As the housing policy debate gets underway this year in Congress, there's really only one big decision to make: will the U.S. government continue to guarantee mortgages? Once that is determined, the rest is really just details about how to best implement policy. The Treasury could be moving away from government guarantees, even though the market and Democrats generally prefer them. In a sprawling op-ed this week in the New York Times, Vanity Fair writer Bethany McLean essentially argues that without government guarantees, the American mortgage market will fail. Is that true?
Here's McLean describing the problems with pulling government guarantees:
Fannie Mae and Freddie Mac, for instance, were created by the federal government to buy up mortgages from lenders, thereby enabling them to turn around and issue more mortgages. Among other things, this allowed the lenders to get off their books the two kinds of risk that a mortgage carries. We're all now sadly familiar with one kind, credit risk -- that is, the danger that a borrower won't pay back the mortgage. The second is interest-rate risk, the danger that interest rates will rise sharply after the mortgage has been made, thereby burdening the bank with money-losing loans. (Interest-rate risk was the root cause of the savings and loan crisis.) The longer a mortgage lasts, the more difficult it is to manage both of these risks. And 30 years is an awfully long time.
Let's consider each of these risks separately. First, there's default risk. Yes, banks and investors are now very concerned about mortgage losses, particularly because the housing market is in terrible shape. Some believe that home prices could still fall more than 20%. So obviously, if you're considering backing a new mortgage, this environment doesn't thrill you.
But that's because the housing bubble is still deflating. Once the market hits a real bottom, default risk can be minimized. When that happens, if mortgages are prudently originated, then default risk becomes relatively insignificant. Good underwriting will result in deep home price declines becoming very rare.
For example, imagine if there were never any wacky mortgage products sold by banks during the housing bubble. And imagine if all banks required at least 10% down payment, and that much equity maintained for a refinancing. Under those circumstances you probably wouldn't have seen a housing bubble, so you also wouldn't have seen home prices rise incredibly and then fall disastrously.
Moreover, prudent underwriting standards will also minimize the potential magnitude of default risk. If borrowers are forced to have at least 10% to 20% equity in a home before a mortgage is written, then suddenly a bank's loss would have to exceed that amount to lose money on the mortgage. And the longer that person has been paying their mortgage, the more that the bank's potential loss declines for two reasons: equity is being built up more and more each month, and the borrower will fight harder to keep his home, rather than walk away and lose his equity.
Even without government guarantees, it's pretty easy to minimize default risk through prudent underwriting. This won't be possible until the housing market stabilizes, however. So the government will likely have to maintain some role until then.
Interest rate risk is potentially even less significant. Sure, "30-years is an awfully long time," but few mortgages actually last that long. More often borrowers will prepay, either gradually or all at once by refinancing. That's why in mortgage banking, a pool of mortgages is said to have an expected weighted-average life different from its maturity. It's often far less than 30-years, depending on the loan characteristics.
That means two things. First, banks can find ways to hedge their interest rate risk pretty easily through buying swaps. These derivative instruments can virtually eliminate fixed interest rate risk by trading it to another investor who wants to avoid floating interest rate risk. This cost of this hedging can be built into the mortgage interest rate.
Second, there's securitization. McLean does touch on securitization, but says that mortgage bond investors still preferred Fannie and Freddie bonds to privately backed mortgage bonds in order to avoid default risk. Well, of course they did. If someone offers you a bond that can never incur a loss and another that might incur a small loss (assuming prudent underwriting), which do you choose? Obviously, you want the safer one. That's different from saying you wouldn't buy the second bond if the first one didn't exist. Investors can stomach some default risk or there would be no unsecured corporate debt market.