Privatizing Fannie and Freddie and the Return of Subprime
In his State of the Union Address President Obama made a quick reference to his hopes for reforming Fannie Mae and Freddie Mac. Unfortunately, reform in this context doesn’t mean “better.” Reform is likely to mean privatization. In fact the most likely form of privatization at this point would feature the sort mix of private incentives and government guarantees that makes another financial disaster virtually certain.
The smart money in Washington is betting on the Housing Finance Reform and Taxpayer Protection Act (S. 1217), better known as the Corker-Warner bill after its two lead sponsors. This bill, which was put together by two of the more centrist senators in both parties, does not just get the government out of the mortgage guarantee business. There actually would be a plausible argument for that position.
But the Corker-Warner bill does much more than just eliminate Fannie and Freddie. In their place, it would establish a system whereby private financial institutions could issue mortgage-backed securities (MBS) that carry a government guarantee. In the event that a large number of mortgages in the MBS went bad, the investors would be on the hook for losses up to 10 percent of its value, after that point the government gets the tab.
If you think that sounds like a reasonable system, then you must not have been around during the housing crash and ensuing financial crisis. At the peak of the crisis in 2008-2009 the worst subprime MBS were selling at 30-40 cents on the dollar. This means the government would have been picking up a large tab under the Corker-Warner system, even if investors had been forced to eat a loss equal to 10 percent of the MBS price.
The pre-crisis financial structure gave banks an enormous incentive to package low quality and even fraudulent mortgages into MBS. The system laid out in the Corker-Warner bill would make these incentives even larger. The biggest difference is that now the banks can tell investors that their MBS come with a government guarantee, so that they most they stand to lose is 10 percent of the purchase price. This doesn’t bode well for a Corker-Warner future, since banks obviously had little difficulty selling junk filled MBS that carried no government guarantee at all.
Certainly the Justice Department’s treatment of the bankers who packaged fraudulent mortgages and misrepresented their quality to buyers will not discourage the same behavior in the future. None of these people went to jail and in most cases they are much richer today than they would have been if they had pursued an honest career.
The changes in financial regulation are also unlikely to provide much protection. In the immediate wake of the crisis there were demands securitizers keep a substantial stake in the mortgages they put into their pools, to ensure that they had an incentive to only securitize good mortgages. Some reformers were demanding as much as a 20 percent stake in every mortgage.
Over the course of the debate on the Dodd-Frank bill and subsequent rules writing this stake got ever smaller. Instead of being 20 percent, it was decided that securitizers only had to keep a 5 percent stake. And for mortgages meeting certain standards they wouldn’t have to keep any stake at all.
Originally only mortgages in which the homeowner had a down payment of 20 percent or more passed this good mortgage standard. That cutoff got lowered to 10 percent and then was lowered further to 5 percent. Even though mortgages with just 5 percent down are four times as likely to default as mortgages with 20 percent or more down, securitizers will not be required to keep any stake in them when they put them into a MBS.
Anyone banking on the bond-rating agencies to protect against the proliferation of junk MBS wasn’t paying attention to what happened to the Franken Amendment in the rules writing process. This amendment, which passed the Senate with a huge bi-partisan majority, would have eliminated the conflict of interest that results from having the bank issuing a MBS paying the rating agency that assigns the rating.
This conflict of interest would have been eliminated by having the Securities and Exchange Commission (SEC) pick the rating agency. This simple step would take away the incentive to rate every piece of junk as investment grade, as was the case during the bubble years.
This change would have taken effect, except the SEC, after being inundated with industry comments, deciding that picking rating agencies was too complicated. As a result we have the exact same system in place as we did during the bubble.
In short, the Corker-Warner plan to privatize Fannie and Freddie is essentially a proposal to reinstitute the structure of incentives that gave us the housing bubble and the financial crisis, but this time with the added fuel of an explicit government guarantee on the subprime MBS. If that doesn’t sound like a great idea to you then you haven’t spent enough time around powerful people in Washington.