November 02, 2014
Yes, that seems to be its fondest dream for the outcome of Tuesday’s election. The bulk of its lead editorial touting the prospects for bipartisanship is focused on pushing the Johnson-Crapo bill, a measure that would replace Fannie Mae and Freddie Mac with a system whereby the government guarantees 90 percent of the value of privately issued mortgage backed securities (MBS). This means that Goldman Sachs, Citigroup and other folks who might issue MBS could now tell their customers that even in a worst case scenario they couldn’t lose more than 10 percent of the value of their securities.
Fans of the market should be asking two questions here. What problem is this intended to solve? And why do private issuers need a government guarantee?
The answer to question one seems to be that the Washington Post doesn’t like public companies (Fannie and Freddie) issuing mortgage backed securities. It gives us no reason why it doesn’t like them. After all, the worst garbage mortgages of the housing bubble days were securitized by private issuers, not Fannie and Freddie.
And everyone agrees that it will be more costly to have private issuers replace Fannie and Freddie, with the range of estimates being that the Crapo-Johnson system will add 0.5-2.0 percentage points to mortgage interest rates. That is the cost of the additional risk, bureaucracy, and profits for the financial sector. So other than raising the cost of mortgage finance and increasing the profits of the financial industry, it is difficult to see what is supposed to be accomplished by this “reform.”
This takes us directly to the second point. If we want the market to handle mortgage finance, why do we need a government guarantee. The Wall Street boys had no problem selling their garbage all around the world when it carried no guarantee whatsoever. Do we think that they will have higher quality MBS now that they can tell customers that the government is capping their losses at 10 percent even if the thing is total garbage.
It doesn’t help matters that not a single bank executive went to jail or was even prosecuted for lying about the quality of the mortgages in the subprime MBS they threw together in the housing bubble days. If we believe in market incentives, why would we think they would act differently in the future? In other words, they gets lots of money for lying and no risk for getting caught.
Those who hope that the regulators will ensure the quality of MBS need look no further than the requirement that securitizers maintain a 5 percent stake in mortgages that have less than a 20 percent down payment. This requirement would have simply raised the cost of these mortgages to customers who are at a much higher risk of default. (Homebuyers with low down payments could also purchase mortgage insurance. This would add roughly the same cost to the mortgage interest rate as replacing Fannie and Freddie with the Johnson-Crapo privatized system.) However due to the pressure of the banking industry and some housing groups, this down payment requirement was eliminated.
In normal non-bubble times, the default rate for mortgages with down payments of 20 percent or more is less than 2 percent. By contrast, according to the advocates of the elimination of down payment requirements, the default rate for those putting less than 10 percent down is 10 percent, more than five times as high.
If the regulations lead the industry to treat much higher risk mortgages in the same way as low risk 20 plus percent down payment mortgages, this is effectively a tax on the low risk mortgages to subsidize the high risk mortgages. If we assume that the cost of a foreclosure is 30 percent of the mortgage value (this is probably a low figure in the case of low-down payment mortgages that have little equity cushion), then the implicit tax on low risk mortgages is equal to 3 percent of the value of the mortgages taken out by high risk buyers (30 percent multiplied by 10 percent). In other words, that would be equivalent to paying $6,000 to a high risk borrower who takes out a $200,000 loan.
This is rather dubious housing policy, since this person could have just taken out mortgage insurance for a cost that is typically around 0.7 percentage points annually. After 3-4 years they likely would have accumulated enough equity to refinance at a lower interest rate.
The other point to keep in mind is that homebuying tends to not be a very good wealth building strategy for moderate income households. (By contrast, it is a great wealth building strategy for the financial industry.) The median period of homeownership for moderate income families is just four years. This is due to the fact that they tend to have unstable employment and family situations. (The referenced study uses data from the 1980s and 1990s, the situation is almost certainly worse in the current economy.)
In short, the financial industry was able to force the weakening of regulations in a way that makes zero sense from the standpoint of limiting risk or promoting the interests of moderate income families. The creation of a privatized system of mortgage backed securities with government guarantees will encourage much more of this manipulation of regulators.
This prospect may sound good to those with an ideological commitment to using the government to make the rich richer, but it probably does not look good to anyone else.
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