In July, the Senate Banking Committee held two hearings focused on what to do with Fannie Mae and Freddie Mac, the government-sponsored enterprises that purchase and securitize most of the nation’s mortgages. The Treasury placed the two mortgage giants into conservatorship at the onset of the financial crisis in 2008, and they remain in that state today.
Most policymakers agree that their conservatorship should come to an end, given their improved fiscal health and robust profits over the last five years, but there is no consensus on what ought to follow the current arrangement. A few have suggested that Congress simply make some modest changes to augment the reforms that have already been enacted and release them from government control. Others agitate for dismantling the current mortgage financing system and remaking it from scratch.
Almost every proposal claims to protect taxpayers. However, in most cases that’s an empty promise, and the federal government remains the backstop in the event of another financial crisis.
For instance, a much-touted proposal by the Mortgage Bankers Association, a trade association of big banks Wells Fargo, claims to protect taxpayers by bringing private “first loss capital” which means that shareholders and investors are (theoretically) on the hook ahead of taxpayers to take losses if an investment went belly up.
At first blush that sounds great, but in reality, this plan would have the government put its unlimited “full faith and credit” on mortgage-backed securities (MBS) issued by big banks, potentially exposing taxpayers to losses should we see another housing bubble inflate and pop.
Thebig banks want to get into the business of making mortgage-backed securities themselves by serving as new “guarantors” to compete with Fannie and Freddie. But a full faith and credit backstop on the MBS they issue would be bad policy for a number of reasons.
First, the false sense of security created by the government guarantee would remove incentives for the big banks to responsibly underwrite mortgage loans and minimize risk in the mortgage space, potentially replicating the moral hazard precipitated the last fiscal crisis. If taxpayers and not banks are on the hook at the next mortgage crisis, banks making loans to be packaged into government-backed securities may not be as vigilant about whether borrowers can repay their loans and the possibility of losses on these investments arises.
Second, a new government guarantee on MBS would affect market pricing and capital allocation. If big banks and investors are convinced that the government guarantee will minimize losses, they will bid up the prices of the guaranteed MBS, pushing down interest rates on the mortgage loans used to create those MBS. While that might be good for borrowers, it would push excessive financial resources into the housing sector instead of other areas of the economy that could use capital more productively. In the lead-up to the 2008 financial crisis, government policies exacerbated the already-heated real estate speculation, which diverted capital from other important sectors vital to job creation. When the housing market collapsed, it exposed weaknesses across the rest of the economy.
Finally, the big banks would potentially become riskier and pose bigger threats to taxpayers under this plan. Post-crisis, the United States and other countries have insisted on rigorous capital requirements for large financial institutions. The requirements, known as Basel III, require capital reserve ratios of 20 percent for mortgage-backed securities held by banks. An unlimited government guarantee on these MBS would obviate this requirement, creating an arbitrage opportunity for these same financial institutions. Big banks would reap a windfall from being able to hold MBS with little to no capital in reserve. Instead of minimizing taxpayer losses, they will be exposed to potentially significant losses.
How big of a deal is this? Zero-percent capital requirements applied to the $1 trillion in Fannie and Freddie MBS held by U.S. banks would save them $200 billion in capital. At a time when regulators want banks to hold more capital against losses, the MBA plan would allow them to hold dramatically less.
This guarantee would undermine and undo the work done by Congress when it passed the Housing and Economic Recovery Act (HERA) in 2008, which reformed the GSEs, and would have taxpayers backstop even more entities.
The Mortgage Banker Association plan would expand the number of issuers of mortgage-backed securities and create a new government backstop benefiting a small class of big securities holders. Taxpayers need stronger protections from having to shore up private-sector risk, and the appropriate way to provide this protection is to implement stronger safety and soundness standards. This can best be accomplished by making additional reforms of Fannie and Freddie, not by creating new players in the mortgage finance game and giving them a taxpayer-funded backstop.