Housing policy reform is beginning to take shape. At this point, it looks like both the financial sector and Washington agree that the government must maintain a big role in the mortgage market. The favored strategy to do so thus far appears to be government mortgage guarantees that require a fee from banks that wish to obtain them. It would be kind of like depository insurance, except for mortgages. What could go wrong? Fannie and Freddie (F&F) provide a sufficient explanation.
The Federal Housing Authority, which oversees these two entities, released a report (.pdf) this week on their status. There are a couple important lessons contained in the assessment, some of which we already knew -- like F&F allowed their underwriting standards to suffer so that they could better compete with banks for mortgages during the housing bubble. But there was an interesting nugget that hasn't been widely discussed. The activity that caused most of their losses was mortgage guarantees.
Here's a figure from the report that tells the story pretty clearly:
Let me explain what's going on here. The figure is concerned with F&F's capital, which has been a major problem since it started incurring losses. It has needed $148 billion from the U.S. government through June to avoid insolvency. This figure indicates where those losses originate.
In particular, the "Capital Erosion" listing indicates each of F&F's business strategies and the size of their respective losses. As you can see, "Single-Family Guarantee Earnings" has hurt F&F the most. Guarantees gone bad have cost the enterprises $166 billion -- accounting for 73% of their total capital erosion.
The implication is clear: F&F weren't charging nearly enough money to guarantee these mortgages. If their insurance premiums had matched the risk of the associated loans, then they would not have incurred these losses. Without this mistake, their capital losses would have been a small fraction of the $226 billion thus far. In fact, considered together, the entities wouldn't have even needed a bailout. Their capital losses would have only been $60 billion, which would have eaten away most, but not all of their $71 billion cushion.
How did they get it so wrong? In part because it's easy to guarantee something that you think is relatively safe. You don't feel like you need to demand much of a premium in return. This can expose a firm to huge losses, however, while it maintains only a very small capital cushion to absorb them. The bond guarantors ran into precisely the same problem, which is why most still in business are hanging by a thread.
Bizarrely enough, as housing policy evolves, this dangerous business is seen by many as the solution. The "reform" suggested would create a new, or several new, government entities that provide mortgage guarantees for a fee. Meanwhile, the government will still feel pressure to keep those fees low, so to continue to encourage home ownership. Consequently, you would likely again have a government portfolio of guarantees that have very little capital to fall back on
if when another economic shock hits. Taxpayers would again be forced to bear those losses.
They say that those who learn nothing from history are doomed to repeat it. Policymakers need only to look to Fannie and Freddie to see why government mortgage guarantees might not be such a bright idea.
We want to hear what you think about this article. Submit a letter to the editor or write to firstname.lastname@example.org.