naked capitalism

One of my cynical buddies often remarks, “Things always look the darkest before they go completely black.”

His gallows humor comes to mind as a result of the hushed conversations inside the Beltway around GSE reform. While the shiny bright object these days in DC is health care repeal, or perhaps Egypt, in quiet corners in think tanks and trade associations the bankers and their allies are getting ready to appropriate themselves a permanent US credit card worth trillions of dollars. The dynamic that became all too familiar during the bailouts is about to repeat itself.

Barney Frank’s great moral passion is low-income housing, and that’s not an accident. The traditional alliance in financial politics since the 1950s was between liberal low-income housing advocates and Wall Street financiers. Since the 1970s, Democrats tried to balance the two sets of interests by creating consumer protections but allowing the capital markets to manage themselves. This dynamic has created a serious political problem in the last four years, because complete capitulation to the banks in the capital markets has pillaged the low-income and middle-income communities the Democrats thought they were standing up for.

It’s not that the people who made this Faustian bargain are bad so much as they are fundamentally irresponsible and childish. The breakdown of law and order in the capital markets arena has created predatory lending, and ultimately has subverted any attempt to implement new laws. Dodd-Frank not just a weak response to the crisis, but actually downright pathetic thanks to the lack of prosecution for anyone who breaks the rules set forth in the bill.

And so, we return to the reform of the GSEs. The Republican mainstream wants to simply hand over government money to banks in the form of a government guarantee. No surprise there. Republicans see the world the way the banks do. Very conservative Republicans, however, aren’t on board. On the Democratic side, the dynamic works through the low-income housing advocates.

A think tank that calls itself liberal, the Center for American Progress, just presented a plan to reform Fannie/Freddie and the housing finance system. It would create an FDIC-like insurance fund for the securitization market, and create entirely private Fannie/Freddie like entities that can offer insurance wrappers on mortgage-backed securities, only these entities will carry explicit government guarantees. These entities can also be controlled by banks. There is a mechanism to funnel money to low-income housing, and ostensibly strict regulation of capital. These people believe that without the government guaranteeing mortgages, the American housing finance system will return to a pre-1930s model of a highly unstable predatory market.

Sadly, as well-intentioned as these people may be, this is just one more bank-friendly proposal designed to suppress debate on the Democratic side. CAP is THE mainstream Democratic think tank for Congress and the administration. Its CEO, John Podesta, ran the transition for Obama and was Clinton’s chief of staff from 1999 to 2001, so he is the embodiment of Rubinite/mainstream (meaning corporatist) Democratic party thinking. His brother is an enormously powerful corporate lobbyist, and I’ve heard his brother also apparently collects and ostentatiously displays pornographically-themed art (a tactic to impress/intimidate clients; ironically, anyone who has done time on Wall Street has seen worse and at closer range too).

That this kind of low-income-advocate/bank-friendly throwback would come from CAP isn’t entirely surprising, since the Administration has made the pet wishes of the financial services industry one of its top priorities, and the CAP generally provides cover for Team Obama initiatives.

You can read the Fannie/Freddie “reform” plan for yourself. Effectively all this proposal does is move Fannie’s and Freddie’s activities to new private entities that will have bigger loss cushions and and an explicit government guarantee. It thus preserves the incentives that led to their being placed in conservatorship in the first place, namely, socialized losses and privatized gains.

It is takes a wee bit of unpacking to depict accurately the multiple levels of hypocrisy involved in this initiative. First, the banking industry has long attacked Fannie and Freddie for distorting the mortgage market. Now they come hat in had to the government hat in hand wanting to be the GSEs.

Actually, that characterization is too kind. They are pushing for a better deal than the GSE had. They want the new entities, which they call to be fully privatized (they are called “Chartered Mortgage Institutions”, while the GSEs had an ambiguous public/private role that became more private over time, and they want an explicit government guarantee, while the old GSE had an implicit guarantee (actually, their documents declared loudly that they were not government guaranteed, but the reassurance of government officials to important foreign investors led them to demand that the US stand behind the guarantees).

The government would guarantee that in the event of the failure of the CMI investors would continue to receive timely payment of principal and interest on CMI guaranteed mortgage-backed securities that meet product structure, underwriting, and securities structure standards. The government guarantee would be explicit and appropriately priced, and the proceeds would be held in a Catastrophic Risk Insurance Fund.

Now the way the banks profit from all this is covered by a fig leaf. The CMIs would not be owned by originators, save through a “broad based cooperative structure”. Um, given how concentrated the banking industry is now, with 10 banks controlling 70 percent of the deposits in the US, who are we kidding? “Broad based” is likely to mean “little banks take token interests”.

But the bigger source of profit to banks will be no doubt be indirect. Take note of the huge lie at the heart of this: the idea that the new CMIs will charge a sufficiently high premium. If the insurance were “appropriately priced”, it would lead to the mortgages having pretty much the same terms as if there were no guarantee. “Appropriately priced” insurance has to cover the risk of expected loss. In fact, third-party insurance is typically more costly than self insuring because people are loss averse and are willing to pay more than the actual expected value of loss to forestall the consequences of Bad Stuff Happening to Them.

But the canard is in plain view; the document explicitly says that the insurance will NOT cover the risk of “catastrophic loss”; that is to be borne by the taxpayer. As we know, the odds of extreme events is higher than finance theory would have you believe. As the quants say, “tails are fat”. And we are vastly more likely to have bad outcomes where we explicitly allow private sector actors to dump the consequences of stupid or greedy behavior on the public at large.

Note also that these new CMIs get other right out of the current Fannie and Freddie charter privileges, such as the ability to own loans in their own portfolios.

