Arnold Kling  

The Author of the Administration's Housing Finance Report

My Berkeley Talk... Mao's Great Famine and ...

As reporters ask me about the report, I in turn ask them where the real report is. I mean, I cannot believe that such a sketchy, half-baked proposal was given an official seal (two of them, one each from HUD and Treasury). My first reaction was that this was like a bad term paper from a public policy grad student.

I was close. As I reached out to colleagues to find out more, someone suggested I look up David Scharftstein a professor at The Business School, which is how Harvard folks refer to it. The resemblance between the Administration report and this paper by Scharfstein and Adi Sunderam is eery. Sunderam is a Ph. D candidate in the econ department at Harvard. So, basically, the Administration outsourced its policy on the entire future of housing finance to a professor and a grad student, neither of whom appears to have spent a single day working in the mortgage industry.

One advantage of the academic paper is that it goes into more detail than the Administration version. The authors write,

our proposal is to establish a government-owned corporation to guarantee MBS. The primary role of this corporation is to ensure the supply of high quality, well-underwritten mortgages during a period of significant market stress such as the financial crisis of 2007-2009. To ensure that the corporation would be able to provide guarantees in a timely fashion during a systemic crisis, we propose that it operate in normal times but with a hard-wired constraint on its market share of no more than 10 percent. This market share could only be lifted with the approval of the Financial Stability Oversight Council in response to a systemic crisis.

The paper has a lot going for it. They argue against any guarantee in the mortgage market. However, the distinction between a "backstop" and a guarantee is blurry in theory, and my guess is it would be even more blurry in practice. Part of me fears that, whether they realize it or not, the authors are acting as perfect tools for Wall Street, along the lines I laid out in my most cynical take.

In my view, their backstop idea is what you would expect from a graduate student--an idea that on paper sounds clever but which is not well suited to practice. A more straightforward approach for government to "backstop" the mortgage market at the onset of a crisis would be to inject capital into key firms, such as mortgage insurance companies, that bear the credit risk on new mortgages. I will put this suggestion below the fold, along with further comments on their paper.

They write,

The alternative of a loosely-regulated private mortgage market is also problematic. Mortgage credit is subject to boom and bust cycles, which can lead to corresponding booms and busts in housing values.

And would you say that government involvement has mitigated or exacerbated these cycles? Inserting a "backstop" to help stabilize housing finance could in its own way prove destabilizing. The problem is that as private market participants feel more protected from extreme events, they make decisions that increase the probability that extreme events will occur. See Minsky on the destabilizing role of stability, or Google the term "Greenspan put."

At the peak of the mortgage credit boom in 2006, Fannie and Freddie accounted for approximately 30% of new Alt-A and subprime mortgage lending.1 While this is a large exposure, many other market participants had to be involved to fuel the growth of low-quality credit. Thus, there is a case to be made for more stringent regulation of private mortgage markets.

Wallison and Pinto might dispute those figures. Even so, if what we need is more stringent regulation of mortgage markets, then that is different from providing a guarantee to mortgage markets. The regulation that we might need is to ban private lenders from making loans without significant down payments and other safeguards. Personally, I don't think we need to go that far. If we could just get the government out of that business, that would be progress.

Later in the paper, the authors explicitly discuss regulating private mortgage markets to stamp out risky lending. And they come out against a guarantee.

Instead of a guarantee, they argue forf a "backstop." Do they think they can craft a "backstop" that Wall Street won't turn into a guarantee? If so, I am inclined to disagree.

Back to their proposal:

We are proposing that this mortgage guarantor be a self-funded government-owned corporation, not a government agency and not a private corporation. As a government-owned corporation with an independent board, it would be less easily influenced by political considerations. More importantly, as a government-owned corporation it would not seek to increase profits by loosening underwriting standards in the way that a private corporation would, making it more likely to be in a strong financial position entering a downturn.

Nice to know that this entity would not have any profit incentive to operate efficiently or avoid making mistakes.

To me, the only rationale for a government guarantee of mortgages is to protect the 30-year fixed-rate product. However, the authors reject that notion.

while it is true that the government introduced and helped popularize the long-term fixed-rate mortgage through subsidies, the two GSEs have been purchasing adjustable-rate mortgages since 1981. Thus, the GSE subsidy has not uniquely preferenced fixed rate mortgages over adjustable rate mortgages for the last 30 years. Yet, long-term fixed-rate mortgages remain popular, suggesting that borrowers now appreciate the value of the long-term fixed rate mortgage and that, demand for it would likely be robust even in the absence of subsidies. If not, it is possible to preference these loans through other types of government policy.

