Insider's Game

“Life Without Fannie and Freddie,” The Wall Street Journal editorial apparently written by Assistant Editorial Page Editor James Freeman, raises a very serious question. Did Freeman read the CBO report that he wrote about?

Here’s what he told Mary Kissel, of the Journal‘sEditorial Board, in the related video:

For people who remember 2008, and I know memories are short, the huge financial crisis [was] really started by these government-sponsored monsters Fannie Mae and Freddie Mac that guarantee mortgage-backed securities. A new report from the Congressional Budget Office says basically not much would change if we took taxpayers out of the equation and let a free market operate.

The CBO report says nothing of the kind. It expresses concern that the government would be compelled to intervene if the market became frozen, and a perception of implied federal support could lead to distortions in the pricing of risk. Also, it expects that the mortgage market would be less liquid.

The report, initiated at the request of House Finance Committee Chair Jeb Hensarling, considers four different scenarios for modifying the current system of housing finance. The Journal Editorial Board wrote about one scenario advocated by Hensarling in his PATH bill, which says the GSEs shall be wound down and simply replaced by private players.

The editorial says:

The housing lobby likes to pretend that 30-year fixed-rate mortgages would hardly exist without a federal guarantee, or would only be available to borrowers at extremely high prices. CBO’s report makes it much tougher to sell that fairy tale.

This could be helpful to Rep. Jeb Hensarling and other Republicans who want to put Fan and Fred out of our misery in the new Congress. Such an effort will be difficult given the housing lobby’s hooks into both political parties, but the reformers have the evidence on their side. Even the Keynesian economists who run CBO recognize that the U.S. can have a vibrant, affordable housing market that better protects taxpayers against the systemic risks known as Fannie and Freddie.

OK, but the CBO also mentions a pretty important condition precedent:

The expected return of a strong private mortgage market also depends on the anticipated recovery of the private-label MBS market or the development of alternative low-cost means of financing privately backed mortgages.

Don’t count on a private-label revival any time soon. The issue among experts is whether the private-label market is “Dead or Dormant.” Institutional investors, embittered by recent experience, contend that private label’s moral hazard problems remain unaddressed.

Historically, the private-label segment that financed prime 30-year FRMs was always pretty small. In the 2000s, the vast majority of private-label deals were subprime, alt-A and option ARMs, while the underlying mortgages were mostly ARMs. Then there’s an inconvenient truth; GSE loan performance has always been exponentially superior to the rest of the market, whereas private label loan performance has always been exponentially worse.

Finally, people who view private-label securitizations as a substitute for GSE mortgage securitizations are pretty ignorant, like the people who confused East Germany with West Germany. Though they both look and sound alike, they operate under different models. Simply put, private-label deals involve the transfer of interest rate risk and credit risk, whereas GSE securitizations transfer interest rate risk only. And credit risk makes all the difference. In real estate, timing is everything. GSE securitizations diversify market timing risk, whereas private label deals do not.

The CBO report suggests those who ignore the lessons of the past are condemned to repeat them.

The notion that government-sponsored monsters started the 2008 crisis does not seem to be one of those lessons. It says:

Full privatization could have several drawbacks, however, including the possibility that a private secondary market might be significantly less liquid than a market with some federal backing, especially during periods of acute financial stress.

For example, in the most recent crisis, private securitization virtually ceased, and issuance of privately financed mortgages severely contracted, leaving less than 10% of new mortgage credit privately backed in 2009. That sharp contraction in the availability of private mortgage credit hurt economic growth and probably contributed to lower house prices, despite a significant increase in federally guaranteed credit.

In addition, committing to a policy of nonintervention in the mortgage market might not prove credible if the availability of mortgage credit is disrupted in the future. If the private firms operating in the secondary market were seen as critical to the functioning of the mortgage finance system, investors might again treat them as implicitly guaranteed by the federal government.

That perception could cause investors in the firms’ securities to demand less compensation for risk than they would otherwise, which in turn could encourage the firms to take on too much risk, thus weakening the financial system. Implicit federal guarantees would also reduce transparency. The costs and risks of those guarantees to taxpayers would not appear in the federal budget, so policymakers would have difficulty assessing them.

Try and reconcile the CBO text with the last sentence of the editorial: “Even the Keynesian economists who run CBO recognize that the U.S. can have a vibrant, affordable housing market that better protects taxpayers against the systemic risks known as Fannie and Freddie.”

A word to the wise: When reading a CBO report, be sure to read all the words, carefully.