I’m a bit late to comment on an important series by the New York Times’ Gretchen Morgenson on the continuing, until now largely behind the scenes, fight over the future of the giant mortgage guarnators, Fannie and Freddie.
In her first article, A Revolving Door Helps Big Banks’ Quiet Campaign to Muscle Out Fannie and Freddie, Morgenson showed, in gory detail, how Wall Street had labored mightily to take over the activities of the mortgage behemoths for their fun and profit. Mind you, it’s not as if they already take a big proportion of the savings from the mortgage guarantee for themselves now; you can see that in refis, where much of the benefit of the interest rate reduction is chewed up in fees and other charges. Her second article, Fannie and Freddie’s Government Rescue Has Come With Claws, discusses in depth how the Administration flagrantly violated the terms of its own bailout deal to hoover up the earnings from Fannie and Freddie for Treasury, rather than give shareholders the proportion they were due, and took other punitive measures that were contrary to the 2008 legislation that set forth how a conservatorship of Fannie and Freddie would work.
These pieces provide insight into the state of play with government sponsored enterprise “reform” and also as a case study of how banks influence government policy, and how eager the Obama Administration has been to take up their cause (not that a Republican or Clinton Administration would behave any differently).
Cynics may regard these two stories as a bit moot, since the banks appear to have lost the fight to take over the operations of the government sponsored enterprises, and the case over the alleged mistreatment of Fannie and Freddie shareholders is being adjudicated. But don’t mistake the fact that the story (save for Morgeson’s recap) is out of the headlines for the notion that the banks aren’t continuing to move forward. As Morgenson points out, they are working to see how much they can get the regulators to cede to them through administrative processes, meaning without getting legislation passed. And as a Congressional staffer stressed, the big financial firms are moving their game pieces into place so they can take up the fight again after the 2016 elections.
But Morgenson’s focus on the machinations of the banks and their allies in government resulted in her not incorporating the policy issues. And without an understanding the policy problems, it’s easy to draw the wrong conclusions about how we got where we are and what might be the best approaches going forward.
At the core is an issue that no one wants to ‘fess up to: that the wildly popular 30 year fixed rate mortgage, which in most cases a borrower can refinance at any time, is a product that would not exist absent government support. It does not exist in any other advanced economy mortgage market (at least in any size). The reason is that it is extremely unattractive to lenders. The lender is potentially exposed to a very long term credit risk*, and he is also exposed to the worst sort of interest rate risk. A long term fixed rate bond is already risky, and is particularly unattractive in a low-yield environment). But even worse, the refi option in US mortgages means that the mortgage disappears (as in gets refinanced) when it turns out to be a winner for the borrower, that is, when interest rates fall.**
A Short History of the Evolution of the Mortgage Market and the GSEs
We’ve gotten here through an odd set of events. Prior to the Depression, mortgages were typically five-year bullets (building and loan societies offered longer maturities of 10 to 12 years). The bank could reassess the borrower every five years and set new terms based on market conditions and any change in the borrower’s fortunes. Down payments were generally higher than now and most borrowers sought to pay down their mortgages over time. The bank failures of the 1930s left many destitute (my maternal grandparents had their money in three different banks, all of which collapsed. They eventually got three cents back on the dollar from one of them). And even people who managed to have funds in banks that survived still found it almost impossible to refinance when their mortgages came due to the general dearth of credit.
Although many had already lost their homes by then, the Federal government set up the Home Owners’ Loan Corporation in 1933. It bought mortgages from banks on a full cashout basis, and was able to give borrowers much lower payments by having lower interest rates than banks offered (5% for HOLC versus the prevailing rate of 6% to 8%) and longer maturities (15 years) with the monthly payments designed to amortize principal over the of the loan. The program was derided by critics as wildly reckless at the time, and 20% of the HOLC loans did default. Even so, when the program was finally wound down, it posted a modest profits.
That started the US down the path of longer-term, fixed rate fully amortizing mortgages.
