Negative intellectual equity traps mortgage reform
Mortgage reform is caught in a negative intellectual equity trap. On Monday the Bipartisan Policy Center, a Washington think tank, unveiled its plan to shake up housing finance. Unfortunately, it rests on the usual received wisdom that the market cannot exist without a government backstop. It’s an idea prevalent among lawmakers, bankers and investors. It’s wrongheaded.
The BPC report is merely a variation on one of the three Treasury proposals from 2011. It recommends replacing mortgage finance bailout twins Fannie Mae and Freddie Mac with a public entity that would provide a backstop in the event of a market catastrophe. Private lenders and mortgage insurers would be on the hook for losses, but the public insurer – funded with premiums paid by the industry - would step in if they run out of capital to make mortgage bond investors whole.
The only innovation is to cap such aid to mortgages that are $275,000 or less. That’s a third smaller than today’s standard limit, which leaves the government standing behind 90 percent of new home loans. But the BPC suggestion is still about 40 percent higher than the average mortgage.
The proposal would at least shrink the government’s presence. But it’s problematic. In good times, the industry will lobby to cut guarantee fees – probably successfully, based on recent history. Setting proper prices is not a strength of the public sector: the Federal Housing Administration, for example, suffers from a $16 billion shortfall after setting its guarantee fees too low.
The plan highlights, though, just how bereft of new ideas both Washington and the mortgage industry are. No one wants to imagine a world without government support. Banks love stuffing their balance sheet with Frannie bonds, treating them as quasi-cash. Other mortgage debt buyers seem quite happy outsourcing the credit risk to Uncle Sam.
The smarter course of action would be for investors to embrace more rigorous analysis of their own and to buy only those mortgages whose lending standards meet their investment criteria – be that ultra-safe loans or riskier, subprime debt.
For now, though, the lazy status quo that allows the United States to be the only country that backstops most of its mortgages looks set to endure.