Trump administration officials announced last week that if Congress doesn’t come up with a plan to overhaul Fannie Mae and Freddie Mac in the next couple years, they will. Their plan is to simply privatize the two giant mortgage banks. A better one would be to liquidate them.
1. Liquidation would not be so simple. Their assets are very atypical. They consist primarily of servicing fees, which are small fees that they take on mortgage payments before they pass those payments on to investors. They also have many contracts with counterparties involving financial derivatives, including complex derivatives known as credit risk transfers (CRTs). So who would buy these servicing streams and derivative positions, and how would the buyer value them?
2. Getting rid of Freddie and Fannie would probably result in the death of the 30-year mortgage, because regulators would not allow banks to take on the sort of interest-rate risk that the savings and loan associations carried in the 1960s, which caused their demise in the 1970s and 1980s.
3. I was invited to offer my opinion on the future of Freddie and Fannie to senior staff at their regulator. But we could not get the scheduling to work. I instead submitted my thoughts in writing. I will paste them in below.
Comments on Housing Finance
Arnold Kling
April 2019
1. From approximately 1950 until 2008, housing finance in the United States was characterized by private profits and socialized risks. Through the 1970s, Savings and Loan associations took on interest-rate risk. When many went bankrupt, taxpayers took the losses. Subsequently, Freddie Mac and Fannie Mae dominated housing finance. They took on credit risk, and taxpayers took the losses.
2. Currently, some of the profits from the mortgage guarantee business go to taxpayers, in the form of earnings taken from Freddie Mac and Fannie Mae. Most of the risk in mortgage loans is borne by the private sector. Mortgage-backed securities transfer interest-rate risk to private firms. Credit risk transfers (CRTs) put much of the credit risk of mortgages into the private sector.
3. It would be a mistake to try to take away the profits from taxpayers and return the functions of Freddie Mac and Fannie Mae to the private sector. Once the profits are privatized, socialized risk-taking is likely to follow. Firms that are vital to the mortgage market will have either an explicit or implicit government guarantee. They will find ways to exploit that guarantee, putting taxpayers at risk.
4. Policy makers should be wary of changing the current system. Housing finance today is more sound structurally than it has ever been in my lifetime. Re-introducing old systems or introducing different entities and new regulatory methods would be unwise.
5. There are some tweaks to the current structure that are worth considering:
6. Congress could clarify and limit the charters of the housing finance agencies. In particular, the agencies could be limited to providing guarantees for 30-year, fixed-rate mortgages. Other mortgages, including ARMs and 15-year fixed-rate mortgages, can be supplied by the private sector. The government guarantee is only needed for the 30-year fixed-rate mortgage.
7. Congress could limit to moderately-priced priced homes the mortgages that the agencies can guarantee. Note that the home price ceiling ought to be national. In high-price cities, the problem is one of supply. Subsidized mortgage lending does not enable middle-income people to afford homes in expensive cities. Instead, it simply drives prices up further.
8. Congress could restrict the loan purpose for agency eligibility to primary residences only. It could forbid the agencies from guaranteeing mortgages that are cash-out refinances. This would ensure that the agencies support household saving through home ownership, rather than speculation or consumer borrowing.
9. Congress could ask the regulators to ensure a single, coherent credit policy and pricing policy for Freddie Mac, Fannie Mae, and FHA. This would prevent mortgage lenders from playing one agency off against another.
10. Congress could ask regulators to periodically monitor concentrations of risk in the private sector. We do not want to see one or two firms take on a dominant role in absorbing interest-rate risk or credit risk.
These are all really good, tho #3 is quite complicated. Wonks will always think that they can find some regulation to avoid the socialized risks, like a “no bailout rule” or somesuch — tho in practice, in a crisis, such rules are certain to be overridden.
I was expecting a down-payment clause, perhaps 6b) Only mortgages which included at least a 10% downpayment can be held.
