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Taking government out of the mortgage business is harder than it looks

A sign in front of the Fannie Mae headquarters is photographed in Washington February 11, 2011. REUTERS/Molly Riley
A sign in front of the Fannie Mae headquarters is photographed in Washington February 11, 2011. REUTERS/Molly Riley

By Bethany McLean

Limbo. That's the word most people use to describe the state of affairs in a critical part of our economy — housing finance. The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, which were nationalized almost five years ago with the seemingly noble goal of eventually getting rid of them, now back some 90 percent of American mortgages. So much for good riddance!

But talk of reform finally seems close to action. Senator Bob Corker (R-Tenn.) and Senator Mark Warner (D-Va.) have proposed a bipartisan bill called, appropriately enough, Corker-Warner. Meanwhile, the House Financial Services Committee, led by Representative Jeb Hensarling (R-Texas), has produced its own bill, the more grandiosely entitled Protecting American Taxpayers and Homeowners, or PATH Act. Last Tuesday, during a speech in Phoenix, President Barack Obama weighed in. "Private lending should be the backbone of the housing market," the president said. That same day there was also a housing policy forum at the George W. Bush Presidential Center in Texas, where, among others, Hensarling spoke.

Everyone (well, almost everyone) seems to agree with the president: Private lending should be the backbone of the housing market. But just how much private capital does that entail? Hensarling and most of the Republicans think the government should get out of the game entirely. American Enterprise Institute scholar Peter Wallison, a long-time critic of the GSEs, recently wrote a piece in the Wall Street Journal entitled "Competing Visions for the Future of Housing Finance," in which he called any remaining government presence "faux reform."

Corker and Warner (and Obama) want the government somewhat out of the way — but still there as a backstop. Then there's the liberal Democrat wing, personified by Senate Majority Leader Harry Reid (D-Nev.), who announced in a radio interview that he fears Obama's proposal will crimp home ownership. Unfortunately, these stances are too often vague stakeouts of ideological positions about the role of government — and too rarely about the very basic math of housing finance.

Right now, there is about $10 trillion of mortgage-related debt outstanding. Fannie and Freddie securities make up roughly $4.4 trillion — slightly less than half — of that. The largest holder, in turn, of these Fannie and Freddie securities are U.S. commercial banks, which in the first quarter of 2013 held roughly $1.6 trillion of them. Another huge chunk — more than $1 trillion — is held by the Federal Reserve. About the same amount is held by "the rest of the world" — often foreign central banks and sovereign wealth funds — and another chunk about that size is held by mutual funds.

These buyers are often looking for particular things — things that they get because Fannie and Freddie guarantee the timely repayment of principal and interest on their securities. First off, that means the buyers don't have to think about credit risk, but only interest rate risk. Indeed, so-called rates buyers, who arguably supply more than half of the mortgage credit outstanding (it is rates buyers who now purchase GSE securities) not only don't want credit risk, but in some cases — for institutional, legal or regulatory reasons — they can't take it. Therefore, they only want to own mortgages that are backed by Fannie or Freddie.

Among other things, they also want their investment to be liquid, meaning it can be traded easily. By contrast, private-label securities (shorthand for securities that aren't backed by Fannie or Freddie) aren't easily tradeable, because it's complicated to analyze the credit underlying a huge package of mortgages.

Nor are new rules always designed to encourage investment in private-label securities. Under the final Basel III rules that will determine how much capital banks have to hold, banks will have to do their own due diligence, to the satisfaction of their regulator, on mortgage-backed securities that don't have a Fannie or Freddie guarantee in order to determine the appropriate amount of capital that must be held against them. Securities backed by a GSE, on the other hand, automatically get favorable capital treatment.

So in Hensarling's vision, which does not see any role for government in the mortgage market, you basically have to replace the investor base for the $4 trillion-plus in GSE securities with investors who want and can take credit risk, and are willing to invest in a far less liquid instrument. Four trillion dollars is lot of money; in a late 2010 article, CSFB analyst Mahesh Swaminathan estimated that a private-only solution would remove between $3 trillion and $4 trillion of funding from the U.S. mortgage market.

