The 7 Things Really Wrong with the Treasury’s GSE Reform Plan

As readers no doubt know, the Treasury Department released its overdue plan for reform of the Fannie and Freddie, otherwise known as GSEs (for “government sponsored enterprise”) last Friday. We were surprised that some normally astute commentators, such as Mike Konczal and Felix Salmon, were taken in by this thin and misleading document. As banking expert Chris Whalen said by e-mail, “The proposal is completely disingenuous. Read 180 degrees opposite what it says.”

What is particularly striking is it is not too difficult to see through the stage management. Throughout the document, the Treasury calls its proposal a “plan” when it is anything but. Putting some stakes in the ground and then offering three mutually exclusive alternatives and no timetable for resolution is not a plan.

The reason for this failure to put forward a real proposal is that Treasury is trying to present itself as a fair broker of a politically fraught process. But that’s bunk. The outcome, unless the public wakes up to this new effort at looting, is already clear.

The fix is just about in. Of the Treasury three proposals, the last is the same as one advanced byt the big guns, from the Mortgage Bankers Association, the Fed (both the New York Fed and the Board of Governors), the Financial Services Roundtable and Mark Zandi of Moodys. This alternative preserves too many bad elements of status quo ante, in particular significant and largely hidden subsidies for banks, for anyone to hail it as reform. Although each proposal has some distinctive wrinkles, all call for the creation of “private” entities that would provide insurance to mortgage backed securities that would then be reinsured by the government, with a full faith and credit guarantee (note that this goes beyond the level of support that the GSEs had, since their securities offerings specifically stated they were not government supported but they were nevertheless widely understood to have government backing. And believing so turns out to have made it so).

The boosters of this idea contend that this would be much safer than the old Freddie and Fannie because the primary insurers would have higher capital requirements than the old GSEs and would also be required to pay into an FDIC-like insurance, which the government would turn to first in the event that the insurers had trouble meeting their commitments.

Despite the Treasury’s efforts to feign neutrality, the Administration’s true wishes are clear. The Center for American Progress, one of the Administration’s pet think tanks, weighed in with a proposal virtually identical to that of the Mortgage Bankers Association.

So what in particular is wrong with the plan, meaning the general framework in the Treasury paper and the specific option that the Administration favors? Its most objectionable features:

1. The most pressing problems in the housing and mortgage finance market remain unaddressed. GSE reform appears to be a distraction from the much harder work of fixing what is really broken in our housing market. While the GSEs are now wards of the state, they were not the central part of the housing crisis. The bulk of the abuses and damage to the economy came out of the non Fannie/Freddie market. The plan gives lip service to some of the broader problems, such as mortgage servicing. There is no acknowledgment of, much the less an effort to deal with, hemorrhaging wounds such as the questionable role of MERS, the widespread failure to convey mortgage notes and liens as stipulated in pooling & servicing agreements, and foreclosure abuses.

We now have virtually no private securitization market because the investors wised up and aren’t about to buy private mortgage paper unless the mortgage industry cleans up its act. But instead of discussing that problem and focusing regulations and clearer civil and criminal penalties as the solution, Treasury wants to subsidize credit instead. If the large segments of the sausage industry were found to be in the business of making poison sausages, this Administration’s response would be to have stress tests to show how much poison the sausages could contain without posing a public menace along with government-funded insurance in case anyone got really sick. So why aren’t we cleaning up the sausage factories instead?

2. The plan continues a bad pattern of using mortgage finance to achieve housing market goals. Laundering housing subsidies through the mortgage market is inefficient, makes it difficult to assess program effectiveness and establish accountability, and often has produced overinvestment in housing. If we want to encourage the development of rental housing, or find ways to promote greater homeownership among lower income borrowers, the policy mix whenever possible should favor budgetary allocations and tax breaks (including tax credit rather than mere tax deductions) over bank enriching and often difficult to target mortgage market gimmicks.

