Anyone who believes the government's role in mortgages caused the financial crisis won't be pleased this week: a new bipartisan bill (.pdf) has been introduced which would keep its influence firmly in place. Although the legislation would eliminate Fannie Mae and Freddie Mac, it would replace them with new utility-like private firms that utilize government guarantees to finance mortgages. Would this new proposal solve the problems that have plagued housing finance?
The "Housing Finance Reform Act of 2011" was introduced yesterday by Rep. John Campbell (R-CA) and Gary Peters (D-MI). It seeks to introduce at least five private firms that would be in charge of funding and securitizing conventional (prime) mortgages. The mortgage bonds that result would then have a federal guarantee, for which these firms would be charged a fee. The firms themselves would not be guaranteed -- just the mortgages bonds they create would be protected. Fannie and Freddie would be dissolved.
Is this new framework any better than what we had in the past? Let's look at the bullets from its sponsors' highlights memo (.pdf):
Preserves Access to 30 Year Fixed Rate Mortgage: Without a secondary mortgage market, loan originators are unlikely to offer long term fixed rate mortgages because they do not want to bear the risk of fluctuating interest rates. The Campbell-Peters bill ensures a strong secondary mortgage market by providing a government guarantee to investors in residential mortgage backed securities.
Of course, some critics of something closer to a free market approach worry that the 30-year fixed rate mortgage will disappear without government guarantees. The above excerpt says that these guarantees are important to the problem fluctuating interest rates pose. It's hard to see how. Government guarantees don't protect investors from interest rate risk; they save investors from default risk. The two are unrelated.
To be sure, some investors will be pleased that the bonds are explicitly as safe as Treasuries, but others will be disappointed with the smaller return that they get as a result.
Encourages Private Sector Investment in the Secondary Mortgage Market: The Fannie Mae and Freddie Mac hybrid model of privatized gains and subsidized losses is eliminated. Instead, privately capitalized associations will be chartered to securitize residential mortgages.
If these five new private companies will be able to seek profit, then it's hard to see how this problem is put-to-rest. They will likely lobby the government heavily when the market is doing well to decrease guarantee fees. At that time, they'll also probably argue for the relaxation of their credit criteria, saying that it would be safe for them to accept riskier mortgages. Even if these firms can fail, it won't necessarily save taxpayers who are guaranteeing trillions of dollars in mortgage debt they sold to investors. Does that sound familiar? See Fannie and Freddie.
Limited Charter: Associations will receive a narrow charter, limiting these companies from engaging in activity that is inconsistent with preserving the accessibility of traditional mortgage products. Associations cannot originate or service mortgages, and their investment and other activities are limited. They also cannot issue securities backed by anything other than conventional residential mortgage products guaranteed by the government.
As just mentioned, no charter is written in stone. Fannie and Freddie once only guaranteed very prime mortgages, but that eventually changed. It can again. It's also hard to see how their inability to originate mortgages helps them assess the loans. Originators understand their loans better than anyone, so being a middle man will make these new firms less able to deeply understand the loans they're guaranteeing.
Limits Taxpayer Liability: By offering a guarantee on the securities rather than on the entity issuing the securities, and by creating a Reserve Fund to cover any losses, the Campbell-Peters bill ensures that private sector capital is at risk rather than the taxpayer funds. Should the Reserve Fund be depleted and federal dollars expended, taxpayers would be compensated through a special assessment levied on associations issuing securities.
This isn't much of a limit on liability. First, most of the huge losses suffered by Fannie and Freddie came from their guarantees -- not their mortgage portfolios. Guarantees can be a very risk business. The assessment sounds like a good idea to shield taxpayers, but which firms would be assessed? Mortgages are highly correlated, so if one of these firms finds itself insolvent, chances are good that they all will. If they're all insolvent, none will be able to pay any assessment.
Accurately Prices Risk: The Campbell-Peters bill requires the independent GAO to issue a detailed report assessing what the actual risk associated with the guarantee is, and requires regulators to use this report when adopting a guarantee fee. If the fee is underpriced and the Reserve Fund does not have sufficient funds to cover its obligations a special assessment will ensure that taxpayers are not exposed to losses.
If you believe that the government will be able to accurately assess risk and won't be tempted to relax its standards in good times, then you'll find this benefit compelling. If you worry that the government lacks the foresight and expertise to accurately assess risk and that politics will get in the way of good sense, then you will find this claim naïve.
Winds down Fannie and Freddie: The FHFA will be tasked with coming up with a transition plan for fully unwinding the GSEs, and putting in place the new system of private associations. The existing enterprises can be terminated within one year of five associations being chartered, or at the latest no more than 3 years after the first two associations are chartered.
In general, it's hard to see how five Frannies are much better than two. Remember, these are for-profit corporations that will be competing with one another. The will feel competitive pressure to relax mortgage underwriting standards in good times and will urge regulators and politicians to respond accordingly.
It's almost impressive how quickly the real estate lobby has swayed some Republicans to slowly back away from their free market ambitions on housing. Although libertarian-leaning Republicans will have trouble supporting this proposal, it provides nice cover for moderates who do not want to upset the housing industry. Now, they can say they did away with Fannie and Freddie, even though this bill fails to significantly weaken the government's role in housing.
The really amazing thing is that this new bill is to the left of all three housing finance reform options presented by the Obama administration policy report in February. None of its options would have provided a full guarantee for most prime mortgages. All three relied far more on the private market to step in to take on mortgage risk, though at varying degrees. The new proposal explained above, however, essentially ensures that prime mortgage securitization will be handled mostly through federal guarantees, leaving little room for private financing to compete.
It's not all that surprising to see Rep. Campbell, the Republican sponsor, come out arguing for continued government involvement in the industry. He represents a large portion of Orange County, which was the cradle of the subprime mortgage industry. It's likely very important to some of his powerful constituents that government protection for the real estate industry remains in place to ensure that big profits continue.
Analysts are right to say that this bill has a solid chance, that is if any sweeping housing finance reform bill has a shot at passing before 2012 elections. Democrats probably won't support a mostly privatized mortgage market. Some Republicans might not support a bill like this, which leaves in place broad government support for the real estate industry. But remember, if all Democrats support this measure, only a handful of moderate Republicans would be needed for a majority in the House -- about 25 out of 242.
If this bill does pass, it will create an interesting experiment. It places a pretty big bet on the idea that explicit guarantees are better than implicit guarantees and that five firms competing as financiers is better than two. If those were the causes for the problems in government housing finance that led to a bailout at $158 billion and climbing, then the new system will work. If they weren't the causes, then history will repeat itself in the decades to come.