The Corker-Warner bill, to which Obama is closer in spirit, calls for a system where, in essence, mortgages will be bundled up and sold as securities, and private capital will absorb the first 10 percent of losses on those securities. After that, a government guarantee will kick in. But it's not obvious that there's enough capital market demand in the world even for this "first loss" piece. For the entire $4.4 trillion of existing GSE securities to be covered up to 10 percent first loss, you would need $44 billion in capital.

It's also worth thinking about this on a monthly basis. Investors have been buying some $100 billion of Fannie and Freddie mortgage-backed securities a month. Issuance is likely to decline as rates rise, so let's say it's $80 billion a month. So you'd need to sell $8 billion a month in credit risk in order to securitize the entire $80 billion of mortgages.

Another idea is for a new breed of mortgage insurers — existing mortgage insurers mostly insure individual mortgages, not pools — to provide insurance for the pooled securities. If you assume the new insurers had to be capitalized at 10 percent, then they'd need a more manageable $9.6 billion in capital each year.

Those who argue for no government involvement in the housing market say that the current numbers are beside the point. In congressional testimony, Wallison said that the only reason the buyers of GSE paper didn't want to take credit risk was because "these government-backed securities attract investors who do not want to take risks." In his view, there are plenty of other investors who would step forward. After all, the private market finances lots of other stuff.

Others disagree, sometimes violently. A source of mine who is a big investor in GSE securities sniffs, "This is what you would expect to hear from someone who has never bought or sold a bond in his life, or managed according to investment guidelines, or had to defend an investment decision to an investment committee or fund's board of directors. It is a think tank answer to a real world problem. Asset allocations do not change in the way he describes. Dollars that are invested in something with zero credit risk don't get re-allocated into something that has credit risk, at least not in the same size and at the same price."

And then, there are those in the middle, like Mark Zandi of Moody's Analytics. According to the Wall Street Journal, Zandi thinks the capital will be there — but it will come at a higher price. Under the PATH bill, he estimates that mortgage rates would rise significantly and availability would decline. Even under Corker-Warner, he thinks rates would rise. As Journal columnist William A. Galston put it, "There are real trade offs, and the public deserves to know what they are."

But there is another concern. The question isn't just whether private capital would step up, but where it could come from. Remember, right now, U.S. commercial banks own $1.6 trillion of GSE securities. Theoretically, they could step up and own that plus more, all with credit risk. But does that accomplish the stated goal of removing risk from the taxpayer? Well, no: You're just shifting risk from government-sponsored enterprises to government-sponsored banks. And as another source says, "If all the risks in real estate get shoved back into the banking system, the big smart guys will dictate the first time a panic occurs. Do you want Jamie or Lloyd determining who will get bailed out the next time there is a crisis?"

My new favorite quote comes courtesy of Hensarling, who in his prepared remarks for the Dallas forum said, "If, at the end of the day, taxpayers are still on the hook, then I fear all you've done is put Fannie and Freddie in the Federal Witness Protection Program, given them cosmetic surgery and a new identity and released them on an unsuspecting public."

He's right. If mortgage credit risk is shifted into the banking system, taxpayers are still on the hook. Fannie and Freddie may be better hidden — they'll be camouflaged as banks — but they're still lurking out there!

So the conversation, in the end, shouldn't be about competing visions, because vision doesn't have anything to do with how the market works. It should be about this beast (which can trick us into believing it's been tamed) called mortgage credit risk. How much demand for it does a reform plan require? Is that demand likely to materialize, and if so, what is the source? And are the costs, whether they are on the backs of taxpayers or homeowners, acceptable to all of us? It's math, not politics.

Bethany McLean is a contributing editor at Vanity Fair, and co-author with Joe Nocera of "All the Devils are Here: The Hidden History of the Financial Crisis." Her first book, "The Smartest Guys in the Room," co-written with Peter Elkind, became an Academy Award-nominated documentary.

Any opinions expressed here are the author’s own.

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