3. The Treasury document perpetuates a mortgage model for 1950s America. The Treasury document makes clear that it gives very high priority to preserving the “pre-payable, 30-year fixed-rate mortgage”. Every advanced economy in the world has a mortgage market that provides affordable loans to the middle class without GSEs or other large scale government guaranteed mortgage product. However, the Treasury uses their failure to provide a “pre-payable, 30-year fixed-rate mortgage” as the justification for creating a new variant on the Fannie and Freddie theme.

There’s no good reason to distort policy and refuse to learn from the experience of other markets to preserve a particular product, especially when there is good reason to think it isn’t as pro consumer as its advocates would have you believe. The big difference between the US and other markets is lenders here bear all the interest rate risk; for the most part, consumers have the option to repay with no or low penalties and can avail themselves of a fixed interest rate. That means when interest rates drop and the lender would enjoy the benefit of having a relatively high yield bond, investors can take it away from them by repaying. That also creates uncertainty for lenders as to how long the maturity of their bond is likely to be (repayments due to home sales are more predictable than prepayments due to refis).

Having consumers share some of the interest rate risk would allow them to borrow at lower costs, yet those options (such as mortgages with prepayment restrictions, or adjustable rate mortgages with interest rate floors and ceilings) are not widely offered (the subprime/Alt-A “adjustables” were teasers with rate resets or option ARMs, which both were products that presupposed a borrower refinancing).

More fundamentally, despite the document’s brave talk of the American Dream of homeownership, a long-dated mortgage no longer fits well with job market and household instability. It was created in the Great Depression as part of the cleanup of that era’s housing crisis, and it made sense then. Most home buyers stayed in the same community all of their adult lives, in a one-earner household. The profile of payments over the life of the mortgage amounted to forced savings during one’s peak earning years.

Now with job tenures short and most households dependent on two incomes, neither of which is assured (plus divorce rates are high), people who commit to 30 year mortgages really have no way of knowing what their incomes will be or where job opportunities will take them in five years, much the less fifteen or twenty five.

4. The Administrations’ preferred solution would keep in place the bad incentives and socialization of risk that got the GSEs in trouble in the first place. A document about why we need to do something different than the GSEs never mentions the real reason they got in trouble: their private/public structure, which led them to do greedy stupid things, namely put their investment portfolio in subprime loans.

Despite the Treasury’s claims that the new GSEs would not fall into the same bad habits as the old GSEs, there is nothing convincing in place to prevent that from happening The new GSEs are likely to become riskier over time. They will in aggregate have a huge amount of lobbying power just like the old GSEs. Think they aren’t gonna lobby together? Think they aren’t gonna seek variances so they can lever themselves up more? If you think otherwise, you need to revisit the history of the financial services industry since 1980.

5. The GSE 2.0 proposal is about propping up the housing market rather than helping consumers. A devastating little analysis by Dean Baker shows that even using Mark Zandi’s presumably pro-new-GSE assumptions, consumers would likely face higher all-in payments than they would under a purely private market system. So why prefer the other scheme? Because it is presumed to lead to higher housing prices, which happens also to be anti affordability. Yet most housing analysts argue that housing prices will eventually have to revert to long-standing relationships between incomes and rental prices. If the officialdom thinks it needs to attenuate the adjustment to buffer the impact to the economy, there are much simpler and cheaper ways to do it.

6. The GSE 2.0 plan has the new GSEs playing the same roles that Fannie and Freddie did, namely making credit decisions and providing liquidity, when the two are in conflict. . Making good credit decisions depends on maintaining standards; maintaining market liquidity requires bucking the judgment of private market investors who have retreated to the sidelines. Some may have done so due to a misreading of actual market conditions, but to the extent that their reading is accurate, the liquidity provision function involves taking credit risks at times when it in fact may turn out to be a bad credit bet, because underlying economic conditions are deteriorating.

Moreover as Raj Date points out, the liquidity function ultimately depends on the Fed, so why have private actors stand in the middle and pull out fees for no ultimate value added?

