Is a Hybrid Public-Private Mortgage System the Answer?

As the debate on housing finance policy continues to heat up, another proposal has entered the picture. While the two extreme ends of the spectrum are those generally being discussed -- the government leaving the market entirely or it backing the market entirely -- there's another possibility. A hybrid system could be developed where the government provides a partial guarantee. Moody's chief economist Mark Zandi and credit analytics director Cristian deRitis suggest this alternative in a paper (.pdf) released today. Would it work?

First, the proposal provides what it believes to be clear benefits of a hybrid system. The problem with full government guarantees is that they exposes taxpayers to huge losses and increases moral hazard. A hybrid system would reduce taxpayers' potential losses, while encouraging banks to take prudent risks. This proposal, in particular, would force the banks to take the first losses up to some threshold after which time the government would cover the remainder. In other words, it's a catastrophic insurance system. In most situations, the private market would cover the losses, but in extreme situations, the government would have to absorb deep losses.

Of course, a fully private system would do an even better job of achieving the desired ends above: it would provide taxpayers with no loss exposure and banks would have to create mortgages knowing that they'll be on the hook if the loans go bad. So why bother with the hybrid model? There are three reasons. First, these authors worry that if credit dries up due to a financial crisis, the mortgage market will shut down. Second, an entirely private mortgage market will demand higher mortgage interest rates. Third, the paper asserts that a hybrid system will ensure that the 30-year fixed rate mortgage doesn't go away, something that mortgage bankers have been threatening will happen if a fully private system is adopted.

The hybrid model solves all these problems, the authors say. Because the government will cover a large portion of potential losses, banks won't be scared to create new mortgages during a credit crunch. Since banks' risk is limited, the 30-year fixed rate mortgage would also be safe. The authors also say that the premium added to mortgage interest rates in the hybrid system they propose, compared to the nationalized system, would be relatively small. 

After a heap of assumptions, Zandi and deRitis write that a totally private system would add around 100 basis points to the average mortgage interest rate compared to a fully nationalized system. But the hybrid system they propose would only add about 10 basis points. Put another way, the privatized system would cost borrowers with a $170,000 (the U.S. median home price) mortgage about 9% more than the hybrid system, if you assume a 6% mortgage interest rate is common once the nationalized housing market stabilizes. The authors say their plan would boost home ownership, as it keeps payments relatively low.

This sounds pretty good, but it raises a few questions. First, why does the hybrid model provide such cheap mortgages? That additional interest rate spread that the private market demands would presumably not be required by the government, because it has a lower cost of capital. But can we be sure that the government will charge a premium actuarially identical to whatever the private market would have charged? Policymakers may be tempted underestimate the cost of the guarantees and provide a benefit even beyond what its relatively low cost of capital would imply. If that occurs, the lower interest rate that borrowers would obtain through a hybrid model will include a subsidy, which will ultimately be paid by taxpayers when mortgages go bad. So instead of charging homeowners a higher interest rate, the cost falls to taxpayers when the insurance premiums fail to cover all losses.

Second, Zandi and deRitis compare this system to deposit insurance, which has been one of the more successful government interventions over the past several decades. Like deposit insurance, a premium will be paid by banks for their catastrophic mortgage insurance. But there's a big difference between these two types of insurance. With deposit insurance, the government covers a limited first-loss piece. Currently, deposits are covered up to $250,000 per account. With mortgage insurance, banks would cover the first portion of the loss and the government would pay whatever loss remains.

This represents a major difference, because it makes a premium for depository insurance easier to estimate. There's a relatively low ceiling to what the government might have to pay, which you can calculate by the number of accounts and balance of their deposits up to the defined threshold. But for mortgages, there's a floor where the government insurance begins and then it could be on the hook for losses up to the entire value of the mortgage, in theory.

With deposit insurance, you just need to make one assumption to figure out how big of a premium to charge: the portion of banks that could fail. With the catastrophic mortgage insurance you need to make two assumptions in order to calculate a premium: the portion of mortgages that could fail and the severity of the losses that will result. Perhaps the latter calculation is able to be estimated accurately through historical precedent, but there's certainly more room for error when more assumptions are needed. So even if the government isn't tempted to provide an additional subsidy to homeowners, it may still have trouble pricing the insurance premiums.

To be sure, a hybrid mortgage system sounds a lot better than a fully nationalized system. At least the government's losses would be lower and the private market would be forced to develop more prudent loan underwriting standards since it would be on the hook for some losses. But it does appear that the government, and consequently taxpayers, could continue to provide some subsidy to the housing financing under the system. So it may still suffer from the generally regressive income transfer from renters to homeowners that was exposed as Fannie Mae and Freddie Mac collapsed. And the harder it is for the government to accurately price the insurance premium, the bigger that transfer will likely be.

Update: I spoke to Mark Zandi about this proposal after writing the post, and asked him about my two concerns. In terms of the risk of the government desire to purposely misprice the risk, he pointed to the FDIC and FHA, who he says have been pretty successful at avoiding losses for the guarantee services they provide. As for the difficulty in pricing, he agreed that the catastrophic mortgage guarantor might have a harder time pricing risk than the FDIC due to the catastrophic guarantee's relative complexity. But he believed that good stress testing could provide a reasonable estimate, which could be tweaked over time for accuracy.