How Expensive Would Mortgages Be Without Government Backing?

At the Treasury's housing conference earlier this week, PIMCO co-CIO Bill Gross said that, without the government's guarantee, mortgage interest rates would climb. He asserted that rates would be a few hundred basis points higher, probably somewhere between 7% and 9%. If you can't guess from that claim, he's for a government guarantee of all mortgages. But is he right about rates?

Hundreds of Basis Points or Just 25?

Former Freddie Mac economist Arnold Kling doesn't think so. Referring to Gross' claim, he says:

Is he just talking his book, or is he serious?

The standard estimate in the literature is that Fannie and Freddie reduce mortgage rates by 25 basis points or less.

But Felix Salmon retorts:

The 25bp figure dates back to the time when Frannie accounted for roughly half of all mortgages: back then the best estimate was that Frannie-conforming loans were about 25bp cheaper than private-label loans, all other things being equal. That 25bp wasn't only a function of the government guarantee, so much as it was a function of the fact that Frannie's capital requirements were much lower than banks' capital requirements, and the fact that Frannie had huge economies of scale when it came to things like managing the risks associated with prepayment and negative convexity.

Now, however, everything has changed: Frannie accounts not for half of the market, but for essentially all of it. And while private money is happily pouring into corporate bonds and other credit instruments, it's still shying away from mortgages, partly because no one really knows how to price them any more.

This is an important point. The world has changed a lot since the literature Kling refers to was likely written. As Salmon notes, the government now backs pretty much all new mortgages, as the private sector wants none of that risk. That's because the market has discovered that real estate actually can decline in value, which is a pretty big change from what everyone assumed since the Great Depression. Consequently, as Salmon notes, no one knows what they're worth anymore. That makes the government guarantee worth a lot more than we thought. Mortgage interest rates were low before by mistake, not by design.

Salmon says that the guarantee is likely more than 25 basis points, and he's probably right. But it also probably isn't several hundred basis points, at least not in the long-term. Right now it might be that high, because the market is still trying to reorient itself. Eventually, once the economy returns no normal, however, mortgages can be re-priced according to the possibility that they lose value. Assuming underwriting becomes (and remains) sane again, default risk will decline and so should mortgage interest rates.

But going forward that price may become more dependent on down payment size. Gross also alluded to this at the conference. There are two risks to take into account when pricing a mortgage: default risk and interest rate risk. A large down payment, say 30%, will probably cover most of your default risk -- even in a serious economic downturn. That will act like a big cushion for potential losses, allowing pricing to be based more on interest rate risk, as in the past. For smaller down payments, however, the interest rate will have to be higher to also cover default risk.

So What?

Even with the larger down payment and time for more prudent underwriting to fully return, it's pretty likely that mortgage interest rates would be higher without a government guarantee. If the private holder premium ends up being somewhere between the estimates by Kling and Gross, they could still be 1% to 2% higher. But so what?

That's the question not enough people engaging in the housing policy debate are asking. So what if a mortgage with only 5% down requires a 7 or 8% interest rate? If that's the price at which the market determines the rate covers the default risk, then that's what it should cost. Why should the government step in to subsidize the mortgage with a guarantee? Credit card and auto loan interest rates are often higher than mortgage rates, but no one is calling for the government to back those loans.

I know; I know. Mortgage are just different, say advocates for government involvement. But different how? Let's say you believe the controversial statement that the government ought to ensure that all Americans can afford housing. That doesn't imply that everyone should have a mortgage. Only those who can really afford a home should be buying one. Others can happily rent. I have known people -- wealthy people with annual incomes that exceed $1 million -- who have rented their homes for their entire lives. The sort of moral argument for home ownership doesn't really make sense from an objective standpoint, particularly if you're forcing taxpayers to subsidize the mortgages of those whose income and savings aren't great enough to afford to buy.

So even if Gross is right and mortgage interest rates must rise substantially without a government guarantee, so what? Americans can just save until they can afford bigger down payments to achieve low interest rates if they want to buy a home. If they don't, then why should they own one?