Category Archives: Housing and housing finance

Freddie, Fannie Profits

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The Washington Post reported (a few weeks ago) that Fannie Mae has made large profits that will go to the U.S. Treasury.

I expect these profits to continue, because the business model right now is excellent. The government is saying to mortgage originators:

1. Do not originate any loans that do not comply with our rules.

2. We cannot tell you what the rules are yet, because they are not final (it’s only been, what, 3 years since Dodd-Frank passed?)

3. But Freddie and Fannie have an exemption, so anything they will take you can originate and we won’t bother you.

Freddie and Fannie do not have to worry much about credit risk, because the housing market bottomed out a while ago, so we are unlikely to see another house price collapse.

Freddie and Fannie are borrowing at Treasury rates, so they enjoy a nice, juicy margin. And the Fed is still holding onto a lot of mortgage securities, which helps keep their prices up.

The one fly in the ointment is that Freddie and Fannie probably are exposing taxpayers to more interest-rate risk. That is, all those 4 percent mortgages that the government is holding on our behalf will not look so profitable if the Treasury’s cost of borrowing should go up to, say, 6 percent. That is already the worst possible scenario from a government solvency standpoint. In that sense, from a taxpayer point of view, Freddie and Fannie are risk-aggravating. Meanwhile, enjoy the windfall.

James Hamilton points out that another fly in the ointment is that a lot of Fannie’s profits are actually tax deductions that come at the expense of the Treasury.

John Cochrane on Housing Finance

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He writes,

Suppose that mortgages were bundled into securities, intermediated by mutual funds whose values float, just like those of equity mutual funds, and held around the world in retirement accounts, pension funds, and our endowments’ portfolios, without government guarantees at every step. This would be a terrific financial structure

I think that this would be an improvement. However, the household demand for risk-free assets might lead banks or money-market funds to offer fixed-rate instruments backed by these floating-rate securities. Add enough leverage and you have a very shaky financial structure. In any case, I continue to believe that if there were no government actions distorting the price differential between a thirty-year mortgage with an interest rate fixed for just five years and a thirty-year fixed-rate mortgage, the latter would cease to dominate the housing finance system in the U.S.

Home Ownership’s Negative Employment Externalities

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David G. Blanchflower and Andrew J. Oswald write,

We explore the hypothesis that high home-ownership damages the labor market. Our results are relevant to, and may be worrying for, a range of policymakers and researchers. We fi nd that rises in the home-ownership rate in a US state are a precursor to eventual sharp rises in unemployment in that state. Th e elasticity exceeds unity: A doubling of the rate of home-ownership in a US state is followed in the long-run by more than a doubling of the later unemployment rate. What mechanism might explain this? We show that rises in home-ownership lead to three problems: (i) lower levels of labor mobility, (ii) greater commuting times, and (iii) fewer new businesses. Our argument is not that owners themselves are disproportionately unemployed. Th e evidence suggests, instead, that the housing market can produce negative externalities’ upon the labor market. Th e time lags are long. Th at gradualness may explain why these important patterns are so little-known.

Pointer from Steve Goldstein of the WSJ.

I would suggest viewing these findings as tentative at best. As the authors write,

We are unable, in this paper, to say exactly why, or to give a complete explanation for the patterns
that are found

There are many conceivable explanations for the findings. Bear in mind that conventional macro distinguishes between cyclical and structural unemployment. To aggravate structural unemployment, home ownership would have to result in permanent mis-matches between skills and labor demand. To aggravate cyclical unemployment, home ownership would have to make wages stickier, or somesuch. In a PSST framework, home ownership would have to make it more difficult for entrepreneurs to discover new forms of comparative advantage.

I personally would rate as low the probability that there is truly a causal relationship between home ownership rates and subsequent unemployment rates. Still, it is refreshing to see a paper that runs counter to the “home ownership is great” mantra.

My Testimony’s Impact

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From a blog on title insurance.

Immediately after hearing the testimony, the American Land Title Association reached out to Financial Services Committee staff to correct the record and to serve as a resource to the Committee. During that conversation, staff confided that they “do not anticipate the Committee pursuing it any further…I really don’t see any momentum here on going deeper than Dr. Kling’s suggestion.”

Shock me, shock me.

The Home Borrowership Crisis

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Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Willen of the Boston Fed write,

the facts refute the popular story that the crisis resulted from financial industry insiders deceiving uninformed mortgage borrowers and investors. Instead, they argue that borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices

This paper from last year was cited the other day by Scott Sumner.

One quibble I have is that the paper makes it sound as if the only variable that shifted during the run-up to the crisis was house price expectations. In fact, the proportion of loans with down payments less than 10 percent shot up (even the authors have a figure showing that the market share of loans with down payments under 5 percent nearly doubled, to almost 30 percent of loans, in just four years–from 2002 to 2006), the proportion of loans backed by non-owner-occupied properties (i.e., speculative investments) went from roughly 5 percent to roughly 15 percent, and the proportion of loans that went to borrowers with lower credit scores also rose.