The second source of the GSEs’ power to backstop liquidity is their portfolios. Because the GSEs are able to obtain debt financing from investors who fully expect a taxpayer bailout in a crisis, their ability to maintain, and even grow, an investment portfolio of mortgages and MBS can defy free-market gravity: their assets can climb as others sink.

This is a real benefit. But it is not additive to what the government can already accomplish, through the “official” lender of last resort, the Federal Reserve. During this financial crisis, for example, the Fed opened its funding to an unprecedented range of financial institutions, and both purchased and advanced loans against a wide range of assets — including GSE and private-label MBS.9 And when the Fed puts taxpayers at risk through such liquidity mechanisms, it is, ultimately, taxpayers that benefit if circumstances turn out well. With the GSEs, by contrast, considerable upside is captured by a number of private parties aside from taxpayers — GSE equity holders, GSE management, and GSE bondholders.

7. These new GSEs will be too big to fail. They will all have the same business model. The various proponents of this scheme argue that it will have better risk buffers, and therefore not blow up, but giving private actors a government guarantee via reinsurance is like giving a kid a loaded gun. Just because you handed it to him with the safety on is unlikely to mean that bad things will not happen.

The GSE 2.0 advocates also contend that we still need not worry, since the authorities will have the authority to wind them down. But putting one in receivership would lead spreads on all the rest to blow out. A sudden increase in financing costs is a death knell for a highly leveraged company that is in the market on a regular basis (roll film showing fates of the monolines, Bear, Lehman, AIG, the GSEs, and the near death experiences of numerous US and Eurobanks). The government will bail anyone who gets in trouble out rather than risk cascading liquidity crises across the guarantors. The most likely approach is not an embarrassing rescue but a gunshot merger into one of the other GSEs, probably with some extra subsidies to make the deal more attractive.

So what exactly have we done here but rearrange the deck chairs on the Titanic?

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  1. attempter

    It’s simply a continuation of the Bailout.

    It continues the basic features of the Bailout: A command economy; socialized financing and risk assumption, privatized profits; zombifying housing prices (reflating the bubble) to temporarily prevent letting nature take its course (the inevitable asset deflation), extend and pretend; zombifying the politics of the “ownership society”, while the real action and goal is alienating ALL non-bank, non-corporate ownership.

    We now have virtually no private securitization market because the investors wised up and aren’t about to buy private mortgage paper unless the mortgage industry cleans up its act. But instead of discussing that problem and focusing regulations and clearer civil and criminal penalties as the solution, Treasury wants to subsidize credit instead.

    Is the goal to trump up a new cohort of subprime loans which now are government-guaranteed, so that investors will let bygones be bygones regarding the old, fraudulent MBS and agree to invest in the new ones with the explicit government guarantee? Maybe a way can be found to switch in the new loans for the rotten old ones, or at least substitute the guaranteed assets for the toxic assets on the banks’ balance sheets.

  2. Doc Holiday

    3. The Treasury document perpetuates a mortgage model for 1950s America.

    ==> It also perpetuates a retarded model from May 1996:

    Options for Improving the GSE Cost-Benefit Balance for Taxpayers

    “Eventually, the Congress could repeal the GSE charter acts and recharter the enterprises under state law as a formality. Breaking the GSEs’ monopoly and replacing the exclusive implicit guarantee with an inclusive explicit one would strengthen Congressional control of the subsidy. For example, the government’s guarantee might eventually be reduced from 100 percent of loss to 95 percent. Alternatively, the government could provide the current volume of federal guarantees of MBSs without charge and meet the growth in demand for guarantees by auctioning additional credit enhancement. Those policy changes could result in budget savings.”

    ==> I also have to get this in here for some reason … something about the metaphorical scale of fraud and corruption… I don’t know; just a happier time, back when warped frustrated old men made money the easy way — before derivatives and financial engineering:

    No, but you…you…
    you’re thinking of this place all wrong.
    As if I had the money back in a safe.
    The, the money’s not here.
    Well, your money’s in Joe’s house…
    that’s right next to yours.
    And in the Kennedy House, and Mrs. Macklin’s
    house, and, and a hundred others.

