The endless and circuitous debate over how to deal with Fannie Mae and Freddie Mac has confused the demands of various stakeholders with the public interest.
The federal government is now even more involved in the design, pricing, allocation and servicing of home mortgage credit than during the subprime lending debacle. Current proposals that call for government involvement would further entrench this situation.
To put things in perspective, there are three distinct types of home mortgage systems: market, state or hybrid. Until 1970 – when the homeownership rate had already reached its current level – the government's role in the private U.S. mortgage market was limited to providing a stable and predictable legal environment. While the competitive market system generally proved to be fair, efficient, and easily amenable to transparently provided government subsidies, any such system is vulnerable to political social engineering and macroeconomic mismanagement.
The state-owned commercial and savings banks in socialist countries during the last century allocated credit politically and loaned only negligible amounts for personal housing. These systems were outwardly stable because the costs of inefficiency were opaque – as was the limitless cost of public support – but contributed to the collapse of those economies.
The 1970 privatization of Fannie Mae and creation of new Freddie Mac and Ginnie Mae left the U.S. with a hybrid system that mixed ingredients of the market and state systems to produce something supposedly better than private markets. Such alchemy is politically irresistible because it allows politicians to deliver fool's gold while obscuring the economic costs and legalizing graft. The state provides unbudgeted subsidies to lenders through deposit insurance and "implicit" agency backing and in return directs credit to politically preferred groups.
The fragility of this hybrid system first showed in the 1980s when federally regulated thrifts (along with Fannie Mae) were rendered technically insolvent by the political pressure to hold fixed-rate mortgages Washington macroeconomic mismanagement. The government continued to operate the thrifts at negative interest rate spreads, bankrupting previously healthy lenders that couldn't do likewise and making the subsequent failure systemic.
The GSE-dominated U.S. hybrid system failed for the second time in two decades in 2008 when the cost of the homeowner subsidies in the form of lower-than-market rates for high-quality and subprime mortgages exceeded the value of lender subsidies in the form of deposit insurance and low capital requirements by trillions of dollars.
Current monetary and housing policies make saving for a down payment difficult and for many foolish while promising access to "affordable," typically fixed-rate prepayable mortgages with little or no down payment for virtually all. Nobody makes the ridiculous case for a state system being able to do that based on the historical record and this is realistically well beyond the reach of a market system as well. But this is the implicit or explicit promise of meretricious hybrid proposals, generally supported by historical myth and delusional optimism.
The main argument for GSE guarantees is that they support the dubious policy objective of encouraging the fixed-rate prepayable mortgage by matching securities with long term investors. As mortgage demand exceeds bank funding ability, some mortgage credit will of necessity come from capital markets. But depository institutions are currently the largest investors, funding almost a fourth of these capital market instruments, enticed by the same regulatory distortions that contributed to the subprime debacle, particularly the extreme leverage necessary to raise returns to market levels.
It goes without saying that the unsubsidized competitive market mortgage rate is higher than the government rate, reflecting the cost and risk of mortgage lending. Private markets can price fixed-rate mortgage securities without a federal guarantee, and did for decades. At a time when real yields are kept artificially low by the Federal Reserve and capital market investors are scouring global markets for yield – causing asset bubbles in their wake – why aren't long term investors lobbying for the government to stop guaranteeing home mortgages?
First, while state and local government retirement funds -- about a third of all retirement savings -- need yield (because they typically fund assuming a real return of 7.5% to 8%, many multiples the market rate) these union-dominated funds have no need to push for politically unpalatable higher mortgage rates. Their benefits are already guaranteed by state and local governments in the event of a funding shortfall.
Second, blaming private lenders for the subprime lending environment established the framework for extorting them when the inevitably messy foreclosure wave hit, undermining confidence in the government's only historic role of providing a stable and predictable legal environment. Mortgage investors are "greedy" and "predatory" when mortgage lending is profitable and "incompetent" when it isn't. Discretionary long-term investors aren't interested.
The recent recommendation of the Bipartisan Policy Center Housing Commission calls for the government to act as a public guarantor of "catastrophic" risk, but as hybrid systems fail catastrophically due to political social engineering and macroeconomic mismanagement, this is really a proxy for political risk. Moral hazard – in which investors make decisions assuming a government bailout – occurs as a result of perceptions, and this proposed system is more pregnant with government support than that of the original or privatized versions of Fannie Mae or Freddie Mac.
In a recent comprehensive series in American Banker, Clifford Rossi convincingly rejects the conclusion that the markets need a federal guarantee and provides a blueprint for numerous comprehensive reforms, but supports the Commission's recommendation of government standardization, a central aspect of a state socialist system.
The problem with inviting any government "help" with functions historically handled by the market is akin to borrowing from the mafia: there is usually a seemingly good reason to do it, but there are always strings attached and demands generally rise exponentially.
When the U.S. hybrid system fails for the third time Congress will undoubtedly once again conclude "nobody could have seen this debacle coming."
Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates and an executive scholar at the Burnham-Moores Center for Real Estate of the University of San Diego.