On October first, the Fannie Mae/Freddie Mac maximum loan limit fell (from around $729,000 to $625,000). The Senate later voted to extend that limit until December 2013. Some House members, such as Rep. John Campbell (R-CA) warned that if the loan limits were not raised back to their previous levels, our housing market would “crater.” And of course the special interests in the real estate industry all but implied that if the taxpayer did not remain on the hook, then we’d all be living in caves before too long.

It was easy enough to make such outlandish statements in the absence of data. Now we have some data, and from of all people, the real estate industry. According to the National Association of Realtors (full disclosure: I worked there about 10 years ago):

Total existing-home sales, which are completed transactions that include single-family, townhomes, condominiums and co-ops, rose 1.4 percent to a seasonally adjusted annual rate of 4.97 million in October from a downwardly revised 4.90 million in September, and are 13.5 percent above the 4.38 million unit level in October 2010. [emphasis added]

You read that correctly. The loan limits fell and then home sales actually rose, which is the opposite of crater. I’m not claiming that the decline in loan limits caused home sales to increase, but I am claiming that the housing market did not crater, as was predicted.

GSE Loan Limits Fell…and Home Sales Went Up is a post from Cato @ Liberty - Cato Institute Blog

Sunday’s dinner of the Society for Development of Austrian Economics featured a keynote from George Mason University economics professor Richard Wagner. The talk brought back a lot of memories for me. Wagner was chair of my dissertation committee and it was in his graduate public finance class (back in 1992?) that I first gave any thought to Fannie Mae and Freddie Mac when I wrote a paper on government sponsored enterprises. Little did I know I’d spend much of the following years working to reform Fannie and Freddie.

During his talk, Wagner invoked a term first used by Jane Jacobs: “monstrous moral hybrids.” I suspect Jacobs used the term to describe how Robert Moses managed to wield unaccountable power over development in New York City (Caro’s account of Moses, Power Broker, still being the single best read on city government). Ms. Jacobs describes two distinct moral syndromes,  commercial and guardian. Obviously commercial pertains to the market, while guardian can pertain to government. The monstrous moral hybrids are when we get the worst of both instincts combined in one entity. For instance, I generally view competition as a good thing; however, competition underwritten by government guarantees will almost always lead to disaster. Its competition without the discipline of failure.

I  repeatedly watched, while working in Senate, Fannie/Freddie invoke their “private” nature in order to avoid regulation while invoking their “public” nature to gain protection and privilege. The result was little accountability from either the market or the government (our largest banks currently enjoy a smaller version). Of course, one of the primary differences in debates over financial regulation is the degree to which one believes that either the market or government provides accountability. Setting aside those debates, we should all be able to agree that companies should be either private or government. That the mixing of the two, government sponsored enterprises, is a recipe for avoiding accountability and transparency. But then I suspect that might have been the intent all along. Monstrous moral hybrids by design.

‘Monstrous Moral Hybrids’ is a post from Cato @ Liberty - Cato Institute Blog

A central reason that Fannie Mae and Freddie Mac have not played a bigger role in rescuing homeowners, or otherwise handing out “freebies,” is that these two companies are in conservatorship.

Conservatorship is almost like a bankruptcy proceeding, or a receivership in the banking context, but without the power to impose losses. I’ve been criticized for believing that a conservatorship requires Fannie’s regulator to “conserve” the company, and not simply allow it to be used as a slush fund. The basis of said criticism is that FHFA, Fannie’s regulator, has a broad public mission, which could include handing out freebies to underwater borrowers.

Matt Yglesias suggests that “clearly the purpose of creating the FHFA and taking Fannie and Freddie into conservatorship can’t have been to minimize direct taxpayer financial losses on agency debt.” Now, Matt makes a lot of Congress being vague in the statute. And he is correct about it being vague, in some areas, but it isn’t here.

As one of the two people (the other being Peggy Kuhn) who actually drafted that section of the Housing and Economic Recovery Act (HERA) during my time as staff on the Senate Banking Committee, I can clearly say the purpose of the drafters, in terms of conservatorship, was to nurse those companies back to health. Again, how do I know that? Because I was there.

