Friday, February 11, 2011

Options for the Long-Term Structure of Housing Finance

by Bill McBride on 2/11/2011 02:20:00 PM

The Obama Administration released an outline this morning on winding down Fannie and Freddie, and for the future of government involvement in the housing finance market.

Here is the Treasury press release on Fannie and Freddie. And here is the report.

The wind down of Fannie and Freddie will be slow and take a number of years, but the key question is what, if anything, will replace them? The plan offers three options:

Option 1: Privatized system of housing finance with the government insurance role limited to FHA, USDA and Department of Veterans’ Affairs’ assistance for narrowly targeted groups of borrowers

The key problem with this first option is what happens when the private markets once again freeze up? With this option, when the next crisis arrives the government would have to scramble (like during the Depression) and come up with some programs to offer financing to qualified borrowers. Prior to the Depression, the most common mortgage loans was short term (like 1 to 5 years), interest only, with a balloon payment due at maturity (see: Mud-Luscious: Balloons for UberNerds for a discussion of balloons). Even though a 50% downpayment was common before the Depression, when these balloon payments came due, the borrower couldn't refinance - even if they had a job, because the private market was completely frozen. At that lack of financing lead to the formation of FHA and FNMA. (To understand the names, see Tanta's: On Maes and Macs)

So we could just scramble again, or have some sort of small program running that could be scaled up during the next crisis as proposed in Option 2.

Option 2: Privatized system of housing finance with assistance from FHA, USDA and Department of Veterans’ Affairs for narrowly targeted groups of borrowers and a guarantee mechanism to scale up during times of crisis

This backstop would maintain a minimal presence in the market during normal times, but would be ready to scale up to a larger share of the market as private capital withdraws in times of financial stress. One approach would be to price the guarantee fee at a sufficiently high level that it would only be competitive in the absence of private capital. It would thus only expand when needed, and that need would be dictated by the market. An alternative approach would restrict the amount of public insurance sold to the private market in normal times, but allow the amount of insurance offered to ramp up to stabilize the market in times of stress.
Option 3: Privatized system of housing finance with FHA, USDA and Department of Veterans’ Affairs assistance for low- and moderate-income borrowers and catastrophic reinsurance behind significant private capital

This is another way of providing mortgages during the next crisis, however I think this approach takes on too much risk.
And while the capital requirements, oversight of the private mortgage guarantors, and premiums collected to cover future losses will together help to reduce the risk to the taxpayer, the reinsurance of private-lending activity, by its nature, exposes the government to risk and moral hazard. If the oversight of the private mortgage guarantors is inadequate or the pricing of the reinsurance too low or recoupment of costs too politically difficult, then private actors in the market may take on excessive risk and the taxpayer could again bear the cost.
My initial reaction is that Option 2 is the best approach.