  3. YankeeFrank

    As Noam Schieber made clear in an otherwise nauseating fluff piece about Tim Geithner in TNR, Timmy and his crew never saw an asset class or income stream they didn’t want to financialize to death. Their answer to every problem is to have the banks slather it in finance sauce and suck the profit up for themselves. They are like the guy with the proverbial hammer who sees everything as a nail. From Scheiber’s article —

    “Geithner hunched his shoulders, pressed his knees together, and lifted his heels up off the ground—an almost childlike expression of glee. “We’re going, like, existential,” he said. He told me he subscribes to the view that the world is on the cusp of a major “financial deepening”: As developing economies in the most populous countries mature, they will demand more and increasingly sophisticated financial services, the same way they demand cars for their growing middle classes and information technology for their corporations. If that’s true, then we should want U.S. banks positioned to compete abroad.”

    Oh goody.

    1. Doc Holiday

      the world is on the cusp of a major “financial deepening”

      ==> Oh God, it even has a definition: Financial deepening is a term used often by economic development experts. It refers to the increased provision of financial services with a wider choice of services geared to all levels of society.

      ===> A wider choice of what, derivatives linked to a new deeper pool of shit connected to freshly minted covered bonds?

      1. miss bank piggy

        He must be just focusing in on the theory that more money will be available after the printing presses churn out QE2, versus the stuff he should be working on like, managing the reserve requirements and separating the fraud deposits from the fraud reserves…. oh wait, he’s doing both. Now that’s deep!

  4. Allen C

    I have difficulty understanding how the US can stop QE. The US seems a long way off from discontinuing mortgage subsidies. One should expect banker friendly policies as long as the politicians remain captured by the bankers.

    The nightmare continues…

  5. financial matters

    The financial crisis seems to be evolving into a currency war. The structural imbalances mainly between China and the US are being played out in their currencies. Both are heavily manipulating them. QE2 is the US manipulation. Both countries are basically trying to protect their economies and their employment levels. This will necessarily hurt all other countries that aren’t able to match these levels of manipulation.

    We’re seeing this being played out in Tunisia, Egypt, Yemen, etc. These are not religious riots but are economic riots largely due to food inflation and in no small part due to our QE policies. This will tend to limit further QE. Other factors that will limit QE are gas and food inflation in our own country as well as an erosion of the value of savings accounts hurting esp retirees on a fixed income.. (ie voting seniors)

  6. maresuke

    T of course also failed to make any mention of the fact that many (most?) servicers are affiliated with holders of large amounts of 2nd lien risk.

  7. Dr. Pitchfork

    But, but…Yves….they SAY it won’t do any of the things you say it will. They even have a “Catastrophic Risk Insurance Fund” to cover any catastrophic risks. You did notice they named it “Catastrophic,” right?

    It’s just like Senator Obama told us back in 2008: “This is not a bailout of Wall St.”

    Or when Pres. Obama told us: “Because of Financial Reform, the American people will never again be asked to foot the bill for Wall St’s mistakes.”

    Moreover(Obama): “There will be no more taxpayer-funded bailouts. Period.”

    1. Dr. Pitchfork

      I should also add (Obama again): “We will bring an end to this war. You can take that to the bank.”

      Although W. was probably most prescient when he said: “There’s an old sayin’ in Tennesee….It says, Fool me once….uh…uh..You fool me — can’t get fooled again.”

