Mortgage buyers Fannie Mae and Freddie Mac, which are the backbone of home lending, owning or guaranteeing some $5 trillion in mortgages, should stay alive but with some restrictions, according to a short, pointed white paper by professors at New York University’s Stern School of Business.
First, they define and answer key questions (Emphasis added. Note: securitized means creating securities backed by mortgages.):
“1. Should mortgages be securitized or not? A majority of the current outstanding mortgages are securitized and spread throughout the worldwide investment community. It seems hard to believe that this quantity of assets could be placed as whole loans within the banking and mortgage lending sectors.
2. If securitized, should the principal and interest be guaranteed? While there is room for securitization both with and without guarantees, approximately 68% of the MBS market is agency-backed whereas 32% is non-agency, some of which is also privately insured. Over the past forty years, a $4 trillion investment community has arisen which focuses on interest rate and prepayment risk as opposed to default risk. A substantial amount of human capital (i.e., knowledge and training) and investment networks are devoted to this product. Removing guarantees would cause a deadweight loss to all the human capital invested thus far.
3. If guaranteed, should the guarantor be the government or a private institution? There are several obstacles to complete privatization of the guarantee function. Generally, private institutions are not good insurers against systemic risk because, by definition, systemic risk occurs very infrequently yet requires large amounts of capital on hand to address that rare eventuality. Moreover, even if a party were willing, who will insure the insurers? Is there any way to credibly signal that the government would not bailout these private institutions in times of a crisis?”
And here are their two recommendations (Note: Fannie and Freddie are often referred to as government-sponsored enterprises, or GSEs.):
“1. The GSE firms should continue their mortgage guarantee and securitization programs for conforming mortgage loans. But in order to reduce the moral hazard problem the programs should now operate within government agencies, in a format parallel to the current Federal Housing Administration (FHA) and successful GNMA programs.
2. The investor function of the GSEs should be discontinued. The current setup leads to “froth” in the marketplace such as the support for weak Alt-A and subprime loans, and, even more serious, systemic risk due to the moral hazard problem of the GSEs taking risky bets.”
By “investor function” the professors — Dwight Jaffee, Stijn Van Nieuwerburgh, Matthew Richardson, Lawrence White and Robert Wright — are referring to Fannie and Freddie buying securities issued by other companies, generally investment banks, and backed by mortgages. They say Fannie and Freddie should stop buying these securities.
Read the paper HERE. Personally, I think the professors’ recommendations outline an appropriate course for the GSEs. Do you agree?
Their whole analysis falls apart on the point of whether to guaranty the loans. Their only justification for continuing to guaranty loans is because we have already invested significant capital towards this. This is faulty logic. The more pertinent question is whether the guarantees are a good idea to begin with? Given the enormous financial stakes and moral hazards promoting further risky, inefficient behavior, the answer should be to clearly remove the guarantees and let the market price this accordingly.
I have to agree with Zed. The idea that all risks in life can and should be guaranteed by the federal government is ludicrous. That line of thinking is what got us in this mess in the first place. Subprime loans were being sold in the private market place for twenty years before some idiot decided to mainstream them into the secondary mortgage market.
I am in favor of keeping Fannie and Freddie and having them become government run programs or private companies that are regulated like utilities, but also have an explicit government backing. I think we need them for the foreseeable future and having them as private companies with an implicit backing never made sense.
However, I agree with the first two readers — why keep the guarantee on principal and interest in MBS deals? Basically, if Fannie and Freddie are government backed then we are promising investors they won’t go bankrupt. But investors buying MBS should price in risk homeowners will default. Why should taxpayers take this risk?
I propose keeping the default guarantee until the housing market settles down and then phase it out, perhaps in 2011. This will mean higher interest rates to compensate investors for risk, but that’s how it should be. Otherwise we are distorting the market and inflating home prices. Also, if we eliminate the guarantee against default, then private companies will have an easier time competing against the GSEs.
Eventually, if enough private companies are doing MBS, we could spin off Fannie and Freddie, and perhaps break them into smaller companies, with NO government backing!
I know people will say Fannie and Freddie still have an advantage over private companies because they can borrow money more cheaply due to government backing. But if their regulator puts more restrictions on types of loans they can make, private companies will fill the void, eventually. The regulator could keep tightening the screws until private companies have say 50-60% of the market. Then government breaks Fannie, Freddie into smaller companies and spins them off. This might be possible in a decade or so.
I see no reason not to accelerate the process of breaking up the GSEs to now. The “systemic risk” argument cited by the professors is exactly *because* of their government-granted duopoly and size. The longer you delay, the longer you prevent the formation of the stable future market.
Remember all that they do is borrow money cheaply due to government backing (implicit or explicit) and buy mortgage loans and MBS. They are middlemen collecting a spread. Break them up and let the best-run mini-mortgage investment banks win.
You interviewed Stan Kurland of PennyMac earlier this year. That’s the kind of company that will set the floor in the market. Money won’t pour into them, however, until investors have a sense that the government won’t keep stomping all over it via irrational competition like a national bad asset bank or Fed monetizations or continued transfusions for the GSEs to buy at losses.
Private money wont go back into home lending because they cant get an accurate assesment of home values. With the government pushing for loan renegotiaions instead of foreclosure, no appraiser or bank can accuretly estimate a homes value. For instance, that HB home that had over 20 offers. Its such a false market. How many houses in that neigbohood should be foreclosed on but instead are being modified by the bank?