Of course, if one simply read that section of the statute, Section 1145 of HERA, which amends Section 1367 of the 1992 GSE Act, one would clearly see what the purpose, duties, and role of a conservatorship actually is. For instance, what does the law say the powers of a conservatorship are? They are to ”take such action as may be—(i) necessary to put the regulated entity in a sound and solvent condition; and (ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.”

Now, I don’t see anything in there about handing out freebies to underwater borrowers. Citing an agency-written mission statement or a vague “purposes” at the beginning of an act is no substitute for actually reading the provisions of a statute.

What’s a Conservatorship Good For? is a post from Cato @ Liberty - Cato Institute Blog

The mortgage interest income tax deduction is popular among homeowners (read: likely voters) despite its role in distorting housing and related markets, its contribution to the housing bubble and its enabling of additional household debt. Never mind that there isn’t much evidence that the deduction boosts home ownership in the United States. Consider also that the tax break largely benefits affluent homeowners living in expensive urban areas.

As Mark Calabria notes in today’s Cato Daily Podcast, it’s well past time for the mortgage interest deduction to be replaced by lower marginal tax rates for all earners.

End the Mortgage Interest Deduction is a post from Cato @ Liberty - Cato Institute Blog

The Washington Post is reporting that President Obama has assigned his staff with the task of designing a new set of government guarantees behind the U.S. mortgage market. Although as the Post also reports the “approach could even preserve Fannie Mae and Freddie Mac.” That’s correct. Despite their role in driving the housing bubble and the already $160 billion in taxpayer losses, President Obama appears to be considering just putting the same failed system in place. Of course, we’ll be promised that it will all work better this time.

Perhaps most offensive is that the Post reports that Obama “officials don’t want to punish the thousands of Fannie and Freddie employees who have specialized knowledge about the mortgage market.” Seriously? What about the many blameless employees of AIG, Lehman Brothers, or Bear Stearns? Or New Century for that matter. Did the janitors and receptionists at those firms really cause the crisis? The truth is that the employees of Fannie and Freddie have been lining their pockets at the expense of the taxpayer for years. What the Administration is really saying is that they wouldn’t want all the political operatives at these favored firms to lose their perks. After all, Obama officials will need somewhere to land after 2012 and Goldman Sachs has only so many slots.

What’s most depressing is that you can’t say Obama hasn’t been given the facts. As the Post makes clear, his economic advisers spelled out the case against massive subsidies for the mortgage market. Austan Goolsbee, chair of Obama’s Council of Economic Advisers, points out: by subsidizing mortgage investments, the government drives capital away from other types of investments. If Obama truly wants to help the middle and working class, then he’d want capital to flow into investments that increase labor productivity, which is the ultimate source of wage growth.  Running up asset prices, like houses, does not make us wealthier in the long run.

But then what should I expect. The President has already entered campaign mode. It would be nice to see the economics win over the politics. But it looks like such a thing will have to wait for another administration.

No Hope or Change When it Comes to Fannie Mae is a post from Cato @ Liberty - Cato Institute Blog

It’s probably never wise to inject oneself into the middle of a food fight, but since I think both sides actually have something right and something wrong, its been a worthwhile debate to follow.  That is the ongoing debate between Peter Wallison at the American Enterprise Institute and David Min at the Center for American Progress (at least we can all agree we love America) on the role of Fannie Mae (and Freddie Mac) in the financial crisis.  If you can’t guess, Peter says Fannie/Freddie caused the crisis, David says they didn’t.

David makes an interesting point, one I’ve actually argued, in his latest retort.  That is, this wasn’t exclusively a housing crisis/bubble.  Other sectors, like commercial real estate, boomed and then went bust; other countries, with different housing policies, also had bubbles.  True from what I can tell.  I will also add that the U.S. office market actually peaked and fell before the housing market, so we can safely say there wasn’t contagion from housing to other parts of the real estate market. 

