THE NEW PAGE: How I Learned to Stop Worrying and Love the Government Guarantee
Scott Simon
JUL 24, 2013 12:00pm ET
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"Let's get the government back out of housing" the cry goes. Back out of housing? Like when? The government has dominated housing policy since World War II and mortgage finance for 40 years. The only time the government didn't dominate mortgage finance was in the mid-2000's and that experiment nearly took down the entire global financial system. Is that what the privatizers want to return to?
"Conventional wisdom" says that housing finance needs to be reformed to bring back private capital, and push out the government and government-sponsored enterprises. I favor pragmatism over conventional wisdom, and therefore believe that government guaranteed mortgage backed securities and a strong GSE are not only "good" but necessary. They are good for the middle and lower classes, housing and the economy. And they don't require a massive taxpayer liability.
Let me come clean: I'm an old-fashioned Reagan Republican. I believe in small government and free markets. I also recognize the importance of initial conditions. Would I design a system from scratch that the government dominated? No. However, voters continuously elected politicians who backed the "American Dream" of homeownership, making it deeply entrenched public policy. The mortgage finance markets not only responded to this, but were explicitly designed for it.
For 40 years, the GSEs financed the rise of middle class homeownership by leveraging their implied government guarantees. The GSE's ran two businesses: guaranteeing "prime" mortgages (most people thought this was their entire business) and managing their portfolios (essentially levered hedge funds). Pressured to achieve earnings growth and maintain market share, the GSEs went off the reservation and bought hundreds of billions of garbage for their portfolios. These toxic loans caused massive losses. The GSEs didn't lose money guaranteeing prime loans. Their prime MBS guarantee business remains very profitable and is why the taxpayers who bailed them out will get their money back.
The GSEs saved the day in 2008 and 2009. Most financing markets shut down but the GSEs allowed $1 trillion of mortgages to be made. Without the GSEs, the housing collapse would have been far worse. Thanks to the government guarantee, the "agency" MBS markets continued to function when most markets seized up.
The markets we have today are set up to make and invest in guaranteed MBS. Large fixed-income investors are constrained by guidelines and ratings. As a result, government-guaranteed MBS trade at much lower yields than non-guaranteed MBS and are infinitely more liquid. This gets the homeowner a much lower mortgage rate and much better credit availability. The government guarantee also ensures a reliable source of funds to the housing market, even during crises.
Some problems with non-government guaranteed MBS: Foreign investors won't buy them; money managers are constrained by guidelines from buying them; and banks are discouraged from buying them by the capital charges under Basel III. I see no current way to restructure the housing finance market that would not require a government guarantee on MBS.
However – and please listen, fellow Republicans – a government guarantee on MBS and risk-sharing on the loans are not mutually exclusive.
While not perfect, the Corker-Warner bill in Congress brilliantly calls for government-guaranteed MBS with risk sharing on the loans. This allows the MBS to trade at very low yields, ensuring a low mortgage rate for the homeowner. It also allows the government to lay off the first-loss credit risk. Who should like this? Homeowners, mortgage investors, politicians who want the middle class to have access to reasonable mortgages and politicians who don't want the government on the hook for massive losses. This concept should garner strong bipartisan support and is a solid basis for honest reform talk.
The competing House GOP plan is disappointing. It would end mortgage availability to the middle class, end the 30-year mortgage and crush home prices. The only winners would be ideologues. To remove the guarantee without crippling damage would take decades.
There are non-debatable, economic facts in housing finance math. All other things held constant, the more the mortgage finance market is funded by private rather than government-guaranteed MBS, the higher mortgages rates, required down payments and credit scores will be; the scarcer credit will be; and the lower the homeownership rate and home prices will be. In a non-government-guaranteed MBS world, everyone from the middle class on down will pray they can get a Federal Housing Administration loan. There will be no other reasonable mortgages available.
The biggest reform hurdles are ideology and economic self-interest. The other big issue is that many involved have zero understanding of how mortgages are made and priced. The reform issues do not have "right" or "wrong" answers. They are public policy questions with foreseeable results. However, many involved seemingly don't know or don't care about those results. Ask yourself this: "beyond your political, ideological or financial self-interest, why do you want to shut down the GSEs and why do you want to end government-guaranteed MBS?"
The GSEs have massive information, skills, systems and efficiencies. They also have an incredibly profitable core business. If you want to shutter the GSEs because they lost a ton of money (for which the government will be repaid), remember that they did not lose the money on their core prime business. I would fold Freddie Mac into Fannie Mae, leaving one GSE with a single security and securitization platform and no investment portfolio, and run that GSE like a utility. The gas, electric or water companies are too important to be unregulated, as are government-guaranteed mortgages.
I believe the government should keep the GSE, though it could be privatized. I'm a conservative, but as a taxpayer I'd rather see the government make the money than a private equity firm. The MBS should be guaranteed, but the GSE should lay off the risk on the loans. This would maintain the ability to sell MBS at low rates (getting the consumer a low rate) without creating a potential governmental black hole. With a non-guaranteed MBS, the rate to the consumer would be high, and the availability low. Housing finance must serve people other than those in the upper class.
GSE and mortgage reform needs to be done in a way that makes sense, helps the country and helps the people. My conservative philosophy guides my thinking on this, it doesn't blind it. Let's hope politicians from both sides of the aisle adopt this approach.
Scott Simon retired in May after 29 years of trading all types of mortgage backed securities, the last 13 years spent as head of mortgage-backed securities at Pacific Investment Management Company
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