My Most Libertarian Post Ever

By James Kwak

(Yes, I know that isn’t saying much.)

Most people think that Fannie Mae and Freddie Mac had something to do with the financial crisis. Some people think that they were the major reason the crisis happened, which (to them) proves that activist government policy was the cause of the crisis. Other people, including me, think they were a modest contributing factor because they did buy a lot of securities that were backed by subprime loans, but they were well behind the curve when it came to mortgage “innovation” and the creation of toxic assets. But that’s not the question here.

The question now is what to do about them. Although they had been private, profit-seeking companies for forty years, they were taken over by government regulators in September 2008 when they had become clearly insolvent, and are still being operated in conservatorship. Because Fannie and Freddie were very, very long housing, they have suffered massive losses since the financial crisis began. But because the private mortgage securitization market has collapsed, they are the bulk of the secondary mortgage market at the moment, which means the housing market could collapse without them.

On Planet Money a couple of weeks ago, Bethany McLean and Joe Nocera took the cutely counter-intuitive position that the most bizarre mortgage product is the thirty-year fixed mortgage — and that it wouldn’t exist without Fannie and Freddie. Basically, their argument goes like this: Borrowers like thirty-year fixed-rate mortgages, but lenders should hate them. Because of the fixed rate, they carry interest rate risk, meaning that if market interest rates rise the value of the mortgage asset will fall. (If you hold it to maturity, you will still get the cash you expected, but if you are a traditional lender you are funding the mortgage with short-term liabilities, and the interest rates you pay on those will go up — as happened to the entire S&L sector in the 1970s.) Furthermore, they carry credit risk, since lots of things can happen to borrowers over thirty years, and as a result they might not pay you back.* So, according to McLean and Nocera, no banker in her right mind would sell such a product — not, that is, without Fannie and Freddie there to buy the mortgage and take the risk off her hands.** Their punch line is that although Americans like to complain about government intervention in the mortgage market, Americans also want their thirty-year fixed-rate mortgages, and you can’t have one without the other.

But this argument doesn’t make complete sense to me. If thirty-year fixed-rate assets are bad, that means no one would buy thirty-year U.S. Treasury bonds, yet people do (at 4.53 percent). A bank could originate a thirty-year fixed-rate mortgage and just buy an interest rate swap to hedge the interest rate risk. And if banks didn’t lend money to people because lots of things can happen to them that might interfere with their ability to repay, then they would never make business loans. Most businesses have much more volatile cash flows than someone with a good job. The first hedge against credit risk is the fact that you’re making lots of different mortgages to lots of different people, so you diversify away the specific risk in any given household. Now, it’s harder to hedge market risk — in this context, macroeconomic factors — especially if you do your lending in a local market. So the second hedge is that the mortgage is secured by the house, which means that as long as you have a reasonable loan-to-value ratio the bank is probably safe. And in any case, if you’re in traditional banking, macroeconomic risk is just part of your business.

The above also assumes that lenders are holding onto their loans. If they can sell their thirty-year fixed-rate mortgages on the secondary market, then the “problem” is completely off their hands. Yes, Fannie and Freddie are big players in the secondary market. But there’s no law of nature that says you can’t have a secondary market without them. What you need are standards, so that mortgages (or mortgage-backed securities) can be traded without investors having to look into every single mortgage. (For example, the development of standards for corn in (I think) the nineteenth century made it possible for different farmers to dump their corn into the same bin at one end of the railroad and for different buyers to take their corn out of the same bin at the other end — without every buyer having to verify her seller’s corn.) That’s one thing Fannie and Freddie provided with the conforming mortgage standards, but again, there’s no law that says that standards have to be set by companies with implicit government guarantees.

In fact, until recently we had a big secondary market for mortgages that didn’t rely on Fannie and Freddie — private mortgage securitization. Now, yes, I know as well as anyone that this turned out to be a big disaster. It turned into a disaster because the “standards” were set by credit rating agencies. But instead of setting strict criteria for underlying mortgages and then verifying that the actual mortgages met those criteria, the rating agencies used statistical models that attempted to predict how new, varied bundles of mortgages would perform, and they didn’t even do a very good job of verifying that the actual mortgages were consistent with the models. So in the end you had a secondary market that was vastly overpaying for crappy mortgages, and when everyone realized that, the market vanished.

So let’s think about what might happen if Fannie and Freddie didn’t exist. People would still want thirty-year fixed-rate mortgages, so some bank would try to originate them. That bank might just hedge the interest rate risk with interest rate swaps and hold onto the credit risk. Banks held onto the credit risk during the postwar boom. [Fixed, see below.] In 1960, for example, banks and thrifts held about $116 billion in home mortgages; government-sponsored enterprises held about $3 billion, with about zero in mortgage pools.***

Alternatively, that bank might try to package and resell mortgages on the secondary market. It doesn’t really matter if they are sold as packages of loans or as tranched mortgage-backed securities. The important thing is that there are verifiable and verified standards so that investors don’t have to inspect all the mortgages. That could be a private sector function, or alternatively there could be a government agency to define conforming mortgage standards and verify that the loans in a given pool comply with those standards. But the government agency doesn’t also have to be buying the mortgages. If investors can be sure that mortgages are what they say they are, then someone will buy them: pension funds, insurance companies,**** hedge funds, rich people, etc.

Now, the question is, how much will they pay? The Planet Money episode with McLean and Nocera cited Bill Gross of PIMCO saying he would demand an extra three percentage points in yield for a mortgage without a Fannie/Freddie credit guarantee. Although Bill Gross is no doubt one of the smartest investors in the world, there are a couple of reasons to doubt this.