Government guaranteed mortgages and Fannie Mae were also creations of the Depression. The FHA provided FHA insurance to FHA-aproved lenders who underwrote loans to FHA standards.
But because this type of mortgage is so pervasively used, eliminating it would have an immediate impact on housing prices, and even assuming someone were willing to try, gradually restricting its use would have to be done in a very attenuated manner. The FHA also supported the issuance of longer-term, fixed rate mortgages (which needless to say, by making housing more “affordable” and increasing the pool of eligible borrowers, helped support home prices).
Fannie Mae was established in 1938 as a Federal agency and put the government even more directly in the business of financing new mortgages, albeit in a backdoor way, by having Fannie Mae provide “liquidity”. Banks could sell mortgages to Fannie Mae, which would free up their balance sheets to make new mortgages. Private lenders eventually started complaining that Fannie was competing unfairly with them in buying mortgages in the secondary market, and demanded that Fannie be wound down or made private. Instead, the compromise was that it was made a “partly private” entity, with the government holding preferred stock and private investors owning common.
In mind that in 1968, Fannie’s was effectively split into two entities, due mainly to the need of President Johnson to no longer consolidate Fannie’s debt as part of Federal indebtedness.*** “government sponsored enterprise” (in part because Johnson did not want to consolidate Fannie’s debt on the government balance sheet), some of Fannie’s functions were returned to full government control and given to the agency Ginnie Mae, which was part of the newly-created HUD. Freddie Mac was created as a private company with an initial cash contribution from the government. It too was to provide “liquidity” to mortgage lenders, in particular savings & loans, that were getting whacked by interest rate increases on their deposits. Freddie’s strategy at the outset was different than Fannie’s, with Freddie packaging the mortgages it bought into mortgage-backed securities, while Fannie at the time was retaining. them. Over time, the two institutions’ strategies became indistinguishable.
Why Does This History Matter?
Fannie, Freddie, Ginnie, and the FHA were all created to deliver Federal subsidies to the housing market. They are also integral to the fact that the overwhelmingly dominant mortgage product, the 30 year fixed rate mortgage with a borrower refi option would not exist absent this extensive government support. Removing that support would mean that other types of mortgages that lenders and investors would be willing to hold absent government support would replace the staple of the 30 year fixed rate mortgage. The result would be much higher interest rates, shorter mortgage terms, and more borrower assumption of interest rate risk. All of those would mean more costly mortgages, which translates into much lower housing prices. That’s not acceptable from a policy standpoint, so the political fight will be over how these subsidies will be administered in the future.
Let us also not forget that despite overt denials (meaning on the face of the securities offerings) of government support of the GSEs, the market correctly assumed pre-crisis that they did enjoy an informal guarantee. Jim Hamilton discussed that fact at some length at the 2007 Jackson Hole conference, that the extreme undercapitalization and super low funding cost of the GSEs meant that investors regarded them as government guaranteed. We have also been told that US officials gave Chinese officials assurance that the US would always support the GSEs (recall that the Chinese government was and is a major holder of US bonds).
So while it might be preferable not to have the government so deeply involved in housing finance, particularly since housing finance is an inefficient way to support the housing market (it’s hard to analyze the impact of the subsidies and they tend to leak to all sorts of parties that are not necessarily the targets of policy), there’s no easy way out of this position. Any reduction of government support for the mortgage market, which would have to include a change in terms to conventional mortgages, would need to take place on an attenuated basis.
Why Have the Efforts to Dismantle the GSEs Failed So Far?
This is the elephant in the room that Morgenson’s otherwise fine articles fail to address. The Republican party hates the GSE, in part because Fannie Mae in particular helped cement a housing coalition that was staunchly Democratic. But as Morgenson points out, the Administration was on board with the program for winding down the GSEs, just not as quickly as the Republicans were. Was this a clever headfake (as in the delay was really a stealth plan to stymie the Republicans) or was something more at work?
In the interest of brevity, I’ll make some observations and let readers chime in.
