January 1, 2017The Priority Resolution
December 31, 2016Gary Cohn on the Chinese currency
December 31, 2016Covenants without the Sword?
December 31, 2016Reading Bastiat's Economic Sophism
December 30, 2016Scott Alexander Calls Out the New York Times
December 30, 2016Growth, or jobs for Americans?
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Frequently Asked Questions
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,
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.
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."
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:
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.
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.
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.
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.
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.
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.
Here is where they show their true ivory tower naivete:
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.