There are at least two ways to estimate what mortgage rates would be without Fannie and Freddie. First, we can look at Fannie and Freddie themselves. Until 2008, they were profit-seeking companies, meaning that they were already paying as little for mortgages as they could. Their competitive advantage in the market was their implicit government guarantee — people thought that, in a crisis, the federal government would bail them out and protect them from default — which meant they could borrow money more cheaply than, say, banks. Without Fannie and Freddie, the new replacement buyers would have higher funding costs, so the increase in the yields they demand should be roughly the same as the difference between their fundings costs and those of Fannie/Freddie. Major banks these days have credit ratings around A, which means they pay about 80 basis points more for seven-year debt than do Treasuries. (I use seven years because that’s roughly the average time before a mortgage is paid off.) Even if Fannie and Freddie were paying the same yield as the Treasury Department, that means that mortgage rates would only be about 80 bp higher without them.

Second, we can look at the spread between conforming mortgages and jumbo mortgages (which are too big to be bought by Fannie and Freddie). A quick search yields this paper by Anthony Sanders, which cites several other studies (see Table 1) that show the spread to be between 16 and 40 basis points.

(Now, Bill Gross might still be right. In today’s market, if a mortgage isn’t guaranteed by Fannie or Freddie, there must be something wrong with it, so maybe you should demand 300 bp more to buy it. But that’s an adverse selection problem that wouldn’t exist without Fannie and Freddie.)

So according to the back of the envelope at least, a world without Fannie and Freddie would not send mortgage rates into the stratosphere. But more importantly: so what if it did?

The immediate response is usually that middle class families wouldn’t be able to buy houses. But this isn’t quite right. Higher mortgage rates mean buyers can’t spend as much on houses. But that means the demand curve would shift down and housing prices would come down; people would still need to move, they would still need to sell their houses, and the market would clear at a lower price level.

The market would also clear at a lower quantity, which means that over time the homeownership rate could go down. But this isn’t as big a problem as it sounds. It’s not like a consumer product market where lower quantity means less stuff. We’ll still have the houses we have; they’re not being destroyed. In fact, the current problem with the housing market is that we have too much housing stock for the number of households in the country (a point often made by Calculated Risk). Since housing at the margin can shift between homeownership and rental, whether a housing unit is used for one or the other doesn’t matter from the standpoint of total production. If we want to soak up the glut of housing, we need new household formation (e.g., people moving out of their parents’ houses). That is more likely to occur if the price of housing comes down. And only when the glut is soaked up will there be a reason for developers to build more.

Instead, one major effect of higher mortgage rates would be distributional: lower housing prices would hurt people who own houses (like me) and help people who don’t. In general, this means hurting the rich and helping the less rich, and that sounds like a good thing to me from a simplistic Rawlsian perspective. But that’s probably the main reason why our government has spent so much effort subsidizing mortgages and propping up the price of houses.

Then there’s the wealth effect, which is fictional on the one hand but unfortunately real on the other. If you have $100,000 in cash and a $300,000 house, and tomorrow the value of your house falls to $250,000 because all housing prices have fallen, you are exactly as rich as you were the day before for most practical purposes, assuming you still want to live in a house. You still have $100,000 and one house.(There are exceptions, like if you plan to move someplace where houses are cheaper, in which case you will end up slightly worse off.) But unfortunately, you feel $50,000 poorer, and that may crimp your consumption, hurting the economy. So if we’re going to move to a world where the government doesn’t suppress mortgage rates, we’ll have to do it gradually.

So here’s my not-very-thought-through proposal: Fannie and Freddie should continue doing what they are doing, as wards of the federal government. But every year, for each $1 in assets that get paid off, they should only invest $0.50 in new mortgages (the rest should reduce net debt). So gradually, over the next 15-20 years, their balance sheets should shrink to small fractions of what they are today, and then they should be shut down as borrowing and investing institutions. As I said above, I think it’s possible and perhaps preferable to keep them in the role of defining and verifying conforming loan standards so that investors have some confidence in securities backed by those mortgages.

Yes, this would be a big experiment. But we’ve had a big experiment in subsidizing homeownership, and I’d say it hasn’t worked out too well.

Now, to reassure regular readers of this blog, I’m not against subsidized mortgages because I’m against government subsidies in principle. I just think government subsidies should be saved for things that are worth subsidizing — like fruits and vegetables, for example. I should add that I’m no expert on Fannie and Freddie and I’m willing to be talked out of this position. But it seems to make sense to me.

* Actually, there’s a third kind of risk: prepayment risk. If interest rates go down, borrowers will refinance and pay off their mortgages. As a lender, you still get your principal back, but now you have to reinvest it at a lower interest rate. But Fannie and Freddie didn’t do anything about prepayment risk anyway — that was still the principal risk faced by investors in mortgage-backed securities.

** In fact, for the most part, Fannie and Freddie don’t buy and hold the mortgages outright. They create mortgage pools that issue mortgage-backed securities that have a Fannie or Freddie guarantee. At the end of 2009 the government-sponsored enterprises had $700 billion in home mortgages, while the pools had $5.3 trillion in mortgages, according to the Fed’s Flow of Fundszy report. Since the beginning of 2010, most of those pools are now consolidated on the Fannie/Freddie balance sheets, presumably because they are still on the hook for losses.

*** The originate-and-hold model did run into problems in the 1970s, but that was primarily because of volatile interest rates, not because of credit risk. Interest rate risk can now be hedged using interest rate swaps, which weren’t invented until 1980.

**** In 1960, life insurance companies held $42 billion in mortgages.

Update: Arnold Kling caught a mistake above. Originally I said “That bank might just hedge the interest rate risk with interest rate swaps and hold onto the credit risk. This is what banks did during the postwar boom.” I meant to say that banks used to hold onto the credit risk, not that they used interest rate swaps. I know that interest rate swaps didn’t exist back then (that’s a point made elsewhere in the post). My point was that banks used to hold onto both interest rate and credit risk, and that model broke down because of the interest rate side, not the credit side. And on the interest rate side, you can use swaps today. Now, maybe there aren’t enough people who want to take the other side of that swap, but there are plenty of pension funds and life insurance companies who need thirty-year assets.

59 responses to “My Most Libertarian Post Ever

  1. What to do with Fannie and Freddie
    by John Hempton, Bronte Capital

    There are a bunch of ideologues out there with solutions to the Fannie and Freddie situation. They argue that government intervention has to end and then propose a system with a permanent role for government. It is not just nonsensical – it is usually in the interest of some large financial institution. All they want is Frannie out of their part of the business. They like government subsidies in the rest of their business.

