Why President Obama’s Plan to Replace Fannie and Freddie Will Fail

After President Obama’s big housing policy speech, folks have been taking a hard look at the proposal to end Fannie and Freddie. This All In segment captured the basics fairly well, I thought:

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In case you can’t watch, here’s the basic story. So Fannie and Freddie buy mortgages and package them into government-guaranteed bundles (mortgage backed securities – MBS), thereby freeing up additional capital for more mortgage lending, the idea being we’ll thereby promote homeownership. President Obama’s proposal is to replace Fannie and Freddie with a new agency that will insure private MBS for everything past a 10% loss, thereby spurring the creation of private MBS to replace what F&F are doing. We don’t have private MBS because (as you probably already know) those were ground zero for the housing crisis that blew up the economy in 2008. (This is basically a cosmetic change, but set that aside for now.)

Over at TNR David Dayen laid out the fundamental reality that the banks which would be creating these private MBS are probably about as corrupt now as they were when they were frantically blowing up the housing bubble in the mid-2000s. He says there’s little reason to expect private capital to jump into a market that is rottener than the one for stolen Ukrainian kidneys, at least without some more explicit subsidies.

His point is well-taken, but I think it’s missing one key part of the equation: price. Investors will buy anything if the rate of return is good enough—if nothing else, you can always just play asset hot potato and try to pass things on to the next sucker before they implode. But the return of MBS is determined by the going interest rate on mortgages, which is quite low (~4%) due to the aforementioned housing crisis and the weak economy. That is way too low to jump into a market that is still smoking from the last time it blew up and nearly took every bank on Wall Street with it. Or, in other words, 4% return is not enough compensation for a very serious risk of a 10% loss.

So to make this work we’d have to increase the subsidy, or increase the interest rate. The first is out of the question because the whole point of this scheme is to put a free-market gloss on housing finance—if you’re just going to subsidize the market to that extent, why bother dismantling F&F in the first place? The second is out of the question because it would strangle the incipient housing recovery. The housing market depends on a constant stream of new buyers, and putting mortgage interest rates anywhere close to their actual risk would upend all kinds of fundamental sociopolitical arrangements.

In any case, this proposal is going nowhere. But in the meantime, I suggest we start looking at valorizing renting instead of owning.

Note: again thanks to Steve Randy Waldman for help with understanding.

Ryan Cooper

Ryan Cooper, a contributing editor of the Washington Monthly, is currently the Washington correspondent for The Week.