That is a point worth considering. I have been thinking that the death of Freddie and Fannie would mean hurt the prospects of the 30-year fixed-rate, and we should just accept that. But I could be too pessimistic about the 30-year fixed-rate in the absence of the GSEs.

Overall, in section 2 of the paper they make a case against government guarantees of mortgages that is, if anything, even more emphatic than the case that I would make.

In section 3, they turn to privatization.

the advocates for privatization, while generally on-target in their criticism of the GSEs, have not provided much detail on the kind of housing finance system that would emerge in place of the current one, nor how it would be regulated. This is a significant shortcoming of the proposal given that a good deal of the responsibility for the subprime crisis resides with private market participants.

This is demagogic and deeply unfair. If you are going to use central planning to design a housing finance system, then you have to provide details. If you are going to rely on whatever emerges in the markets, then how are you supposed to provide details? At most, you can make predictions about what would emerge. But it would be oxymoronic to provide a detailed plan for an emergent process.

privatization will increase use of private securitization, which the recent crisis has shown to have serious flaws both in the quality of underwriting and in the incentives for renegotiation.

I disagree. I think that private securitization of mortgages is just about dead. I could be wrong about that. But private securitization depended on two phenomena that are unlikely to reappear any time soon. One was that bank regulators were willing to offer capital leniency for banks holding securities with AAA ratings from rating agencies. The other was that the agencies were willing to be quite generous with AAA ratings for mortgage securities. Assuming those mistakes are not repeated, I do not think that private securitization of mortgages will come back in any significant way. Alternatively, if it does come back, it will be a lot safer with ratings that are honest and capital requirements are stricter.

Eliminating government guarantees on MBS increases the banking sector's exposure to mortgage credit risk both from portfolio loans and their holdings of MBS. This increases the likelihood that shocks to the housing sector will get transmitted to other sectors by impairing
banks' capital and reducing their willingness to lend

The authors correctly point out that under a privatization scenario, banks are likely to hold more mortgages. This exposes them to both credit risk and interest rate risk. Because of deposit insurance and too-big-to-fail concerns, this in turn exposes taxpayers to more risk.

Indeed, credit risk and interest-rate risk have to go somewhere, and the "tail risk" (the risk of extreme events) always threatens to fall back on the taxpayer. The challenge is to come up with policies that prevent banks from gaining profits by loading up on tail risk. That challenge exists in any regulatory environment that we are likely to see. As much as I would like to privatize risk, some taxpayer exposure is probably inevitable. My guess is that the risk is greater with creative new approaches to financial regulation than it is with patched-up versions of older approaches. Better to rely on the painful lessons of the past than to start from scratch.

If all housing credit were supplied by banks one could conceivably rely on macroprudential
bank regulation to limit excess volatility in the supply of housing credit. However,
given the importance of securitization in housing finance, bank regulation alone will not be

They discuss a number of ideas for placing restrictions on mortgage products and the securitization process. Such regulations probably are no longer necessary, but, by the same token, they would do little or no harm.

Finally, we get to the "backstop" proposal.

we propose establishing a "guarantor of last resort" for the housing market. This entity would be a government-owned corporation responsible for for guaranteeing and securitizing new high quality, well-underwritten mortgages when private securitization and bank balance sheets are significantly constrained...

At present, Fannie Mae and Freddie Mac (with government backing), and the FHA are effectively playing this guarantor-of-last-resort role. With private capital still on the sidelines, the GSEs and FHA are together responsible for almost all new mortgage originations today. The backstop we are proposing would formalize this guarantor-of-last-resort role in a separate government-owned corporation, rather than having existing organizations fill the role on an ad hoc basis.

The backstop's market share during normal market conditions would be small - in the range of 5-10%. The reason it should have even a small market share is to maintain the risk management infrastructure, personnel, and private market contacts necessary for the backstop to act effectively and expeditiously in a severe downturn.