    Anyway I have the free market solution to the Fannie and Freddie situation – and – I hate to say it – it is dead obvious.

    Answer: raise Frannie’s pricing.

    read more at http://brontecapital.blogspot.com/2011/01/what-to-do-with-fannie-and-freddie.html

  2. Michael Sterling

    “Major banks these days have credit ratings around A, which means they pay about 80 basis points more for seven-year debt than do Treasuries. (I use seven years because that’s roughly the average time before a mortgage is paid off.) Even if Fannie and Freddie were paying the same yield as the Treasury Department, that means that mortgage rates would only be about 80 bp higher without them.”

    Correct me if I’m confused, but haven’t you argued persuasively in the past that the major banks’ borrowing costs are subsidized by the implicit government guarantee that their TBTF status grants them? Now it may be that you’re right that rates would only go up 80 bp, but it doesn’t seem right to say that those rates would be free of any government subsidies.

  3. Most countries actually don’t have 30-year fixed mortgages. In the UK, for example, most people have variable-rate mortgages or “tracker” mortgages (i.e. they track the Bank of England base rate) – and even if you get a fixed-rate mortgage, it’s only fixed for 2-5 years. This comparative approach suggests that despite your reasoning, without Fannie and Freddie, you indeed don’t get 30-year fixed mortgages.

  4. If you believe the folks who make up derivates it should also be possible to make up a pre-payment risk derivate. (Anyway today its not something you have to worry about rates aren’t going to go lower) so that today its the churn of housing, which is somewhat well understood.
    In fact my model of mortgage is 1 Standard is a 5/30 arm, but, you can pay a fee for a fixed interest rate longer (the bank slices the swap it buys up and passes the cost on explicitly). Then you can buy a more lenient pre-payment penalty than 3% of amount paid in the first 5 years for yet another fee. Unbundle the features and charge for them. For example if you are not planning to stay in a place for more than 10 years, you might just buy a 10 year fixed rate.

  5. I’ll ask you the same question I ask people who want to phase out the home interest mortgage tax deduction:

    What are you going to do with state and local governments—who cannot monetize their debt—who will take a huge hit on property tax revenues when you suppress the housing market relative to the baseline?

    These governments are already in big trouble. Get expertise in Chapter 9 bankruptcies and profit?

    Please remember that much of these taxes go into things that have very important effects on housing prices themselves, like schools. It could create a runaway effect in some cases.

  6. James –

    There are a few minor misconceptions in this = especially vis the viability of thirty year mortgages. (The issue is refinanceable 30 year mortgages.) Anyway – contact me – I think we can both benefit.

    John Hempton

  7. Terrific post. The Planet Money crowd struck me as the least understanding of and the least able to question the arguments made about the market. Hence, I stopped listening to them in somewhere in the first quarter of 2009.

    I like your solution to Freddie and Frannie. The government needs to get out of these quasi-private entities including the USPS.

  8. In the 1950s, steelworkers, autoworkers and teachers bought their first houses with 10 year fixed rate mortgages. Most were retained by the local bank.

    Mortgates once came standard with pre-payment penalties which transferred some of the interest rate risk back to the home owner.

    Long before the current crisis hit, plenty of individuals bought CMOs (Collateralized Mortgage Obligations) accepting both interest rate (a two pronged problem since higher rates lengthened average maturities) and pre-payment risks in exchange for a higher yield. There were plenty of popular mutual funds that invested entirely in CMOs. The same individuals also bought Freddie and Fanny bonds with their implied federal backing.

    Variable rate mortgages in a steady interest rate environment would be best for both buyers and lenders.

  9. Keenan Parsons

    They make similar arguments in their book “All the Devils Are Here”.

  10. When the laws were changed and architects no longer were required to sign off on “housing developments”,

    one of the most enduring achievements of any great civilization – architecture – was tossed into the predatory usury bin.

    Architecture took in so many different elements – environment (weather and location), access to trade routes and constant transportation access (why are the biggest cities on waterways?), stability of FAMILY friendly communities, proper amount of space for maximum human health and hygiene,

    not to mention CONSTANT INNOVATION in building materials and methods…

    I am honestly appalled at the ignorance and shallow disdain of James Kwak on the topic of housing. You need to leave the stage on this one, Sir. You got nothing to offer in the way of contributing something of lasting value to the progress of history history through the BASIC necessity of housing.

    It’s the ONLY thing a woman needs. A safe place to nurture a hapless infant. What the hell is wrong with you, James, when it comes to this topic?

  11. Herbert Wetherby

    Prior to that, once the mortgage was paid in full. The broker would deliver a mortgage button to your house, which was mortised into the colombe to be admired by individuals invited into your home. It was a simpler time, when neighbores helped one another to further a community and enhance the efficiency of the local economy.

  12. these governments need a new cash stream. States could, for example, increase their income tax rates (which would be healthier for them and their citizens IMHO) or, if they wanted to be regressive, could increase sales taxes, lisencing fees for cars, hunting, etc. There is really no end to the ways that states and municipalities could gain new revenue, it’s just that property taxes are relatively “invisible” taxes, so are more palatable to the electorate.

    SOCIETY COSTS MONEY PEOPLE, lets stop pretending it doesn’t or that Mr. Laffer’s Curve will always make reducing taxes beneficial. Lets also stop hobbling our state and local governments by making their primary revenue stream something as volatile as taxes based on real estate values have proven to be.

  13. I disagree with some of your characterizations, but I’ll get to that at the end. Even if you’re right,though, the point of my first comment is: *how*?

    Your suggestion is that in order to implement a slightly more ideal mortgage marketplace, we have to implement a vastly more ideal state and local tax system. You are compounding the impracticability, which only makes my point for me.

