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.