WORD ON THE STREET: The U.S. is the only country with mortgage intermediaries of the form of Fannie Mae and Freddie Mac, two very large government-sponsored enterprises (GSEs). We also have the 12 Federal Home Loan Banks and the Federal Housing Administration (FHA) to address.
Other countries with well-functioning mortgage markets do not have the mortgage intermediaries of the sort we do. There is no evidence of which I am aware that mortgage markets abroad function less well than ours. Indeed, the failure of Fannie Mae and Freddie Mac, at a taxpayer cost of about $150 billion so far, should be a clear warning to us.
Moreover, the worldwide financial panic was a direct consequence of the bust in our subprime mortgage market. Quite frankly, any claim that our mortgage market serves us better than the markets abroad sounds pretty fishy to me.
Putting the mortgage market aside, U.S. capital markets are the envy of the world. Our markets are more liquid and more innovative than those elsewhere. We should be very careful not to kill innovation in the financial markets.
It is true that, for some years, Fannie and Freddie seemed to work well. They grew to an immense size, supported by the implicit federal guarantee of their liabilities. The guarantee meant that the U.S. taxpayer was providing insurance against failure, without charging an insurance premium.
The guarantee permitted Fannie and Freddie to pursue portfolio policies that no purely private firm could. They grew and grew, and their shareholders – and especially senior management – enjoyed handsome returns. I regret that the Occupy Wall Street protesters have not taken aim at Fannie and Freddie, and even more that they were nowhere to be seen when the opportunity to reform these firms was a live issue five and more years ago.
It is absolutely essential to understand the importance of taxpayer subsidy of risk. A period without loss does not mean that there is no subsidy. If the federal government were to provide fire insurance on my house, there would not have been a loss over the years I have been a homeowner. I am careful and have never had a fire. I hope that I never do have a fire. Nevertheless, I do have homeowner's insurance. Everyone understands this point – I could explain to a fourth grader why it makes sense for me to have insurance and why the absence of loss to date does not mean that my purchase of insurance is unwise.
Pricing of insurance is complicated, and fire insurance is much more complicated than life insurance. With a widely diversified group of policyholders, life insurance actuaries can project quite accurately loss experience in future years. Losses from fire insurance are much more episodic, and the same is true of losses on mortgages. The essence of underwriting fire insurance is that the properties insured be highly diversified so that relatively few properties are insured in any one community to avoid conflagration risk.
Mortgage risk is unavoidably subject to conflagration risk, because the business cycle affects so many communities at the same time. Nevertheless, I urge you to not accept industry arguments that the federal government must support the market because the presence of correlated business-cycle risks means that private firms cannot handle the risk. The private market can handle the risk, as demonstrated by foreign experience and by U.S. experience over business cycles before this most recent one.
The Private Mortgage Market Investment Act discussion draft bill
In the context of standardizing mortgage products, Fannie Mae and Freddie Mac functioned more like private firms than they did in the accumulation of their portfolios. The issue at hand is whether we need a continuing federal presence in the design of mortgage products.
I am not an expert on many of the technical issues in the discussion draft. However, I confess that I read the draft bill with dismay.
I understand, and am in complete sympathy with, the motivation to avoid another catastrophe of the sort we have been living through. Still, the bill reads as an effort to design a complicated product in Washington. Would you ever do the same thing for the design of a computer, a smart phone or a website? I am quite sure not.
Even if Washington could create a fine mortgage product today, could the product evolve over time as conditions change? I apologize for using strong language, but it is folly to design a complicated product in Washington and expect the product to remain current and innovative.
I recommend that the committee staff put together, with the assistance of the GSEs, a timeline of changes in the major areas of the bill. I suspect that you will find an evolution over time in these provisions, and you should ask whether a federal regulatory framework is likely to be as responsive to changing conditions. I realize that is an argument for delegating many details to the Federal Housing Finance Agency (FHFA).
However, the extensive delegation of power to the director of FHFA and the vagueness of the criteria that are supposed to guide his decisions worry me. If this product cannot be designed by this committee and its expert staff, why should it be any easier for the director to design? What this grant of authority to the director would do is invite a never-ending process of industry pressure and complaint. What the industry does not achieve by direct influence on the director it would seek to achieve through Congress, getting obscure provisions written into legislation.
Why would we want to magnify the decidedly unpretty process under way today as regulators attempt to implement the Dodd-Frank legislation?
The financial crisis was not primarily a consequence of the defective design of mortgages. Instead, banks, including investment banks, accumulated too many subprime-backed securities while holding too little capital. Banks violated banking principles 101 from 150 years ago by holding risky assets financed with excessively short liabilities and much too little capital.
The problem was not that investors and rating agencies had too little data on the underlying mortgages. They just did not look for the information that was available. Michael Lewis, in his very readable and informative book, The Big Short, makes clear that the data were there for any portfolio manager who would dig a little. The few who did dig found what they needed.
Standards for securitization should be determined in the market and not by the federal government. Should a hedge fund, for example, want to get into the securitization business, perhaps in some innovative way, should it be blocked by legislation of this sort? Some, I know, would say absolutely yes. I simply disagree. We already have a plethora of rules against fraud, enforceable in the courts through private actions. We must not bog down the private economy with rules and regulations unless we have specific ills that can be addressed that way.
Reform transition
I have long favored a death sentence for Fannie Mae and Freddie Mac. A pleasing and easy transition into history should not be difficult. Two simple things need to be done: phase down the conforming mortgage limit and increase securitization fees, perhaps at the rate of 10% per year.
Both should be legislated and not left to administrative discretion. The legislation might provide that both transitions would begin one year after the bill becomes law. Fannie's and Freddie's portfolios should be frozen, and the existing mortgages permitted to pay down in the normal course of business. There is no need to sell the existing portfolio – letting it run off will shrink the companies rapidly, and they will be mostly gone in seven to 10 years.
It is terribly important to put these provisions into statute law and not leave them to administrative discretion. That is the only way to provide reasonable certainty to potential private competitors that it is worth the investment to develop this market. Without that certainty, private competitors will be slow to enter the market and those who want to maintain the GSEs will be able to claim that the private market cannot handle the business.
I cannot understand those who are defenders of the market in the abstract but are squeamish about starting this transition. I well remember Ronald Reagan's confidence that ending price controls on natural gas would end the shortages in that market, and the conservative doubts about the strategy. Reagan was right, and the evidence appeared in a matter of days.
Dr. William Poole is the distinguished scholar in residence at the University of Delaware. This article was adapted from testimony that Poole prepared for a Dec. 7 House Financial Services subcommittee held to discuss the Private Mortgage Market Investment Act introduced by Rep. Scott Garrett, R-N.J. Poole's complete testimony can be found here.
