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The future mortgage finance system should have a robust private secondary market for the largest segment of the business: prime, conforming mortgage loans. In this market, private investors should put private capital at risk, and prosper or lose as the case may be. This is the most obvious case where the risks are manageable and no taxpayer subsidies or taxpayer risk exposures are required or desirable.
There may decades ago have been a case for GSEs (Fannie Mae and Freddie Mac) to guarantee the credit risk of prime mortgage loans in order to overcome the geographical barriers to mortgage funding, which were created by government regulation. There was lately a case for using GSEs to get through the financial crisis which they themselves did so much to exacerbate. But as we move into the future mortgage finance system, the prime mortgage market should stand on its own. Covered bonds, as well as securitizations, might well be part of this evolution.
A private secondary market for prime mortgages should have been a natural market development. Why did it never develop? The answer is obvious: No private entity could compete with the government-granted advantages of the GSEs. There could be no private prime conforming mortgage loan market while they used those advantages both to make private competition impossible, and to extract duopoly profits (“economic rents”) from the private parties.
That element of the old housing finance system should not survive.
The old GSE duopoly could be taken out of the prime market by limiting GSEs’ activity by regulation-but a better and more direct solution is to structure a transition to a world of no GSEs.
Housing finance inflation was at the center of the financial crisis, and the GSEs were at the center of housing finance inflation. No mortgage system reform can be meaningful which fails to address Fannie Mae and Freddie Mac, as I think everyone now agrees.
In my view, this is the core issue: You can be a private company, with market discipline; or you can be part of the government, with government discipline. But you can’t be both. Trying to be both, in other words, a GSE, means you avoid both disciplines. Fannie and Freddie, or parts of Fannie and Freddie, should become one or the other.
A large part of them should become a private company competing, sink or swim, in the secondary prime conforming market, with zero special advantages. The part of Fannie and Freddie which makes nonmarket loans and provides housing subsidies should be merged into the structures of the Department of Housing and Urban Development, subject to the normal government disciplines of the budget and appropriations.
The desired transition is somewhat easier at the moment because Fannie and Freddie are not now GSEs. They are government housing banks, owned for the most part and controlled entirely by the government.
Therefore in my opinion, it is quite clear that, as recommended by the Congressional Budget Office, they should be on the federal budget. Fair and transparent accounting seems to demand that they not get off-balance-sheet accounting treatment, which comes in for so much criticism in other areas.
The retention of credit risk or “skin in the game” in mortgage finance is a lesson drawn by a great many observers from the mistakes of the bubble. In my view, there is indeed a fundamentally important idea here (which I did a lot of work on starting in 1994). What should be more natural to ask of someone creating and then wishing to sell you credit risk than, “How much are you keeping?”
I propose that the retention of credit risk by mortgage originators should be facilitated, but not required, by public policy. One size is very unlikely to fit all, and the painful risks of “originate to sell” models are unlikely to be forgotten for several years. During that time, we should bend our efforts to make sales with originator credit retention, in various forms as the market develops, a real and robust alternative. I believe many investors will prefer such loans and they may well command premium prices. We should focus on removing the regulatory and accounting obstacles to this healthy development.
I believe the essential locus of credit risk retention is the originator of the loan-the place at which the credit decision is made and controlled. Naturally, some originators will provide enhancements which are more credible than others. What we want is the market always asking about this factor.
Financial cycles, particularly in real estate, are inevitable. But they could be moderated by developing countercyclical elements to the mortgage finance system. This is one of the most important things we could do.
Two promising ideas of this kind are countercyclical loan-to-value ratios and bigger (countercyclical) loan loss reserves in good times.
Bubbles involve an unstable positive feedback loop between asset prices and credit availability. For a possibly extended period of time, as in the 21st century housing bubble, higher asset prices (of houses, in this case) call forth more aggressive lending with higher LTVs, and more aggressive lending allows buying which drives the price of the asset higher. This cannot last forever, of course, but it can last a number of years.
As asset prices inflate higher and higher in a boom, the risk of loans seems to be decreasing, when in fact it is increasing. As assets prices go further and further above their trend line, the risk of their subsequent fall is becoming greater and greater. The logical and necessary thing to do is to reduce the amount being lent against the current market price of the asset.
But what generally happens in fact is the exact opposite: with increasing optimism, LTVs rise instead of being reduced. “Innovative” low-downpayment and no-downpayment mortgages, for example, are promoted and made, and are politically popular. This helps inflate the credit bubble further, ensuring that the inevitable bust will be worse.
In short, we need to create a mortgage finance system in which LTVs fall and down payments increase as asset prices inflate-then we would have countercyclical LTVs.
Turning to loan loss reserves, as now mandated, they are procyclical. Successful private risk bearing requires the opposite of our current accounting: specifically, much bigger loan loss reserves should be created in the good times. This is required, because it is in the optimism of the good times that you are making the bad loans that will later haunt you.
With bigger, more old-fashioned loss reserves, we can do better in the next cycle.
If we do not succeed in transitioning to no GSEs, and Fannie and Freddie survive in some GSE form, an essential reform to prevent financing them from being promoted through the regulations and capital rules of the banking system. Banks have been encouraged through government policy to invest in GSE preferred stock, unsecured debt and MBS. This channels government-insured deposits into GSE balance sheets. It is double-dipping on the government guarantee and a doubling down on the financial system’s concentration in real estate risk.
I suggest that in a continuing GSE world, banks should have to hold 100% equity against equity investments in GSEs, and that exactly the same concentration limits on unsecured credit to one entity be applied to GSEs as to any other debt issuer.
Savings and loan associations were once central providers of mortgage finance. But the original leaders of the “movement,” as it then was-for they considered themselves a movement for personal and social improvement-were very clear about the order of things: first the savings, then the loan.
Our subsequent political development seems to have forgotten about the “savings” and put all the emphasis on the “loan.” Even savings in the form of building up equity in the house by retiring the mortgage loan has turned into ways of extracting the equity instead.
Alex J. Pollock is a resident fellow at AEI.
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