Politicians designed a future crisis to facilitate mortgage finance reform
Politicians intentionally set up Fannie Mae and Freddie Mac to fail so they could reform mortgage finance without fear of voter backlash.
You never let a serious crisis go to waste. And what I mean by that it’s an opportunity to do things you think you could not do before.
Everyone in Washington knows the GSEs must be eliminated because the GSEs can’t exist outside government conservatorship. The taxpayer liabilities from backing most mortgage loans are enormous, and taxpayer backing for the GSEs ensures the misallocation of credit. Ed DeMarco prepared for final shutdown of GSEs, but the final implementation was left to Mel Watt and Congress, but they failed to make any progress. Concerned citizens hoping for careful deliberation and a consensus solution (good governance) will be disappointed.
Washington is so polarized that politicians need a crisis to get anything done. To that end, politicians created circumstances at the GSEs likely to result in a future crisis that will generate need for political action.
The Federal Housing Finance Agency was instructed by Congress to reduce their capital buffer until it reaches zero by 2018. The idea is to gradually move Fannie and Freddie closer to a financial catastrophe, spurring legislative reform. With no capital buffer, any losses would require the FHFA to ask Congress for bailout money. The political outcry over such an eventuality will give politicians political cover for implementing some very unpopular reforms.
Is this really how we want our government to work?
Fortunately, Mel Watt is doing a surprisingly good job running the FHFA. He has implemented a number of stealth reforms that may serve as a template for a post-GSE world.
… no one should be misled by the lack of comprehensive Congressional action into thinking that GSE reform is on hold. Fundamental reforms already have or are now taking place – reforms that reduce risk, protect taxpayers and build on lessons we learned from the 2008 crisis.
The most fundamental reform is loan quality. The GSEs would not have gone into conservatorship if they simply hadn’t made no doc (Alt A) loans and purchased MBS securities. With QM and strong underwriting standards, Alt A is a thing of the past. And GSEs have not only stopped making portfolio purchases, they are unwinding their existing portfolio holdings.
In the old system the GSEs provided insurance to pools of mortgage bonds much like they do today. However, they were always thinly capitalized on the assumption house prices would always go up, and there was no way the collateral backing the loans they insured would ever be worth less than the amount they insured. This proved to be a foolish assumption.
The GSE also sold bonds to investors to buy portfolios of mortgages in addition to providing insurance. These bond investors overpaid for these bonds knowing the GSEs were under-capitalized because they rightly assumed the government would bail out the GSEs if they were ever in trouble. This under-capitalization also allowed the GSEs to provide stellar returns to equity investors who also benefited greatly from the implied government guarantee.
The second sea change is risk sharing. Almost all new GSE loan purchases now involve some form of risk sharing, also known as credit risk transfer. …
My guess is that GSE reform will have this feature. Risk needs to be properly priced, and one way to do that is to transfer this risk to private investors willing to buy it. The competitive market among sophisticated, deep-pocketed investors like insurance companies (solid counter-parties) should price risk properly.
There is now a strong regulator – the Federal Housing Finance Agency. Everyone agrees the pre-Crisis regulator, Office of Federal Housing Enterprise Oversight, was too weak and timid. Since it took over in 2008, FHFA has required sound-underwriting standards, imposed higher servicer and mortgage insurer capital standards, and established a Scorecard to measure performance, including areas like access to credit. …
Finally, the model of “private gain, public loss” that characterized the pre-crisis GSEs is gone. When taxpayers stepped in to backstop the GSEs in 2008, they had received no premiums from previous years to cover the risk and cost of that action.
This is no longer the case. In fact, we have gone too far in the other direction. Under the Sweep Agreement, 100% of GSE quarterly profits are swept to taxpayers – and each GSE’s capital has been arbitrarily reduced to $1.2 billion today, going to zero in January 2018.
FHFA Director Mel Watt recently referred to the GSEs’ thin capital buffers as their “most serious risk.” Even a small non-cash accounting loss would precipitate a Treasury advance, which in the director’s words could “undermine confidence in the housing finance market.”
Such a manufactured crisis would be bad for consumers and housing markets.
But it would be great for cowardly politicians.
… opponents of the GSEs are characterizing any efforts to build capital as a return to the failed ways of the past.
And proponents of recapitalizing the GSEs are generally investors who want to see a return of low-risk profits with a government guarantee.
The FHA and the FDIC provide a good model for how housing finance should work. A sufficient pool of capital must be maintained to absorb any losses, and the insurance fees must be adequate to cover any payouts and maintain capital reserves. It’s not really that complicated.
The problem with housing finance reform is the cost. The fact is that Government-backed mortgages should be expensive. Higher interest rates or higher fees are the only way to properly price risk and avoid any future government bailouts in the housing sector.
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; thus we don’t have housing finance reform.