Can the Government Ever Escape Backing Mortgages?

Even if the housing finance system is fully privatized, the government will still have to back it in times of crisis. This assertion was made today by Treasury Secretary Timothy Geithner in a House Financial Services hearing about his new mortgage finance policy plan. He argues that, even without an explicit guarantee, an implicit one will always exist. Is this true?

For those of us who have watched Geithner since his confirmation hearings back in 2009, it's clear he has become a pro at testifying before Congress. Throughout the hearing, argumentative questions never fazed him, as he provided calm, thoughtful responses. Early in the hearing, Chairman Bachus (R-AL) asked the Treasury Secretary whether a catastrophic backstop would effectively function as an implicit guarantee of the entire market. Geithner addressed this question more broadly, saying:

I don't think it's quite right to think about these things as a stark choice between a purely private market and a market where the government in crisis or in normal times is guaranteeing mortgages. If you leave all these mortgages in the banking system, like many countries do, the government is still there with an implicit commitment to back the banking system. So if you look at the model that Canada, and many European counties, have adopted, where in contrast to our model, they leave most of these mortgages with banks. The government provides a lot of support for banks. It's very reluctant in those countries to let banks fail in a crisis. So the support is there, but it's just implicit -- it's not explicit. Banks don't have to pay for that support, but it's not quite the private market idea that many people think.

The distinction here that Geithner makes is important. He asserts that in times of crisis, the government will always step in. He then explains that there's really no such thing as a truly private system. Any attempt to create such a framework will just result in an implicit government guarantee. He implies that such a private mortgage finance system might not be as favorable as it sounds, because with an implicit guarantee, banks do not have to pay for their government support. If a more explicit guarantee policy were chosen, however, banks would have to pay fees for the protection the government provides.

Geithner's explanation is quite astute, but it relies on a very important assumption: the U.S. would be forced to bail out the mortgage market again in the future, even if privatized. This may or may not be true, depending on whom you ask. Some effort was made during last year's financial regulation effort to avoid government rescues like those we saw in 2008. The foremost includes a non-bank resolution authority which would take over large, failing institutions and wind them down if they get into trouble.

But let's take a step back for a moment. With that new non-bank resolution authority, there are two ways in which an institution that holds mortgages in a privatized framework can be dealt with by the government. If it's a small- to medium-sized depository institution, then the Federal Deposit Insurance Corporation can seize the bank and wind it down, just as it has for decades. That protection is explicit, for which banks pay deposit insurance premiums. But banks still ultimately fail: the insurance benefits their customers, not their shareholders or creditors.

Then, there's the new alternative explained above. Now, the FDIC can also wind down a large financial firm that runs into trouble. Unlike the regular bank resolution process, however, no insurance premium is collected. Of course, there are also no insurance payments provided to the big financial firms' customers. This non-bank resolution process was designed in such a way to ensure that taxpayers do not take a loss; that loss is instead imposed on shareholders and creditors.

So in theory, Geithner is wrong. In a privatized market, taxpayers would not be on the hook in a crisis if the mortgage market hiccups. But theory does not always align with practice. While this non-bank resolution authority sounds great, there's some question of whether it would really be able to wind down several large institutions simultaneously in the event of a serious market collapse. If losses imposed on those shareholders and creditors would bring down the entire financial system, then the government might not be able to resist a rescue.

What will actually occur ultimately depends on what the market believes. If banks and investors really believe that the government will forbid future bailouts, then they should respond with more reasonable loan writing and thoughtful investing. But if they continue to take mindless risks, assuming that the government will always step in to save their hides, then future, deep crises will occur, and taxpayers won't be spared.

Perhaps that's where regulation comes in. If moral hazard is too great and the market cannot be trusted to exercise prudence, then new rules should be put in place to prevent excessive risk. Some such rules have already been proposed, like boosting minimum mortgage down payments to at least 10% or 20%. If loans are originated with safety in mind, even a deep recession and crisis should not result in dramatic, economy-killing losses where a government bailout is unavoidable.