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Housing Finance: Role of the Government Guarantee

posted by Adam Levitin

I'm testifying before the Senate Banking Committee on Tuesday about the role of the government guarantee in housing finance (a/k/a wtf do we do with Fannie and Freddie). My testimony is here. I expect it will manage to piss off people left, right, and center, but that's the nature of this GSE reform debate. 

I'm not thrilled with the prospect of a government guarantee, but I just don't think that there's sufficient the market demand for credit risk on U.S. mortgages for a non-guaranteed system to function. Do we really think that $6 trillion dollars of interest risk investors are suddenly going to decide they want credit risk as well?

Realistically, if it gets hairy enough, the government will bail out the system, Dodd-Frank, Tea Party, and all that jazz aside. We'll keep chanting no more bailouts until we do the next bailout. (Remember the War to End All Wars?) That means that it's better to have an explicit guarantee and price for it.  

Put differently, the choice we face is not guarantee or no guarantee. That's just a false dichotomy. The choice instead is between an explicit and an implicit guarantee. The implicit guarantee is a guarantee of moral hazard. The government will bail, but won't price for it. The explicit one certainly has its own problems, but at least it means we are being candid about the risks the government is assuming and trying to price for them and structure the guarantee to mitigate the risk that it will be used.   

Comments

As a business person, I can state that the "GSE Business Model" is fatally flawed for a million reasons, if you have trouble getting by the first reason .............the government guarantee.

I firmly believe that of the GSEs were shut down this week, next week we would be well on our way to a viable mortgage industry.

Let free enterprise energize this industry without taxpayer involvement and we will soon see what it is all about.

Private mortgage insurers have been around for decdes. If a government guarantee disappeared, they would grow to fill the gap. The capital markets are excellent about developing solutions for financial demand. But they impose more discipine than the political world. The undercapitalization of the GSEs and their financial failure are a direct consequence of the government guarantee and the compulsion to expand home ownership. That is, the GSEs enabled the expansion of home ownership but as the GSes took on more risk, their equity declined and they became more dependent on using government guarantees to raise the necessary capital, until finally those guarantees had to be made explicit. While most private sector subprime exposure began to be cut back in 05-06, the GSEs added that risk in 06-08. So this past decade just shows that a private market for mortgage insurance, regulated for protection of insurance holders, as insurance companies are normally, and not regulated to expand risk as the GSEs were, would be best.

The mortgage market would recover pretty quickly if Fannie/Freddie were eliminated. We already have portfolio/jumbo lenders that are pricing almost as competitively as Fannie/Freddie loans.

IMHO, Fannie/Freddie adds a lot of bureaucratic/underwriting friction. The free market does in fact work pretty well. Remember, greed is good and if there is a market for certain types of loans, the banks will find it.

The main thing though is the government has to get off this kick that everyone needs to own a home. Some people will never be home owners and we have to accept that fact.

If you eliminated F/F next week, the US economy would collapse. Period. We don't have to like them, but they are what is holding the housing market afloat at this point.

PMI have been around since 1957 in their modern form. They did such a good job managing risk that they're all basically insolvent now. If we just had PMI, where would that leave us?

It is hard to imagine how anyone could screw up "mom's apple pie" ( mortgage financing), the GSEs and those that operate them for their own beneficial interst have done a pretty good job of it over a fifteen year period!

If you tried to sell the Model to a Wal Mart merchandising committee, it would not warrant an hour of their time.

The mix of business and government is what has brought the economy to its knees and will continue to do so unless drastic measures are taken. Every player in the Model has worked the franchise to its own end which has led to it being hoplessly conflicted at every level. To try to make sense out of nonsense defies all logic.

The Model is "fatally flawed" and poses a systemic risk, it simply does not work. The investors have learned this basic business conclusion..........thus the implosion.

A couple of years ago, I asked Jamie Dimon of JPM about the GSE Business Model subject and he responded; " we have been worried about Fannie Mae for a long time.....over ten years". Of course, if Mr. Dimon were so worried about FNMA, why does he sell 95% of his mortgages on a daily basis to them? Kindda like Bernie Madoff stating to his investors that he was worried about the stock market in defense of his Model.

?

Any related impact to underwater 2005-2007 borrowers of new FHFA Debt Collection rules at 3/29/2011 76FR17331 [finalizing 10/10/2010 75FR68956]... if they do/do not participate in impending mass refi?

"Put differently, the choice we face is not guarantee or no guarantee. That's just a false dichotomy."

While I appreciate Mr. Levitin's excellent work on behalf of consumers, this statement requires a citation.

Professor, I don't think the counterproposal to your position is to eliminate them overnight. It is to phase them out slowly and let private institutions replace them slowly.

While you may be right that the PMIs are "basically insolvent", they are obviously hundreds of billions less insolvent than F&F. And they are not as interconnected and do not pose systemic risk. Regulators are not bending risk-weighted capital rules to induce purchases of PMI debt. They don't have politicians threatening to punish them if they choose not to take on risk in a falling market. If there were another dozen of them, as opposed to one big concentrator of systemic risk, whose approach to credit risk is politically motivted as opposed to economically motivated, the nation would be better off.

I do hope they go away like right now. I called Fannie Ma foe help and the rep was soooooooooooo rude. Told me to wait for the sheriff to come and lock me out. Unbelievable arrogant. Sigh.

ps: that is suppose to say "for help". smile

For anyone who is interested in data and facts about the performance of the GSES relative to the performance of Wall Street banks that securitized mortgages, there's a great new paper out which discusses these issues in detail (with ample data, in easy to read charts).

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1924831

(Shameless plug)

Adam,

Who on the left do you believe you are upsetting? Most of the literature and data I have seen says, essentially, that the structure of government support for 30 year fixed rate mortgages --- including the necessity of ringing in trillions of dollars or private capital to the fixed rate mortgage market -- has benefited the growth of a stable middle class in America for 75 years. There are many criticisms of the specific companies, Fannie and Freddie, in how they took advantage of the implicit guarantee, but you take that on as well. Those who have asserted that if the government just "got out of housing" all would be well have based that on an ideological belief, not a set of evidence. Well done.

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