    2. Фашистская зазывала

      Re: “Or when Pres. Obama told us: something about fatcats… what was that he said, fatcats want changes in the size of their bonuses and I’m gonna give them every penny and then some, so help me God, and God bless America, because God knows we have the fattest cats in the world, and God loves fatcats. That is a quote, but not sure from where…

  8. rational

    All of Yves other good points notwithstanding there IS NO RMBS BUYERS STRIKE – rightly or wrongly, investors are paying premium prices for existing RMBS with all the problems enumerated in this post… With respect to new issue, its been a sellers strike, with banks unable to evaluate the cost/benefit given all the regulatory changes and required credit enhancement changes. Also, given that FNM & FRE are guaranteeing huge loan balances, the non-conforming market is quite small. Nonetheless here is the info on the first private-label deal of 2011: — [Sequoia Mortgage Trust 2011-1]$290.4m via lead manager CS; Co-mgrs: JPM and
    Jefferies; Private Label RMBS; Transaction is not officially announced, said in
    the pre-marketing phase; It is expected to include a $274.102 million A-1 class,
    in addition to AA-rated B1, A-rated B2 and BBB-rated B-3 classes; The expected
    closing is on or about March 1; All of the mortgage loans are secured by first
    liens on one-to two-family residential properties, condominiums, cooperative
    units, planned unit developments and townhouses.

    1. furiouscalves

      so what you’re saying is they are paying a premium to front run an expected govt. guaranteed cash flow from any old junk MBS- or something like that?

      bill gross? is that you?

      1. rational

        No, what I am saying is the most senior securities in mortgage RMBS appear to have enough credit enhancement that they will not take principal loss based on the rate on which loans are defaulting and the recovery of principal on foreclosure. They are not discounting these securities for perceived risk around MERS, assignment in blank, etc.

        1. furiouscalves

          oh sorry – i think you must mean senior security investors, even in this crappy market, still want to buy guaranteed to pay securities. why is that surprising? the very structure seems to make these investors indifferent to risk because there just isn’t any for them. i would assume that lower tranches are just forced to take even more risk related to assignments and such and those are the investors that would therefore “be on strike”.

          Isn’t that what we are talking about? – senior investors still getting a free lunch. guaranteed yield, no skill, research, worry or thought needed just a hunk of cash to park and watch it flow in. the problem is the line of greater fools to peddle risk to is very short – enter the need to this time formally rape in broad daylight the taxpayer to get market going again. let the investors really know that you got their back. right? help me out here.

          1. rational

            No, not guaranteed to pay, extensive research and skill shows that they can be expected to pay given cash flow analysis. I’m not trying to interrupt your rant, just make the point that the structural flaws Yves is concerned about, which these bonds are subject to, don’t seem to be deterring people, hence no “buyer’s strike”. Hope that helps you out.

          2. furiouscalves

            finally it is getting through my head.

            you are saying that investors in an upcoming private RMBS are not concerned about the assignment problem and they are not pricing this risk in. therefore, i am now lead to believe that an assumption has been made that TPTB will not let this assignment thing be a problem and will fix it for the senior investors somehow – just like last time.

            got it. thanks. my brain hurts now.

    2. Yves Smith Post author

      With all due respect, are you kidding me with this comment? You point to a single deal that won’t close till March as proof that the non FF market is working?

      And jumbos do have an interesting feature….there are so few loans in a jumbo that investors can effectively do more due diligence. They can and do look eyeball the loans individually. It still falls far short of the loan level disclosure that investors have been pressing for for some time.

      1. rational

        No, I agreed that the market is not functioning, but my point is because of reluctance of sellers, not buyers. If this deal is well-received the onus is on you to demonstrate the buyers strike – where are the deals that had to be withdrawn or repriced due to lack of interest? How much non-conforming origination are banks holding that they want to sell? Saying it don’t make it so.

        1. Yves Smith Post author

          A thriving secondary market proves nothing if there is no appetite for new issues That point is simply not germane.

          1. rational

            it is germane to the allegation that investors are frightened away by assignment, MERS, etc. Investors are aware of those issues and there is demand for the bonds that exist. It is true there is no demand for bonds that have not been offered, I concede that point! Having said that, I will be surprised if MERS is a part of the new deal and I will also be interested to see if there are changes to the assignment language in the P&S. While you can dismiss this as “one deal”, since it is the only private label deal so far this year it will receive a lot of scrutiny as to what new transactions will need to look like.

