Congress recently heard conflicting testimony from three professors and one think tank fellow on a simple, straightforward question: Should there be a guarantee for mortgage securities in the future?
Among the numerous arguments for continuing government guarantees:
• We’ve always had them, since Alexander Hamilton had the Treasury guarantee state debts.
• Bankers always cause financial crises; government always saves them.
• When it comes to the choice of mortgage instruments, underwriting standards, allocating credit among borrowers and designing financing instruments, government always knows best.
• Government guarantees are needed for mortgages to trade and be hedged.
• Mortgage policy is a good way to make the distribution of income more "fair."
• Private markets haven't always worked perfectly, so better to have the government do it.
• Governments provide implicit guarantees, e.g., deposit insurance, so it's better to make them explicit and charge the actuarial price.
This was comical!
Past mortgage market policy caused the collapse of the global financial system and the economy generally, and mortgage markets remain moribund, so the question deserves a more urgent answer.
Perhaps the question was too straightforward. Most analysts would take the question to mean "Do third-party capital market investors require the government to act as credit guarantor for mortgage-backed securities?" The two follow-up questions are: "If so, what is the best way to do this?" and "If not, what is the best alternative, and what does it require to work?"
But the question Fannie Mae and Freddie Mac proponents actually addressed was, "Should the government allocate housing credit, and if so, how?" And their implied answer was, "Yes, just the way we did it at Fannie and Freddie with an implicit government guarantee!" That's a bad answer to a different question.
Such government allocation of housing credit is almost exclusively the domain of nonmarket economies. Moreover, the public risk for private profit model — unique to the U.S. — is the worst way yet devised to do this, and the root cause of the systemic collapse of the entire financial system. Proponents of credit allocation should choose a better model, one that transparently budgets subsidy costs and doesn’t severely distort the financial system!
The straightforward answer to the committee's question is that investors don't require a government credit guarantee for other asset classes, have never requested it for mortgage securities, and have never explicitly gotten it.
The initial motivation for the Ginnie Mae pass-through certificate was to bypass all conflicting state and federal laws and regulations that, among other things, would have required separate security registrations in all 50 states for each offering, making mortgage-backed securities prohibitively expensive relative to whole-loan sales. This bypass was easy because its securities were treated as federal government issues with a federal preemption of state and local laws. Ginnie Mae was a politically expedient solution to unnecessary and excessive regulations (that have since been changed or eliminated) that by IRS ruling could not act as a credit guarantor.
The implicit guarantee for Fannie and Freddie didn't originate with investors either. Investment banks historically had two trading (market-making) desks, government and corporate. As GSE MBS issuance and speculation-driven trading volume skyrocketed in the mid-1970s, it was the lawyers at and advisors to the Wall Street trading firms that made a judgment that Ginnie, Fannie and Freddie securities could all be traded on the government desk. The judgment that such securities would be backed by the government in the event of default — despite the specific disclosures to the contrary — reflected their federal sponsorship with their regulatory and tax exemptions of a public entity. This judgment was proven correct when Fannie was propped up through its technical insolvency of the early 1980s, and again in 2008 when Fannie and Freddie were put into conservatorship.
It is not credit risk that concerns today's potential mortgage investors, but political risk. The U.S. history of private investor interest in funding home mortgages is as long and deep as that of Europe, where homeownership rates exceed those of the U.S. and mortgages are cheaper. The more recent history, three decades of GSEs, resembles the experience of national housing banks in less developed, less market-oriented countries. The uncertainty about foreclosure and eviction, mortgage cramdowns and investor liability for the myriad new regulations does as well. It's not just the written laws and regulations but decades of their application that makes outcomes predictable and breeds investor confidence.
A federal guarantee won't cure what ails the home mortgage market unless, like the initial Ginnie Mae pass-through security, it provides appropriate exemptions from inappropriate and excessive state and federal regulations. If a guarantee is to be offered, the best way to do this would be to introduce a Ginnie conventional pass-through certificate that emulates the FHA/VA pass-through certificate. Take Ginnie regulation out of HUD, which is where the "mission regulation" that fueled the subprime lending debacle still resides.
The private MBS market either needs much better regulation, or much less. Better regulation would eliminate regulatory inconsistencies and the opportunities for regulatory arbitrage for mortgage-backed securities and bonds while providing proper oversight of entities, e.g., credit rating agencies, to which it has delegated risk evaluation. Alternatively, it would rely on much more on market discipline. But this requires not only a measure of deregulation, but a convincing elimination of implicit guarantees, which may be a bridge too far. Ginnie may once again be a politically expedient second-best solution, but then again that's what Freddie executives long argued in defense of Fannie and Freddie.
Kevin Villani was senior vice president and chief economist at Freddie Mac from 1982 to 1985.
