Rethinking the Goals of a National Mortgage Bailout

Front and center this week have been the ill fortunes of Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs) that together own trillions of dollars’ worth of US home mortgages.

At this point in time, there really is no reason to own the stock of either company. The Administration is said to be looking carefully at whether and how to do a government takeover of one or both. The grand 35-plus year experiment in semi-public support for US housing may be coming to an end.

But that’s far from the only problem in the mortgage/housing sector. In fact, it may be the easy problem. The hard problem is what to do about all the homeowners that are falling behind on their payments.

This is a time bomb that continues to tick away, and Congress has been working hard to pass a huge bailout bill (the Dodd-Frank Act). President Bush has vowed to veto it, but he’ll break that promise.

But what are the objectives (both political and economic) of this enormously costly legislation? Can it actually meet those objectives? And are they the right objectives in the first place?

Keep reading.First, a few words about the GSEs. As you know, they borrow money from investors and use it to buy mortgages. Their cost of capital is uniquely low for privately-owned entities, because they have always benefited from two things: they’re allowed to buy only very safe mortgages that are unlikely to default; and there has always been an unspoken assumption that the Federal government would guarantee their debt. (A third entity, the Government National Mortgage Association, or “Ginnie Mae,” actually does have an explicit government guarantee.)

But the GSEs are now being questioned by investors, and not only because they’ve suffered larger-than-expected losses on their mortgage portfolios. The spread, or difference, between what they must pay on their debt (the so-called “agency bonds”) and what the US Treasury pays on debt of similar duration is now at abnormally high levels.

That means the cost of capital for the GSEs is higher than it should be, considering that the debt is implicitly guaranteed. That tells you that investors are reluctant to be lending money for home mortgages, and it also means that the GSEs’ profit margins are under pressure. Hence the decline and fall of their stock prices.

If this keeps up, there is at least some risk that Fannie, Freddie, or both may start losing money. If they can’t keep borrowing at low enough rates to finance affordable home mortgages, there’s no alternative but for the government to take them over. And you, dear taxpayer, could suddenly be the owner of trillions of dollars’ worth of home mortgages.

What makes all of this worse is several recent Bush Administration initiatives. It turns out that Fannie and Freddie have been called on to temporarily relax the strict standards under which they buy mortgages, and which are a key reason their capital costs have been low. They’re now buying much larger mortgages (the limit was raised from below $500,000 to over $700,000), and other parameters were changed too.

All of this exposes the GSEs to much more credit risk than they (and their bondholders) are used to taking. In essence, Congress and the Administration responded to the extreme stresses in the mortgage market by making Fannie and Freddie something akin to lenders of last resort, a role they were never intended to play.

And that brings us to the Dodd-Frank Act. It’s being reported this morning that the bill will pass the Senate today (with the cooperation of Richard Shelby of Alabama, the Finance Committee’s ranking minority member), and will move to the House next week.

The basic idea of this mammoth legislation is provide relief to people who are having trouble paying their mortgages. It contemplates a $300 billion expansion of the Federal Housing Administration (FHA), which is the New Deal-era agency that insures mortgages against default.

The thinking is that there are a lot of people in danger of losing their homes because they can’t afford their mortgage payments. The details get really complex (and have been fought over in Congress for months now), but the plan is to replace existing mortgages with fixed-rate loans on a somewhat smaller principal amount. (Lenders would need to provide the principal reduction, and in return they would receive some of the upside in case home prices rise in the future.)

And the replaced loans would receive a guarantee from the FHA, and in turn would be shoveled into Fannie Mae or Freddie Mac.

But a lot of the people who benefit from this program probably won’t even be able to afford their replacement mortgages. We the People are going to make up the difference. The legislation provides for $300 billion in taxpayer money to back up the FHA’s guarantees. And even Barney Frank has been muttering that it might not be enough.

Now I’d like you to ask yourself: why the hell do we need a bailout like this? Why should we reward millions of people for making mistakes they shouldn’t have made in the first place?

Because Congress and the Administration deem it unacceptable for a large number of people (perhaps millions) to lose their homes and have to move back to rentals.

This will be one of the largest interventions in free markets in history. But the Administration and Congressional Republicans are going along with it because of the very real fear of an economic collapse if we have millions of foreclosures.

The government is proposing to pin people into homes they can’t afford. It’s the foreclosure that they’re trying to prevent. Foreclosures will lead to widespread reductions in home values, even for homes without distressed mortgages. The value of all residential real estate will adjust massively downward. This will also reduce the value of existing mortgage securities and agency debt, and will probably result in a sharp increase in mortgage rates, which will reduce home values even more.

This potential for an ugly deflationary spiral (sometimes referred to as “Great Depression II”) is what has some very smart bond-market people totally spooked.

What has me spooked is that the bailout may not even work. We may not be able to prevent a downward adjustment in the real-estate market, because the adjustment reflects reality. Housing is overvalued now. By providing a huge bailout that seeks to lock today’s market distortions in place, we may be creating new stresses that will come out some other way. The massive deflation might happen anyway. It just might take years longer to do, and years longer to recover from. And no matter what happens, the US housing market will be permanently federalized.

Is it economically possible for the bailout to actually work? Yes, it’s possible. It would amount to the same kind of medicine as a fiscal stimulus. It’s basically a huge wad of money creation (aka, inflation) that just might result in a sudden stabilization of mortgage values and end the global credit crisis. That would be the grand-slam home run scenario. There are intermediate possible outcomes between the two extremes.

Which outcome is most likely? History is no guide. The only honest answer that anyone can give you (and that includes Barney Frank, Paul Krugman, Bill Gross, and Hank Paulson as well as yours truly), is: We won’t know until we try it.

What should the goal of the bailout program really be? It should be to make it possible for people who can’t afford their mortgages (and who are already behind on their payments) to get eased into foreclosure, out of their homes, and back into rentals with the minimum amount of fuss. If we really are prepared to accept some moral hazard, then let’s give these people a small subsidy to take the deal. But let the adjustments happen and let the market find its level. This plan is where we’ll end up in a year or two, if the current bailout plan lays an egg.

Political reality, however, dictates that some kind of a bailout will happen. We’ll be rolling these dice. Hold on to your hat.

-Francis Cianfrocca