The Treasury's Smart Plan to Get the Government Out of Home Financing

The private mortgage financing market has been dead for four years. This program could bring it back to life.

600 geithner housing REUTERS Jason Reed.jpg

Once upon a time, when the housing market was thriving, investors loved mortgages. They didn't care if they were prime, subprime, privately financed, or government-backed -- their love seemed unconditional. Investors threw so much money at housing that a gigantic bubble inflated. But then, it popped. Investors got burned: the mortgages they trusted turned out to be poisonous. Billions of dollars in losses from toxic securities nearly killed the investors. So the relationship ended on very bad terms. Even now, most investors will only look at mortgage securities if they're disguised as Treasuries. But the Treasury reportedly has a pretty slick idea to get these estranged lovers together again.

How Do You Jumpstart a Dead Market

Right now, the government backs something like 90% of new mortgages. Back when the housing market was thriving, private label mortgage-backed securities -- those not backed by the government -- were responsible for funding roughly 40% of mortgage originations. Three years after the crisis, the private label market remains virtually dead.

How do you restart it? You could take a simple sink-or-swim approach: the government could just cut the amount of mortgages it will back. But this is a dangerous move, as the housing market remains very weak. If mortgages become more expensive or even harder to get, then prices might fall faster -- even below wherever their nature bottom should be.

But banks are only funding most mortgages because they know that the government will provide them financing through Fannie Mae, Freddie Mac, or the Federal Housing Authority. With their guarantee, those mortgages can be passed on to investors who are happy to take on the debt, since it's backed by the U.S. Without the government's promise to provide a guarantee, banks won't fund as many mortgages, because investors won't want them.

The Treasury's Plan

This is where the Treasury comes in. Default risk isn't going to stand in the way of the government buying mortgages; after all, it's backing most of them anyway. It doesn't expect -- or need -- investors to take on this risk as a condition of financing. But it could make it worth some investors' while to take on the default risk of some mortgages. This would kind of get them reacquainted with mortgage risk. That's essentially the plan.

In particular, the Treasury may push Fannie and Freddie to create some mortgage-backed securities that do not provide a government guarantee. They would provide a higher-than-usual bond yield to investors who are willing to purchase them. That will compensate those investors for the default risk that they would be taking on.

Do you see what happened there? The sticking point in restarting the private mortgage-backed securities market is that lenders are scared to sell mortgages to borrowers without the government guarantee in place. So the government will buy some mortgages and strip off its guarantee. It can then test the market by seeing what bond yield investors will demand to buy those mortgages.

The resulting bonds would effectively be private label mortgage-backed securities sold by the government. It might seem like a strange idea, but it could be the kick in the pants that the market needs to realize that the prime mortgages being originated today are actually a pretty good investment -- even without the government's backing.

Could Anything Go Wrong?

The only foreseeable problem here is that the government could end up losing a little money on these mortgages. It charges lenders a guarantee fee when it backs a loan. That guarantee fee will presumably serve as most of the money used to pay the extra yield to compensate investors for buying mortgage securities without a government guarantee. If the bond yield paid to investors turns out to be greater than the guarantee fee plus the interest received from the mortgages, then the government will lose money on the transaction.

This probably shouldn't be too serious of a concern. If investors demand too much bond yield so that the government would lose a significant amount of money on the transaction, then the program will likely just fade away. But if the government does lose a small amount of money on a successful implementation of the program, then it could be worth the cost. If this is what it takes to jumpstart the private mortgage financing market, then paying a little extra now could save taxpayers a lot of money in the long run as their mortgage exposure begins to decline.

Image Credit: REUTERS/Jason Reed