Will the Mortgage Market Die Without Government Guarantees?

As the housing policy debate gets underway this year in Congress, there's really only one big decision to make: will the U.S. government continue to guarantee mortgages? Once that is determined, the rest is really just details about how to best implement policy. The Treasury could be moving away from government guarantees, even though the market and Democrats generally prefer them. In a sprawling op-ed this week in the New York Times, Vanity Fair writer Bethany McLean essentially argues that without government guarantees, the American mortgage market will fail. Is that true?

Problems

Here's McLean describing the problems with pulling government guarantees:

Fannie Mae and Freddie Mac, for instance, were created by the federal government to buy up mortgages from lenders, thereby enabling them to turn around and issue more mortgages. Among other things, this allowed the lenders to get off their books the two kinds of risk that a mortgage carries. We're all now sadly familiar with one kind, credit risk -- that is, the danger that a borrower won't pay back the mortgage. The second is interest-rate risk, the danger that interest rates will rise sharply after the mortgage has been made, thereby burdening the bank with money-losing loans. (Interest-rate risk was the root cause of the savings and loan crisis.) The longer a mortgage lasts, the more difficult it is to manage both of these risks. And 30 years is an awfully long time.

Default Risk

Let's consider each of these risks separately. First, there's default risk. Yes, banks and investors are now very concerned about mortgage losses, particularly because the housing market is in terrible shape. Some believe that home prices could still fall more than 20%. So obviously, if you're considering backing a new mortgage, this environment doesn't thrill you.

But that's because the housing bubble is still deflating. Once the market hits a real bottom, default risk can be minimized. When that happens, if mortgages are prudently originated, then default risk becomes relatively insignificant. Good underwriting will result in deep home price declines becoming very rare.

For example, imagine if there were never any wacky mortgage products sold by banks during the housing bubble. And imagine if all banks required at least 10% down payment, and that much equity maintained for a refinancing. Under those circumstances you probably wouldn't have seen a housing bubble, so you also wouldn't have seen home prices rise incredibly and then fall disastrously.

Moreover, prudent underwriting standards will also minimize the potential magnitude of default risk. If borrowers are forced to have at least 10% to 20% equity in a home before a mortgage is written, then suddenly a bank's loss would have to exceed that amount to lose money on the mortgage. And the longer that person has been paying their mortgage, the more that the bank's potential loss declines for two reasons: equity is being built up more and more each month, and the borrower will fight harder to keep his home, rather than walk away and lose his equity.

Even without government guarantees, it's pretty easy to minimize default risk through prudent underwriting. This won't be possible until the housing market stabilizes, however. So the government will likely have to maintain some role until then.

Interest-Rate Risk

Interest rate risk is potentially even less significant. Sure, "30-years is an awfully long time," but few mortgages actually last that long. More often borrowers will prepay, either gradually or all at once by refinancing. That's why in mortgage banking, a pool of mortgages is said to have an expected weighted-average life different from its maturity. It's often far less than 30-years, depending on the loan characteristics.

That means two things. First, banks can find ways to hedge their interest rate risk pretty easily through buying swaps. These derivative instruments can virtually eliminate fixed interest rate risk by trading it to another investor who wants to avoid floating interest rate risk. This cost of this hedging can be built into the mortgage interest rate.

Second, there's securitization. McLean does touch on securitization, but says that mortgage bond investors still preferred Fannie and Freddie bonds to privately backed mortgage bonds in order to avoid default risk. Well, of course they did. If someone offers you a bond that can never incur a loss and another that might incur a small loss (assuming prudent underwriting), which do you choose? Obviously, you want the safer one. That's different from saying you wouldn't buy the second bond if the first one didn't exist. Investors can stomach some default risk or there would be no unsecured corporate debt market.

The beauty of securitization is that you can structure mortgage bonds to appeal to different kinds of investors by shaping them to have different maturities and risk profiles. In other words, a pool of 30-year mortgages can be sold, in part, to investors who only want a very safe 5-year bond, some who want a fairly safe 10-year bond, and so on. This also minimizes the problem of interest-rate and default risks.

Arguments that claim the mortgage market can't function without a government guarantee should always look suspicious, because other developed nations don't provide such guarantees but still have healthy mortgage markets. Some creative thinking might just be necessary to make mortgage assets more attractive to banks and investors. There are a few ways to do this.

Solutions

Higher Down Payments

Most advocates for broadening home ownership hate the idea of increasing the size of mortgage down payments. They shouldn't. The real reason why home ownership is so attractive to the middle class is due to the mortgage interest deduction. If that's eliminated-- and it should be -- then other saving will actually become equally as or more attractive than using your home as your savings account. Without this subsidy, saving for a down payment isn't any worse than saving through accumulating mortgage principal through monthly payments.

Think about a young adult, just out of college. She wants a home, but can't afford a 20% down payment. So she rents.

Let's say over the course of 10 years in the workforce, she saves $50,000. That's not a small sum, but not infeasible for someone in the middle class. That would provide a 20% down payment on a $250,000 home. If she had obtained a mortgage right out of college instead with zero down, her equity would actually only amount to less than $47,000, based on a 5% interest rate and a 30-year term over a 10 year period. But with that 20% down payment, she can get a 20-year mortgage for approximately the same monthly payment.

In other words, nothing was really lost by waiting 10 years -- she'll still owns the home by the time she's about 52 years-old. The 20% down payment didn't ultimately hurt her home ownership path. At higher interest rates, the advantage of a big down payment becomes even greater to the borrower.

As mentioned, high down payments make mortgages much more attractive to banks and investors, because default risk is minimized. But they can also provide the borrower an opportunity to obtain a mortgage with a shorter term, which those banks and investors will also like, because interest-rate risk is a little easier to stomach over a shorter term.

Financial Innovation That Creates a Safer Market

Innovation became a dirty word after the financial crisis. And rightly so: those option adjustable-rate mortgages and synthetic collateralized debt obligations did a lot more harm than good. But it's possible to invent other new mortgage products that help to keep home ownership sufficiently broad, but also protect banks and investors against losses.

I wrote about one such possible new product back in August called the "DJI Mortgage." It would essentially provide the borrower with a relatively high interest rate initially and a low down payment. But as equity is built up, the bank's default risk would be minimized, so the interest rate could reset downward.

This is just one potential product. Certainly others could be dreamed up. And there are also ways that the U.S. market could evolve to make mortgage funding easier for banks to obtain. One way could be to encourage the creation of a covered bond market in the U.S., a security that makes mortgages more attractive for banks to keep on their balance sheets.

It's a cop out to simply throw up our hands and declare that the government can't be gradually cut out of the mortgage market, since it's been involved for so long. Just because that has been the status quo for some time, doesn't mean it has to be forever. Change is possible, and looking to other nations' mortgage markets shows that quite clearly. The market might not love the change at first, but it will adjust. There's a difference between banks and investors saying that they would prefer a world where the government stood behind all mortgages and saying a private mortgage market is impossible.