GSE Reform

Posted in Financial Markets, Politics and Policy at 6:36 am

There are two primary issues, orthogonal to one another, that need to be addressed:

  1. How should the GSEs be organized (public agency, private for-profit company, some sort of hybrid)?
  2. What functions should the GSEs perform?

I’ll address the second question first, as the answer will impact how we frame the solution to the first question.

Currently, the GSEs (Fannie and Freddie) engage in three separate activities:

  1. Purchasing whole mortgages from lending institutions and packaging them into MBS.
  2. Providing a guarantee on the MBS they create.
  3. Purchasing MBS (their own and private label) to hold in their portfolio.

They issue debt (agency bonds) to finance #1 and #3.

Function #3 should be eliminated.  It is this function that created most of the systemic risk and required taking the GSEs into conservatorship.  The GSEs were essentially operating a hedge fund here, and a highly leveraged one at that.  It makes no sense whatsoever to concentrate MBS holdings at any one or two firms to that degree, and that is the case regardless of whether we’re talking private companies or quasi-government enterprises.  That level of size, market risk, and leverage is hazardous anywhere.

Function #1 should probably also be eliminated.  It’s not particularly harmful, but there’s no reason why private firms cannot fulfill what it a relatively mundane function.

Function #2 should be kept.  Without some sort of guarantee, interest rates would be much higher, potentially several hundred basis points higher as Bill Gross of PIMCO noted yesterday, the mortgage market would be highly illiquid, and it would be prone to periodically locking up.

What do we end up with if we eliminate Functions #1 and #3 and keep #2?  We end up with Ginnie Mae.  That is exactly what Ginnie Mae does today – they provide guarantees and nothing else, they do no buy whole mortgages to create MBS nor do they hold any securities for their own portfolio.

Now we can address the first question – How should the GSEs be organized?  Onstensibly, prior to Fall 2008, they were private companies, however they had an implicit public guarantee, no matter how vehemently they denied it.  Thus, they were a sort of hybrid.  This was the worst of all possible worlds, and should not be repeated.  Somewhat better than this would be to structure them as purely private, for-profit corporations.  There are two problems with this approach – 1) the market will always perceive there to be some sort of implicit guarantee, regardless of what is said and 2) since their ultimate purpose is to perform a public policy function (enabling low-cost liquid mortgage markets), why create an inherent conflict (between shareholders and policy makers) from the start?  The best solution is to make them an explicit government agency.

Once they are made an explicit government agency, however, another question arises.  Why have two additional agencies that are structured the same as Ginnie Mae and perform the exact same function?  Why not just expand Ginnie Mae?  This, I believe is the ultimate solution.  One government agency, providing mortgage guarantees and little else, subject to a specific set of restrictions on the underlying mortgages, for a specified fee.

The specific set of restrictions should be based on the GSE conforming loan standards that served the market well for many decades before the explosion of subprime: 20% down payments, LTV <= 80%, 28/36 DTI plus a FICO score (or substitute) somewhere in the low to mid 600′s as a minimum.  Approved mortgages should be standardized, with just a few options – 15 and 30 year fixed, and 3/1 and 5/1 ARMs (with perhaps slightly higher income requirements for the ARMs).

The fee (insurance premium) charged for the guarantee should be actuarily sound (balanced against claims over a moderately long horizon) and high enough to avoid underpricing of risk by the unscrupulous.

Let’s be absolutely clear.  This will, to a large degree, run counter to a policy of encouraging homeownership, particularly amongst the lower income strata.  At least in the short term it will.  I offer 2 arguments why this is a good idea:

  1. We don’t do low income potential home buyers any favors by putting them into houses they cannot afford and making foreclosure a near certainty.
  2. We don’t do low income potential home buyers any favors by artificially driving up the demand for houses, and thus increasing their prices.  Such policies, designed to make houses more affordable, run counter to their own purpose and make houses less affordable.

Government really ought to pursue the following two objectives with regard to the mortgage market, and these two objectives only:

  1. Ensuring that lenders are not discriminating against CREDIT WORTHY applicants on the basis of race, religion, ethnicity, sex, or geography.
  2. Ensuring that the mortgage market remains liquid and avoiding seizures (like what happened in late 2008 to early 2009) where credit worthy borrowers suddenly cannot find mortgage financing anywhere at any price.

This is the path forward.  It assumes a clean sheet of paper.  How we get from where we are today to the future, is a separate question, and a very difficult one.  The economy and the mortgage market are both fragile, and should not be disturbed excessively in the near term.  Implementation will have to involve a period of time when the current GSE portfolios are wound down simultaneously with the new system ramping up.


  1. Ed said,

    08.18.10 at 4:06 pm

    Like the Economist often has in the past, I would go farther and question whether expanding home ownership should be a government objective. My opinion developed from several reasons (I’ll continue the list in the next comment):

    1. Its easier for renters to move to a different labor market if times get tough in their location.

    2. Its questionable whether home owners who have to make mortgage payments for decades, or face repossession, and may have only a small portion in equity in their house in any case, really “own” their home in any material sense. At best, they may have a sort of capital lease.

  2. Ed said,

    08.18.10 at 4:10 pm

    (continued from previous comment)

    3. Its possible to structure rent laws to encourage longer term leases and make it somewhat difficult to throw renters out of their residences, encouraging the sort of stable investment in their communities home owners are supposed to offer, though free market types tend to hate these laws when and where they are enacted.

    4. The various explicit and implicit government subsidies for home ownership have gotten quite costly, and are more market distorting than the handful of renter protections.

    5. After decades of government policies promoting home ownership, we may have reached a point of inbalance or diminishing returns, even if these policies were sound when they were first enacted.

  3. RueTheDay said,

    08.19.10 at 6:50 am

    Ed – I agree. The government should not necessarily be directly targeting an increase in home ownership rates as a goal. The primary argument in favor of home ownership is that positive externalities accrue because owners of homes are more likely to take care of their homes and be active participants in their communities. There is truth to that, though at the same time, there are downsides such as the decreased mobility of labor that arises when people are tied to a geography due to home ownership. I also question the subsidy that we grant via the home mortgage interest deduction, which primarily benefits the wealthier strata. Nevertheless, I do believe that a well-functioning mortgage market is vital to a modern economy, and so support government measures to keep that market well-functioning.

  4. Ed said,

    08.19.10 at 11:31 am

    My understanding is that the GSEs back only residential mortgage backed securities, and student loans. The don’t back commercial mortgage backed securities. If their objective really was to maintain a well-functioning mortgage market, and not to increase home ownership, there would be no point in them guaranteeing residential mortgage backed securities and not commercial mortgage backed securities.

    This is true even of some asset backed securities. You do far more for poor people by backing securities made up of car loans than you do by backing securities made up of housing loans. Owning a car is of more use to a poor person trying to get out of poverty than owning a house.

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