Guest Post: A Fannie-Freddie Model That Aids Homebuyers, Protects Taxpayers

Submitted by Jed Graham of Investors.com

Ideally, reforming the government-controlled mortgage financing
behemoths Fannie Mae and Freddie Mac would achieve three goals:

1) Minimize the government’s balance sheet risk from a future collapse in home prices.

2) Promote a more constructive pricing of risk that isn’t distorted by government guarantees.

3) Avoid an increase in borrowing costs that could come as the
government’s role is redefined. (Well, this goal might not be ideal:
There is something to be said for a world of lower home prices and
higher market-based credit costs, but any idea that produces that
result seems a political non-starter.)

These three goals might seem contradictory: If the government narrows
its role in housing finance and risk isn’t being underpriced, doesn’t
that imply higher mortgage rates?

That’s why most reform proposals for Fannie and Freddie would simply
preserve a government guarantee and make it explicit, although that
guarantee has cost taxpayers $148 billion in the past two years.

The guarantee of Fannie and Freddie debt means a low cost of funds
for the two companies and riskless principal for all who invest in its
debt and mortgage backed securities.

The guarantee amounts to a subsidy that has enriched prior company
executives and MBS investors, with some benefits filtering down to
homebuyers in the form of modestly lower mortgage rates.

But there seems to be little justification for investors to enjoy
above-Treasury yields for investments that are free of credit risk,
especially when it encourages risky behavior for which the government
may have to eventually foot the bill.

An alternative approach could deliver government support directly to borrowers and avoid endangering government finances.

The idea reflects the reality that there is a portion of each home
loan that is very close to riskless. That is the portion backed by the
expected foreclosure value of a home given a potential house price
decline. Let’s say that portion equals 40% of the purchase price.

Now, say that the government, instead of putting its guarantee behind
a conventional 30-year $160,000 mortgage, opted instead to take on
the very low risk of backing the first $80,000 of the loan and
providing the borrower with an ultra-low, interest-only loan of some
modest amount above the 10-year Treasury yield. Based on today’s
rates, let’s say 3.5%.

By focusing its low-cost-of-funds support on home loans up to the
foreclosure value, the government could avoid making risky mortgage
guarantees that might distort lender behavior without hurting home
affordability.

A low, interest-only rate on the first $80,000 of the loan would
provide private lenders the opportunity to fully price the risk
involved in the other $80,000 part of the loan without curbing
affordability, i.e. raising monthly payments.

This approach could encourage responsible behavior by borrowers and
lenders alike. Because there would be no government bailout for those
who invest in bad loans, investors would hold lenders to a higher
standard.

For borrowers, because the privately financed portion of the loan
would carry a higher interest rate, they would have a greater
incentive to pay down principal as fast as possible, which would in
turn make the loans more secure.

As a further way of limiting risk while providing market support when
needed, the size of the government portion of the loan could move in
a countercyclical fashion, going perhaps below 40% of the purchase
price when markets are operating smoothly and somewhat higher during
times of heightened stress.

One last point: Unlike a world in which mortgage risk is all held
privately, under this approach private investors would have zero
incentive to foreclose, because they would stand to be wiped out, and
every incentive to make a loan sustainable if possible.

Comments

[Misean]

"

Ideally, reforming the government-controlled mortgage financing behemoths Fannie Mae and Freddie Mac would achieve three goals:

1) Minimize the government’s balance sheet risk from a future collapse in home prices.

2) Promote a more constructive pricing of risk that isn’t distorted by government guarantees.

3) Avoid an increase in borrowing costs that could come as the government’s role is redefined. (Well, this goal might not be ideal: There is something to be said for a world of lower home prices and higher market-based credit costs, but any idea that produces that result seems a political non-starter.)"

So, that's friggin' easy.  Nuke 'em from orbit, it's the only way to be sure.  Anything else is hot air and horse poop.

[docj]

Ideally, the only "reform" of the government-controlled mortgage financing behemoths Fannie Mae and Freddie Mac that is required is their liquidation - followed by burning them to the ground and salting the earth where they stood so nothing could ever rise from their ashes.

[RagnarDanneskjold]

Nothing more needs to be said. 

[spekulatn]

SNIP>>

Fannie and Freddie could not be shuttered immediately; they are too large. A sensible transition plan would have them stop buying new mortgages, and their portfolios would decline as the mortgages they own are paid down. Within 10 years, the portfolios would shrink to insignificance.

Their securitization business, whereby they purchase mortgages and issue securities against them, should likewise be wound down. A practical approach would be to set a gradually rising schedule of fees, motivating private companies to enter the securitization business.

In 10 or 15 years, the companies would be gone, closing a chapter in American financial history that enjoyed considerable success but ended very badly and at great taxpayer cost.

http://www.nytimes.com/2010/08/12/opinion/12poole.html?_r=2&ref=opinion

[faustian bargain]

+1, I can't believe anyone is seriously trying to talk about 'reform' of something that shouldn't even exist.

[overmedicatedun...]

doc, seems most here on ZH agree. kill the twin leaches  and be done with it.

