Does the Federal Government Want to Fix Fannie and Freddie?

John Hempton wants to get the government out of the business of subsidizing the credit risk in the US mortgage market.  His suggestion is simple--so simple that it might actually work:

Answer: raise Frannie's pricing.

At the moment there is nobody doing conforming mortgages except Fannie and Freddie. Indeed there is almost nobody doing mortgages of any kind except Fannie and Freddie. If the free market wants the business they can have it. (They just don't want it at this sort of interest rate spread - and I don't blame them.)

All the government need to do is tell Frannie to raise their price a little each quarter. Currently they charge 20-25bps for guaranteeing mortgages. (The free market won't take credit risk at that price.) So it is entirely open to the FHFA (and hence the Treasury) to tell Fannie and Freddie to raise their prices by 5bps. The government will get paid better for the risk they are taking (and what free market ideologue will disagree with that) and the private sector can compete if they want to.

I doubt the free market will. But then in a quarter or two Frannie can raise their pricing by another 5 bps. And a quarter or two later Frannie can raise by another 5bps.

At some stage you will get to a level where the private sector chooses to compete. Frannie should not set its price competitively though. In another quarter they should raise the price another 5bps. And in another quarter they should raise again.

Over time Frannie will become non-competitive. It will shrink simply because bankers and mortgage brokers do not bring it business. And so Frannie is put into market chosen run-off and the business is effectively privatized.

You can do the same thing with Frannie's portfolio - you could ask them to raise their internal revenue exectations on any mortgage they buy by 5bps. They might buy less - they may not. Don't limit the size of the portfolio: raise the profitability of the portfolio. When another quarter elapses raise spreads by another 5bps. Eventually of course the private sector won't bring Frannie business - and so Frannie will shrink.

If you want the government to keep supporting the housing market (an object of policy it seems) then you just slow the rate of price increase down. Do 5bps per half rather than 5bps per quarter - or even 8bps per year for a slow exit.

It would work, but here's the problem: does the government actually want to do it?

Six months after the last buyers who were eligible for the first-time homebuyer's tax credit closed on their homes, the pattern in the market is flat to rising volume, but falling prices.  Sales of both new and existing homes rose by double-digit amounts in December, albeit to levels that are still extremely depressed.  But the latest Case-Shiller index showed that home prices fell in November for the fifth straight month.  In other words, as soon as the government stopped subsidizing them, home prices began dropping again.

It seems clear that the government's goal at this point is to support housing prices, in the hopes that they can prevent foreclosures for long enough that economic growth, population increase, and inflation can step in and do the job of raising prices for them.  At this point, the government essentially is the US mortgage market--between Fannie and Freddie, the Veteran's Administration, and the Federal Housing Administration have accounted for about 95% of new mortgages since the market collapsed.

Obviously, the government knows how to decrease its market share: stop issuing below-market loans, and tighten up credit standards.  But it clearly doesn't want to.  Moves to tighten up credit quality have so far been incredibly tentative: the FHA required borrowers with credit scores of less than 580 to put down a 10% downpayment, instead of only 3.5%.  I've even heard a theory that the reluctance to push harder on mortgage principal writedowns stems from worries that this will enable people who would otherwise be stuck in the house to sell, pushing prices down even further, though I'm not really sure I buy this.

I assume that the government's primary desire is to at least slow the decline of housing prices, but there's also the fact that as long as they do the lion's share of the mortgage business in the country, they're in control.  Once they start pulling Frannie out and inviting private bankers in, they lose considerable leverage over the sector.  They couldn't easily reassert control once they'd lost it--the markets will go along with the current situation out of inertia, but if the government tries to open up the markets to private competition, and then changes its mind, people will freak out.

So I agree that this is an easy and painless way to slowly withdraw the subsidy, I'm not sure anyone's actually looking for an easy and painless way to withdraw the subsidy.  They're mostly looking to avoid doing anything that might rock the shaky housing market.