Five Questions About Government's Role in the Mortgage Business

There is a good article in The Washington Post, by Zachary A. Goldfarb and Dina ElBoghdady. The article discusses the role of the federal government in the current mortgage market. The authors conclude that there would be no mortgage market today without the government, as nearly 90% of all mortgages issued today are funded or guaranteed by the government.

This leads immediately to questions, such as:

1. Can the government be effective as a mortgage banker?
2. Should the government be in the mortgage business?
3. Can private capital compete in the future?
4. What would the situation likely be today if the government was not in the mortgage business?
5. Will public policy trump sound financial judgment?

Let's tackle these questions one at a time.

1. Can the Government Be Effective?

The answer depends on perspective. If effective means getting money into the housing market, the answer is yes. If effective means making good individual lending decisions, the answer is probably not. Goldfarb and ElBoghdady give the following example:

Philip Zanga, an investor, signed a contract on a $367,000 condo in Bethesda this summer and paid a $15,000 deposit. He planned to put down 60 percent, but his loan was rejected. Investors and loans for condos are both deemed risky by Fannie (FNM) and Freddie (FRE).

One can just imagine how this decision was reached. Somewhere early in the screening process, an administrative process, maybe a computer and not even a person, went through a short checklist. On this list were items that included "investor" and "condo". If any two things on this list got checked, the loan application was rejected. It would never get reviewed on the merits.

Of course, the process just described is entirely hypothetical. But it has credibility because if reflects the nature of bureaucratic systems. In the days of local lending, the application in the example would have a high probability of approval.

So the answer is yes, the government can be effective on a macro scale, but there will be incidences of ineffectiveness in individual cases.

These statements are made with full recognition that private lenders (banks and mortgage companies) have a track record for effectiveness that gives the government a very low standard to meet.

2. Should the Government be in the Mortgage Business?

It is a little late to ask this question. The National Federal Mortgage Association, Fannie Mae, was chartered by Congress more than 70 years ago. The question might better be, "Should the government remain in the mortgage business?"

It is clear that, in terms of management of investment risks, government sponsored enterprises (GSEs) have suffered from the same mismanagement as private sector banks. In that regard the GSEs can be considered not superior. Improved regulatory boundaries must be established for both.

The question is often raised about the social engineering efforts of Congress to influence GSE lending practices. A popular target is the Community Reinvestment Act of 1977. The idea of a significant contribution of CRA to the current housing crisis has been thoroughly debunked by many different analyses, but the question still remains whether legislation such as the CRA could prove to be an Achilles' heel in the future. If the GSE arrangement is to be continued, safeguards must be taken to ensure sound financial management is not compromised by political interference.

My personal answer to the question is yes, the government should remain in the mortgage business. This question can be revisited when we have a sound financial system, but that is many years in the future.

3. Can Private Capital Compete in the Future?

If GSEs are allowed to run at a loss and be supported by repeated infusions of taxpayer dollars, it is unlikely that private capital can compete. A major problem in conducting this discussion at the present time is that private capital is also operating at a loss with support from infusions of taxpayer dollars.

My answer is yes, with qualifications. It requires return to sound financial practices for both GSEs and private capital. It is not clear that we are moving in that direction yet. From the Post article:

Fannie Mae and Freddie Mac were chartered by Congress four decades ago to create a marketplace where mortgage lenders could sell the loans they made and use that money to make more loans. The two companies were owned by private shareholders and, for a fee, guaranteed investors in mortgage loans that they would get paid. After the government seized Fannie and Freddie, it offered them an unlimited line of credit and pledged to inject up to $400 billion to keep them solvent.

But this is not the only form that government involvement in housing finance takes.

The Federal Reserve is purchasing hundreds of billions of dollars of mortgages with the aim of ultimately owning $1.25 trillion worth. This buying spree has flooded the mortgage market with money, forcing down interest rates and assuring lenders they have somewhere to sell their loans. The Treasury Department has a similar, though smaller, program."

The Federal Housing Administration, meantime, is dramatically increasing the amount of home loans it insures. Its share of new mortgages jumped from 1.8 percent in 2006 to 18 percent so far this year, according to Inside Mortgage Finance. It expects to insure about $400 billion this year. Several other agencies, such as the Department of Veterans Affairs, also provide mortgage guarantees.

So, Fannie and Freddie own or guarantee about $5 trillion in mortgages; the Fed is on a path to owning $1.25 trillion; the FHA is adding about $0.4 trillion to what it already insures; other agencies also are providing guarantees; and the Treasury is absorbing poorly performing mortgage securities. The government is associated with at least half of the existing mortgage base and is currently involved with the origination of just under 90% of the new mortgages.