But the problem with this argument, at least for David, is that it undercuts the Dodd-Frank Act, which he has regularly defended.  The implicit premise of Dodd-Frank is that predatory mortgage lending caused the crisis, so now we need Elizabeth Warren to save us from evil lenders.  But how does predatory lending explain the office market bubble?  Do we really believe that deals between sophisticated parties, poured over by lawyers, were driven by predatory lending practices?  Do we also believe that other countries were also plagued by bad mortgage brokers?  Again, I think David is right about the problem being beyond housing, but he can’t have it both ways.

What is the common factor driving bubbles in commercial real estate, housing, and foreign real estate markets?  Maybe interest rates.  This was a credit bubble after all.  Especially since the Fed basically sets interest rate policy for the world.  It is hard for me to believe that three years (2002–2004) of a negative real federal funds rate isn’t going to end badly.  This is what I think Peter misses, the critical role of the Federal Reserve in helping blow the bubble.  But Dodd-Frank does nothing to change this. 

Now there are a ton of things I think both still miss.  We could argue all day about what a subprime mortgage is.  I think the definitions used by Wallison (and Pinto) are reasonable.  There is also a degree, a large one, to which David and Peter are just talking past each other.  For instance, there is something special about the U.S. housing market that transfers much of the risk to the taxpayer.  In contrast, the bust in the office market didn’t leave the taxpayer to pick up the tab.  That has to count for something, unless one just doesn’t care about the taxpayer. 

There are a few other issues that make Fannie/Freddie uniquely important in the crisis, but I lack the space to go into them here. Instead, I’ll wrap up by saying that their role in the overnight repurchase (re-po) market is under-appreciated and their ability to essentially neuter the Fed was critical in keeping the bubble going.  What’s for dessert?

The CAP-AEI Fannie Mae Food Fight is a post from Cato @ Liberty - Cato Institute Blog

Sunday’s New York Times Magazine has an interesting exit interview with Sheila Bair, who until this past Friday served as Chair of Federal Deposit Insurance Commission (FDIC). While I haven’t always been her biggest fan, I did find it refreshing to hear a bank regulator state the obvious:  we should have let Bear Stearns fail. As she puts it:

Bear Stearns was a second-tier investment bank, with — what? — around $400 billion in assets? I’m a traditionalist. Banks and bank-holding companies are in the safety net. That’s why they have deposit insurance. Investment banks take higher risks, and they are supposed to be outside the safety net. If they make enough mistakes, they are supposed to fail.

I’d be hard-pressed to say it better. Assisting the sale of Bear to JP Morgan created the expectation that anyone larger, like Lehman, would be assisted as well. Perhaps the most interesting part of the interview is that Bair gets right to the heart of the matter: the treatment of bondholders. ”Why did we do the bailouts?” Bair states “It was all about the bondholders.” Again she couldn’t be more correct. If there was anything Dodd-Frank should have fixed it was this, ending the rescue of bondholders and injecting market discipline back into bank.  It is also refreshing to hear her admit: ”I don’t think regulators can adequately regulate these big banks, we need market discipline. And if we don’t have that, they’re going to get us in trouble again.”

Where I disagree, besides her misguided take on mortgage re-sets, is whether Dodd-Frank will actually impose losses on bondholders. Bair expresses some optimism that such is the case, but there are just too many holes in Dodd-Frank to make that believable. Plus you pretty much have the same set of rules in place for Fannie Mae and Freddie Mac, yet the last time I checked the bondholders are still being protected at the expense of the taxpayer. If we don’t impose losses on Fannie creditors, even now after the panic, what makes anyone think we will do so to Citibank. Section 204 of Dodd-Frank is quite clear that the FDIC indeed retains the power to rescue creditors. Something that Bair was willing to do during the crisis, even if pushed to do so by Tim Geithner. Despite some errors, the interview is really a worthwhile read and has some real lessons for avoiding the next financial crisis.