Here is where they show their true ivory tower naivete:

Like any mortgage guarantor, the backstop is at risk of adverse selection; mortgage originators could try to put the lowest-quality mortgages into pools guaranteed by the backstop. The guarantor could control the scope for such adverse selection by offering guarantees on mortgages with a relatively specific set of observable characteristics. Giving the guarantor the ability to levy significant penalties on originators who pass on low-quality mortgages would also help mitigate adverse selection problems.

Basically, this is like sending an rookie poker player to Las Vegas to go up against professionals by saying, "You'll be fine. Just don't bet on any inside straights."

When I was at Freddie Mac, we called this function Risk Management. It employed hundreds of people, had several layers of policies and procedures, was constantly being revised and improved, and still we suffered several costly screw-ups. And that was in the late 1980s and early 1990s, when the mortgages we were buying were plain vanilla compared to what came later.

I think that the best way for a "backstop" to avoid adverse selection is to not allow the other players to choose which loans to sell to it. Instead, require every loan that you might backstop to get private mortgage insurance, and require every mortgage insurer to send you their entire list of eligible new loans. Then randomly pick a sample of those loans to reinsure.

During normal times, you would not have to actually reinsure any loans. You could just simulate the process. Go through the motions of picking the sample, and track it to make sure that the system works. Then, if the regulator spots an emerging crisis, you can flip a switch and turn the system live, using it to take over the insurance of, say, a 20 percent random sample of new mortgages.

In effect, what that does is lever up the capital of mortgage insurance companies. So you could accomplish the same thing by injecting capital into the MI companies when a systemic crisis is at hand. That would be much cleaner and simpler. As long as there are enough solvent companies in the MI industry, the capital injection approach would work.

Comments and Sharing

COMMENTS (10 to date)
OneEyedMan writes:

Great review.

I'm concerned that promising to shore up the mortgage insurance business is economically equivalent to promising to insure the banks themselves and has the same behavioral problems.

We need to have auction or market mechanisms to make sure that mortgage insurance is properly measured, even if ultimately subsidized.

One way of backstopping the mortgage business without a guarantee is to do a partial guarantee. Instead of insuring the full principle, the state could insure 80%. That might be enough skin in the game for debt holders to monitor but not so much that people would be scared of leaving them holding the bag in the event of default. In financial crises they could move the fraction guaranteed up.

R Richard Schweitzer writes:

Any word there about why the Federal government should be (constitutionally or otherwise) a "guarantor" of the risks of specific investors?

Any issues there about whether the Constitution limits Congress to regulation rather than operation of whatever is now "Interstate Commerce?"

Shayne Cook writes:

One of my most effective tools in adding clarity to a document/report/proposal such as this is to import it into my favorite word processor.

Then use the "Find and Replace" function to Find every ocurrance of the word, "government" and Replace it with the word, "taxpayer".

It is remarkable how much difference that can make in clarity.

Shayne Cook writes:

Follow up ...

I apply the same "Find and Replace" function to articles/statements/speeches that are heavily laced with the phrase, "we need" as well. I Replace every ocurrance of "we need" with "I need", and re-read the piece.

Again, remarkable results.

And, (again), ditto R Richard Schweitzer.

Joe Seydl writes:

I find it incredible that the "backstop" discussion has become paramount in the debate on fixing the mortgage market. In a lot of ways it's like saying, "we can't do anything to prevent Wall Street from gambling with people's mortgages, but at least we'll be prepared the next time their excessive gambling threatens to bring down the financial system."

Unless you better regulate mortgage finance and securitization in the private sector, keeping or eliminating Fannie & Freddie really doesn't do a whole lot. All of the data show that the problem didn't “begin” with Fannie & Freddie; they both came and took market share late in the game. The problem began in the private sector. The problem began when subprime loans were targeted by private lenders whose only intention was to sell them off to securities firms for repackaging. The way I read it, this report from the Treasury Department and Department of Housing and Urban Development doesn't address any of these issues. And, quite frankly, nor did Dodd-Frank. The fact is, we still have a slew of “too big to fail” banks and a largely unregulated shadow banking sector nearly two and a half years after the financial crisis, which is pretty sad IMO.

James A. Donald writes:

Everyone is trying to square the circle: Issue government guarantees, yet not encourage risky behavior.

This can only work if the things that government guarantees are stupidly simple - if government has very precise rules for what it guarantees, rules that any idiot can understand and enforce, so that the what the government guarantees is never risky on average.