One problem buried in all the above numbers is summarized in the following anecdotal note from the Post:

Some people who are no longer eligible for loans elsewhere have turned to FHA, which does not demand top-notch credit scores or sizable down payments. But for some consumers, such as Lisa McCracken of Stafford County, the FHA's minimum 3.5 percent down payment can be a stretch.

McCracken, a traveling nurse, has been scrimping to raise the down payment, living with her parents to save money. "I think I can swing it, but it won't be easy," she said. "I'll be wiping out a lot of my savings to buy a house."

Lending with 3.5% down can work in a stable housing market and a healthy employment outlook. It is a recipe for disaster if house prices drop further and employment remains depressed. How many underwater 3.5% down people will walk if home prices fall another 10% or more?

Can private capital compete in the future? Over the next three to five years, probably not. Five to ten years, maybe. Ten years or further, the answer had better be yes. These projections can all be upgraded significantly if home prices have actually bottomed. This author thinks that is probably not the case for the national median and average, but there could be local markets that have seen the bottom.

4. What if the Government Was Not in the Mortgage Business?

With nearly 90% of 2009 mortgages involving the government, home sales would be substantially lower if the government was not in the mortgage business. Banks are not lending, as shown in the following graph:

It is likely that new home sales would be reduced by much more than half since most are purchased with mortgages. Existing home sales might be reduced less. There are many reports of investors making cash purchases of foreclosed homes at deep discounts. I do not think it is unreasonable to estimate that new home sales could be reduced by some amount a little less than 86% (the fraction of new mortgages having some form of government sponsorship). As a conservative estimate, let's use 50% for the impact on existing home sales.

The estimated effect on GDP for reduced new home sales can be calculated. Let's assume that the reduction would have been 75% in 2009 and half of that in 4Q/2008. This means that some of the 86% financed with government backed mortgages would have found other financing, but most would not. This does not include any ancillary effects on other economic activity from the reduced home sales. This could be a large effect, maybe even approaching the impact of reduced home sales themselves.

Using just these numbers (without ancillary effects), revised GDP estimates (including an estimated 37.5% reduction in home sales for 4Q/2008) are shown in the following table:

If the government had not stepped up to the plate to maintain a mortgage market, the economy would have fallen a lot deeper into the hole. It is not likely that the other aspects of the economy that have elevated GDP numbers in the second quarter would have taken hold in the face of ancillary damage from the mortgage collapse. The -1.0% (or -0.5%) number for the second quarter almost certainly would have been much more negative.

We can be very happy we do not have to experience the world that would have resulted had the government not taken charge of keeping mortgages available.

5. Will Public Policy Trump Sound Financial Judgment?

This is where the most uncertainty lies. In Section 3 we discussed the FHA allowing 3.5% down mortgages. This may be simply keeping some air in a bubble that is still trying to deflate. If such mortgages are issued in areas that still have further price drops to come, 2009 mortgages may be adding to the foreclosure overhang from the earlier years. I see significant risk here, especially since employment is still falling and loss of employment can put still more foreclosures into play.

It is clear that public policy has attempted to slow the crash. But, in my opinion, such policy is only of value if it makes the decline more orderly, not if it attempts to prevent it. Equilibrium is equilibrium and metastable states can be (and in economics often are) temporary conditions that ultimately are resolved by reaching true equilibrium.

If public policy attempts to support artificial price levels, or tries to move supply or demand without recognizing their natural states, the outcomes will be less than optimum, at best. At worst, we have the huge failures of Hoover with respect to GDP and employment; the failures of FDR with respect to maintaining the stability of GDP growth and the resumption of full employment; the failures of Truman, Johnson, Nixon and Ford with the misapplication of price and wage controls; and the failure of Greenspan who believed that artificially low interest rates was an effective way to prevent economic declines and support continuous growth.

We may be doomed by the conceit that public policy can control major economic forces. On the other hand, we have seen repeatedly throughout history, that self-regulation by monopolistic interests also leads to doom. Such self-regulation has always led to advancement of self interest to the exclusion of almost everything else.

Will we ever find a way for public policy, regulation and free enterprise to discover an optimal formula? Perhaps, but it has certainly been proven that we have not come close yet.