Exit Interview with Sheila Bair is a post from Cato @ Liberty - Cato Institute Blog

• Regulatory privilege is not consistent with competitive markets–that’s why Fannie Mae and Freddie Mac need reform.
• Thank goodness the U.S. Supreme Court found that education tax credits are not consistent with the fictitious notion of a “tax expenditure.”
• President Obama’s budget plan is not consistent with either his own deficit commission’s plan or the Constitution.
• The modern “Executive State” is not consistent with Article II of the Constitution.
• Cyberbullying laws are not consistent with the First Amendment and our concept of free speech:

Monday Links is a post from Cato @ Liberty - Cato Institute Blog

Debates over the causes of the financial crisis sometimes center on whether Fannie Mae and Freddie Mac were “late to the party” in terms of subprime lending.  As it relates to the recent crisis, I address this question elsewhere. 

The GSEs and their apologists do claim to have been big contributors to one party: the expansion of homeownership in the United States.  Yet the facts suggest otherwise.

The chart below compares the GSE’s market-share, in terms of home mortgage lending (as reported in the Fed’s Flow of Funds data), with the national homeownership rate (as reported in the Decennial Census). 

The chart makes readily apparent that the largest increases in homeownership occurred before the GSEs played much of a role, if any, in the mortgage market.  For instance, by 1970, the homeownership rate had reached 62.3, yet the GSE market-share was just above 6%.  Even a decade after Fannie was “privatized,” the GSE market-share was still under 20%.

The real growth in GSE activity occurred during the 1980s, particularly the later half.  The reason?  The implosion of the savings and loan industry.  It seems we simply substituted several thousand mismanaged and under-capitalized thrifts for two large mismanaged and under-capitalized thrifts.  Interestingly enough, as the GSEs were doubling their market-share in the 1980s the homeownership rate actually fell.  By the time the GSEs had reached a market-share of 50%, the U.S. homeownership rate had already come close to the rate we see today, of 66%.

The data clearly show that we became a nation of homeowners with little assistance from Fannie and Freddie.  Not only did they join that party late, they simply took the place of the last group to ruin the party:  the S&Ls.

Fannie, Freddie: Late to the Party? is a post from Cato @ Liberty - Cato Institute Blog

• America’s unemployment rate has nothing to do with immigration.
• It’s possible to cut waste in government without succumbing to the Washington Monument ploy.
• Does this anti-obesity crusade make me look fat? (No, the junk science behind it shaping policy does.)
• Did Wall Street greed create the housing crisis? Or did government subsidies incentivize subprime lending by buying up 40% of new private-label subprime mortgages during the height of the housing boom?

Wednesday Links is a post from Cato @ Liberty - Cato Institute Blog

The Washington Post is reporting that current Federal Housing Administration (FHA) head David Stevens, who only last week announced he was leaving FHA, is going to be the new head of the Mortgage Bankers Association (MBA).

When Stevens was first nominated to head FHA, I have to admit I was concerned.  FHA has a long history of prioritizing the interests of the mortgage industry over that of the taxpayer.  And here was a guy right out of the real estate industry (former Freddie Mac exec).  My expectations weren’t exactly high.  Maybe because of that, I’ve been largely impressed.  As FHA Commissioner, Stevens has taken eliminating fraud seriously, as well as avoiding a taxpayer bailout of FHA (so far).

All that said, it is hard to imagine that in under a week’s time, he interviewed with and was hired by the Mortgage Bankers Association.  So while there’s no evidence that he was looking at an MBA job while carrying out his duties running FHA, there is certainly the appearance of such.  The appropriate thing to do would be to leave FHA before getting a job with the very industry that FHA regulates and subsidizes.

Again I think Stevens has done a far better job at FHA than many of his predecessors, and I don’t believe he played a role in the financial crisis, but I do believe the cozy relationship between the mortgage industry and our federal government did play a huge role in the crisis.

The Mortgage Industry-Government Revolving Door is a post from Cato @ Liberty - Cato Institute Blog

As Congress and the White House continue to debate the future of Fannie Mae and Freddie Mac, one of the oft heard concerns is that if we eliminate all the various mortgage subsidies in our system, then the cost of a mortgage will increase.  There certainly is a basic logic to that concern.  After all, why have subsidies if they don’t lower the price of the subsidized good.  Of course some, if not all, of said subsidy could be eaten up by the providers/producers of that good.