Which means that the rules would have to fit on a postcard, or at least in a seven page booklet. In today's environment, that is not going to happen. The rules will be a dozen bookshelves long, and will grow a several bible sized collections of additional rules every day.

Which insiders will game, so that government finds itself guaranteeing worthless rubbish.

Doc Merlin writes:

" more straightforward approach for government to "backstop" the mortgage market at the onset of a crisis would be to inject capital into key firms, such as mortgage insurance companies, that bear the credit risk on new mortgages"

mmm zombies

Grant Langdon writes:

Tinkering with mortgage securitization - what are the risks?

In the discussion regarding the US mortgage securitization market it seem to me that most commentators, including Arnold Kling, have failed to weigh the efficiency benefits of securitization and the impact that changes would have on the cost to borrowers.

Specifically, some commentators who support getting the government out of the mortgage business have pointed to Canada as a model. In fact, the government in Canada is heavily involved in insuring mortgages, but the Canadian model does demonstrate that not having a mortgage securitization market adds huge costs to mortgage borrowers and a brings huge benefit to mortgage lenders, primarily banks.

In Canada: (1) real mortgage interest rates are much higher, and currently more than twice as high as in the US; (2) 30 year fixed rate mortgages, which are the US standard, are non-existent with the longest available term being 10 years; and (3) for a payoff before maturity the Canadian borrower bears the risk on any decrease in interest rates, although the lender retains any benefit if interest rates increase - thus in Canada borrowers cannot refinance existing mortgages to take advantage of interest rate reductions. I believe that those differences can all be attributed to the lack of widespread mortgage securitization in Canada.

Regarding the first point above, risk free interest rates in Canada are actually lower than in the US (3.5% for a 10 yr Canadian govt bond v. 3.64% for a 10 year US Treasury), but a 10 year mortgage in Canada is about 6.6% v. about 4% in the US. The extra interest paid in Canada flows directly into the revenues of Canadian lenders, primarily banks and similar entities. Discounting for the inflation assumption 10 year TIPS (of 2.3% inflation in the US and 2.05% in Canada) the real 10 year mortgage rate in the US is about 1.7% v 4.5% in Canada.

An analog is the commercial paper market. Before the development of that market, banks had a nice business of intermediating between savers and large commercial borrowers. By cutting out the banks the commercial paper market substantially reduced the rates paid by large commercial borrowers and while also increasing rates available to savers.

I am not sure how government involvement in the mortgage market would best be structured, (although it seems to me that the original Fannie/Freddie model with decent underwriting standards was actually quite robust), but before changes are made, it is essential they not have the potential to wreck the residential mortgage securization market. That market has come in for much anecdotal criticism on the basis that banks sell mortgages and borrowers are no longer dealing with the local bank they thought was their lender, but I doubt many borrowers would be happy increasing their mortgage payments by 40%-50% for the privilege of keeping their paper at the original lender.

Mortgage securitization, which is uniquely American, greatly benefits borrowers. I am sure that the banking and financial industry would love to see it destroyed. There also seems to be no question that the banking industry has the ear of this administration, and that this administration is quite capable of doing really stupid things based on wishful thinking. That could be a recipe for disaster.

Jeremy, Alabama writes:

This problem will last indefinitely until Americans overcome their cultural resistance to a) kicking people out of houses they can't afford and b) allowing the house market to bottom out, however far down that may be.

Politicians are happy selling us the following utter fiction:
- that lenders are encouraged to lend with a good interest rate that is also, magically, low for borrowers.
- that home owners get to keep their equity safe, nay, growing, while preserving low prices for new entrants into the market.
- that people who can't afford their homes get to keep them with no cost to the taxpayer and without transferring wealth from new entrants to deadbeat homeowners.
- that the middle class mortgage interest deduction can be retained without raising taxes on everybody else.

Anybody who believes this, which unfortunately is most of the population of the US, deserves what they get.

Lorne Marr writes:

Very good review, simple written and very understandable. The regulation system you propose sounds a lot better that Scharfstein's ideas. IMO, this kind of "random" reinsurance would be much more fair to the market and would stimulate the market to regulate itself.

I also like the Greenspan put you described:

"The problem is that as private market participants feel more protected from extreme events, they make decisions that increase the probability that extreme events will occur."

Businessmen tend to push their actions to the edge only to secure bigger profits.

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