Imagine a World Without the GSEs

This post was written by Adam Rust and is cross posted from

The political current in Washington seems predisposed to wind down Fannie Mae and Freddie Mac. The drive is so strong that even a center-left group like the Center for American Progress has abandoned its support for some public-purpose entity. The climate is so hostile that supporting the GSEs, even in a very different and scaled-down orientation, is somewhat of a radical point of view.

The logic provided by the supporters of such a measure is that private investors will step in to buy mortgages on the secondary market. That might happen, because yields would go up for the loans that were formerly packaged into agency pass-throughs. At the same time, those loans would be stripped of their “implicit” government guarantee. Most wouldn’t have nearly the same credit rating. Thus, there might be more yield, but there it would come in step with more risk.

We need to look at this problem and at least give some consideration to the worst-case scenario. It isn’t implausible that investors won’t buy all of those mortgages. After all, the risk-reward proposition isn’t that much different now. Today, Fannie andFreddie are buying more than 60 percent of all conventional loans.

One of the few sources of private investment in MBS comes from insurance companies. Unfortunately, that demand would shrink in a post-GSE environment. Insurance companies can’t afford to pursue high-yield high-risk investments. They have to hold low-risk assets.

Our mortgage market is entirely driven by government demand for MBS. Treasury is buying $1.2 trillion of MBS. The government is backing FHA loans. This is really a product of risk aversion. Knowing that their appetite has limits, banks are originating scores of FHA loans for borrowers with risk profiles that don’t meet the standards in the Loan-Level Pricing Adjustment matrix. That risk aversion on the part of investors should inform any calculation of the probability that the worst-case scenario comes to fruition.

In the worst case scenario, a cascading series of bad things happen. First, interest rates go up. Way up. That will dampen the prices on housing. For every one percent increase in interest rates, the cost of borrowing goes up ten percent. Some people say that mortgage interest rates would head north of 7 percent. That implies another 25 percent drop in home prices.

That leads to the next problem. With higher interest rate prices, fewer people buy homes. We already have a nine-month supply of homes on the market and another few hundred thousand homes circulating through the shadow market.

Fewer people will qualify for a refinance. Remember that housing prices have fallen twenty-five percent. It is hard to imagine that there are going to be many people where loan-to-value is still below 75 percent.  The refi problem could mean that more people are trapped in unsustainable mortgages. That could bring about more foreclosures. Of course, very few people are going to want to qualify for a refinance, because new loans will cost a lot more than old loans.

Then this spills over to the job market. If it is hard to sell your home now, imagine what it will be like when borrowers can’t afford to borrow. This isn’t just a problem for employees. It is also going to frustrate employers. Imagine that you need a new mechanical engineer or a new school teacher. The pool of such workers is going to dwindle. It creates a real paradox: fewer people have jobs, but employers have to pay more for labor!

GSE “reform” isn’t taking place in a black box, either. Regulators are about to raise the minimum capital ratios for our biggest banks. (I agree with Tom Brown‘s thoughts on this!) How many banks are going to want to hold onto a 30-year mortgage? Banks make those loans because they can sell them. Mortgage origination is about fees, not long-term interest payment. Under a higher capital ratio environment, holding a mortgage loan eats up precious capital. No thanks.

Did I mention the 30-year mortgage? My mistake. There will be no such thing.



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