All this begs the question, with all the subsidies we have for mortgage finance, are mortgages actually cheaper in the U.S.?  While not perfect, one way of answering that question is to look at mortgage rates in other countries.   Although every developed country has some sort of government intervention in their mortgage market, almost all have considerably less support then that provided by the U.S.  (For a useful comparison of international differences see Michael Lea’s paper).

The European Mortgage Federation regularly collects information on mortgage pricing by EU countries.   The latest complete annual data from the EMF’s Hypostat database is for 2009, with at least a decade of historical data.

A quick glance reveals that mortgage rates in most European countries are not all that different than rates in the U.S.  For instance in 2009, the U.S. 30 year mortgage rate was, on average, 5.04; whereas mortgages in France averaged 4.6 and those in Germany averaged 4.29.  In the UK, the average was 4.34.

Part of this difference is driven by product type.  For instance, in France, most mortgages tend to be 15 year, which one would expect to be cheaper than a 30 year.  But the French 15 year rate of 4.6 isn’t all that different from the current U.S. 15 year rate of 4.1.  As lending rates are usually bench-marked off the rate on government debt, part of the slightly higher rate in some European countries is due to their higher government borrowing rate.  If we instead measure mortgage costs as a spread over government funding costs (as reported by the OECD), then many European countries look more affordable than the U.S.  For instance, German mortgages price about 100 basis points over long-term German govt debt; whereas U.S. mortgages price about 140 basis points over long-term U.S. government debt.

I don’t expect these numbers to settle the debate.  A variety of other costs, such as points paid or required downpayments, differ dramatically across countries.  Unfortunately that data does not seem to be readily available.  What the preceding comparison does suggest, however, is that even without Fannie and Freddie, U.S. mortgage rates aren’t necessarily going to be a lot higher.

Are Mortgages Cheaper in the U.S.? is a post from Cato @ Liberty - Cato Institute Blog

The latest canard offered for keeping taxpayers on the hook for mortgage risk is that, without such, homeownership would limited to the wealthy.  Sarah Rosen Wartell of the Center for American Progress stated before the House Subcommittee on Capital Markets, “The high cost, limited availability, and high volatility of pre-New Deal mortgage finance meant that homeownership was effectively limited to the wealthy.”  Congressman Al Green repeated the point.  As I’ve generally found Sarah to be one of the more reasonable CAP employees, and that this is fundamentally an empirical question, I would have expected her to offer some evidence to support such a claim.  Alas, she did not.  So I will.

According to the US Census Bureau, at the turn of the century in 1900, the US homeownership rate was 46.5%.  I’m pretty sure that even Sarah wouldn’t claim that close to half of US households in 1900 were “wealthy.”  Interestingly enough, homeownership after the first 10 years of the New Deal was lower than before the New Deal.

While 46.5% is about 20 percentage points below the current rate, the population in 1900 was considerably younger, and one thing we do know is that homeownership is positively correlated with age.  In 1900, 54% of the US population was under the age of 25, a reasonable cut-off for homeownership.  Today, that number is 35%.  I don’t think it would be a stretch to say the greatest driver behind the homeownership rate over the last 100 years has been the aging of the US population, probably followed by the increase in household incomes (homeownership and income are also closely correlated).

Hopefully this will put to rest the myth that FDR and the New Deal gave homeownership to the masses.  The fact is that homeownership was fairly widespread long before the New Deal.  I await the next myth from the Fannie Mae apologists.   If they are wise, they will try one that isn’t so easily falsified.

Homeownership Before the New Deal is a post from Cato @ Liberty - Cato Institute Blog

On Friday the Obama Administration released its report on “reforming America’s Housing Finance Market.”  The report claimed that the Administration would work toward “winding down Fannie Mae and Freddie Mac on a responsible timeline.” 

While the report was silent on what a responsible timeline would be (surprise, no details); I assumed, perhaps naively, that a reasonable timeline would be 5 to 6 years.  So you can imagine my surprise while reading the Administration’s budget proposal (see Table S-12 of the summary tables), released Monday, that the Administration is projecting that the government will be receiving, between 2012 and 2021, $89 billion in dividend payments from Fannie Mae and Freddie Mac.  In 2021 alone the White House projects $8 billion in dividend payments.  But here’s the rub, for Fannie Mae and Freddie Mac to be paying dividends in 2021 requires that they still be around.

