David Min / Federal backing stabilizes mortgages - pressofAtlanticCity.com: Commentary

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David Min / Federal backing stabilizes mortgages

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Posted: Thursday, March 7, 2013 12:01 am

David Min / Federal backing stabilizes mortgages

How should we reform our broken housing finance system? To what extent should the federal government continue to provide guarantees for mortgage financing, such as the ones it provides for Fannie Mae and Freddie Mac? With Fannie and Freddie in a federal conservatorship that has already cost taxpayers more than $140 billion, it is politically popular to suggest that the answer is "not much."

But policymakers should be wary of that consensus. Historically, government-backed mortgages are closely linked with stability, an inoculation against the chronic cycle of boom and bust.

Federal guarantees have been a part of the U.S. housing finance system since the New Deal. Before then, mortgage markets were extremely unstable, experiencing a financial crisis every decade or so.

Problems in pre-New Deal private housing finance culminated in the banking crises of the early 1930s. Roughly half of all banks failed, triggering the Depression. Policymakers responded by introducing federal guarantees into mortgage finance, administered through new institutions including the Federal Housing Administration. Several decades later, federal guarantees were introduced for the mortgage-backed securities issued by the government-sponsored enterprises Fannie Mae and Freddie Mac.

Beginning in the 1940s and continuing until the early 2000s, such federal guarantees existed for roughly 70 percent of all housing finance in the U.S. The onset of these guarantees coincided with an unprecedented period of financial stability. From the 1940s until the 2000s, unlike in any other period in our nation's history, the U.S. did not experience a major systemic financial crisis. (The savings and loan debacle in the early 1990s was not a financial crisis, nor was it systemwide.)

But by the early 2000s, the share of mortgages financed by federally guaranteed sources of funds experienced a steep and sudden decline as Wall Street's securitization of mortgages grew at a stunning rate, from 12 percent of the market in 2003 to nearly 40 percent of all mortgages originated in 2005 and 2006. The sharp increase in home prices of the housing bubble was almost exactly contemporaneous. Of course, the bursting of the housing bubble led to the 2008 financial crisis. It was only when government guarantees declined precipitously that we saw a return of the financial instability that had been absent since the 1930s.

One factor in the close historical correlation between government guarantees and stability may be the role guarantees play in promoting consumer-friendly loans, specifically the 30-year fixed-rate mortgage we take for granted.

In the 1930s, the typical home loan favored the lender: It was an expensive, short-duration, interest-only affair that required refinancing every few years. It took government guarantees (and the accompanying regulation) to direct capital toward 30-year fixed-rate mortgages, which carries more risk to the lender and less to the borrower.

Indeed, in the absence of government guarantees, mortgage finance gravitates toward "rollover" loans. During the 2000s mortgage boom, Wall Street's unguaranteed mortgage securitization pipeline emphasized (and paid handsome incentives to lenders to originate) loans that were relatively high-cost, adjustable-rate, interest-only, and designed to be refinanced every few years.

From 2001 to 2008, only 30 percent of the loans financed by Wall Street securitization were traditional 30-year fixed-rate mortgages, compared to 88 percent of loans financed by Fannie and Freddie securitization. Interest-only rollover loans are the industry standard in commercial real estate finance, which does not enjoy government guarantees.

Not surprisingly, these loans default at extraordinarily high rates during periods of distress. In the Depression, rollover loans experienced a delinquency rate of about 50 percent. In the recent recession, the delinquency rate was 29.8 percent, roughly six times greater than the rate for 30-year fixed-rate mortgages.

Government guarantees are crucial for promoting housing finance stability, in part because they promote loans that default at far lower rates. Policymakers interested in financial stability should consider this carefully as they reform our broken housing finance system. If the government's footprint in housing finance grows too faint, it may once again mean disaster for borrowers, lenders, investors and the economy.

David Min is a law professor at UC Irvine. His paper, "How Government Guarantees in Housing Finance Promote Stability," will be published in an upcoming edition of the Harvard Journal on Legislation. He wrote this for the Los Angeles Times.

Posted in on Thursday, March 7, 2013 12:01 am.

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