    3. Yves Smith Post author

      I got further confirmation from MBS Guy who saw your comment and objected vociferously:

      Last year’s Sequoia deal had a pool balance of $292 million, according to the commentor. According to S&P the deal had a grand total of 255 loans in it (note the numbers don’t tie out perfectly, S&P was probably looking at a preliminary pool): The current deal is somewhat smaller at about $274 million. It will likely have fewer than 300 loans in it. The average loan balance is about $932,000 (and since the average LTV is about about 56%, this means the average home value is about $1.7 million).

      While these deals may be over-subscribed, the total borrowers benefiting from these two deals is less than 550. Basically, the deals have virtually no impact on the economy and affect a ridiculously small percentage of Americans.

      I wouldn’t view the deals as any sign of strength in the market or any indication of future market health. Any investor in these transactions could quite reasonably review every single borrower in the transaction without too much effort, and probably did.

      Considering the small number of borrowers and small deal sizes, I don’t the transactions provide any evidence that there is not an investor strike for MBS generally. As the commentor concedes, banks have no idea how they will go about securitizing more traditional mortgages to a much larger number of borrowers. Other than for a very select group of borrowers, many of whom probably make as much or more than the investors in the MBS, the securitization market is not available as a means to funding mortgage transactions.

  9. Cedric Regula

    “So why aren’t we cleaning up the sausage factories instead?”

    I realize that I have absolutely zero aptitude to be a government technocrat, but I still think that if we just made the sausage factory eat their own sausages, then the rest of us wouldn’t have to.

    1. Yves Smith Post author

      They did that in the run up to the crisis. They ate the toxic sausages (the CDOs) but took patent medicine to suppress the immediate symptoms (hedged them with CDS in the negative basis trade). The traders got extra special bonuses for this scheme, since the toxic sausages looked like a really good food source.

      Then the banks nearly died and got special expensive medical treatment and now have their own special government health care plan. The officials are also trying to get them to clean up their diet and exercise, but the banks instead are still in the hospital and ordering in from the local gourmet restaurant. No toxic sausages eaten lately as far as anyone knows, however.

      1. Cedric Regula

        I follow your analogy of course, and read a lot about the details of what happened with securitization in your very informative book and other places as well, but the CAP post and this post got me off into my own fantasy world of Savings and Loans and this comment just dropped out and I neglected to type all the context about just letting Savings and Loans be originators, holders of the loan, servicers, negotiators of mods, etc….and making the GSEs, private label securitizers and MERS disappear into a bad dream world – all wild fantasy of course.

  10. Eric

    I am quite surprised to see point 1 on this list. This site has seemed dedicated to the idea that in fact there is an existing solution to the note/mortgage situation. Namely, enforce existing state laws. Put back defective MBS with imperfectly secured assets; stop foreclosure by parties without foreclosure rights; and convert mortgage loans to equity loans where the note is irrecoverably separated from the mortgage. For months I’ve been reading here that mortgages and MBS could have been done properly and it was fundamentally a case of being cheap and lazy above all else that put so many loans at risk. It has been repeated over and over here that the legal opinion letters that if X, Y and Z the OK were, in fact, entirely correct. So just go back to doing X, Y and Z. Why would a GSE plan need to get within 100 miles of this?

    1. Yves Smith Post author

      The mortgage industry continues to insist its procedures are fine, so it has not been converted to doing things the right way. They seem to believe the economics will favor them continuing the bad practices even if they get caught.

      And they have good reason to think that. The costs of their non-compliance fall on the investors. The banks (servicers) still collect their fees. So they don’t suffer any pain except embarrassment and getting hauled before Congress and called names as a result of their bad acts.

      1. ScottS

        Yes, the pissing and moaning over name-calling is priceless.

        Things are perfect the way they are! Just need a little band-aid on regulation and a pinky-swear from the bankers that they won’t do it again. That’ll hold ‘er.

