Setting Up Another Sub-Prime Crisis

With the housing market largely stabilized, Congress is beginning to consider proposals that would do away with Fannie Mae and Freddie Mac. Instead of government-sponsored entities (GSEs) like Fannie and Freddie issuing mortgage-backed securities (MBS), many of these proposals would create a system in which private financial institutions would be able to issue MBS with government guarantees. A new report from the Center for Economic and Policy Research (CEPR) raises some serious concerns about such a system.

In the report, "Bringing Back Subprime? The Hazards of Restructuring the GSEs," Dean Baker and Nicole Woo of CEPR raise serious questions about this major proposed overhaul of the system of housing finance. They note that the rationale for government intervention in the mortgage market is to provide an interest rate subsidy that makes it easier for low-income and middle-income families to be homeowners. The right question for assessing any proposed overhaul is whether the value of the subsidy is worth the risks that the system creates for the government.

"Bringing Back Subprime? The Hazards of Restructuring the GSEs" raises questions about both sides of this equation. In terms of promoting homeownership, the paper points to research showing that even before the housing bubble, most low-income families who bought homes remained homeowners for less than five years. As such, these homeowners clearly don't live in their houses long enough to accumulate wealth. In most cases the transactions costs from such a short period of ownership would have made renting a better option. In this context, the gains from an implicit interest rate subsidy overwhelmingly go to middle-income and wealthy owners. Moreover, research by the Federal Reserve before the housing bubble, indicated that the savings on mortgage interest from a government guarantee was relatively modest at less than 10 basis points. Even if the Fed's research understated the subsidy by a factor of 5, a subsidy of 50 basis points would have limited impact on the affordability of homeownership.

The paper also raises serious questions about the safeguards provided by these proposals. Under current plans, mortgages issued with only 5 percent down could be placed in pools without issuers retaining any stake. Considering the inconsistencies in the appraisal process, it is virtually guaranteed that a substantial number of underwater mortgages will get into these pools. With the government accepting most of the risk from bad mortgages, private issuers and investors would have less incentive to ensure mortgage quality than they did when they created subprime MBS in the housing bubble years.

Given the enormous moral hazard issues associated with this sort of hybrid system, it is more efficient to leave the current system in place. Taking into account the amount of risk involved and limited savings to homeowners, the country would better-served by taking the government out of the secondary market, rather than having the government guarantee privately issued mortgage-backed-securities.