From 1945 to 1975, before the era of the government-sponsored enterprises, the U.S. homeownership rate rose from 45% to its approximate average level of the next quarter century of 65%. This was financed largely by mutually chartered savings and loan, savings bank and life insurance company intermediaries, which required saving before borrowing and a fair balance of risk and reward between savers and borrowers. Federally sponsored deposit insurance protected deposit-funded lenders from a repeat of the Great Depression policy debacle, but political interference in mortgage lending was otherwise limited.
This model worked for centuries before ultimately succumbing to political risk. In particular, federally chartered savings and loans were limited to investing exclusively in fixed-rate mortgages financed with short-term deposits, a strategy sure to result in insolvency if inflation exceeded expectations or unstable monetary and/or fiscal policies resulted in volatile interest rates. Both occurred in the 1970s, rendering the S&L industry technically insolvent. Policymakers could have saved this industry in the 1980s, but Fannie Mae was also technically insolvent for the same reason and they couldn't save both. Politics favored saving the "too big to fail" GSE, which exploited its agency status to obtain a lower borrowing cost, squeezing the margins available to private mortgage investors. The subsequent subprime lending debacle occurred in the U.S. because the federalized and politicized secondary mortgage market — which broke the traditional links between borrowing and saving — excessively favored borrowers while implicit federal guarantees protected savers, shifting the ultimate risk of failed intermediaries to taxpayers.
Over the centuries, home mortgage lending to households has proven safer than lending to governments and business. While the institutional landscape has changed dramatically since 1975, there is no reason, in principle, why private companies cannot once again fund the U.S. home mortgage market, including FRMs, without federal guarantees. Whether they will or not depends on only one thing, the level of political risk inherent in mortgage lending, as this is the single most important determinant of private mortgage lending across developed and developing economies. Unfortunately, having blamed private lenders for the subprime lending debacle, politicians have left in place all their prior political distortions while further politicizing the market.
At the micro level, long established legal and regulatory precedents are being cast aside. Among the many questions lenders should be asking themselves are: Will home mortgages be subject to a cramdown in bankruptcy, as proposed? Is it possible to mitigate concern with the prospective regulations of the Consumer Financial Protection Bureau? Will the state attorneys general be successful in extracting ex post subsidies to borrowers, and if so find new excuses to do so? Will lenders bear the consequences of irresponsible lending practices required to meet federal racial and low-income lending quotas? Will lenders be taxed $20,000 for each foreclosure they pursue as California politicians have proposed? Will full recourse be allowed, and if not, can the moral hazard that results from government-encouraged mortgage default without eviction or recourse ever be reversed?
The macro-level political risks are even more daunting. Will inflation be controllable when real government budget deficits are many multiples the levels of the 1970s that resulted in mortgage rates approaching 20%? Will nominal interest rates remain sufficiently stable and predictable to foster financial intermediation in nominal terms without resulting in technical insolvency? More importantly, will lenders be allowed the flexibility to balance borrower and lender risks when designing mortgages and to price risks to reflect the market cost of hedging and risk management? None of this seems very likely, and these risks are highly correlated.
Lenders and their legitimate concerns are being virtually ignored in the current policy debate, which is largely taking place between consumer advocates, politicians and regulators. Regulators are once again fashioning regulatory arbitrage rules for mortgage-backed securities, e.g., whether 5% risk retention refers to "horizontal" (i.e., first loss) or "vertical" investments in risk tranches, and proposed capital requirements are different for comparable risk among alternative financing mechanisms, e.g., MBS, covered bonds, Federal Home Loan bank advances and deposits. The Department of Housing and Urban Development is lobbying that mortgage loans with only a 10% down payment be exempt from risk-retention rules, i.e., treated as risk free. By the time lenders are invited to the table, they will inevitably require a government guarantee of some sort to mitigate political risk, with proponents again arguing that government is needed to ensure the availability of FRMs.
There is nothing inherently wrong with fixed-rate mortgage lending and no reason, in principle, why lenders — including commercial banks — won't continue to offer FRMs. The introduction of interest rate swaps in the 1980s addressed the interest rate maturity mismatch problem, and the extension to banks of access to FHLB advances in 1989 addressed the liquidity problem.
The real problem with FRMs is that state and federal politicians have generally prohibited prepayment penalties when refinancing, and borrowers have ruthlessly exploited this advantage for decades, refinancing repeatedly in a falling rate market. There is nothing inherently wrong with borrowers speculating at the lenders' expense, but lenders, including GSEs, face high costs and imperfect strategies hedging prepayment risk as there is no natural other side of the market for this form of speculation. Hence this option has been underpriced at taxpayer expense.
Politicians have a choice between this path and a return to the status quo ante. The path to restoring a private mortgage market is well lit, and the benefits obvious, not the least of which is a sound asset class for community banks. But they won't consider the private option because politically vested interests oppose it, and politicians continue to find the opportunity to meddle enriching, so when the next systemic failure occurs they will once again say "nobody saw it coming" and blame the lenders.
