When you combine very low levels of down payment on the borrower side and very low levels of capital on the investor side, it's a toxic mix. At some point the leverage party stops. —Edward Pinto, economist at the American Enterprise Institute
America's favorite mortgage, the 30-year fix with its low monthly payments and the ability to refinance if rates drop, would become a rare bird on the American financial landscape if Edward Pinto had his way.
Five years after the housing crisis, monster mortgage brokers Fannie Mae and Freddie Mac, the two semi-public for-profit corporations taxpayers spent $200 billion rescuing, remain under direct federal control.
Ninety percent of new mortgages today are still issued or guaranteed by those two entities, leaving many to wonder if root causes have been or ever will be addressed.
The most prominent vehicle for fixing the housing market at the moment is a bill that would eliminate Fannie and Freddie while creating new rules to rein in risky lending and borrowing. The bill, proposed by Sen. Mark Warner (D-VA) and Sen. Bob Corker (R-TN), has recently gained strong bipartisan support.
Already 10 of the 22 members of the Senate Banking Committee have cosponsored it, with equal numbers from both parties.
The Corker-Warner proposal steers a middle ground between consumer demands for affordable loans and taxpayer protections against future bailouts, shifting much of the risk of mortgage loans back to the private sector. But at the same time it creates a new system of guarantees to ensure that the market will provide the loans consumers expect.
The proposal’s basic principles have been endorsed by think tank economists, industry leaders and even the White House. “For too long these companies were allowed to make huge profits buying mortgages, knowing that if their bets went bad, taxpayers would be left holding the bag," President Obama said in August of Fannie and Freddie. "It was 'heads we win, tails you lose.'”
But committee leaders from both parties have not yet put their fingerprints on the proposal, and when the Senate takes it up this fall, many expect key provisions to be watered down.
Politics over markets
Any more watering down would leave very thin soup, according Pinto.
The greatest indicator that the bill is not serious, in Pinto’s view, is that Corker-Warner seeks to guarantee the survival of the 30-year mortgage, which Pinto calls an "unnatural instrument.”
Without government-backed entities buying up and guaranteeing those loans, says Pinto, an economist at the American Enterprise Institute, they would be very unattractive to investors. In Canada and much of Europe, freely prepayable, long-term and fixed mortgages are rare. Much more common are "rollover mortgages," where the rate is adjusted every 5 to 10 years.
Pinto likewise argues it was politics, not markets, that led to the housing bubble and the subsequent crash in 2008, spurred in large part by government encouragement of high risk loans aimed at overstretched borrowers.
And it is political pressure, he argues, that is keeping politicians from addressing the roots of the housing crisis.
The Corker Warner bill would phase out Freddie and Fannie, removing that threat of private gain on the back of public risk. It would re-create a private mortgage market that disappeared in 2008, putting a chunk of private capital at risk before taxpayers would be on the line. But the bill would also try keep mortgages affordable for middle- and lower-income families by maintaining ultimate government guarantees, creating a Federal Mortgage Insurance Corporation that would regulate and collect and maintain insurance fees.
For better or worse, the 30-year mortgage would survive under the Corker-Warner regime.
The pressure behind this balancing act is a battle of competing identities. As consumers, most homeowners value the easy access to affordable long-term mortgages and flexible refinance options. As taxpayers, they may resent the fact that twice in 20 years taxpayers have been forced to cover lending disasters covered by government guarantees, the last time being the 1988 Savings and Loan Crisis.
No man's land
Corker-Warner thus tries to navigate a delicate balance, merging the ying of taxpayer risk with the yang of political demands for easy access to home ownership.
It’s a balancing act that will never please everyone, says Philip Swagel, chief economist at the White House Council of Economic Advisers and now a scholar at the Milken Institute. On one side is political pressure for easier loans, spurred in part by advocates for low-income and minority families, who see any shift toward private housing markets as a threat to accessible home ownership.
“It will make it virtually impossible for many in the middle class, and particularly people of color, to purchase homes in the future,” the NAACP's Hilary Shelton told Mortgage Servicing News.
On the other side are market-oriented economists, like Pinto, who argue that government entanglement in the mortgage market, encouraging and guaranteeing "unnatural" loans, will lead to more of the same.
Kevin Villani, chief economist at Freddie Mac from 1982 to 1985 and now a scholar at the Burnham-Moores Center for Real Estate at the University of San Diego, sees the blending of "insurance" and "guarantees" as a contradiction.
Villani argues in American Banker that "federal government guarantees are the opposite of insurance," arguing that insurance is an actual business model that leverages the risk of default against the security of large numbers.
Guarantees, Vilanni argues, "were the centerpiece of the public-risk-for-private-profit model that caused the last systemic failure of the mortgage system, and deposit insurance caused the prior failure of Savings and Loans."
The sweet spot?
"Any time you have a government guarantee," Swagel said, "you have moral hazard," or the temptation to take risks when other people will bear the losses. But Swagel argues that the political reality is that consumers and voters will demand access to mortgages that the market will not provide without government guarantees, and the key is to control and channel the dangers.
But the Warner-Coker proposal would leave the federal government as the ultimate insurer in case of catastrophe. Without that guarantee, supporters argue, affordable mortgages would not be available to many middle- or lower-income families. With that guarantee, opponents respond, the market will be skewed again and taxpayers will end up paying the tab.
This has happened twice in just 20 years, Pinto said, pointing to the Savings and Loan Crisis in the late 1980s. "When you combine very low levels of down payment on the borrower side and very low levels of capital on the investor side, it's a toxic mix. At some point the leverage party stops."
Swagel fears that free market opponents of the bill are "letting the perfect be the enemy of the good."
"The Corker-Warner bill makes the system more private and protects taxpayers," Swagel said. ""It doesn't go all the way to a fully private system, because that is not feasible."