Comments

[markfl:]

A recent Barron's article reported that bank lending standards are now 90% tighter than what they had been in recent years. Given the importance of mortgage financing to any economic growth, it does make it rather difficult for the government not to be the mortgage banker of last resort if banks aren't willing to lend. I could understand 50% tighter standards, but 90% seems a little extreme.
online.barrons.com/art...

Sep 09 11:41 AM

[Leftfield:]

Home ownership was once touted as a crown jewel of the rewards of capitalism in the US. Now it is emblematic of self-absorbed, mediocre leadership, entitlement politics and generally, the corner we've painted ourselves into. It requires endless deficit financing at the public trough to replace the failed financial sector which also is at the public trough.
Like Iraq and Afghanistan, there is no end game at all here. I see no chance other than for endless government meddling and growth imposed on an increasingly pauperized citizenry as we forget how to produce for what we earn more completely, with each step we're taking.

Sep 09 11:49 AM

[conceptwizard:]

I agree that 90% is extreme, which only convinces me more that they truly are insolvent.

"Watch what they do, not what they say"


On Sep 09 11:41 AM markfl wrote:

> A recent Barron's article reported that bank lending standards are
> now 90% tighter than what they had been in recent years. Given the
> importance of mortgage financing to any economic growth, it does
> make it rather difficult for the government not to be the mortgage
> banker of last resort if banks aren't willing to lend. I could understand
> 50% tighter standards, but 90% seems a little extreme.
> online.barrons.com/art...

Sep 09 11:51 AM

[Joseph L. S...:]

One of the primary stated goals of the taxpayer bailout of the big banks was to allow the banks to begin making loans or renegotiating loans to individuals in trouble. They were to make loans available again to consumers and small businesses.

How are they doing in this alleged endeavor? If you believe their PR flacks, really well. B of A just trumpeted that it “doubled the number of people it has helped under the government’s ‘Making Homes Affordable’ program to help delinquent homeowners who can afford their homes if mortgages are modified.”

Doubled. Right.

Left unsaid is that B of A has used our money to give themselves large pay raises and bonuses rather than help individuals. As of last month, B of A had modified just ** 4%** of the mortgages of qualified people who had applied for renegotiation. 4 in 100. Then Congress threatened to revive legislation that would allow bankruptcy judges to modify mortgages, if the banks didn’t do better.

So B of A, only under the duress of Congress taking away one of their favorite loopholes, “doubled” their activity. Now they are deigning to offer slight relief to 8 out of every 100 qualified applicants.

Their response is as underwhelming as their humility, gratitude and business sense…

Sep 09 01:10 PM

[Tony Petroski:]

I've been involved in real estate and lending my whole adult life. During this time, the federal government has been heavily involved in both subsidizing the lending cost and in regulating the behavior of lenders and builders. Thus I'm puzzled by this quote from the article:

"We may be doomed by the conceit that public policy can control major economic forces. On the other hand, we have seen repeatedly throughout history, that self-regulation by monopolistic interests also leads to doom. Such self-regulation has always led to advancement of self interest to the exclusion of almost everything else."

Of course it is a conceit that public policy can control economic forces in part because public officials are at least as prone, if not more so, to the lure of greed and the toleration of mismanagement that they claim to be regulating.

When was the era of self regulation?

The short version of the article: Fannie and Freddie were created precisely to expand mortgage lending in order to expand home ownership. By definition, if you expand lending, you expand risk to the marginal borrowers. Everyone involved knew that. The lenders, especially the mortgage agents, knew full well who they were lending to and how risky that was but as long as they could off-load the mortgages to quasi-federal agencies, the risk was to the economy and the government, not to them personally.

Could the business survive without these government agencies. Yes of course, although the marginal borrower would have to rent and may not be able to put a chicken in their pot.

In an era of inflation (that is to say, every era) lenders of their own capital would not lend at 5% for 30 years with an option by the borrower to be able to pay the entire amount back early with no penalty.

The example of investor Zanga given earlier would be the kind of borrower who would get funding, perhaps a loan on the balance of the condo at 9% on a five-year mortgage. Investor Zanga would then pay the loan because he would be able to rent the condo to those not able to pull a loan and buy their own.

Would the business be radically different than today? Yes. Would it be radically worse? It's hard to see how.

Sep 09 01:59 PM

[Moon Kil Woong:]

The government's role in home ownership has been touted by politicians for years with both Fannie Mae and Freddie Mac who have made it impossible for legitimate rivals as has the implementation on the Community Reinvestment Act. Both have ben disasterous.

