Let’s be clear: I’m not a fan of Fannie and Freddie. Subsidizing housing finance is a lousy way to subsidize housing (and that’s before you get to the question of whether housing should be subsidized at all, save for low-income people). It’s indirect, inefficient, and very hard to measure what the effects are.
But reality is path-dependent and we need to remember where we are now. As much as the Republicans have good reason to go obsess over Fannie and Freddie (they were Democratic party pork machines) and the conservatorship mandates their wind-down, both parties have been utterly unwilling to take any serious steps needed to have either a functioning private mortgage securities market or see about migrating more mortgage lending back onto bank balance sheets (the latter tends to be reflexively rejected as “too costly” since banks have to put up equity and pay for FDIC insurance, and the need to cover those expenses typically leads to higher consumer mortgage rates. Can’t make houses less affordable, as in cheaper, now can we?).
We now have a mortgage market that has gone before the crisis from having Federally-guaranteed loans as a large component of the market to being virtually the only game in town, with the GSEs as the biggest providers. You’d think a critical first step would be at least to get a decent private label market back in running. But for the most part, investors are still correctly leery, since the sell-side has successfully beaten back meaningful investor protections (such as a proposal floated by the FDIC in early 2010).
Reuters gives a brief overview:
Under the bill, which is being led by Tennessee Republican Bob Corker and Virginia Democrat Mark Warner, the two companies would be liquidated within five years. The legislation would provide for government reinsurance that would kick in only once private creditors had shouldered large losses.
“It lessens the footprint of the federal government in housing and winds down Fannie and Freddie,” Corker said at a news conference. “But at the same time it keeps the housing finance industry in a liquid state.”
So this proposal is basically a reworked version of some plans floated by the Treasury in 2011, which we shredded then in The 7 Things Really Wrong with the Treasury’s GSE Reform Plan. Every problem on that list is still operative here. This is not a plan to get rid of GSEs, it’s to create new, supposedly better/safer GSEs 2.0, which it calls the Federal Mortgage Insurance Corporation (FMIC).
But the problem is the “better/safer” feature is a great big fantasy, a bipartisan private market version of Obama magic sparkle ponies. The scheme hinges on having private insurers take the first 10% of losses, not the government. Reader MBS Guy explains why there is less here than meets the eye:
The idea of private capital taking a first loss position isn’t bad. However, in reality, this isn’t that much of a change. Currently, privately owned mortgage insurers take a first loss on all Fannie/Freddie loans with LTVs over 80, which is a large portion of the overall portfolio. Then Fannie and Freddie guarantee the securities.
Mortgage insurance is essentially a failed business model – several went bankrupt and all would be insolvent if not for waivers of capital requirements from Fannie and Freddie due to higher than expected losses. The insurers had carve outs from their coverage which turned out to be larger than they had marketed them as.
This proposal would effectively replace have mortgage insurers provide some of the first loss capital with having some other private entities provide all of the first loss capital. In all likelihood, the same flaws, qualifications and massive lobbying would crop up over time with this structure.
I can’t really see what the difference would be between Fan/Fred MBS guarantees and FMIC reinsurance or why this distinction carries some meaning in DC. Would a reinsurer not have interest rate risk, investment risk, corruption risk, etc.? Consultants, lobbyists and lawyers will make gobs of money replacing one failed system with a new system that is not dramatically different.
As MBS Guy points out, for insurance to work, you really need for risk to be transferred to the insurer. That does not happen under the current private mortgage insurer system. If Corker-Warner relies on insurers, it’s hard to see that the risk transfer is anything other than a chimera, since PMI insurers have never been well enough capitalized to be credible counterparties. It’s not hard to predict that if this insurance were to be put in place, the new PMI insurers would be rescued if they were to get in trouble, since the mortgage market would come to depend on them.
The other route might be to use bonds to transfer the first-loss risk. That sounds great, since risk would be transferred to well-diversified deep pockets. But in reality, this idea will founder for a different reason: sophisticated investors are unlikely to want this paper, except on a very selective basis.
Remember, this is exactly how subprime worked. Subprime bonds were tranched by credit risk, with the riskiest tranches bearing the greatest risk of loss and therefore getting lower ratings (this was achieved by having they higher-rated tranches get priority in payment, and only when the money borrowers sent in every month met the amount due for the AAA tranches did any funds go to the AA tranche(s), and so down the ladder. The effect was that the lowest tranches bore the first losses. Now the very very bottom tranche (net income margin bonds, or NIM bonds) got extra goodies (extra interest margin in the deal, a loss buffer) so they were popular, since on a risk adjusted basis, if the deal worked out at all, they paid out fast and paid a premium return. So the real turkey was the lowest rated tranche, usually a BBB or BBB- tranche.
Here’s the dirty secret: there was never enough of a market for that stuff. Both times the US had a meaningful subprime market (a small one in the 1990s and the bigger one we know all too well), it depended critically on CDOs. The CDOs would buy the drecky stuff no investors wanted, plus some better stuff to make them more palatable. They were then tranched. But really no one wanted the bad parts of the CDO either (sometimes stuffees bought them, sometimes correllation traders would go long one tranche and short the one immediately above it) and so they were mainly rolled into OTHER CDOs. So the subprime market was ultimately a Ponzi scheme, and both times (late 1990s and the 2000s) both the CDO market and the subprime market imploded.
MBS Guy explains:
The financial crisis showed that the market is pretty horrible at pricing and understanding first loss mortgage risk. It seems odd to think that the market will get it right this time. First loss bonds are, by their nature, illiquid, hard to price, volatile and extremely sensitive to small market changes. I’m fairly skeptical that we can replace Fannie and Freddie with a stable housing infrastructure that depends on liquidity in a market for first-loss mortgage risk that has repeatedly shown itself to be illiquid and volatile.
It’s unlikely this proposal will go anywhere. It lowers the maximum eligible loan size from $625,000 to $412,000 (broker and homebuilder howls to raise the ceiling to old GSE limits guaranteed) and claims to make lending standards more stringent (right now, lenders are being bloody-minded, but that’s not guaranteed to continue). With the Fed’s tough taper talk having scared the mortgage market, the last thing anyone is going to want to do is make credit less available when the central bank might have halted the housing “recovery” (we won’t know for sure what the impact is until July data is in, which will be in September).
The sad bit here is the resistance to ending the 30-year fixed rate freely refinanceable mortgage. That’s the real impediment to fixing housing credit. An adjustable mortgage with interest rate floors and ceilings (which would mean borrowers would not have to refi to benefit from falling rates and would be protected from big rate jumps) or restrictions on refis (say for the first five years) would make it possible to move a lot of mortgage lending back on bank balance sheets, since it would greatly reduce interest rate risk. Having the lender have real skin in the game is a better way to provide the right incentives than trying to make failed markets work. But all we are likely to get is more discussions of how to rearrange deck chairs on the mortgage Titanic.