  11. ScottS

    I took Dave Min from CAP up on emailing him to have a talk about GSE reform. Here’s my response to his response to my response to Yves response to his response to Yves response to his proposal (got it?).

    You haven’t answered any of the points Yves mentioned. None of that was ad hominem.

    Sorry, I was speaking tongue in cheek about the readers who were calling me a fascist/etc. in comments. Didn’t mean to refer to Yves in that way, or to be offensive in general. Bad humor, I guess.

    Take it as a compliment. “Fascist shill” is how commenters on Naked Capitalism greet each other.

    So I’ll state quickly that these are really big questions, and I’m actually working on a longer piece defending the guarantee in the markets. So I apologize in advance if any of these are overly shorthand.

    I appreciate the response and look forward to your paper.

    My questions:
    1. What’s so great about a fixed-rate mortgage?
    We can’t seem to do it without putting the tax payer on the hook. Maybe we should let it go.

    2. What’s so great about 30-year mortgages?
    People fail to realize how much interest they are paying on a 30-year mortgage, fixed or not. It’s roughly double the purchase price.

    3. What’s the downside of letting the 30-year FRM die?
    Housing prices go down, which is great for people trying to buy. People pay less interest in the long run on shorter mortgages.

    4. What’s so great about securitization in general?
    It seems like a game of pass-the-trash onto pension funds.

    1-3) I’ll refer to my piece here: and also state this: the mortgages that caused the highest rates of losses were ARMs, not fixed-rate mortgages. FRMs have always been far superior at reducing risk, being more sustainable (thus reducing systemic risk), etc. It was 2-5 year ARMs that have suffered the highest rates of default and been the proximate cause of the crisis. I can tell you for certain, and anyone who is being honest and knowledgeable about mortgage finance would agree: if we had only originated 30 yr FRMs in the last decade, we would not have had the crisis. Also, on your claim about house prices, that’s actually not matched by the empirical evidence. ARMs and short-duration loans actually have much higher volatility in home prices, something fund by Sir David Miles (a member of the UK’s Monetary Policy Committee who conducted a comprehensive report on the UK’s mortgage system in the early part of this decade).

    The Fixed-Rate Part
    I agree that the loans with adjustable rates and short durations blew up. But was it the adjustable rates and short durations that blew them up? A lit match may be the proximate cause of the powder keg exploding, but I wouldn’t ban matches.

    Likewise, the people who got into ARMs generally had poor prospects to start with. They were going to get caught out eventually when the bubble popped — whether it was ARM or FRM.

    Yves suggested using what other countries used — a window — to allow some flexibility on the lender’s side to interest rate shocks, and allow the borrower some idea of a worst case scenario. You could peg the rate to the prime rate plus X, with a lower and upper bound.

    So let’s say I borrow $215,000 for 15 years, with a window of 4%-7%.

    4.0%: $1,590/mo. (min)
    5.5%: $1,761/mo. (avg)
    7.0%: $1,932/mo. (max)

    Max difference of $342/mo. Deviation from average of +/- $171.

    Is +/ -$171 a month really worth government subsidies and the moral hazard involved?

    In my layman’s naive observation, interest rates tend to be high in the good times, low in the bad. This would mitigate some of the “shock”, and put the brakes on when things get heated and ease things when it collapses.

    The 30-Year Part
    So let’s put some numbers to the case against the 30-year part. Let’s say I’m a potential homebuyer with around $1600/mo to spend on a mortgage. In scenario A, there are no 30 year FRM. Scenario B, there are.

    Using the interest rates and calculator here:, I come up with the figures for the two scenarios:

    A. $215,000 loan at 4.29% for 15 years = $1,621.75/mo, $291,915 total, $76,915 total interest. Bank gets $5127/yr interest.

    B. $300,000 loan at 5.02% for 30 years = $1,614.13/mo, $581,086 total, $281,086 total interest, plus greater property tax, realators’ fees, etc. Bank gets $9369/yr interest.

