Opinion

Mortgage market doesn't need explicit government backing

On Feb. 13, the Mortgage Bankers Association sent its members an early Valentine’s Day gift: an open letter to Congress asking for explicit federal guarantees in the secondary mortgage market. The letter touts ideas included in the recently leaked legislation put together by Sen. Bob Corker, R-Tenn., and it is no coincidence.

Nobody needs explicitly guaranteed mortgage-backed securities, but a whole bunch of special interests want them.

Ultimately, what Corker and advocates like the MBA are proposing — and what is now being seen as acceptable policy by many in the administration — would drastically increase the risks of future bailouts, while creating public losses and private gains for the largest asset managers like BlackRock.

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Those calling for an explicit government guarantee behind all prime mortgage-backed securities ignore a key reality: To effectively limit the risks to taxpayers, we need to reduce the government’s guarantees in the mortgage market.

There is no question that the government will remain involved in the mortgage market to the extent that housing policy is public policy, but proposals to place a government guarantee behind all conforming mortgage backed securities are reckless. They only serve the interests of the largest banks and those investors that seek a constant flow of securities with strong returns, without requiring them to take any real credit risk.

How do advocates for such a government guarantee propose to do this? Opacity and complexity, of course. They propose that rather than having well-capitalized secondary market insurers, like government-sponsored enterprises Fannie Mae and Freddie Mac, with substantial levels of capital that would prevent the need for any government guarantees, the government should create a “mortgage insurance fund” that would be capitalized by banks to take losses ahead of the taxpayers.

The MIF is comparable to the Federal Deposit Insurance Corp. fund, but it would be used for investors in mortgage securities. This approach reinforces the “too big to fail” status of our largest banks — and, in crisis, it will force the government to choose between bailing out investors in those government-guaranteed securities or depositors in those banks.

Why is that?

Given the concentration of the mortgage origination market, where the five largest mortgage lenders originate over 30% of originations, another mortgage (or other) crisis will likely lead to their weakness or failure at the same time, just as during the 2008 crisis. Such an event would obviously lead to undercapitalization of the MIF and would require that the MIF increase the assessments they charge to the surviving firms.

The government would thereby be forcing those mortgage lenders who have been prudent in their lending to absorb the losses of those who were irresponsible. Of course, this increased burden would come at exactly the same time banking regulators would want these firms to get stronger by increasing their capital.

"Perhaps it is time for Washington to realize that sufficient private equity capital, behind financial firms, is the surest way to protect the public."

This plan also exacerbates a dangerous incentive that contributed to the last crisis. Today, banks that hold GSE mortgage bonds have a 20% capital risk weighting on those securities and a 15% leverage risk weighting for high-quality liquid assets. Under this guaranteed mortgage-backed securities plan, unlike GSE securities, the taxpayer would explicitly guarantee those securities. As a result they would be treated as sovereign obligations, and bank capital risk weighting and HQLA leverage requirements would be reduced to zero — thereby reducing the capital the banks hold against the risks to those loans and allowing banks to hold an unlimited amount of them.

This would create incentives for banks to issue more mortgage securities and then buy and hold unlimited amounts of these securities because they have become more “capital efficient.”

More troubling still, this plan would create a direct conflict between depositors in failing banks and investors in those new government guaranteed mortgage securities. To understand this risk, let’s assume, in the next crisis, that a large financial firm is on the edge of collapse. Under Dodd-Frank, the FDIC is required to place the bank in receivership and liquidate its estate for the protection of depositors. But the government-guarantee plan is all about protecting investors in mortgage securities.

Such a plan provides an incentive for banks to load up their portfolios with government guaranteed securities so they can capture the benefits of the lower capital requirements of these “low-risk” assets. This is similar to the GSEs’ inappropriate use of their portfolios before the crisis.

As a result, the plan sets up a showdown between the FDIC and the MIF. In the case of a failure, the FDIC would want to collect on the guarantees to protect the depositors, but the MIF will want to take those securities to shore up their insurance fund, thus protecting investors in guaranteed securities.

It is highly likely that in the next financial crisis liquidity in the mortgage market would disappear, thus forcing the federal government to choose between the bailout of investors or depositors. And, of course, the counter-cyclical function the secondary mortgage market is intended to play would become pro-cyclical on a larger scale than we saw with the GSEs in the financial crisis.

Instead of creating new and complex answers that pretend to be solutions, perhaps it is time for Washington to realize that sufficient private equity capital, behind financial firms, is the surest way to protect the public. The government should shrink its financial commitment to the housing market rather than expand it.

This article originally appeared in American Banker.
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