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.