First, I am actually a bit surprised (as well as gratified) that the efforts to dismember the GSEs have failed so far. As indicated, I’m not a fan of these subsidies, but we are where we are, and as questionable as these subsidies are, it’s better to have them under government control than in a public/private hybrid (which as we saw did not work out very well) or even worse, with purely private actors getting more subsidies and having even lower accountability than they do now by virtue of being private. The privatization plans are basically another scheme for looting, unless the new “private” entities are set up and run as utilities, with regulated profits and oversight of executive pay and perks.
Second, my guess as to why the plans put forward a few years ago never got anywhere is they were too greedy and lame. The only bennie of “private” ownership was that the new mortgage guarantors would be a bit better capitalized than Fannie and Freddie. Um, there’s no reason to dismantle Fannie and Freddie to to that. Another optical excuse was that there would be more “sons of Fannie and Freddie” created, so they would be more robust. As readers of Andrew Ross Sorkin’s Too Big to Fail may recall, Freddie was clearly in trouble, yet Paulson insisted on putting both Fannie and Freddie in conservatorship over the vociferous objections of Fannie’s board. Why? Paulson argued, and I think correctly, that the market did not see Fannie and Freddie as all that different, and putting Freddie in conservatorship would result in an immediate spike in borrowing rates and the availability of credit to Fannie, which had the potential to put it in a crisis. The same logic would apply to “sons of Fannie and Freddie” which would all be pursuing the same general strategy.
Third, and I suspect this is a far bigger consideration than anyone has acknowledged publicly, is that the GSEs have huge and very complex systems, both computer systems and the human processes and the documentation around them. Reconstituting them in new entities is an extremely daunting task. I saw nothing in the “son of Fannie and Freddie” proposals that gave me any comfort that the designers were taking these extremely large operational risks seriously.
As indicated at the outset of this post, the Morgenson articles are an important reminder that the battle over the future of Fannie and Freddie, and who controls government subsidies to housing, is ongoing even though it has retreated to the background for now. And given how the Presidential election appears to be giving social and broader economic issues higher priority, it’s not clear that any of the candidates will have much to say on this issue. But rest assured it will come back to the fore not all that long into a new Administration.
* A 30 year mortgage is shorter in duration than, say a 30 year Treasury or corporate bond, since the bond amortizes over its life. Due to the prepayment options, MBS are priced off of 5 to 7 year bonds, since the odds at a time when yields are “normal” that a lot of borrowers will experience enough of an interest rate decline in the first ten years of their mortgage for them to have a refi opportunity that most take. And mortgages are also paid off due to selling the house as a result of death, divorce, job loss, moving, or trading up. However, a top mortgage expert has been pointing out for years that the mortgage originators, as well as the Fed, the GSEs, and policy-makers, have greatly underestimated what will happen if/when interest rates go up. Everyone will hang onto the current crop of low-interest rate mortgages. He contends those mortgages that were modeled as being a 5 to 7 year risk will turn out to be a 15 year risk. That in turn will create all sorts of havoc for holders, who might have made some allowance for making a bad bet that was outstanding for the balance of the 5 to 7 year average life, but not for 15 years.
** Other countries, including ones with much higher ownership rates than the US, have borrowers assume at least some interest rate risk, via adjustable interest rate mortgages, or ones that reset periodically. The US has had some more borrower-friendly adjustable-rate mortgages, such as ones that float only in a certain range (as in they have both a rate ceiling and a floor). That means that borrowers get the benefit of declines in interest rates without having to go through the cost and hassle of refis.
*** One of the biggest macroeconomic mistakes of all time was Johnson’s refusal to raise taxes to finance the unpopular Vietnam War (or in MMT terms, to drain demand so as to combat inflation). Running government deficits at a time of full employment when the Federal government was sending a man to the moon, fighting a war on poverty, and leading a ground war in Asia set off the inflationary spiral of the early 1970s, which was made worse by the oil shock.