    But, there are some states where income taxes are barred by the state constitution. California–about 10% of the population and economy of the country–has a hard cap on property taxes which has, in fairness, “artificially” *inflated* the property market, but requires a state-wide referendum/initiative or 2/3rds vote in the legislature or local referendum/initiative for *any* tax increase. You’re never going to be able to reform the taxing policies of 50 different states just to accommodate some wonkish reform like this. So, that means, if it happens at all, it will do exactly what I said it will and put more state and local governments into insolvency.

    I’m all for good policy solutions and I don’t mean to interpose political problems into them. (Obviously, none of this is politically likely.) But the point is that there is more than just the calculation put forth in this post that has to be considered in the *policy*.

    Kwak is saying he thinks this is a bad use of government subsidy. Before I even consider debating that point, I want to how many eggs we have to break to make this omlette. How many angry homeowners are going to turn against this kind of “reform” and only make it less likely?

    Finally, this whole notion that all we have to do is improve which subsidies the government is making is silly. We all know that a cancelled one won’t be replaced with a better one, if at all. Most likely, it will just be cancelled.

    Now. I’m not entirely sure income taxes are more or less regressive than property taxes, and I would think that anyone arguing in favor of the above-presented solution seems to think that unfairly advantaging people’s large balance sheet wealth in their houses is wrong and should be stopped because it’s “artificial.” In the econowonk world, they’ll just sell their house and get a cheaper one, right? Maybe, but in the real world people get far more pissed when they have to sell their house and move than they do with a little more income tax. You seem to agree on the latter point, which just makes me confused as to why you think it’s bad to subsidize home equity wealth through “artificially” low mortgage rates but not through “artificially” low property taxes.

    I agree society costs money. I tend to think that getting people to pay the most with the least resistance is the best way to go about it.

    If nothing else, I would think that in the last few years we should have learned how chimerical economic perfections can seem in the face of people’s natural need for home and hearth.

  14. The comparative approach you’re talking about would be relevant if we were talking about designing a system from scratch. We’re not. You’re talking about changes for the sake of–what exactly, I’m not sure–that with every basis point blip causes real human suffering and intense resistance.

    Ab initio the 30-year mortgage may be stupid. But we’re not talking about getting there for zero; we’re talking about getting there from here.

  15. I’m not sure what this means, but I think tinkering with the housing market (even more than it was “tinkered with”)–remember this is the centerpiece of the “American dream”–makes the so-called “third rail” of Social Security pale in comparison.

    All of this tinkering with this or that housing “subsidy” or tax deduction etc. is so much policy masturbation that will not occur in our lifetimes (unless of course it is somehow for the benefit of “THE MARKET”).

    To paraphrase the author, I’m not against economists wasting time on mortgages because I’m against economists wasting time. I just think economists’ time should be saved for things that are worth wasting them on.

  16. I disagree with the assertion that “People would still want thirty-year fixed-rate mortgages, so some bank would try to originate them.”

    Demand does not generate supply in the banking sector. Just because I’m not feeling great about getting only 25 basis points on my savings account doesn’t stop me from saving money in it. Demand for better returns on savings investment will not create them.

    According to Robert Shiller’s iTunesU lecture, in the 1930’s bankers only wrote for 7 years interest only loans with a payment for the principal due at the end. Most home owners opted to renew the loan because they didn’t have the cash. If no bank wants to lend long, they don’t have to, regardless of demand. The 15 year amortized loan was not created by demand but by government intervention.

    And stop calling Freddie and Freddie QUASI anything. They never were. They are not now.

  17. Michael Hudson comments on the FCIC final report:

  18. Yeah, HW, I remember when the standard was the 20-year mortgage. And nobody said “fixed rate” because nobody had thought up anything else. And I’m not THAT OLD.

    You guessed it, buddy. My house is paid off. Of course, it ain’t worth jack because of what the jackals have done to my community and its housing market. So it goes…

  19. Bayard Waterbury

    James, this is an interesting, even fascinating article. First, I would point out that people who purchase homes and finance them, generally do so to reside in them, and not as an investment. Few people stay in the same home for more than ten years, and the median time of ownership is probably in the realm of seven years. When they sell the loan is paid off (except for the rare assumption), and so the bank has all of the money back to invest. Rememmber that the interest (at every rate) is “front loaded” due to amortization, and, therefore, aside from fees earned during the origination of the loan, the “margin” or “spread” gained in the discounting process (90% of the time it is there), and the money it may make from securitization (or participation in that process), the bank is engaging it a very high profit exercise. Traditionally, the default risk is actually nominal, especially on “fully underwritten” loans. And, one last matter, the turn on mortages to account for both sales and refinances is probably somewhat less than five years. In any case, the main reason why the market blew up was because everyone in the chain, from borrowers to loan officers to banks, to mortgage companies to investors got addicted to what the market was giving them, and that meant stepping into loans where they shouldn’t have gone. Once the ratings agencies decided to go blind, and underwriting standards vanished, this was inevitable. I saw it coming 15 years ago. What amazed me then is how long it took for the wreck to occur, and what amazes me now is that everyone seems to think that we are done with the outcome. No chance, even if Fannie and Freddie ultimately heal somehow. The economic malaise is not going to vanish no matter how many trillions Bernanke decides to pump into the economy. Of course that only raises other issues without actually taking care of the original problem.

    I really love your suggestion for Fannie and Freddie. In the current market climate, the 50% of receipts would be fine, since activity is way down at present.

  20. James,

    A couple of things:
    1. The US 30 yr PREPAYABLE fixed rate mortgage does (as far as I know) not exist anywhere outside the US. In addition, virtually nowhere are mortgage debtors able to walk away if their house is worth less than the mortgage. These two things should make them uniquely unattractive to most investors. Without the securitization market (slicing and dicing) , there would probably not have been much lender appetite during the past 25 years. Now, with much of the origination and handling apparatus in cold storage, interest rates at long term lows and the future of house prices generally perceived as much more uncertain than a few years ago, even a bundle of loans with well diversified credit risk would not make an appealing investment, despite the fact that prepayment risk is less than it would be with higher interest rates (but prepayment is not only driven by refinancing, there are more factors, plus, I guess PIMCO has a point: this stuff would demand a considerable premium over treasuries with similar duration (if anyone knows what the durations of these is in the first place) and as the premium goes up, so goes the nominal rate and hence the prepayment risk.

