing people into homes they cannot afford is bad policy. But creating an explicit federal guarantee that lowers mortgage rates-thus increasing the price of housing-does the same thing, since it is artificially lowering the financial barrier for entry into housing, while at the same time encouraging a price bubble. We’ve seen how that story ends.

Treasury should not fear that “complete privatization would limit access to, and increase the cost, of mortgages for most Americans too dramatically.” Public policy should encourage the accumulation of equity in a home, not make an arbitrary determination of what price change would be “too dramatic.” Even if that means there are fewer homeowners, more renters, lower priced houses, and a weaker construction market than boom years.

Rethinking homeownership is a complicated, and difficult task. It requires wrestling with how government’s actions will ultimately impact the market. And when proposing options for a guarantee, Treasury misses the mark. Again, the starting point is a good baseline from which the debate about long-term reform can begin. Treasury has the right steps in mind for winding down Fannie Mae and Freddie Mac. But for the rest of the housing finance system, we need to be looking at the overall picture in a more fundamental way that acknowledges any federal backstop will ultimately yield a destabilized market with misaligned resources and one-way ticket to the next boom and bust.