As mentioned Fannie Mae and Freddie Mac has acted like a poison killing off the mortgage market while entwining government in their overly low interest loans which end up on the governments balance sheet by either the Fed or Treasury buying them up or by simply losing so much they need loans or money directly infused into their failing corpse. Their business model is monopolistic. If there was real antitrust enforcement in this industry they would have been broken up ages ago.

CRE has also been disasterous and is cited by Republicans as one mjor facet for the problems in the mortgage market. By requiring banks to loan to people with less than stellar credit and in certain areas if they wish to do business they had created a vast market of high risk loans. This was exacerbated when Glass Stegall was removed thus letting insurance derivatives sterilize these bad loans which encouraged even more gorging on bad loans. Finally, they were bundled and sold to Fannie Mae and Freddie Mac as they still are today. Garbage going onto garbage.

Thanks for the article. Indeed the mortgage market has been socialized for decades now. No wonder it unhinged from the real market and left the government with massive losses. Being that it is still more than ever dependent on the government makes us realize we are destined to relive the recession we are in now. Give it a few years or a few dacades depending on how unscrupulous the powers that be are.

Sep 09 08:59 PM

[joeflynn:]

during crash bought BAC preferred yielding 14% then refinanced house with BAC at 4.375%. The interest checks to my account are 4 times the monthly payment to BofA. As soon as the loan closed it was sold to Fannie. Thanks for the stimulus Ben.

Sep 09 10:38 PM

[Thomas J. G...:]

John's conclusion is the government saved the day by keeping mortgage money flowing in 2009. I would ask this question. Would we ever had have the real estate bubble in the first place if more conservatvely lent private money was the only source of mortgage money? They had big bwana government that John thinks is so skillful in managing the mortgage market, in the Soviet Union and it didn't save the economy. I believe that very little the gov't does, saves the economy.

Sep 10 12:08 PM

[a fat panda:]

"1. Can the Government Be Effective?"

John, The illustration that you have given deals with someone not getting a loan. This isn't the problem with government, or even a problem for risk management. The loans that you don't make can't be a problem. The ones that you do make, on the other hand, can be a significant problem. And at this point, I have not seen any example where the government is competitive with the private sector. In fact, the government has decided to back the people who made the bad loans in the first place. That pretty much demostrates that the government has no process in place to decide what loan to back, other than political favoritism.

Sep 10 12:28 PM

[Zmartmoney:]

And so, 3.5% down - is that neck-choking standards tightening? No skin in the game is the big problem we're paying for already. If there's no real downside to an investment, everybody should dive in - oh, wait, they did that already. Here's your share of the bill...


On Sep 09 11:41 AM markfl wrote:

> A recent Barron's article reported that bank lending standards are
> now 90% tighter than what they had been in recent years. Given the
> importance of mortgage financing to any economic growth, it does
> make it rather difficult for the government not to be the mortgage
> banker of last resort if banks aren't willing to lend. I could understand
> 50% tighter standards, but 90% seems a little extreme.
> online.barrons.com/art...

Sep 10 12:53 PM

[joegold:]

certain people moon, please elaborate what you mean by "certain people"....newsflash, the majority of lending in the past 5 years no matter what color, "income"(if documented), or region the loan was originated in was probably "sub-prime". The standards were relaxed for everyone. And please don't respond with the tired and subversively racist CRA excuse, it's getting old.


On Sep 09 08:59 PM Moon Kil Woong wrote:

> The government's role in home ownership has been touted by politicians
> for years with both Fannie Mae and Freddie Mac who have made it impossible
> for legitimate rivals as has the implementation on the Community
> Reinvestment Act. Both have ben disasterous.
>
> As mentioned Fannie Mae and Freddie Mac has acted like a poison killing
> off the mortgage market while entwining government in their overly
> low interest loans which end up on the governments balance sheet
> by either the Fed or Treasury buying them up or by simply losing
> so much they need loans or money directly infused into their failing
> corpse. Their business model is monopolistic. If there was real antitrust
> enforcement in this industry they would have been broken up ages
> ago.
>
> CRE has also been disasterous and is cited by Republicans as one
> mjor facet for the problems in the mortgage market. By requiring
> banks to loan to people with less than stellar credit and in certain
> areas if they wish to do business they had created a vast market
> of high risk loans. This was exacerbated when Glass Stegall was removed
> thus letting insurance derivatives sterilize these bad loans which
> encouraged even more gorging on bad loans. Finally, they were bundled
> and sold to Fannie Mae and Freddie Mac as they still are today. Garbage
> going onto garbage.
>
> Thanks for the article. Indeed the mortgage market has been socialized
> for decades now. No wonder it unhinged from the real market and left
> the government with massive losses. Being that it is still more than
> ever dependent on the government makes us realize we are destined
> to relive the recession we are in now. Give it a few years or a few
> dacades depending on how unscrupulous the powers that be are.

