Four Key Questions on Housing Finance Reform

Arnold Kling at U.S. News & World Report.

As Congress returns from its August recess and prepares to take up the issue of housing finance reform, the history of special-interest pleading and taxpayer bailouts will loom large. Here are four questions that our legislators should ask:

1) Why should we reward Wall Street and mortgage bankers?

One widely floated proposal would eliminate government backed enterprises Freddie Mac and Fannie Mae while creating a new government guarantee for mortgage securities. This is perfect from the standpoint of Wall Street firms that package and distribute mortgage securities, as well as the mortgage bankers who sell their loans and depend on the securitization market. It would complete the 50-year project by these interest groups to pry the mortgage lending business out of depository institutions (banks and savings-and-loan associations) — but this shift doesn't serve the public well.

If anyone's fingerprints are all over the financial crisis, it's the mortgage bankers who only originate loans in order to pass them off to investors and the Wall Street firms who manufactured supposedly AAA-rated assets out of the mortgage bankers' junk loans. If mortgage securitization is really a safe and efficient mechanism as its advocates claim, it should be able to survive without a government guarantee.

2) Where will the interest-rate risk go?

Today, almost all mortgage finance reform focuses on preventing a repeat of the breakdown in mortgage credit risk that caused the 2008 crisis. The risk of default can be minimized with proper underwriting and the requirement of a 20 percent down payment. But the more difficult risk in mortgages, and the one that brought down the savings-and-loan industry in the 1970s, is interest-rate risk, which cannot be reduced — only transferred.

For example, the 30-year fixed-rate mortgage with no prepayment penalty has considerable interest-rate risk for lenders. If you fund such a mortgage with, say, 20-year debt and interest rates fall, you will be stuck with the high-rate 20-year debt while your mortgage assets go away as borrowers prepay. Conversely, if you fund with short-term deposits and interest rates rise, you will then have to pay a higher interest rate to attract deposits than the interest you are receiving from the mortgages.

With Freddie and Fannie holding large portfolios of mortgage assets, regulators knew that they needed to pay attention to the interest-rate risk exposure, management practices and capital adequacy of those two entities. But the regulators fell down on the job by allowing Freddie and Fannie to count very soft assets as capital, and allowing them to hold minimal capital against their holdings of highly rated mortgage securities — regardless of the underlying mortgages' low quality.

Without Fannie and Freddie, Wall Street would embed interest-rate risk in the securities it distributes, including various exotica, such as "residuals" and "swaptions." The risk will find its way to the institutions with the least alert management and the least aware regulators.

At the height of the sub-prime crisis, the exposure to mortgage credit risk built up by a small division of AIG shocked regulators. Who will be the AIG of interest-rate risk when the next interest-rate shock hits?

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