Obama housing options silent on repos

The Obama Administration’s proposals to fix housing finance do not mention the repurchase market, would not improve its stability and could make it worse.

The proposals, released Thursday, call for completely phasing out Fannie Mae and Freddie Mac and offer three options for replacing them. Option Three represents the least change, because it continues a government guarantee for mortgage-backed securities.

By failing to discuss the critical role mortgage-backed securities play as collateral in the repurchase market, the Obama Administration proposal obscures one of the main elements of the debate on how to fix the broken U.S. housing market. 

Mortgages guaranteed by agencies like Fannie Mae and  Freddie Mac currently collateralize about 25 percent of U.S. repo transactions, or $704 billion daily, based on activity reported by the Federal Reserve’s 20 Primary Dealers. Surely financial institutions will not easily give up this taxpayer-guaranteed collateral. And if they have to, will they increasingly rely on the non-guaranteed mortgage securities that triggered the run on repo in 2007 and 2008?

A proposal that does not discuss the role repo has to play in these decisions appears incomplete.

Here are the Obama Administration’s three proposals:

Option One has no goverrment role in housing (except to continue to support low- and moderate-income borrowers through existing programs at the Federal Housing Administration, the U.S. Department of Agriculture and the Department of Veterans’ Affairs). In other words, the bulk of the housing market would be conducted by the giant bank companies using private capital, which presumably means securitization and repurchase agreements. 

This private-label mortgage market is precisely where the panic occurred in the financial crisis of 2007 and 2008, a fact the report ignores. In fact, the report says the private mortgage market could be safer than a mortgage market based on taxpayer guarantees.

“Risk throughout the system may also be reduced, as private actors will not be as inclined to take on excessive risk without the assurance of a government guarantee behind them,” says the report, with no explanation as to why the private actors, who happily took on excessive risk without a government guarantee prior to the crisis, would suddenly not be willing to do that under Option One.

For now, though, lenders do not seem to want private-market mortgage securities as collateral for repo loans, and the report also does not say how private-market securitization, now nearly dead, would be revived.

Option Two has no government role in housing except to ride to the rescue with all guns blazing when the system is in a crisis. In the absence of Fannie Mae and Freddie Mac, this option would set up a temporary crisis mechanism to manage the rescue.

Option Three has private insurance companies insuring mortgage securities and the federal government providing reinsurance for a fee. In other words, the taxpayer would step into the insurance companies’ shoes if they went broke in a crisis, roughly the way the FDIC insures deposits.  

The Obama Administration believes this option would be the most attractive to repo lenders and buyers of asset-backed securities and asset-backed commercial paper, presumably because the government would be the ultimate insurer of the collateral securities.

“… this reinsurance will likely attract a larger pool of investors to the mortgage market, increasing liquidity,” the report says. But the administration sees problems:

… while the capital requirements, oversight of the private mortgage guarantors, and premiums collected to cover future losses will together help to reduce the risk to the taxpayer, the reinsurance of private-lending activity, by its nature, exposes the government to risk and moral hazard.

If the oversight of the private mortgage guarantors is inadequate or the pricing of the reinsurance too low or recoupment of costs too politically difficult, then private actors in the market may take on excessive risk and the taxpayer could again bear the cost.