    2. What would you do with Ginnie Mae?

    It would be a good idea now the US gvt-in-disguise- is now the main mortgage lender, to strip the product of is main risks (prepayment risk, long maturities, default consequences), nationalize Fannie and Freddy, merge with Ginnie, bring the whole lot under Fed supervision and switch to bank-like regulation, in order to ultimately truly privatize these things. I would like to add to that a reduction in fiscal stimulus as well but that may be a bridge too far.

    OECD and IMF appear to be in complete agreement with this but it is clearly outside the capacity of US gvts to change this system: probably the world’s most spectacular example of gvt intervention to correct a market failure greating much bigger problems that the original one.

  21. Not sure we have a choice here James. As I have told both Joe Nocera and Peter Wallison, be careful what you wish for. The GSEs provided the illusion of a commodity market in home mortgages. We are now going back to the pre-1938 model of originate to retain. I think the private sector can replace the GSEs, but so many of our fellow citizens are financially illiterate that the prospects for success are small. We have a market of agents who in theory represent the beneficial party. And none of them can either price a mortgage or follow the option-adjusted duration of an MBS. The GSEs are fascist models true a la FDR, but also very convenient. Just ask Barney Frank and Chris Dodd, the realtors, the mortgage bankers, home builders, Wall Street dealers, etc.

  22. Doesn’t Dean Baker argue that the problem with F&F is their transformation into public/private entities under Clinton’s Robert Rubin driven neoliberal Administration, so that F&F engaged in high risk activities to drive profitability (and executive salaries) while having the implicit backing of US Fedgov.

    This public-private model, in turn, became the model for the entire financial sector bailout–now every sleazy effectively unregualted (or actually unregulated, in the case of hedge funds) “too big to fail” financial entity has that very same Fedgov guarantee, codified into law in the so-called “financial reform bill” during Obama’s neoliberal Administration.

    During the Cinton era principled LIBERTARIANS, as distinguished from simple minded pro-business (therefore) antigovernment “libertarians,” disliked the F&F public-private model because Fedgov backing an institution run like a private corporation would generate excessive moral hazard. (They might also have preferred to get rid of F&F entirely, but that’s a separate issue).

    I think the bottom line is that if you look at the career of Robert Rubin, you will see that it is singlemindedly devoted to bringing about the fusion of the state and the private financial sector, with latter riding herd on the democratic process. Just think of the Latin American bailout, that he engineered before being hired by Citibank, while doing an end run around Congress.

    F&F were a critical model and a tactical lynchpin in generating political acquiescence/acceptance for a government supported high risk financial sector amongst *liberals and Democrats,* the point on the ideological spectrum (apart from principled libertarians (of which there few)) where you would least expect it.

    It’s working. Establishment Democrats and their legions of teabag hating culture warriors aren’t thinking about the implications of this at all.

  23. Econtalk podcast on this subject:
    http://www.econtalk.org/archives/2010/07/kling_on_the_un.html

    Guest Kling agrees mostly with Nocera/McLean (that 30 yr fixed would not exist). There is discussion about how to value the “embadded options” — “default option”, prepay option.

  24. Three cheers. Nice post.

  25. @ jon-erik

    It means that there’s too much room for monkey business in the home mortgage markets, period! Thirty, Twenty, Fifteen, Ten, and Five, and variables just to monkey-wrench up the econowonks’ thesis.
    Homeowners like the fact that their children have a secure future predicated on their *own* terms. Schools, neighborhoods, tangible environment extremities void of any disenfranchisement through interpersonal selection which is a plus when so many questionable exogenous freedoms are at a flighty premium today?
    Granted families are a lot smaller than the past…where we slept three (my poor family) brothers in a room the size of todays walk-in closet. Where a top slot, or bottom on bunk-bed row meant alpha-dog supreme? Yea, big families no more, but they do make great practical use for the “Extended Family” – coming to your neighborhood for the next generation or so,..? Yep, it surely is getting more and more amazing to see historical via empirical outcomes – these ghosts of the past now being fingerprinted? Indeed, just one fragmented section called housing, from the devastating effects caused solely by repealing the Glass-Steagall Act. Thinking backwards again…”Life Insurance Co’s” holding $42 bn in Home Mortgages back during the 1960’s! Wow! This is the bottom-line?

    Thanks James and Simon :-)
    PS. Looks like a few are beaten you up again today – should certainly help your Law Career. Excellent Post as always!

  26. Housing discussions today are driven by interest rates or financial sector points of view. However other factors beside interest rates and secondary markets impact housing cost. Most housing built over the past 40 years has been part on the ever expanding urban landscape converting AG and open space into suburban tracts. These tend to be larger and more expensive homes then erected in prior times and require homeowners to own several automobiles capable of commuting long distances. Homes two thousand sq ft and larger are the norm and as they age maintenance costs for windows,roofs, heating,air conditioning, remodeling become significant direct out of pocket costs.
    Rising fuel cost, high home maintenance costs, automobile necessity, will become greater parts of the housing afford ability landscape.

  27. Great post, and lots of great, well-written responses.

    On the whole, I’m with JK. I think his logic is very sound on this one.

    The most intriguing counter-argument is by Jon-Erik, IMHO, as I do want to get there from here, and we can’t rewrite history. However, I don’t think your arguments are strong enough. You can’t just cave to the monstrosity that is Prop. 13 and leave yourself hostage to cities who want property tax revenue.

    You have to demand that those wrongs be righted, too.
    I never said it would be easy, but we should at least ask for things to be better as a system. It sure wasn’t pleasant how our current system handled this crisis…a lot of eggs were broken already. I’m ready to take a chance on less eggs being net broken with JK’s good ideas.

  28. Appendum

    Ref: “Commentary: A Financial Frankenstein” ,by Lou Grumet (1/5/09)

    http://www.accountingtoday.com/ato_issues/2009_1/30108-1.html

  29. Most countries speak languages other than English. If we shift to, say Chinese, we should be able to communicate perfectly. Does that mean the switch would be painless?

