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?