    Where is the $85,000 difference in principle going to come from? A combination of personal savings, buying a smaller house, buying a house in a “less nice” area, and bargaining down seller’s asking prices (depressing housing prices). Maybe I’ll ask for a raise at work (gasp!), up my education to find the right job to increase my earnings, etc. to add to my savings. It’s also 50% less time for interest rate and credit risk to ruin the mortgage.

    In other words, all pluses for the 15-year FRM. Unless you’re a realator, banker, or local government. Bankers lose about 46% of their interest per year. The homebuyer loses a formal living room, no big deal.

    The Prepayment Part

    My understanding is that mortgages are a “volume” product, and prepayment messes with that. As long as lenders were upfront with the terms of the mortgage, including prepayment penalties, we could put a price on prepayment and ease the need for government subsidy.

    4) Nothing is great about securitization, except that mortgage finance has to come from somewhere.

    [snip … double-digit inflation in the disco era killed private 30-year FRM]

    The major problem today is that if you get rid of Fannie and Freddie (and don’t replace them with something that attracts investors), there’s just not enough capital left in the system to come close to meeting mortgage demand. You might say that’s a sign we’ve got too much housing, but we’re not talking about a small gap, but rather an enormous one (the last chart of this WSJ piece: actually illustrates the point pretty nicely).

    Does the mortgage finance have to come from somewhere? I don’t see this mortgage demand your talking about. There’s a huge inventory on the market, and an equally huge shadow inventory of people in/about to be in/ foreclosure.

    Again, making the credit more difficult to get will drive down house prices — a very good thing from my point of view.

    And with respect to the “gap” chart — if people saved money instead of pissing it away on underwater mortgages, wouldn’t that bring the mortgage debt down and the deposits up?

    As to your final point I don’t think that’s right. The 2/5 year ARMs caused much more price inflation than the 30 year fixed, which has been around for decades.

    My gut feeling is that the housing bubble would have happened with or without adjustable rates. Yves has covered this in detail — John Paulson, Magnetar, various others were stoking the bubble to short it. I say the ARMs made it even worse, but the real problem was stated income documentation.

    1. rational

      ARMS defaulted at high rates not because they were adjustable per se (low LIBOR actually made many of these loans adjust downward) but because floating rate mortgages were in demand for the floating rate CDOs that were being placed with investors with floating-rate demand. That is, the crappiest mortgages were also adjustable because of demand for adjustable product which was indifferent/ignorant with respect to the crappiness of the loans… In Europe its all ARMs and performing much better…

      1. ScottS

        Right. A floating rate could ease things for people right now. If I understand ARMs correctly, it was the balloon payment that blew them up.

        Interest rates were highest slightly before the financial crisis (see This must be where Dave Min gets his data.

        Have CAP/Treasury/MBA established that these high interest rates caused the ARMs to blow up? And what if the ARMs were bounded above and below like Yves suggested?

        1. Cedric Regula

          Ya. I think it’s good to have bought a house or two in your life, or at least pretend to, before reading complicated papers about it. One thing you’ll notice is they qualify you based on the monthly mortgage payment as a percent of pretax income, typically 33% or more, rather than the price of the house.

          But in my alternate reality where I envision an industry called “Savings and Loans”, first of all the idea that they make home loans to consumers is not considered a preposterous idea. And there is a lady in that reality by the name of Elizabeth Warren to negotiate the standardized T’s C’s in loan contracts. Then they offer Jumbo-Jumbo, FDIC insured, AAA rated CDs of various maturities that attract money from an enormous number of silly places and is a favorite AAA candidate for pension funds and places like that. So investor money is no problem.

          At the moment there is no consumer demand for their 30 year fixed product at the price quoted by the S&Ls, but that’s why these places are still around. Their Federal Reserve was successful at raising inflation expectations.

  12. Фашистская зазывала

    “Fascist shill” is how commenters on Naked Capitalism greet each other.

    ==> Good morning!

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