    You may be right that maybe the US does not need 30 year mortgages … but your logic does not get me there.

    Not having 30 year mortgages means higher monthly payments and/or lower home prices. People will feel poorer. Less local taxes will be collected leading to worse local deficits.

    I would rather pay $300 Billion dollars once every 60 years if that is the price for having a housing system with GSEs that is proven to work. (And, mark my words, the final cost will end up much much less that that.)

  30. You are perfectly right, sir.

    Maybe that is why James Kwak titled this a “Libertarian” post. This idea that we can and should institute a system that hews to impractical ideals, no matter who pays what price, does certainly have a Libertarian flavor.

  31. Enforce capitalism and existing laws,every negative equity homeowner is entitled to a similar financial incentive to remain a negative equity homeowner based on the precedent set.

    Now the question becomes,do we give principal reductions cripppling Wall Street or do we do a true
    Negative Equity Streamlined Uniform Modificaton System as proposed on the petition of Unitedinprosperity.org to stop unnecessary taxpayer losses while allowing the profits to remain private, any questions, email me directly.

  32. I think the comparison with other markets is essential – as noted by some others here, the long-tenor fixed rate mortgage is for the most part non-existent in other countries.

    The question about the long-term fixed rate no-preypayment penalty mortgage is to a large degree about how much extra it would cost if priced to bear the full risk – and whether it would see much (if any) demand at that price. Check the pricing at Canadian banks, keeping in mind that the rate differentials between long and short fixing periods are low by historical standards, and these are recourse, prepayment penalty mortgages; beyond ten years is basically non-existent (and above five years a minuscule portion of the market).

    Your interest-rate swaps argument has a little too much of the waving-of-the-invisible-hand/deus ex machina. By which I mean, long-term interest rate swaps have a counterparty risk problem – yes, you can book swaps, but how good are the counterparties? (Or following the logic of TBTF banks and how bad they are, the money-centre banks that dominate the swaps markets are effectively subsidized by the state – because they can’t be unwound). Would the long swaps market be deep enough or cheap enough?

    I believe it would simply disappear if fully priced. But there’s an easy way to find out – raise Frannie’s prices quarter by quarter and see if anyone else offers it.

  33. Bruce Krasting

    You suggest that a bank with a single A can borrow at 70 over and should be more than happy to lend at 80 over. You have your numbers wrong by a big figure. To entice a holder they have to have at least a 1% carry.

    So you and John Hempton above come to the same conclusion. Mortgage interest rates have to rise (as a spread to Treasuries) and there has to be prepayment penalties.

    Fine. I agree. Raise prices (and credit standards). Never book a loan that did not have 20% equity and a yield that allowed for it to be sold to a willing investor. If we do that the mortgage problem will go away and we can stop worrying.

    Baloney. If we do that housing will flat out nose dive.With it will go the broader economy. We will have wasted all the money spent on ARRA,TARP,ZIRP and QE.

    Drag out the necessary changes over a decade you say? I say we won’t make it ten years before we blow up.

    Sorry guys. There is no solution. Every direction is trouble. Big trouble.

  34. Herbert Wetherby

    Sorry guys. There is no solution. Every direction is trouble. Big trouble

    Its too bad you are in that pickle, our direction is right on par with our goals. Everybody agrees too. Like is wonderful with our small town.

  35. Enronistas sucked out currency that should have been flowing to modernizing the electrical grid,

    health insurance companies (CEO packages of 1.8 BILLION) sucked out the currency that should have been flowing to clinics, hospitals and health care providers (mano et mano, so to speak)

    mortgage schemes in USA have sucked out the currency that should have been flowing to MODERNIZING the cities and cross country infrastructures (flood control, clean waterways, etc.)

    And all these schemes are FRAUD.

    This planet is everyone’s HOME. When everyone on the planet looks at what has happened to USA (Detroit, for example) and visits this site with its autistic policy masturbations (great phrase, btw)

    then looks at the winners of the “how to become a billionaire” game – a global cabal of war lords and drug lords

    well, no matter what scheme is concocted next to throw WOMEN and CHILDREN out into the gutter

    whatever the new MORTGAGE shell game will be

    it doesn’t matter.

    What is worthy of note is the timing of this particular pull out the rug and throw them out (USA history is very consistent when it comes to create homelessness – it’s a tradition)

    everyone was going 75 miles per hour with INNOVATION in architecture – energy efficient, inner food gardens, building materials, etc.

    we would have CUT the dependence on foreign oil in a decade by, obviously, and unacceptable amount simply through HOME building and how EVERYTHING else in civilization flows out through that BASIC necessity.

    So you can all shove this autistic math where the sun don’t shine – it went too far, too fast.

    No one has a moral obligation to bend a knee to war lords and drug lords – especially when they go so far as this “foreclosure” scheme.

    You all might want to start calculating how much it is going to cost you to pay off the stupi USA born and bred citizens from – how’s that song go, ah yes, “burning down the house”…

    blow it up so we can re-build – 2 billion a week in the Kyber Pass…?

  36. The best solution is to raise property taxes; actually, to split the tax into a land component and an improvement component.

    If the land component is extremely high, then the rent generated by the land will go to the state instead of rentiers.

    Future homeowners come out ahead: the NPV of what they owe for the land under the house they buy is the same, but they pay less in non-property taxes because of the revenue generated by the land tax.

    It’s been known for more than a hundred years that the real secret to a dynamic economy is for government to tax rents before other things.

  37. Herbert Wetherby

    During the neopolitian wars, Europe was ravished and had to look to the U.S. for its food. Farmers began to make a profit for the first time. That was when property taxes sky rocketed to point where the farmers gave a hugh portion to the gvt at the same time the citizens could not afford the food grown here because European money sent the food over there.
    The war ended, but the taxes did not, and have actually risen steadily ever since.

  38. I really like this post. On balance, I tend to look at things from an environmental perspective first and I would be happy if the suburb building industry shut down entirely. There is plenty of space in the inner-ring suburbs and in the cities to rebuild as new housing stock is needed, but let’s quit spreading further out.