Of course, the expectations of rising home prices helped fuel the decline in lending standards, because you cannot be punished for making a bad loan in a rising market. And the deterioration in lending standards helped fuel rising home prices, because it broadened the market to buy homes. Hence the bubble.

Against Home Borrowership

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Dean Baker writes,

If homebuyers knew that they had to put down 20 percent to get a lower cost mortgage, then they would be more likely to have a 20 percent down payment than in a context where this was not a requirement

Pointer from Mark Thoma.

I wish Baker had been there to help me at the hearing yesterday. The Congresspeople were chanting at least three scary mantras.

1. We need more home ownership.

2. We need to make sure that people who can’t make a big down payment can purchase homes.

3. We need to preserve the thirty-year fixed-rate mortgage that is pre-payable at any time.

I could not address any of these.* Instead, I tried to focus on debunking the idea that government needs to revive the mortgage securities market in order to “provide sufficient private capital” for mortgages. The other witnesses, and pretty much every Congressperson, were against me.

I am afraid that the housing lobby is alive and well, and very few economists share Dean Baker’s willingness to take it on.

*I tried a little bit, and more in my written testimony, to address (3), and in particular to explain that the interest-rate risk on the thirty-year mortgage is likely to be borne by taxpayers. Any institution that takes on a large portfolio of thirty-year mortgages has to, in addition to issuing long-term debt, purchase derivatives to hedge the prepayment option. Who will be on the other side of such transactions, writing these out-of-the-money options? My concern is that buried in the housing finance system somewhere will be the equivalent of AIG financial products. That is, an institution with way too much risk in its book, which regulators will discover only when it is too late.

aaAARRGGH!!!!

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That sums up my post-mortem on the hearing today. You can watch a replay here. The witness testimony begins about 1/5 of the way through, and I am the last witness, so I start about 23 percent of the way through. (My media player does not show minutes.) After that, there are questions/speeches from members of the House Committee.

I left with a sense that it was me against everyone else. Everyone else thought that the problem with withdrawing FHA, Freddie, and Fannie from the mortgage market is that private capital is not ready to take their place. I tried to point out that all of the capital in the mortgage market today is private capital. The real issue is that taxpayers are taking much of the risk in mortgage lending. If taxpayers were not taking that risk, then, yes, interest rates would rise, particularly on 30-year fixed-rate mortgages. But to say that private capital is not ready to come into the market makes it sound as though the consequences of phasing out the GSEs would be much worse than actually would be the case.

Even more frustrating to me were the other three witnesses, who insisted that securitization is necessary for mortgage markets. The guy next to me was particularly insistent on that point, and some of his comments during the Q&A reminded me of the worst of the spokesmen in the Freddie/Fannie propaganda machine. It took a lot of restraint on my part not to yell “baloney sandwich!” at the top of my lungs.

It disgusts me that these witnesses are the people that Congress brings in to “educate” themselves. Interest groups are not the people that you want providing education. They can provide input to people who are educated, but if you are not educated enough to know when they are informing you and when they are spinning you, you should not be listening to them.

This is the Financial Services Committee, and I think they need a basic course that teaches the concept of financial intermediation. After that, they could take my housing finance course, but right now my course would be too advanced for them.

Of course, I should be the last person who is surprised by the knowledge-power discrepancy. But for some reason I was not prepared to be reminded of it, and I walked out of the hearing with a need to scream.

Type I errors, Type II errors, and Congress

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The Wall Street Journal reports,

Lawmakers of both parties questioned Sunday whether law-enforcement officials did enough to monitor the activities of suspected Boston Marathon bomber Tamerlan Tsarnaev before last week’s terrorist attack, given his apparent extremist beliefs.

The failure to stop Tsarnaev was a type I error. However, there are probably hundreds of young men in America with profiles that have at least as many “red flags” as he had, and few, if any, are likely to commit acts of terrorism. One sure bet is that for the next several years we will see a lot more type II errors, in which the FBI monitors innocent people.

Speaking of Type I errors, type II errors, and Congress, I will be testifying at a hearing on mortgage finance on Wednesday morning for the House Committee on Financial Services. Part of what I plan to say:

It is impossible to make mortgage decisions perfectly. Sometimes, you make a reasonable decision to approve a loan, and later the borrower defaults. Sometimes, you make a reasonable decision to deny a loan, and yet the loan would have been repaid. Beyond that, good luck with home prices can make any approval seem reasonable and bad luck with home prices can make any approval seem unreasonable. During the bubble, Congress and regulators beat up on mortgage originators to get them to be less strict. Since then, Congress and regulators have been beating up on mortgage originators to be especially strict. I expect mortgage originators to make mistakes, but the fact is that they do a better job without the “advice” that they get from you.

Here is my talk on type I and type II errors for my housing course.