You could argue that Fannie Mae and Freddie Mac, two “government-sponsored enterprises” (GSEs) in the mortgage business which received the biggest bail-out of the financial crisis, have paid their debt to society. At any rate, the revenues they have generated for American taxpayers since the Treasury took charge of them in 2008 now exceed the $187 billion spent to rescue them. It might be a logical time for the government to stop underwriting Americans’ personal loans. Yet the thrust of the bill to reform their status that is gaining some momentum in Congress is the opposite. For an example of how a post-crash crutch becomes a permanent financial distortion, look no further.
Federal support for mortgages started as part of the New Deal, in 1934. The Federal National Mortgage Association, or “Fannie Mae,” was made private in 1968, and was joined by a twin, the Federal Home Loan Mortgage Corporation, “Freddie Mac,” in 1970. They aimed to ease mortgage finance by buying loans from banks and pooling these into mortgage-backed securities (MBS) which could be sold to pension and mutual funds. They also held MBS directly, funded by issuing debt.
The GSEs’ business was risky, and it rested on implicit state support. A 1996 study valued this subsidy at $6.9 billion. As the GSEs grew, the estimates did too. A 2003 Federal Reserve paper put the subsidy between $119 billion and $164 billion. Around 50 percent of this went straight to shareholders. But the GSEs were seen to serve the politically popular goal of expanding access to housing, so they enjoyed lower tax rates and lighter regulation than other financial firms. Leverage magnified short-term profits: with equity ratios of just 3.5 percent their returns on equity hit 20 percent. Contented congressmen and shareholders ignored the warnings of conservative think-tanks about this cushy arrangement.
At first look a bill sponsored by Tim Johnson, a Democratic senator from South Dakota, and Mike Crapo, a Republican senator from Idaho, seems a reasonable reversal of past mistakes. It treats the GSEs’ infrastructure, the kit they use to pool loans into MBS, as a public utility. The logic is that, as with train lines or water pipes, there are huge fixed costs in building financial architecture. Rather than replicating it, it is better to let private firms access it. The model is akin to the treatment of Britain’s natural monopolies — gas, electricity and telephone systems — following Margaret Thatcher’s privatizations in the 1980s.
Under the Johnson-Crapo plan, Fannie and Freddie would be replaced by the Federal Mortgage Insurance Corporation (FMIC). Banks would use its securitization services, and be charged a fee to reflect the FMIC’s costs. Strong rules would tamp down risk. For each $100 of mortgage lending securitized by the FMIC, the banks that issued the mortgages would have to hold $10 of capital. The winners would be investors in MBS. The FMIC would completely neutralize risk for them. In the event of widespread defaults, the lenders’ 10 percent capital would offer an initial buffer, with the FMIC backstopping the remaining 90 percent.
The plan is neatly packaged, but worrying. For one thing the transfer of ownership runs in the wrong direction: privately built plumbing is becoming public. Moreover, it is not clear that this utility is worth having: American home-ownership rates are decidedly mid-table (see chart). Borrowers are able to get 30-year fixed rates, but loans are not especially cheap. Studies show that unsubsidized mortgages are just a fraction dearer than the government-insured sort.
And whereas the FMIC’s benefits are debatable, the costs are not. Stripping all risk from markets removes investors’ incentive to check on the lenders they are buying bundles of loans from. It is true that those making the loans will have “skin in the game.” But shareholders have a poor record in constraining red-blooded CEOs. This is why most other countries are trying to get bondholders to provide more market oversight, not less.
For those who would like to see the government out of the mortgage industry, there is a chink of light. The Johnson-Crapo bill deliberately backs away from the full privatization under consideration in the House of Representatives and attempted in the Senate three years ago. But it includes a requirement, eight years in, to assess whether the FMIC could be privatized. The problem is that history, and Washington’s enduring fondness for state-supported lending, suggest reasons will be found to keep it in government hands.
© The Economist Newspaper Limited, London (April 12, 2014)