    The subsidized housing market was an environmental disaster long before it was an economic one. It’s already done enough damage: let it die. Let Fannie and Freddie go away. Force people to save some money to buy a house again. I also have a feeling that as fewer people get in a rush to buy houses, houses will become more affordable and saving won’t take so long.

    I bought a really cheap house at the height of the market. I don’t think I am going to take a bath on it because it didn’t cost much in the first place (the boom never quite made it to North Philadelphia), but I wish the lender had told me no at the time. I wish I’d never bought it. I just don’t like being a homeowner. It isn’t fun. I wish I’d kept renting and now I am all stressed about getting out.

    In a more restricted world, people would have to spend a lot more time working to buy a house. I put $1500 down on $57K house. I wish they would have said, “No, no– you need $12,000 before you can buy.” That would have been great.

  39. @BradyDale: back in the day, when my ex- and I bought our first house, a standard mortgage was for 20 years, you couldn’t get one for more than 3 times your annual income, and you had to put a minimum of 20% down. We borrowed the down payment from my mom, but we paid her back. Of course, that was in the bad old days of strict banking regulation.

    With your interest in the environment, you might want to check out the case for steady state economics and perhaps even sign the position statement at http://www.steadystate.org.

  40. Yes, you’re right about that. The paper I cite above does mention that if you calculate a Fannie/Freddie subsidy on top of bank pricing, you’re calculating a subsidy on top of another subsidy.

    But the latter, it seems, is not going anywhere anytime soon.

  41. Damn Annie,
    I love you. Yeah, other than monopolies in Banks, Insurance(Health and Life and Auto), Drugs(Legal), Media, Universities(expodential hikes in the last 15 years), Military Equipment, Oil, Gas, Utilities, etc etc., everything is Just fine..

    Anyway, you got my vote for any office you desire.

    All restrict competition and you know, actual investment HERE.

  42. Here’s a libertarian idea for you James.

    Close the Fed’s discount window to those who were considered too big to fail but are now just sucking down unknowable amounts of federal lent money at rock bottom prices only to loan out for a big profits or worse yet, betting it all on black (or Facebook).

    Can someone tell me the difference between a GSE and Goldman Sachs? If not, the Greenspan Put has now been covered and raised by the Bernanke Put.

  43. Could some please explain this sentence????

    Because of the fixed rate, they carry interest rate risk, meaning that if market interest rates rise the value of the mortgage asset will fall. (If you hold it to maturity, you will still get the cash you expected, but if you are a traditional lender you are funding the mortgage with short-term liabilities, and the interest rates you pay on those will go up — as happened to the entire S&L sector in the 1970s.)

    How does a bank fund a 30 year mortgage with short-liabilities? Does the home seller demand all the money at once? What type of instruments would they be? I’m confused….. x^P

  44. The FEAR and trembling in D.C – and the machinations of delusional PRETENSE that the “elite” are in charge of the future because they have BILLIONS in useless paper –

    is that WE THE PEOPLE are actually going to go ahead and have that Constitutional Convention.

    WE have no other MORAL choice. Plus it is our LAW – read it. This “cycle” of stealing wealth is the only thing that history books are full of, so OUR “founding fathers” stated that anytime “x” kicks in

    WE HAVE THE CONVENTION to amend the Constitution.

    Am I really the only USA born and bred person on this blog!!!???

    We could also show the other countries struggling against the same global cabal and for the same reasons as us how to get it done :-) Time to get Rosa Parks about it – give THEM the “YOU are crazy” facts…

    And than you for your vote, 1 Kings – we’ll wait together for the white smoke and cheer my crowning as “Pope Annie” – spiritually infallible and living in some great digs – what a great job, eh?

    LOL

  45. oh, and BURN THE PATRIOT ACT…

  46. Well, yes refinanceable 30-year mortgages carry pre-payment risk (to the lender) but there’s a compensating benefit.

    As the mortgage is paid off, the risk of the loan decreases dramatically, especially in the last 10 years, as the loan-to-value (LTV) decreases.

    I think you can argue that a 30-year mortgage in its 25th year is a pretty damn good credit. And yet, the interest rate doesn’t decline. That, I think, is the compensation to the lender for bearing the prepayment risk.

  47. No country can claim to be “chosen” or GREAT when it has embraced INJUSTICE and codified unfairness as an IDEAL “economic” math formula.

    Millions of us did NOTHING wrong – we do not deserve to be treated with such psychotic “logic” and force by DELUSIONAL monkey brains.

    So how much should we ask for in the way of $$$ currency to not blow it all up? Shoot, 2 billion A WEEK going to war lords and drug lords in 14th century dark ages Kyber Pass…

  48. The amount of Secrecy and Security force-fed into our government the last few years will not make it any easier. And our fellow citizens are more than distracted, if not blissfully-ignorant. State banks should be #1 priority, since this can not be argued as a ‘security’ measure, and even said igs. know the Banks are corrupt.

    Now of course you know, once you are ‘elected’ via the white smoke, someone will be working behind the scenes to depose you. You’ll have great shoes though…

  49. “Until 2008, they were profit-seeking companies, meaning that they were already paying as little for mortgages as they could”

    That, my friend, is where you take your first wrong steps. That simply was not the case.

    And, as John Hempton has pointed out, the real problem is prepayable 30yr mortgages. A few years ago the UK Treasury contacted me to ask advice on how to make the UK mortgage market more like the US. I told them it was a stupid idea and required extensive Government intervention. Funny how we now see the US market trying desperately to become more like the UK. :-D

  50. One other factor that seems to have been missed.

    Generally, mortgage lenders DEMAND that a home-owner repay the full balance of his mortgage if he sells the underlying collateral.

    In round numbers, the US has about 75 million units of owner-occupied housing (including single family homes, condos and coops). US Census Bureau

    Annual sales of existing homes run around five to six million.

    Simple math suggests that on average a 30-year mortgage will be repaid every 12-15 years because the owner sells the house and repays the mortgage.

