New Bipartisan Bill Seeks to Maintain Government Role in Mortgages

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 Plan

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.

Its Principles

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.

Presented by

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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