Government Mortgage Guarantees Will Be Sneaky Subsidies

It's looking more and more like the Uncle Sam is going to keep his hands in the mortgage market. The Obama administration and two major financial lobbying firms appear to be on the same page about a plan that would require lenders to pay a fee to the government for guarantees, according to the Wall Street Journal. That probably seals the plan's fate. My colleague Megan McArdle says this doesn't make sense. She right, but I'd like to take this a step further: the financial industry would only fight for such a plan if it includes an implicit subsidy.

In questioning the plan, Megan writes:

After all, what is the appropriate cost of the guarantee? Why, it's the amount that the guarantee is reducing the cost of the mortgage. Since the banks would then charge this amount to the homeowners, the net effect should be zero.

This relates to an argument I made back in May when this plan was proposed by a few academics. One way to capture a mortgage risk premium is to require the borrower to pay for it with a higher interest rate and/or larger down payment. Alternatively, the bank could require that the homeowner pay for default insurance from a private guarantor, which would result in same cost, in theory. Of course, if the government instead provides for that insurance, then again, the overall cost should again be the same -- and ultimately be paid by the borrower.

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So why have the government involved? Because the industry likely expects that the government will charge less than the market would. Some might argue that this could be a result of the government not having a profit motive, so the insurance costs wouldn't include any return to a private firm's shareholders. But it's more likely that the government will purposely misprice this protection so to keep the cost of mortgages low due to its public policy preference to broaden home ownership. This is precisely what Fannie Mae and Freddie Mac did. Once all that risk caught up with them, taxpayers were stuck with the bill.

Even if you believe that regulators are smart enough to price mortgage risk -- and they probably aren't, considering that the market didn't even get it right -- the temptation for politicians to use the guarantees to please constituents is just too great.

Megan also notes:

Now, maybe you think that the liquidity guarantee will prevent "runs" on the housing market and thus, like the FDIC, generate more value than it consumes. But I'm having a hard time seeing how this model is applicable. Indeed, the problem in the housing market seems to be that homeowners are not rushing to sell.

In fact, the model isn't applicable. Guaranteeing a mortgage will do little to prevent home prices from declining if they become overinflated. If demand sinks or developers overbuild and inventory ramps up, prices will decline -- even if the holders of mortgages are made whole by the government when borrowers default. And in a credit crunch there are other ways to keep the mortgages flowing other than to rely on government guarantees, as noted here. So the government liquidity guarantee isn't necessary in any sense, and comparing it to depository insurance doesn't work.

Unfortunately, all the sound reasoning in the world probably doesn't matter on this one. When Washington and bank lobbyists align, there's little hope for opponents of their effort. Let's just hope this guarantee program is run more effectively than Fannie and Freddie were, and without any political affiliation.