    This fact is already priced into any 30-year mortgage or a security composed of such mortgages.

    FWIW, before the housing bubble increased housing stock and the crash decreased the rate of existing home sales, I would’ve said housing stock is about 68 million and the run rate of existing sale is a little above 6 million, implying that a lender would rationally expect the average 30-year mortgage to be repaid in about 10-11 years even absent a prepayment option.

  51. you joe and bethany are the right track. the more complete view is there are 16 reasons why mortgage paper is bad paper. i sent this to my friends in July 2007, shortly before i shorted the mortgage insurere and fannie and freddie.

    1.The borrower has a “put” prepayment right anytime, including when rates are lower or the home sold. Most loans are prepaid. But exercise cannot be accurately forecast when the loan is granted (or later)
    2.Borrower ability to pay is not completely researched, sometimes not at all, and is not updated.
    3.Many loans require major jumps in borrower payments or bullet repayments.
    4.Small or no down-payments are common.
    5.The collateral is not marked to market. It has started to trend down in value in many areas
    6. There are appreciable default rates, even for “prime”
    7.There is some fraud with 100% loss
    8.Therefore the cash flows are highly uncertain compared to the predictable cash flows of corporate or government bond fixed income
    9.Rating agencies applying normal fixed income credit standards to these products miss most of the risks
    10.Performance and valuation of pools can be partially anticipated only with detailed demographic and other “quant” studies and are best purchased by mortgage experts. Each pool has its own unique qualities and risks.
    11.Needed prepayment and risk spreads were way underpriced–lead by Fannie and Freddie. They have encouraged fixed income investors to value the asset purchase based on the face value of the mortgage—big original sin.
    12.The collateral is hard to realize via repossessions, expensive,
    13.State limitations usually prevent any further claim beyond repossession. Borrowers with negative net equity can often hand over the keys, without further consequences.
    14.Second liens often cannot be exercised without the primary lender agreeing.
    15.Pools are often packaged with derivatives and tranches in a misleading way. Their total price is further inflated as much as 2-3 % pts.
    16.As spreads rise, even relatively good paper should be marked to market (discounted) for the higher rate.

  52. i mean bad paper like wilbur ross meant it. lower quality second tier paper. its fixed income that aint fixed. but there is still a market jumbo mortrgages in normal times go for 200 bp higher than the subsidized, fake insured FF rate. (not your 14-60PB you are including “conforming” jumbos in high cost markets guaranteed by FF.

  53. I don’t think the status of the GSEs or the length of the loan is that important.
    What is important is regulators that enforce reasonable standards.
    Sure, you can make various arguments about how this or that change, under this or that set of assumptions, looks better on paper.
    But most of the actual, real, known problems come because regulators allowed poor loans to go forward – the exisiting laws were not enforced.
    Corporations, in 21st century American are, for better or worse, hyenas; you can’t blame them for being viscous predators; all you can do is fence them in and shoot the rabid ones.

  54. you seem to have hit on an important point that others are ignoring – because interest payment is front loaded, the effective rate the bank gets is higher then the APR if prepayment occurs – is this true ?
    If so, lot of meat in that argument

  55. Herbert Wetherby

    And that meat today comes in the form of cash on the sidelines. For if you have none, no one can make a beefy argument against you.

  56. “Now of course you know, once you are ‘elected’ via the white smoke, someone will be working behind the scenes to depose you. You’ll have great shoes though…”

    I have a Plan :-)

    I’m going to veer to the center, throw my car into a 360 spin and steer out of the cluster f–k that will happen when the predators (it’s a CROWD of drunk and drugged “drivers”, my friend)

    smash into those chasing me to “depose” me…

    very cartoon-like, no?

    meep meep

    Oh wait, the cluster f–k CRASH, judging by all the desperate wonking viagra “mortgage” masturbating,

    has already happened…

    Italian shoes, nice thought – see all the beauty (and $$$) without going for the “mobster” option…?

    Of course, monkeys can’t think about truth beauty and goodness…don’t have the “brains”, the proper intel chip….

    Constitutional Convention and BURN the Patriot Act.

    FRAUD is what brought down the economy – the paper shufflers have been sucking it out for decades…and now their crowning achievement

    The Patriot Act – it’s LEGAL to gather “information” at will…

  57. Your analysis here seems flawed for a few reasons.

    1) Jumbo mortgages are typically better credit risks than standard mortgages.
    2) Jumbos, up until the crisis, have had a strong bias away from 30 yr FRMs and towards shorter duration loans. So the fact that jumbo rates were available at 16-40 bps above conforming rates, when jumbo 30 yr FRMs were the exception, doesn’t strike me as resolving the question of what would happen if the entire market were financed without Fannie/Freddie.
    3) You’re citing spreads during the middle of a credit bubble, when the primary funding mechanisms for jumbo mortgages (PLS) were by any measure severely underpricing risk!
    4) Maybe you’re right that with enough standards and govt regulations, we could create liquidity around a 30 year mortgage without an explicit backstop. But by putting the government imprimatur on these MBS (essentially that the loans are all high credit quality, etc.), wouldn’t you be creating an implicit government guarantee here?
    5) At the end of the day, we’re talking about $12 trillion in capital (maybe $1-2T a year in new originations). Is there really $12T in demand for long-dated assets that don’t carry a wrap? I somehow doubt this, but would love to see the evidence either way.

  58. Herbert Wetherby

    Is there really $12T in demand for long-dated assets that don’t carry a wrap? I somehow doubt this, but would love to see the evidence either way.

    There most certainly is, it’s in the form of a new pipeline of evidence, now it’s doubtful you will ever see it, but you most definitly will feel the evidence in your pocketbook as your dollars decrease in direct perportion to your desire to find this new pipeline of evidence. Love it or not, it really is there.

  59. You have to include the fact that the U.S. went through four decades of trade deficits, that more than 60 pct of U.S. households own their homes (compared to only around 20 pct in Europe), and that everyone was borrowing heavily to spend happily in an economy based significantly on consumer spending.