This would also be a good time to address the mortgage interest deduction:
11) The maximum lifetime mortgage interest deduction shall be 10 times the median gross reported income. [Currently 10 * $61k = $610k], After reaching this amount no further interest can be deducted. [Your SS # / taxpayer ID number would include the amount of interest deducted]
An alternate way to address the Mort. Int. would be
12) Interest deductions would be replaced by a flat 20% credit of the full house buying amount, up to a lifetime maximum of 10 * med inc.
One bad loop needs fixing.
The IRS grants tax exemptions for mortgage payment then Fanny and Freddy insure. That loop is a promise that the system will be under severe stress in a recession. When the jobs go away, temporarily, the houses get sold as the tax deductions loses luster, big cycle happens.
Two things:
1) In all reality, banking and finance is risky. Period. Most developed nations have suffered some a form of housing and financial crisis. (OK I believe Australia and Canada have not.) And the United States have numerous over the years.
2) The plan for the Fannie and Freddie needs to make the housing finance system competitive.
3) Long term controling US economic debt levels will control the dangers of any US financial system.
And finally, honestly having the Trump Administration lead this effort is a little concerning considering some of Trump’s losses occurred during the S&L bust. It was $1B over 10 years! so I imagine Trump was smart to get others to lose the money.
Arnold’s 10 (or 9) points seem like excellent, sensible small-c conservative ideas to this liberal. They are therefore very unlikely to be taken into account.
Conservative small ‘c’, but for a libertarian, the solution is let them all compete, unbundle them.
Why the difference? Because the null hypothesis here, all these agencies are unstable, or more properly called meta stable. They need a wealth consuming fund to control stability.
A conservative says, ok, we are stuck with it, pay the stability price and control it. The libertarian says, do we know? Let the agencies compete, in the market and in Congress; and whatever happens, great.
Thats what I was thinking…
Going to take a run at trying to understand this post. I have limited knowledge in this arena so this comment is really just a talking aloud learning exercise and I undoubtedly have missed relevant issues.
So to be explicit, Dr. Kling endorses making the US conservatorship of Freddie Mac and Fannie Mae that began in 2008. And by “their regulators” I presume he is referring to the Federal Housing Finance Agency. And I believe we are talking about a total of $5 trillion in guaranteed mortgages here.
President Trump, on the other hand, just announced that he is interested in getting them out of conservatorship and believes that they lack competition, that taxpayers remain on the hook for any losses and that the companies aren’t being run as well as they could be.
Dr. Kling assets that “some of the profits from the mortgage guarantee business go to taxpayers.” I believe that he has that backwards. The profits that I believe he is referring to are those that are retained by the government. The government does not file tax returns, private companies do. I’m willing to bet that profits going to the private sector have a higher multiplier than profits going to the government. It is not clear that keeping money away from investors should be a a governmental imperative.
And what does the Federal Housing Finance Agency do with the profits?
Average salary and bonus for about 600 employees is around $170,ooo per employee with about 120 getting over $200,000 per year. Thankfully Fannie and Freddie were prevented from making political donations after the government takeover and such giving continued post conservatorship with over $140 million given away between 2009 and 2011 (not finding more recent data).
The most recent IG report on the web identifies $776,300,000 in funds that could be put to better use.
And taxpayers remain at risk under conservatorship. The Federal Housing Finance Agency has submitted legislation to the past several Congresses to eliminate statutory impediments to shifting risk to the private sector.
Seems hard to argue that either case is persuasive. Personally, I would want a lot more info before deciding between the two alternatives. And I suspect that we have a lot to learn from Canada which seems to perform better policy wise in housing. They seem to combine the virtues of conservatorship with pretty tight regulations on who can get insured mortgages. Dr. Kling’s tweaks seem consistent with the Canadian practice and maybe would be a step in the right direction of an overall reduction in risk carried in the mortgage market.
What is the compelling economic reason for preserving the 30-year fixed rate mortgage? Canada doesn’t have it (typically, if the mortgage has a fixed rate, it is reset every five years) and the home ownership rate is higher than in the United States. Moreover, Canadian taxpayers did not have to bail out housing finance companies during the Great Recession.