So would the Administration please be straight with us for just a minute: are you or are you not proposing that Fannie Mae and Freddie Mac disappear; and if so, when?

Another odd thing from the budget, again Table s-12 lists the net equity position of Fannie and Freddie as negative.  Well that’s obviously true, but it also raises the question of why they are still in conservatorship, as the law requires them to be taken into receivership once they’ve reached negative equity.  Then perhaps OMB and Treasury have different definitions of net equity.

Administration Playing Both Sides on Fannie Mae is a post from Cato @ Liberty - Cato Institute Blog

Remember that “tough study” promised by Senator Chris Dodd to deal with Fannie Mae and Freddie Mac?  Well it is finally out.  All 22 pages (of doubled-spaced large font).  And less than half those pages actually discuss Fannie and Freddie.

While the report does say a lot of the right things — such as protecting the taxpayer — it is awfully short on any real details.  And in many areas, the report makes clear that the Obama administration intends to keep the taxpayer on the hook for future losses arising from Fannie and Freddie.  For instance, after assuring us that the GSEs will have sufficient capital to meet their obligations, including debt, the report tells us that such capital will not come from investors, but from the taxpayer.  One has to wonder whether this report was written for the benefit of the Chinese Central Bank (one of the largest GSE debtholders) or for the benefit of the U.S. taxpayer.

Equally vague is the discussion of “winding down” Fannie and Freddie.  While that sounds great, how is this to be accomplished? And how long will it take?  Again it seems that this “wind-down” will be financed by the taxpayer.  It is suggested that the GSE guarantee fees will increase.  Again, by how much and when?

Paragraph 2 of Section 1074 of the Dodd-Frank act, which required this study, also requires an “analysis” of various options and impacts.  In all due respect to HUD and Treasury and their efforts, there is nothing in this report that remotely resembles an “analysis” — just vague generalities.

I appreciate the administration’s stated desire to move us closer to a private market solution, but we’ve heard these empty promises before.  Remember that financial reform was going to end “too big to fail” and bailouts?  Health care reform was going to “bend the cost curve”?  It is past the time of fluff.   We need actual details and an actual plan.  

For details of immediate action that can be taken, see my testimony from earlier this week.

Administration Punts on Reform of Fannie and Freddie is a post from Cato @ Liberty - Cato Institute Blog

Last week the conservative House Republican Study Committee released its Spending Reduction Act of 2011, which would cut federal spending by $2.5 trillion over the next ten years. Sen. Jim DeMint (R-SC) will introduce it in the Senate.

The vast majority of the savings, $2.3 trillion, would come from freezing non-defense discretionary spending at fiscal 2006 levels over the next ten years. The rest would come from cutting the federal civilian workforce, privatizing Fannie Mae and Freddie Mac, repealing the state Medicaid FMAP increase, repealing remaining stimulus funds, and immediately reducing non-security discretionary spending to fiscal 2008 levels.

Of the $2.3 trillion over 10 years that would be saved by freezing nondefense discretionary spending at fiscal 2006 levels, only $330 billion in savings are actually specified, or about $33 billion annually. That’s only about 5 percent of nondefense discretionary spending, and nondefense discretionary spending only accounts for about 17 percent of total federal spending.

The RSC targeted an array of small and silly programs such as $17 million in subsidies for the International Fund for Ireland. They would eliminate mohair subsides saving $1 million, but that’s tiny compared to the needed termination of all farm subsidies. And proposing to eliminate “duplicative education programs” is fine, but the Department of Education doesn’t need house cleaning — it needs to be cleaned out.

The plan does include some good cuts that have been proposed at Downsizing Government:

• Amtrak subsidies
• Community Development Fund
• Department of Commerce business subsidies
• High-speed rail subsidies
• Economic Development Administration
• Some transit subsidies
• Some energy subsidies

However, most of the RSC’s savings are generated by a largely amorphous promise to keep domestic spending flat for years to come at 2006 levels. Unfortunately, this evades the needed national conversation on closing down major agencies and departments.