Sep 10 02:27 PM

[THofler:]

The Federal Reserve had complete authority to rein in the excesses of the independent mortgage brokers and failed to do so; at least until the sub-prime was already blowing up. Then it took Bernanke about 5 minutes to fix the regs.

Why didn't Greenspan or Bernanke act sooner?

I don't pretend to be a mind reader, but allow me to suggest that any good chairman takes the notion of Fed independence extremely seriously. I'm sure that all chairmen are aware that a general displeasure with the Fed on Capitol Hill can be translated into an evisceration of the Fed's authority with a few quick strokes of the pen. This is partly underway right now in the guise of a Consumer Financial Protection Agency.

The political impact of the CRA, Fannie, Freddie, hacks like Franklin Raines, and a general cheerleading for lower income home ownership made it impossible for the Fed to do the right thing.

Sep 10 04:06 PM

[robert.b.fe...:]

Competence is not something you will find a great deal of in Federal Government decision making. Between political cronyism, greed, and the Peter principle no one should be surprised that Government run programs are the least efficient any where. This applies to every program they run including the military. At least with military expenditures we expect death and destruction. With Fannie and Freddie things were going to be peaches and cream. A single family dwelling for all and a new car in every garage. Soon all that will remain of the McMansions is the granite counter tops emitting radon from the rubble created by Government meddling. Great article John.

Sep 10 04:43 PM

[Andrew Butter:]

I wrote a letter to Hunk Paulson in July 2008 (to which he did not reply as expected but I thought it was my civic duty) telling him to get into the home mortgage business.

I still believe that if he had done what he was told there would not have been the catastrophic collapse of the financial system.

Must better to help the grass roots through the crisis (and housing is under-valued now so there is not a huge risk), than handing out $2.7 trillion to moron bankers so they can make money borrowing at 0% and lending at 6%, and as you note they are not lending that money out, they just used it to cover the losses they made (but boy are they making a fortune on the loans they have that are performing).

Sure government intervention is not good, but handing out trillions to banks so they can pay their gambling debts is the worst sort of crony capitalism.

Sep 10 07:51 PM

[Steven Hansen:]

the government must have home ownership as part of its retirement benefits. it must do everything it can to increase home ownership or retirement will become a larger problem for the next generation of Americans.

in singapore for example, the government go so far as being the developer for housing to ensure ownership. this exists side by side with the private sector. both prosper and co-exist.

i consider housing infrastructure - like roads and water supply. although i would prefer housing be left to the private sector, the reality is that my parents were homeowners complements of the GI bill - and I became a homeowner complements of FHA.

What the government is doing with interest rates will destroy private sector lending. But I would view it as a transient event, and the industry can rise like the Phoenix when it is profitable again.

Sep 11 12:57 AM

[J Clinton Hill:]

JL:

thx for taking the time to put this together... this is a very tight piece of research & nicely balances the considerations of govt intervention vs. true free market capitalism.... also underscores the obsolence of our economic models & need to recognize that no economic philosophy has a monopoly on correct & effective policies.... at least this is the context in which your analysis impacted my thinking....

cheers...

Sep 11 02:57 AM

[J Clinton Hill:]

spelling typo on "obsolescence" but i'm sure you will forgive me...


On Sep 11 02:57 AM J Clinton Hill wrote:

> JL:
>
> thx for taking the time to put this together... this is a very tight
> piece of research & nicely balances the considerations of govt
> intervention vs. true free market capitalism.... also underscores
> the obsolence of our economic models & need to recognize that
> no economic philosophy has a monopoly on correct & effective
> policies.... at least this is the context in which your analysis
> impacted my thinking....
>
> cheers...

Sep 11 02:59 AM

[John Lounsbury:]

Thanks JC. My word sounds something like a contraction between obese and insolence. I hope no one considers that represents my thinking.

Sep 11 09:15 AM

[John Lounsbury:]

JC - - -

My bad - it was your word.

Sep 11 09:16 AM

[J Clinton Hill:]

yep.... it was my bad, not yours.... i could've been a little clearer.... hope you're enjoying the weekend.... look forward to your next post....


On Sep 11 09:16 AM John Lounsbury wrote:

> JC - - -
>
> My bad - it was your word.

Sep 12 09:36 PM