Donald Marron and Phillip Swagel have just completed a smart, comprehensive report on the future of Fannie and Freddie for Economics 21, and it’s a real coup for us. As you know, many observers have been throwing their hands up at the scale of the GSE problem, recognizing that there is little political will to tackle what is almost universally recognized as a serious problem. Marron and Swagel have decided to do a jig on this third rail. Rather than offer a radical overhaul that would never win congressional approval, their proposal strikes me as sober, moderate, and politically realistic, though certainly not a piece of cake.
Under this proposal the two firms would become private companies that buy conforming mortgages and bundle them into securities that are eligible for government backing. The reformed firms would not have the investment portfolios that were the main source of risk under their previous structure. The federal government would offer a guarantee on mortgage-backed securities composed of conforming loans. This guarantee would be explicit, backed by the full faith and credit of the United States. To compensate taxpayers for taking on housing risk, Fannie and Freddie would pay an actuarially fair fee to the government in return for the guarantee, and the shareholders of the firms would take losses before the government guarantee kicks in. Other private firms such as bank subsidiaries would be allowed to compete by securitizing conforming loans and purchasing the government guarantee. Over time, entry into these activities would help ensure that the benefits of the government support are passed through to homeowners and would reduce the risk that the failure of any one firm would pose a threat to the housing market or the overall economy.
One can imagine this as part of a broader series of reforms designed to make the federal government’s role in the housing market more transparent and cost-effective. I hope and expect that the report will attract a good deal of attention. Donald Marron offers introductory thoughts at his excellent blog.
Our proposal would also free Fannie and Freddie from regulatory requirements that promote affordable housing. As worthy as those efforts can be, we believe they should not be run through these reformed organizations with their narrower missions (and no investment portfolios). If policymakers think that the conforming mortgage market should help finance those efforts, that can be done through a tax on the MBS guarantees, above-and-beyond the actuarially-fair fee for the government insurance. The resulting revenue can then be directed to affordable housing programs through usual budget channels.
How did we come to this proposal? Well, we were trying to fix what we see as the major flaws of the old model (lack of transparency, uncompensated taxpayer risk, misalignment of incentives), while maintaining its benefits (e.g., that mortgage credit kept flowing for conforming loans even during the depths of the crisis and that government-insured MBS are a useful asset class when the Fed wants to do quantitative /credit easing). In addition, we felt that some backstop role for the government is inevitable as a matter of political economics and that it ought to be explicit at the outset.
This addresses one of Raghuram Rajan’s central concerns in Fault Lines, namely the increasing tendency of the federal government to avoid explicit transfers in favor of hidden subsidies. If we want to use government to promote affordable housing, we should pay for it through tax dollars rather than through regulatory efforts that could generate far larger costs down the line.