How "my side" blew it on GSE reform
Promoted by Brendan
In my previous entry , I focused on the flawed GSE reform bill which passed the House in 2005.
As it turns out, there was a much stronger bill coming out of the Senate Banking Committee at about the same time. That bill , authored by Chuck Hagel (R-Nebraska), addressed many of the problems which eventually contributed to the downfall of Fannie Mae and Freddie Mac.
The main feature of the Hagel bill was the establishment of a "world class regulator" to oversee the GSEs. The regulator was to be given powers similar to the regulators of banks and other key financial institutions:
- The bill gave the regulator full power to limit the size of their own investment portfolios at the sole discretion of the regulator in order to ensure the soundness of the GSE
- The regulator could also prohibit any assets unrelated to the mission of the GSEs from their portfolios, again at the sole discretion of the regulator
- The regulator was given authority to limit what kind of business the GSEs could undertake.
- Finally, the regulator was given full authority to take over a failing GSE.
Sounds good to me; the situation cried out for a strong regulator. The GSEs had been recklessly abusing the borrowing power afforded to them by their government charter-- accumulating huge, debt-financed investment portfolios and engaging in sophisticated hedging strategies to manipulate earnings which had nothing to do with their mission of ensuring the availability of mortgages. But while the bill passed in committe, it was on a strict party line vote, getting no votes from Democrats, which virtually assured that the bill would not become law.
One Democratic objection to the bill was the portfolio caps :
In opposing portfolio caps, Democrats expressed concern that such restrictions would harm Fannie and Freddie's ability to ensure the mortgage market liquidity needed to foster affordable housing.
"There seems to be an expectation on the part of some that if Fannie and Freddie stop holding the assets in their portfolios, that the rest of the market will somehow instantaneously fill the void and that prices will not be affected," said Sen. Jon Corzine (D-New Jersey). "I do not believe that is a reasonable expectation."
In other words, Corzine was worried that Fannie and Freddie wouldn't be able to buy as many mortgages if the Hagel bill became law; they would only be able to buy as many mortgages as they could package up as securities and sell. Dems like Corzine may have calculated that many investors who wanted exposure to the American residential real estate market, especially international investors in Fannie Mae and Freddie Mac bonds, would not be interested in direct purchases of Fannie and Freddie Mortgage-Backed Securities (MBS) instead of the GSE bonds.
But there was a flaw in this reasoning. The real reason why international investors found Fannie and Freddie debt attractive was the implied government guarantee of the debt, not the quality of Fannie and Freddie's investment portfolios or the soundness of their businesses. There was good reason why a prudent investor wouldn't have wanted those securities which were in the portfolios of the GSEs-- they were chock full of mortgages which should have never been made. If the GSE's had been required to sell all those extra MBSs, they likely would have had to reach out to a more discerning class of investor. Those MBSs likely would have commanded a lower price or simply have been rejected out of hand due to the quality of the underlying assets. In either case, the end result probably would have been that Fannie and Freddie would have had to scale back their purchase of mortgages, but those that they would have purchased would have been of a higher average quality.
In retrospect, that would have been much better for everybody involved. If it mean that mortgage originators had to make fewer mortgages, that would have been okay, because nobody was served by the last marginal 10% of mortgages made during the housing bubble anyway -- not the homebuyer, who found him/herself underwater on their mortgage and unable to pay the payments a few years later, and certainly not Freddie and Fannie, who found themselves crushed under the size of their portfolios, losing billions once the MBS assets began to lose value.
Democrats wanted to promote homeownership, but were trapped in linear thinking. The way to promote home ownership at that moment was not to maximize the number of mortgages that Fannie and Freddie could buy, but rather to ensure the soundness of Freddie and Fannie so that they could weather a downturn in the housing market and live on to fulfill their mission.
Senator Hagel responded to the concerns of the Democrats:
S. 190 co-sponsor Sen. Chuck Hagel (R-Nebraska) countered that the GSEs' portfolios are profitable for Fannie Mae and Freddie Mac shareholders, but do little to advance their housing mission.
"Fannie and Freddie are public companies with shareholders, and their boards have a fiduciary responsibility to those shareholders. But Congress did not create GSEs to enrich share-holders and executives," said Hagel. "They were created to provide stability and capital in the secondary housing finance market."
Hagel is to be particularly commended for bringing up the issue of stability. Stability is seldom compatible with "maxing out". The GSEs were maxing out on the number of mortgages they were purchasing (by lowering their standards), keeping an increasing amount of them in their own portfolios, and financing this by floating increasing amounts of debt at artificially low interest rates to people and institutions who really didn't care what kind of crap they had on their balance sheet because this debt was essentially insured by the American Taxpayer. This was sustainable only so long as home prices went up, because the balance sheets would fall apart like a $100 sofa otherwise. There was nothing stable about any of it. It was like building a beachfront house out of heavy cardboard and hoping the hurricane never comes.
I have generally supported Democrats for all of my life, for a variety of reasons. If they would like to enjoy that continued support, however, they had better have a little better foresight on important issues than they showed on the issue of GSE regulation. They blew it on this one.
Crossposted from Source of Title