With Government Mortgage Guarantees, Risk Retention Isn't Needed

At the Treasury's Conference on the Future of Housing Finance yesterday, it was pretty clear that government guarantees for mortgages aren't going anywhere. As mentioned before, it's easy to figure out how this story ends. When affordable housing advocates, Main Street, and Wall Street are all on the same page, taxpayers don't stand a chance. So as long as the government continues guaranteeing mortgages through some Fannie- or Freddie-like government-sponsored entity (GSE), it can dictate what kinds of mortgages it will accept. This makes bank risk retention unnecessary for those loans.

A Brief Primer

Before explaining why, here's a brief primer that you can skip if you already know the issues. The Dodd-Frank bill requires that banks have "skin in the game" when creating mortgage securities, in the hopes that they'll originate higher quality loans if they have to eat some of their own cooking. As noted yesterday, this should really be targeted at lenders instead of securitizers, but in either scenario, the desired end is essentially the same: higher quality mortgages and mortgage securities.

The Power of Conforming Criteria

Now, let's assume that the government continues to guarantee some specific segment of new mortgages, which appears a likely outcome after yesterday's conference. In order for lenders to attain that guarantee, it can (and does) stipulate certain criteria that loans must adhere to in order to get its backing. If banks originate loans that don't follow these rules, then the GSE can either reject the loan initially, or put it back to the lender if found to fail the test after-the-fact. So essentially, you have a situation where regulators can ensure that mortgages are high quality -- even without forcing banks to retain some of the risk.

Of course, this was much how the world looked during the housing boom, and it didn't work out so well. Fannie and Freddie had criteria, but they watered them down or ignored them entirely. Of course, a similar potential problem can be noted about risk retention. Banks owned billions of dollars in mortgage-backed securities -- so they ate plenty of their own cooking. In order to make this work, tough regulators will have to remain uninfluenced by cyclicality and resist the temptation to loosen the criteria. While this isn't ideal, neither is risk retention for much the same reason.

Competitiveness Doesn't Matter

One big criticism about the Frank-Dodd risk retention requirement is that the Federal Housing Authority (and possibly Fannie and Freddie) doesn't have to follow it. If the GSEs did, would this potentially solve the problem noted above? Not really -- as just mentioned the private market made the same mistakes as regulators. Moreover, if you require lenders to keep some of the risk for these loans, then it essentially nullifies the entire purpose of having the government's backing. It's precisely this risk prevents lenders from originating these mortgages without the guarantee at a low cost. And remember, the lender will already be required to pay a premium for the guarantee.

The reason why it's particularly harmful that GSEs wouldn't be subject to risk retention requirements has less due to the fear that they will back bad mortgages than it is that this preferential treatment would crowd out the private market. But if the government already explicitly backs some segment of the mortgages originated, then there wouldn't be any private market there anyway. No private firm can compete with the government's appetite for risk.

We still don't know how the government will guarantee mortgages going forward. It's pretty likely that it will continue to have a role in trying to secure mortgages for lower income borrowers through the FHA. In this and any other segment of the market where the government is involved, there's no point in forcing banks to take on some of the risk when obtaining the government's backing. Private guarantors can't compete anyway and the government can stipulate criteria for the mortgages it guarantees to mitigate risk.