Government-backed mortgages should be expensive

If government-backed loans carry higher costs, private lending will steal market share and get the government out of the mortgage business.


Legislators and bureaucrats who protect the interests of taxpayers want to reduce the government’s footprint in housing finance. Realistically, there are only two ways to do this: raise interest rates, or raise the fees on government loans. Higher mortgage interest rates would provide investors better risk-adjusted returns, and higher fees on government loans would make other sources of capital more competitive. Either method would bring more private capital to the market.

Of course, rising interest rates is the last thing lenders and housing bulls want to see. Higher interest rates would reduce mortgage balances, make housing even less affordable, and ultimately will either halt appreciation or cause prices to decline again. Since the banks are still exposed to hundreds of billions of mortgages without collateral backing, they need prices to rise back to peak levels to prevent billions in losses.GSE-warning

So the solution best suited for bringing private capital back to the mortgage market is to keep raising the fees on government-backed mortgages. At some price point, the government is charging more than the risk warrants. When the fees cross this threshold, private money will find an opening to undercut the government and make an appropriate return. Therefore, I believe government-backed mortgages should be expensive; in fact, they should get progressively more expensive until they lose market share, as is already happening at the FHA.

Getting Government Out of the Mortgage Business, DOJ-Style

By Mark A. Calabria, September 19, 2014 4:32PM

Yesterday [the OC Housing News] reported that Federal Housing Administration (FHA) purchase loan guarantees “plunged” compared to a year ago. Part of that plunge, of course, was an expected decline in refinance activity. Currently, FHA endorsement activity is almost 80 percent purchase, whereas a year it ago it was just over half for purchase. Looking at trends in purchase endorsements, the decline looks a lot more moderate.

Even so, there has been a modest decline. Many in the banking industry, as expressed to Bloomberg, believe this is because FHA and the U.S. Deparment of Justice have been too tough on lenders, making them take back soured loans and assessing damages. JP Morgan CEO Jamie Dimon recently asked, because of the legal risk, “should we [JP Morgan] be in the FHA business at all?”

Shouldn’t we make lenders take back bad loans? If they kept loans on their own balance sheets, they would be cautious. Why should we allow them to be less cautious with a government-backed loan?

Is the obviousness of that simple truth too much for lenders and politicians to grasp?

They could easily make the rules clear and transparent. In addition to their other standards, simply state that if for any reason the loan fails within one-year of origination, the originating lender must buy it back. That clears up all the ambiguity, and it puts all the origination risk where it should be — on the originating lender.

The only reason there is any argument about this idea is because lenders want to make risk-free profits. Screw them. Lenders must make good loans or they shouldn’t make loans at all, just like they would if it were their own money at risk.

Personally, this sounds like little more than jawboning. As illustrated by FHA’s recent credit reports, lenders are still dumping an awful lot of junk onto FHA. The average credit score is around a 680 FICO, meaning about half of FHA’s recent business is subprime. Beyond that, even subprime borrowers typically face downpayments of only around 5%, and then there’s the high debt levels witnessed. Lenders should be held responsible for making loans of such poor credit quality.

With the US taxpayer still backing more than 80% of all mortgages in the United States, it’s good public policy to keep mortgage lending standards tight in order to prevent future losses. Many parties would like to see lending standards loosen so facilitate reflating the old housing bubble. Lenders want looser standards on government loans so they have less risk of a put-back loss. Both lenders and homeowners want to see looser standards on all loans to increase the size of the buyer pool to help push up prices. Politicians want to see looser lending standards to make lenders and homeowners happy, and they want to deflect complaints that they are shutting people out of home ownership. With all these calls for looser lending standards, its surprising that they remained prudently tight for so long.

The reality is that government officials don’t want to see a repeat of the GSE bailouts and the upcoming FHA bailout. These bailouts are an embarrassing reminder of bad governance and poor decisions made in the past. Plus, they are costly. The few good stewards of the public coffers left in Washington are rightfully blocking any efforts to relax standards on government loans.

Eventually, the pressure to reduce government lending standards will lessen because private money will take a larger role in housing finance. As long as they underwrite loans that meet the qualifying mortgage standards, if they want to risk their money on those with marginal credit scores or spotty income histories, it’s their money to make or lose. As private capital returns, the government’s footprint in housing finance would get smaller, and lending standards will loosen incrementally until we find the proper balance between access to capital and the risk-adjusted cost of capital.

Regulators do not need to relax standards; they should be going out of their way to increase costs and tighten standards even further. That’s what will finally bring private lending back to home finance. By continually tightening standards at the GSEs, regulators create opportunity on the fringes for more private lending. This protects the US taxpayer will simultaneously encouraging more private lending with private capital. That’s a win-win as far as I’m concerned.

If DOJ fines on poorly performing FHA loans are chasing banks away from FHA, then I say “great.” … As Congress is unlikely to ever scale bank the various mortgage subsidies, perhaps our only hope is that DOJ makes those subsidies so unattractive that lenders won’t use them. …

Works for me.


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