Bankers, wonks, and policymakers converged at the Treasury today for its Conference on the Future of Housing Finance. It sought to begin the discussion of the biggest hole in this summer's financial regulation bill: what should the U.S. do to reform its housing policy, and the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, in particular. In the first panel discussion, by far the most interesting remarks were made by PIMCO co-founder and co-Chief Investment Officer William Gross.
Some might naively believe that the head of an asset management company with over $1 trillion in assets would be against the government's involvement in the mortgage bond market. In fact, Gross was the strongest advocate on the panel for the government insuring all mortgages written. Why? Because if the government takes on all the default risk, then he won't have to take any.
Here is Gross' basic view:
PIMCO advocates a 100% government finance, with government guarantees that are protected by adequate down payments obviously and sufficient insurance premiums, as discussed previously, to never again put American taxpayers to subsidize a $300 to $400 billion black hole.
Of course, so long as the government is backstopping the entire mortgage market, the possibility of taxpayer losses is pretty hard to avoid entirely. After all, taxpayers will ultimately be on the hook if things go badly and the premiums charged weren't high enough. But he also explains the point from his perspective:
PIMCO will not buy a private or privately insured mortgage pool unless it was accompanied by a 30% down payment -- too high in today's marketplace to permit new housing or even secondary market purchases. Without government guarantees, mortgage rates would be hundreds -- hundreds -- of basis points higher, resulting in a moribund housing market for years.
This is an interesting point. No matter how prime the mortgages originated, he says investors like him will demand a 30% down payment -- significantly higher than the market currently calls for under the government's influence. Moreover, even with those down payments investors will require extremely steep risk premiums, leading to much higher interest rates for borrowers. He said that mortgage interest rates would be between 7% and 9% in such a world. Later he says:
In terms of addressing reality, it's an $11 trillion secondary mortgage market. Agencies are about a half of it. The other half, or a good portion, were financed when people thought housing couldn't go down in price. We know that's not the case now. So to suggest there's a large place for private financing in the future of American housing finance is unrealistic. We've been dealt a significant blow and the only way to bring housing back and to create liquid financeable mortgage financing going forward is to provide a government guarantee. What would that government guarantee provide? It would provide the guarantee of principal and interest and payment and maturity. It would be provided for by adequate insurance by sufficient down payments and over encompassing regulatory environment that, instead of allowing no docs and liar loans, that provides supervision for any mortgage going forward. . . . The government is part of our future in not only the mortgage market, the housing market, but other markets as well. We need the government balance sheet. And to suggest the private market can come back in and take the place and do the same thing they've done for the past 20 or 30 years is simply impractical. It won't work.
Because the market now realizes that -- surprise! -- real estate can lose value, the game has changed. That's likely true, but there is a price at which investors will buy mortgage securities again. That price is just higher. For example, cars lose value, but auto loans are still securitized -- just at a higher price.
So in the past, the market wrongly believed that houses couldn't lose value and wrongly priced the securities that resulted too low. The prices the market charges for mortgage should be higher, given what we now know. Either all taxpayers bear that cost through government guarantees or homeowners do through higher interest rates and bigger down payments.
Why is Gross practically aching for a government-backed mortgage market? Such a world makes investors like him much, much better off. Suddenly, he no longer needs to worry about risk management. If a mortgage bond has trouble, then the government just covers the losses. It's a winning proposition for an investor. Indeed, they don't even need to even worry about any due diligence -- Uncle Sam's word is good enough, and better than a measly AAA-rating. Investors get a yield that pays more than Treasuries, but with virtually zero risk.
Without a government guarantee, suddenly investors would have to evaluate the pool of mortgages the bonds they buy reference. That would require they ramp up their research staffs. Moreover, it would put more risk on their shoulders. After all, their researchers could get it wrong. Instead, Gross would rather the government just take on all that risk. Can you blame him? His wanting a government safety net is entirely self-serving.
Just how much government involvement in the market does Gross want? Even more than this. He also calls for a new stimulus measure to be taken by refinancing all GSE-held mortgages at below-market interest rates. He said:
The American economy is approaching a cul-de-sac of stimulus, both monetarily and fiscally. It will slow to a snail's pace incapable of providing sufficient job growth going forward. Unemployment rates will approach and remain at double digits unless a positive fiscal stimulus is provided in the next six months. This home financing to my way of thinking and to PIMCO's way of thinking where you take 5%, 6%, and 7% and turn them into 4% mortgages, basically will provide a push, a stimulus of $50 to $60 billion of consumption.
To see why this is a dangerous idea, check out this post. Other than the economic problems it would cause, it is horribly unfair. Why should only Americans who happen to have a mortgage held by Fannie or Freddie obtain a direct government stimulus thanks to this amazing refinancing deal? According to the Treasury, it has no plans to push for such a program. But if influential market players like Gross continue to call for one, perhaps they'll begin thinking about it.
Really, Gross' view of housing finance was just an extreme version of the vast consensus of the conference participants. They virtually all believed that the government needs to maintain a significant role in the mortgage market. The conferees only differed on their view of the degree of influence the government should have over the market.