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.