ECONOMY OCTOBER 21, 2011
When historians look back at this benighted moment in time, they may find themselves puzzled by how we refused to take the necessary steps to improve our economic situation. Depending on what happens in coming months, they may find that the best solutions—aggressive fiscal and monetary stimulus here in the United States, bank recapitalization and debt restructuring in the EU—were left on the table, while millions unnecessarily suffered.
A footnote in that history may be the decision of Fannie Mae and Freddie Mac not to do more to help the housing market recover. Faced with a flailing market and an alarming amount of underwater mortgages, Fannie and Freddie have nonetheless refrained from implementing bold plans to help out homeowners, citing their fiduciary duty to taxpayers as the reason. But by encouraging more refinancing and principal reductions of the mortgages these institutions either hold directly or insure, our government-sponsored housing giants could simultaneously improve both housing security and the overall economy.
At present, there are about 14 million underwater mortgages out there, with almost half of them more than 30 percent below sea-level, and most are insured or owned by Fan and Fred. Research has been very clear on this point: The most effective intervention to help these homeowners is to reduce their loan principal and bring what they owe more in line with what their home is now worth.
It’s no slam dunk—even with loan haircuts, some folks will still default. And there’s real moral hazard here: a legitimate fear that if people don’t face the economic consequences of buying too much house for their wallets, a lot more people will take that risk. But there are ways to diminish that risk, and the greater hazard isn’t moral, but economic: If Fannie and Freddie insist on staying out of the principal write-down business, the housing market will, at best, keep bumping along with hardly any growth for much longer than it needs to.
Of course, there’s a rationale for the behavior of these agencies: From their perspective, they’re protecting the taxpayer. Because of massive losses to their portfolio when the housing bubble burst, these two government sponsored enterprises (GSEs) became essentially wards of the state. That was a necessary move to keep the housing market from completely shutting down, as private banks got out of the mortgage business for a while (since the bust, the GSEs have originated or insured over 90 percent of new mortgages). But it also had a negative side effect. These agencies are independently regulated by the Federal Housing Finance Agency (FHFA). The regulator’s mandate is to protect the taxpayer from further losses and, as it sees it, any loan forgiveness is a direct hit on taxpayers. (I’ll elaborate in a moment how the mandate could be interpreted in ways that do get Fannie and Freddie into the refinancing and writedown business.)
But it’s not just the regulators: The GSEs are themselves complicit in the failure to get the housing market on more sustainable footing. Given how low mortgage rates are right now, we should be seeing twice the refinancing activity currently taking place across the country. But the only way banks will refinance mortgage loans right now is if the GSEs will backstop them, either through insurance or through buying bundles of the refinanced mortgages, packaged as MBS (mortgage-backed-securities). Having been burned before, however, the GSEs are now insisting on some protection against defaults: They’re either charging the banks a hefty fee or the right to “put back” the loan (i.e., sell it back to the originating bank) if it fails, or both.
Once again, the GSEs are ostensibly just protecting the taxpayer, but these protections are blocking a critical exit ramp from the recession. One mechanism that’s supposed to be helping the economy right now works through the Federal Reserve getting interest rates down—which they’ve done—and homebuyers responding with refinancing and new purchases. But the policies of the GSEs, motivated by the FHFA’s mandate to avoid losses and protect taxpayers, are blocking refinancing and therefore jamming the machine.
But is the FHFA really protecting the rest of us? Like I said, I understand and respect their rationale, but I think they’re wrong. Without shaving off principal from a number of these loans, they will default, and who foots the bill when that happens? That’s right—Fannie and Freddie themselves, because they either own or insure the loans. In this respect, they’re doing the same “extend and pretend” shuffle that private banks are doing, hoping that home prices reverse course and what’s now underwater will eventually be sailing on the surface. For a lot of borrowers, however, that’s just not going to happen. Granted, there are loans that would be okay without reductions, and I’m not suggesting it’s a cakewalk to figure out the best ones to bet on. But as discussed here, some private banks are already finding promising ways to do just that.
And the GSEs’ resistance to refinancing doesn’t make much sense either. Again, because they’re insuring most of these loans anyway, making it easier for homeowners to make their payments is a winner for both these individuals and the economy at large. Shave a couple points off of the typical mortgage and you’re saving between two and three-hundred bucks a month. Aggregate that across all the people who could benefit from such a mortgage refinance and you’ve got an economic stimulus worth tens of billions.
What we have here is a case of regulatory failure: The mission of the agencies, as they perceive it (protecting taxpayers by avoiding refinancing and writedowns) stands in direct opposition to what homeowners and the broader economy needs right now.
So what should we do? Nudging or replacing the FHFA’s current regulator, Edward DeMarco, might work, but the conflict here is the regulator’s mission, not the individual. The only surefire solution is for Congress to temporarily assign control of the GSEs to the administration. This would mean passing legislation that temporarily put the administration in charge of the GSEs so they could implement the loan modifications their current regulator has resisted.
The government has already assumed temporary responsibility for financing the GSEs, but there’s a strong rationale for the government to actively change their mission as well. Taxpayers own 80 percent of these agencies, after all, and we’re in extremely unusual times in terms of housing finance: If Fannie and Freddie are going to be public agencies, they should be made to serve public ends.
Admittedly, the precedent would be worrisome here—just suppose a later Congress decided to take over the Fed for a while. But it’s less so given that within the next few years the GSEs are set to either die off or be recreated in a new, less interventionist format, as proposed by the Treasury and HUD white paper a few months back. Fannie and Freddie, in other words, are already living on borrowed time.
Of course, such legislation would be a heavy lift for any Congress, and far more so for this one. But the logic is solid. The FHFA sees itself as following its mandate. They may be wrong, but they’re not likely to move much. As a result, the only path I see to quickly getting the refinancing and writedowns that will finally get homeowners the help they need, and the macroeconomy the boost it needs, is for the administration to take over from the FHFA until the crisis has passed.
Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities and the former chief economist to Vice-President Biden. He hosts jaredbernsteinblog.com.