Another disappointment with the RSC plan is that there are no proposed cuts for the Department of Defense. That could be a major political error as more and more conservatives have been coming to the conclusion that it needs to be downsized. And by failing to include the Pentagon, any chance of support by congressional Democrats is killed.

GOP Conservatives Propose Spending Cuts is a post from Cato @ Liberty - Cato Institute Blog

Chinese President Hu Jintao’s visit to Washington brought renewed focus on China’s currency.  It was likely the largest point of discussion between President Obama and President Hu.  I suspect a less public, but related, issue was China looking for some certainty that America would make good on its obligations; after all, China is our largest lender.

What is often missed is the connection between these two issues:  currency and debt.  When China receives dollars for the many goods it sells us, instead of recycling those dollars into the purchase of US goods, it uses that money mostly to buy US Treasuries and Agencies (Fannie/Freddie securities).  These large Treasury/Agency purchases (foreign holdings of GSE debt are over $1 trillion) have the effect of increasing the demand for dollars and depressing that for yuan, resulting in an appreciation of the dollar relative to the yuan.  This connection exposes the hypocrisy of President Obama’s complaints about China currency manipulation – without massive US budget deficits, China would not be able to manipulate its currency to the extent it does.  If the US wants to end that manipulation, it can do so by simply reducing the outstanding supply of Treasuries and Agency debt.

Another solution, which would also do much to end the “implicit guarantees” of Fannie Mae and Freddie Mac, is to take Fannie and Freddie into a receivership, stop the US taxpayer from having to cover their losses, and shift those losses to junior creditors, which include the Chinese Central Bank.  Were the Chinese to actually suffer credit losses on their GSE debt, they would quickly start to reduce their holdings of such.  They might also cut back on Treasury holdings.  These actions would force the yuan to appreciate relative to the dollar.  And best of all, it would end the bottomless pit that Fannie and Freddie have become.  It is worth remembering that even today, under statute, the Federal government does not back the debt of Fannie and Freddie.  It is about time we also teach the Chinese a lesson about the rule of law, by actually following it ourselves. 

Of course this would increase the borrowing costs for Agencies (and maybe Treasuries), but then if China were to free float its currency, that would also reduce the demand for Treasuries/Agencies with a resulting increase in borrowing costs.  We cannot have it both ways.

Fannie & China: 2 Birds, 1 Stone is a post from Cato @ Liberty - Cato Institute Blog

Just in time for the holidays, the Congressional Budget Office has released its analysis of the costs and benefits of various alternatives to our current system of mortgage finance, particularly the role of Fannie Mae and Freddie Mac.

The report examines three possibilities:

1. A hybrid public/private model in which the government provides explicit guarantees on privately issued mortgages or MBSs;
2. A fully public model in which a wholly federal entity would guarantee qualifying mortgages or MBSs; or
3. A fully private model in which there would be no special federal backing for the secondary mortgage market.

The report doesn’t really push one option over another, but simply lays out the advantages and disadvantages of each.  Some highlights worth keeping in mind as the debate continues into the new year:

“Relying on explicit government guarantees…would also have some disadvantages…If competition remained muted, with only a few…firms participating in the secondary market, limiting risk to the overall financial system and avoiding regulatory capture could be difficult…federal guarantees would reduce creditors’ incentive to monitor risk. Experience with other federal insurance and credit programs suggests that the government would have trouble setting risk-sensitive prices and would most likely end up imposing some cost and risk on taxpayers. In addition, a hybrid approach might not eliminate the frictions that arise between private and public missions.”

“Privatization might provide the strongest incentive for prudent behavior on the part of financial intermediaries by removing the moral hazard that federal guarantees create.  By increasing competition in the secondary market, the privatization approach would reduce the market’s reliance on the viability of any one firm. Private markets may also be best positioned to allocate the credit risk and interest rate risk of mortgages efficiently, and they would probably be more innovative than a secondary market dominated by a fully federal agency. Further, privatization would eliminate the tension between public and private purposes inherent in the traditional GSE model.”