The second bit of hypocrisy is the pretense that this program is anything other than a massive handout to the banking industry and is somehow necessary for the health of the housing market. If you want to see who is the real moving force behind this idea, compare the CAP proposal to a fall 2009 proposal by the Mortgage Bankers Association. You’ll notice the main provisions are the same, but the MBA proposal at least free of the sanctimonious posturing of the CAP plan.

As an aside, it’s important how the banks are maintaining message discipline on this issue. The only proposals receiving any sort of push are virtually the same, whether it be the CAP plan, the older MBA proposal, or those from the New York Fed and Financial Services Roundtable. The one partial exception is the Federal Reserve’s plan, which has the dubious distinction of being an even bigger handout to the industry by advocating that pretty much the entire asset backed securities market, including auto loans and credit card receivables, be government backstopped. Well, we did it in the crisis, why not make it policy? After all, we’ve conditioned the banks to expect it, right? Ain’t Mussolini-style corporatism wonderful.

People who are on the Fannie/Freddie beat, such as financial services industry expert and self-styled “recovering GSE analyst” Josh Rosner, recoiled when they learned of the CAP plan. From the Huffington Post:

“This whole cooperative idea, handing the banks the keys to the kingdom to become the new GSEs, that’s just a terrible plan,” says Joshua Rosner…”Why create a new class of too-big-to-fail GSEs? The banks have wanted to be the GSEs forever, and now they think they’ve finally got their chance.”

The report contains other serious distortions. It implies that this sort of scheme is necessary to preserve thirty-year mortgages. But we had a robust thirty year mortgage market ex Fannie and Freddie before the crisis, namely, so-called “jumbo” or non-conforming mortgages. And the premium over Fannie and Freddie mortgages was not high, typically 25 to 40 basis points, which ironically is less than the 50 basis point premium over current Fannie and Freddie pricing set forth in the CAP document.

Skeptics will argue that the private mortgage market, ex Fannie and Freddie, is pretty much dead. That’s correct, but the logic in having more heavily backstopped GSEs as the remedy is all wrong. The reason we have virtually no private securitization market right now is investors are on strike. And the reason they are still on the sidelines is the securitization industry has fought sensible pro-investor reforms tooth and nail. As we pointed out, the FDIC put forward a very well thought out plan a full year ago and presented it at the American Securitization Forum. The ASF, which represents the sell side (it pretends to represent the entire industry, including investors, but anyone close to the action knows better) has thrown its full weight against it as well as a weaker plan from the SEC. So the banks are engaged in a full bore effort to continue to suck as much blood as possible from the general public rather than clean up their act and suffer reduced profits and top brass bonuses.

Another major misrepresentation is that the alternative to this plan is to do nothing; the straw man is always to compare these proposals to shuttering the GSEs overnight. But there are other ways to get Fannie and Freddie out of the housing finance business, and some are remarkably straightforward.

For instance, we featured a vastly simpler plan here, one from John Hempton, which was later endorsed by Floyd Norris at the New York Times, and it’s actually pro-market as well. Just raise Fannie and Freddie fees gradually over time. That will eventually result in mortgages being priced so that it makes sense for private parties to offer them. Hempton also pointed out (boldface ours):

Every proposal for the government to get out of Fannie and Freddie is in reality a proposal for the government to get out of only a bit of Fannie and Freddie.

For example: if you are a business that likes managing interest rate risk you want Fannie and Freddie out of the interest rate risk management business but you want them to stay in the credit risk management business. You would prefer the government take the risks that you don’t want. And moreover you would prefer they took it at the lowest possible price.

The worst proposal out there (much worse than doing nothing) comes from Phil Swagel and Don Marron. They propose that the government exit the interest rate risk management business (the only business at Frannie that never lost money) and allow ten or so new competitive companies with government guarantees to compete with each other to sell government guarantee of credit risk. That means that credit risk (the risk that blew up the system) will be priced as close as possible to zero with the government wearing the downside. I can’t see that Swagel and Marron learnt anything from the crisis.

Note that the plan the Center for American Progress recommends looks virtually identical to the plan Hempton deemed to be worst. Now that stance may look unprincipled, but it’s a tad more complicated.

The banking industry has managed over time to get the affordable housing do-gooders into their camp. The problem, of course, is that providing housing subsidies that help the middle class actually doesn’t directly help lower income people much and in fact arguably hurts them, since artificially cheap loans actually increase housing prices. In addition, they conveniently obscures the true cost, since the subsidy appears cheap (it’s a mere guarantee) when in fact the bills come due in arrears, via the expenses of bailouts (first of the savings and loans, now of the GSEs).

And to the extent there are net plusses, it’s inefficient to achieve housing goals by laundering money through the banking industry. It’s tantamount to being in favor of having the mob run numbers rackets because it brings more funds into the neighborhood. And the banksters must be amused that they’ve gotten this crowd on their side on the cheap. They’ve no doubt respect them more if they insisted on being paid properly.

If we want to subsidize housing to advance social goals, the only sensible way to do that is through formal government programs with explicit goals, oversight, and accountability. And despite the bad name that overly aggressive and poorly thought out initiatives have garnered, we have had affordable housing programs that produced good outcomes at low cost. For instance, traditional FHA loans had low default rates because they had tough borrower screening and documentation requirements.

But we’ve learned what a bad idea it is to conduct housing policy by distorting the mortgage market, and separately saw what a bad idea it is to give the banking sector to place “heads I win, tails you lose” bets on the taxpayer dime. Yet a group that wraps itself in the mantle of representing public would have you believe that bankster-enriching failed ideas are just what the doctor ordered.