[wang]

no no no - Big meeting coming up August 17 that will fix everything with a cast of leaders that have the best interest of America at heart, lots of favorites but if I had to choose I think Ellen Seidman would be my pick - got to love that Chicago / ShoreBank / Obama bailout connection (especially the ShoreBank logo * (no wonder they were pulled back from the brink):

* http://www.shorebankcorp.com/bins/site/templates/splash.asp

Obama Administration Announces Panelists and Agenda for Conference on the Future of Housing Finance

·         Barbara J. Desoer, President of Bank of America Home Loans

·         Ingrid Gould Ellen, Professor of Urban Planning and Public Policy at New York University's Wagner Graduate School of Public Service and Co-Director of the Furman Center for Real Estate and Urban Policy

·         Bill Gross, Co-founder and Co-chief Investment Officer of PIMCO

·         Mike Heid, Co-president of Wells Fargo Home Mortgage

·         S.A. Ibrahim, Chief Executive Officer of Radian Group Inc.

·         Marc H. Morial, President and Chief Executive Officer of the National Urban League

·         Alex Pollock, Resident Fellow at the American Enterprise Institute

·         Lewis Ranieri, Chairman of Ranieri and Company, Inc.

·         Ellen Seidman, Ellen Seidman, Executive Vice President for Mission and Strategy, at ShoreBank Corporation, and Chair of the Board of Directors at the Center for Financial Services Innovation

·         Michael A. Stegman, Director of Policy and Housing for the Program on Human and Community Development of the John D. and Catherine T. MacArthur Foundation

·         Susan Wachter, Richard B. Worley Professor of Financial Management, Professor of Real Estate, Finance and City and Regional Planning at the University of Pennsylvania's Wharton School

·         Mark Zandi, Chief Economist of Moody's Analytics

http://treasury.gov/press/releases/tg826.htm

more on ShoreBank

http://www.chicagobusiness.com/article/20100625/NEWS01/200038691/shoreba...

[Guillermo]

Jesus Christ. WASP's built this country. Displacement would be ok if the new elite were competent.

[Sancho Panza]

The risk associated with the privately-financed portion of the author's scheme is astronomical.  The free market rate for this portion would be so high it would ruin the author's objective #3.

If there is one thing we should have learned by now is that you cannot eliminate risk.  You can only change its allocation. 

[GittyUP]

Banks dont care about who backs the riskless part of the loan.  Its called riskless for a reason!  Whether the govt backs it or nobody they are still going to get the foreclosure value of the loan.  They'd rather just write it themselves and get full yield. 

[CulturalEngineer]

Here's one up-vote!

It's only with a first glance but it seems like the kind of reasoned approach that ought to be looked at.

Though unfortunately it's not going to help get us out of the existing mass clusterf**ck that we call the current residential real estate situation.

And it may be entirely too upsetting for future Ponzi scheme plans to be seriously considered by Congress.

[Atomizer]

US Treasury Schedule

http://www.ustreas.gov/offices/domestic-finance/debt-management/auctions/auctions.pdf

[Monkey Craig]

None of this is meant to protect taxpayers. They are the patsies and they must keep sending in 40% of their paycheck to keep our game going. - sarcasm off

[rational]

Its an interesting idea, but I think home prices would just inflate to the maximum degree the bbanksters felt they could get away with in exploiting the "risk-free" government loan. Then tey would blow up and the taxpayers will bail out the banksters again, they just won't be called fannie and freddie.

[Freewheelin Franklin]

The entire home ownership (American Dream) thing is nothing more than a form of social engineering. It was fueled by the GI Bill and Levitt homes at the end of WWII. Fannie and Freddie were created to artificially prop up home prices to protect the investment of the homeowner.

Set the market free!

Fannie and Freddie must die!

[QQQBall]

Get the fricking government out of the economy. Why must mortgages require a gubbermint guarantee?  I believe there is a study floating around that concluded that FNM lowered borrowing costs by a whopping 7 bps. All this hand wringing and brain damage for a 5.00% vs 5.07% interest rate?

[jag]

Should there be any government policy to encourage home ownership?

This is eminently arguable in the first place but should there be ANY argument that the government has no business  offering subsidies to homes priced over, say, the median price of homes ($250k?)?

And why should the government encourage any home ownership beyond the purchase of one's FIRST home? Sure, helping a growing FAMILY (not an individual) secure a sound (if modest) home likely helps society in general by aiding in the process of stabilizing BASIC family life. But when people move up, shown they can manage finances soundly, shouldn't they be encouraged to be as prudent as possible? Prudence is imposed by the private sector in its normal search for balance between risk and reward.

Is it at all arguable that every government subsidy just increases financial instability by reducing normal, prudent, market driven behavior?

I defer to those who think it should be ONLY market driven. However, politically speaking, if any real estate subsidy should be considered it really should be focused on FAMILIES and ONLY on helping at the most modest levels of income. Subsidizing mortgage attainment, mortgage rates and deduction of mortgage interest above the most modest levels only, ultimately, drive up risks and costs for everyone involved. The perfect example of this is the recent $8,000 credit. It simply increased the sales price of property for a brief period.