By John Hempton, a Sydney-based investor, recovering financial services analyst, and former Australian government official who writes at Bronte Capital
There are a bunch of ideologues out there with solutions to the Fannie and Freddie situation. They argue that government intervention has to end and then propose a system with a permanent role for government. It is not just nonsensical – it is usually in the interest of some large financial institution. All they want is Frannie out of their part of the business. They like government subsidies in the rest of their business.
Anyway I have the free market solution to the Fannie and Freddie situation – and – I hate to say it – it is dead obvious.
Answer: raise Frannie’s pricing.
At the moment there is nobody doing conforming mortgages except Fannie and Freddie. Indeed there is almost nobody doing mortgages of any kind except Fannie and Freddie. If the free market wants the business they can have it. (They just don’t want it at this sort of interest rate spread – and I don’t blame them.)
All the government need to do is tell Frannie to raise their price a little each quarter. Currently they charge 20-25bps for guaranteeing mortgages. (The free market won’t take credit risk at that price.) So it is entirely open to the FHFA (and hence the Treasury) to tell Fannie and Freddie to raise their prices by 5bps. The government will get paid better for the risk they are taking (and what free market ideologue will disagree with that) and the private sector can compete if they want to.
I doubt the free market will. But then in a quarter or two Frannie can raise their pricing by another 5 bps. And a quarter or two later Frannie can raise by another 5bps.
At some stage you will get to a level where the private sector chooses to compete. Frannie should not set its price competitively though. In another quarter they should raise the price another 5bps. And in another quarter they should raise again.
Over time Frannie will become non-competitive. It will shrink simply because bankers and mortgage brokers do not bring it business. And so Frannie is put into market chosen run-off and the business is effectively privatized.
You can do the same thing with Frannie’s portfolio – you could ask them to raise their internal revenue exectations on any mortgage they buy by 5bps. They might buy less – they may not. Don’t limit the size of the portfolio: raise the profitability of the portfolio. When another quarter elapses raise spreads by another 5bps. Eventually of course the private sector won’t bring Frannie business – and so Frannie will shrink.
If you want the government to keep supporting the housing market (an object of policy it seems) then you just slow the rate of price increase down. Do 5bps per half rather than 5bps per quarter – or even 8bps per year for a slow exit.
Over time the government will make a full exit from the mortgage business. Along the way the taxpayers recover as much money from Frannie as possible.
If you look at my long series on Fannie and Freddie and compare my model predictions to current results you will notice that the credit losses are lower than my projections. The revenue however is much lower than my projections. The lower projected revenue has been a government choice: the Government has been forcing Frannie to charge lower spreads to support the housing market.
This is so obvious it is painful: if you want to remove the subsidy remove the subsidy. If you want to do it slow do it slow.
So why can’t anyone see it?
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.
But Swagel and Marron are an extreme variant of the typical proposal. Everyone’s proposal involves getting Frannie out of their business whilst leaving subsidies (preferably increasing subsidies) in the parts of the value chain they don’t compete in. Every proposal is thus about maximizing profits of some financial institution whilst sticking those risks that they don’t want to the government.
Are you surprised?
Disclaimer: Every proposal out there is conficted. I am too. I own defaulted preference shares in Frannie on my own behalf and on behalf of my clients. A proposal that allows Frannie to maximize revenue on their way to oblivion is in my interests. But then I only get paid if taxpayers get back 100c in the dollar plus penalty interest and fees. And from the perspective of a US taxpayer it is hard to see what is wrong with that. You exit Fannie and Freddie and it does not wind up costing anything.