It is worth remembering that over the years, the CBO has actually been quite strong in warning against the dangers of the GSE model.  Sadly Congress simply chose to ignore those warnings.  Here’s hoping that the CBO has little more influence on this issue than they’ve had in the past.

CBO on Fannie, Freddie and Mortgage Finance Options is a post from Cato @ Liberty - Cato Institute Blog

A recurring concern we have heard since the financial crisis erupted is that banks are simply not lending, and that this is holding back economic activity.  If only banks would lend, the economy would grow.  As usual, the truth is a little more complex. 

Unlike in the Great Depression, and despite about 300 bank failures, the balance sheets and deposits of insured commercial banks and thrifts has been steady, if slowly, expanding throughout the financial crisis and recess.  Banks have continued lending during this time; however, they have changed who they are lending to.  Over the last two years we have witnessed a massive shift from lending to the private sector to lending to the public.

The chart below shows banking business lending and bank holdings of U.S. government securities.   The chart suggests that the approximately $500 billion increase in bank lending to Uncle Sam came at the expense of a $400 billion decline in lending to private business.  If one assumes that bank balance sheets have either been stable or increased slightly, then a loan to the government must off-set a loan otherwise made somewhere else.

While its hard to exactly measure the job impact of this reduced business lending, some estimates have been made on the impact of SBA lending.  According to one study, every $41,600 in new small business loans is associated with 1 new job created.   While this number should be taken with a grain of salt, it implies that the $400 billion reduction in business lending has cost over 9 million jobs.  Of course, one might argue that the half-trillion in lending to the govt has created or “saved” some jobs.  Accepting the difficulty of coming up with a reliable estimate, I think its fair to say that on net a few million jobs have been lost due to this shift of lending from the private to the public sector.

Also of interest is that since the financial crisis, and despite the failures of Fannie and Freddie, commercial banks and thrifts have increased their holdings of Fannie/Freddie/Ginnie securities by over $300 billion.

Textbook economics usually teaches that government crowding out of private investment only really occurs when we are near full-employment.  Yet looking at the balance sheets of our commercial banks and thrifts, would suggest that U.S. Treasuries and Agency securities have crowded out significant lending that would otherwise go to the private sector.   But this should come as no surprise, since banks can borrow for close to zero and invest risk-free in government debt, earning a nice spread of 3 to 4 percentage points.

Banks Are Lending, but to Whom? is a post from Cato @ Liberty - Cato Institute Blog

An argument often heard for keeping Fannie Mae and Freddie Mac, or some sort of subsidy for mortgages, is the desire to keep the 30 year fixed rate mortgage “affordable.” The 30 year fixed certainly has some merits – which borrowers should be willing to pay for – but it also has the downside of reducing the impact of monetary policy in stabilizing the economy.

Generally interest rates go down in a recession and up in an expansion.  Part of this is the reaction of the Federal Reserve, which tends to cut rates in a recession, but part is also the fact that the demand for credit also declines in a recession and increases in an expansion.

If borrowers moved to adjustable rate mortgages, then in recessions they would likely see a reduction in their mortgage rate, resulting in a reduction in their monthly payment, which would increase their disposable income, which itself should have some positive impact on consumption, helping to stabilize a weak economy.

The reverse would work in an expansion.  If the economy became over-heated, interest rates would likely go up, pushing up monthly payments, resulting in reductions in income and consumption.  While of course this would be unpleasant for the borrower, it would have the benefit of moderating a booming economy, reducing the likelihood of inflation and the occurrence of bubbles.

The latter effect would also increase the degree to which consumers care about inflation and demand price stability from the central bank.  Normally, borrowers have an incentive to favor inflation, as it reduces the real value of their debt.  If however, inflation resulted in an increase in their mortgage rate, their preference could switch toward price stability, which would in the long run be better for growth and the overall economy.

While I do not expect the above to settle the debate over the role of the 30 year fixed rate mortgage, we, as a society, should openly and loudly debate its costs and benefits before we simply assume it needs to be subsidized.

ARMs as Automatic Stabilizers is a post from Cato @ Liberty - Cato Institute Blog