Five measures necessary to reduce government mortgage loan guarantees
The US taxpayer insures most of the mortgages in the United States today, exposing you and me to trillions in potential losses in a future housing bust.
Prior to the collapse of the housing bubble, when lenders gave free money to loan owners, it was theirs to give — and to lose. But when the losses overwhelmed our banking system, the government took conservatorship of the GSEs, and they backstopped the largest banks with our too-big-to-fail guarantees. With those two steps and the dramatically increased market share of the FHA, the government now assumes nearly all risk of loss in the US mortgage market.
With taxpayers absorbing future losses through explicit and implicit guarantees, lenders have every reason to inflate another housing bubble. Another bubble would generate enormous fee income at origination and interest income through ever-increasing loan balances. When it all blows up, the government pays the tab and lenders get big bonuses for their financial prowess. Frankly, that pisses me off.
So how can taxpayers be protected?
It’s essential to scale back or eliminate government mortgage loan guarantees.
Scaling back loan guarantees is accomplished with five specific policies:
- break up the too-big-to-fail banks,
- dissolve the GSEs,
- Tighten FHA guidelines further,
- raise FHA down payment requirements,
- restore mark-to-market accounting and require timely liquidation of REO.
Let’s examine each of these in more detail.
Scale back or eliminate government loan guarantees
The surest way to protect taxpayers to get them out of the loan guarantee business. Taxpayers currently insure over 75% of the mortgage market. In 2006, the US taxpayer was ostensibly covering about 2% of the mortgage market through the FHA, VA, and other government programs. We need to return to the days of near zero government guarantees, and we need to prevent the conditions where implied guarantees may become explicit as happened in 2008.
1. Break up the too-big-to-fail banks
Too-big-too-fail is too-big-to-exist. When banks no longer fear going bankrupt and losing money for their investors or depositors, they are likely to take unnecessary risks. This is an unconscionable risk for the US taxpayer to bear, and I can’t understand why there is debate on this subject. The too-big-to-fail banks should be broken up at the earliest possible opportunity — like today.
2. Dissolve the GSEs
As long as the GSEs exist in any form, they will have the implied guarantee of their entire portfolios. Politicians will try to suggest otherwise, as they did for nearly half a century prior to taking them into conservancy in 2008. Politicians proved without any doubt that no matter what promises they make, no matter what assurances they give, if the GSEs get in trouble, they will get bailed out. As long as these entities exist, the US taxpayer will have an implied guarantee on every loan they own or insure.
3. Tighten FHA guidelines further
In lending, defaults occur at the fringes of qualification. Borrowers with 800 FICO scores default much less frequently than borrowers with 500 FICO scores. Borrowers with 20% debt-to-income ratios default much less frequently than borrowers with 40% debt-to-income ratios. Whenever lenders draw lines in the shades of gray, the largest number of defaults will come from those people near the lines. For taxpayer-backed loans, these lines should be as narrowly construed as possible. The FHA should be the safest loan in the industry, not the substitute for subprime.
Currently, FHA will allow FICO scores down to 580 or even 500 with some restrictions. Default rates on FHA loans with FICO scores from 620-650 is 15%. That is far too high. Each standard for an FHA loan should be carefully examined, and qualification standards should be tightened to nearly eliminate risk on FHA loans. The effect should be to greatly reduce FHAs market share as private lenders willing to take more risk will provide competing loans, which has historically been the FHA’s function. They are supposed to be the lender of last resort; we need to relegate them to that role again.
4. Raise FHA down payment requirements
The FHA guideline which exposes taxpayers to the most risk is the low down payment. Since it costs a buyer at least 6% (probably closer to 9%) to liquidate a property when factoring in discounts, commissions, and closing costs, any down payment of less than 10% is exposing taxpayers to risk of loss. The risk of loss goes up exponentially as down payment requirements drop. This exponential increase in loss severity is due partly to liquidation costs as described above, and partly due to the fact that default rates go up significantly as down payments decrease.
5. Restore mark-to-market accounting and require timely disposition of REO
Once the loan guarantees are scaled back or eliminated, lenders must be forced to endure the full brunt of the losses for their foolishness. The fear of forced buy-backs helps, but more could be done.
One of the main reasons the economy has suffered since house prices collapsed is because so much capital is tied up in unproductive uses. The silver lining of recessions is the purge bad business models and Ponzi debt and the reallocate capital to more productive uses. We didn’t go through the necessary purging during the recession, so rather than endure a short but deep recession, we endured a somewhat less deep but much longer one.
To restore the engine of economic growth, we need to return to mark-to-market accounting, and force lenders to take their write downs and dispose of their REO. That frees up capital for better uses. Over the last eight years, money tied up in residential housing has been dead money contributing nothing to economic growth.
None of what I wrote today is new. Most industry observers realized these measures were necessary years ago; however, since financial interests control our political process and these changes would cost them money and power, very little progress occurred on any of these issues.
And I lost hope anything will change.