Former Freddie Mac Chief Economist Says Housing Finance Model Can Be Found Outside The U.S.
May 15, 2013 12:59 p.m.
Related Story: Former Freddie Mac Chief Economist Says Housing Finance Model Can Be Found Outside The U.S.
CAVANAUGH: I'm Maureen Cavanaugh. It's Wednesday, May 15. Several sectors of the U.S. economy are improving since the economic downturn. Employment is up, housing prices are going up, but what some say started the recession, the housing finance market is still struggling. The private home lending market has not rebounded. The mortgage market is almost entirely backed by the government. That is not a good thing, according to my guest, doctor Michael Lee. This former chief economist for Freddie Mac is headed to Washington next month to testify before the house financial services committee. He is the director of the Corky McMillin Center for Real Estate at SDSU's College of Business Administration. Welcome back to the program.
LEA: Always great to be here.
CAVANAUGH: Before we get to the substance of your testimony, can you give us a brief mortgage finance lesson? How did the government wind up backing most home mortgages?
LEA: Well, let's go all the way back to the depression where to jump start the housing market and the housing finance system, we created entities like Fannie Mae and the FHA in order to entice more money to go into housing finance, more lenders to provide those kind of loans. And that government legacy has stayed with us through to the present. If you add up Fannie Mae, Freddie Mac, the FHA, the government is backing almost 90% of all new mortgages made and 60%-plus of all mortgages outstanding.
CAVANAUGH: What connection do Fannie Mae and Freddie Mac have with the government? Are they government agencies?
LEA: Fannie Mae was originally a government agency, and it was "privatized." It wasn't really and Freddie Mac was created in the early 1970s. They are called government-sponsored enterprises, which means they're government-chartered corporations that have a very defined function.
CAVANAUGH: Okay. Therefore why did Fannie Mae and Freddie Mac need to be bailed out by the government just recently?
LEA: Yeah, 2009. They had this special status where they're backed by the government implicitly is what we've always called it. And the markets really always believed if they ever got in trouble, the government would step in. And they're grown so large together, these two corporations, they're either backing or funding over $5trillion of mortgage credit that when they ran into problems with a lot of loan defaults and security markdowns, they didn't have any capital left to support those losses. And in order to back up their guarantees on their securities, government had to step in.
CAVANAUGH: If I were a bank, I would probably like an agency that guaranteed a loan that I gave a lender and basically had the full faith and credit of the United States government behind it and said no matter what that lender does, you're going to get paid back.
LEA: It is. And that's one of the difficulties in changing the system. There are a lot of interests that like and benefit from government guarantees. And there are very direct beneficiaries. Banks that can sell those mortgages and get a very good price for them because of the government backing. And everyone that's in the home industry likes the fact that mortgage rates are low. And one of the reasons they're low is the government backing.
CAVANAUGH: So why would you like to see things changed? And how would you like to see things changed?
LEA: Well, I think that people on both sides of the aisle really don't think that it's healthy for us to have, first of all, over 90% of all new mortgage credit backed by the taxpayer. We haven't had good success with this. We have gone through multiple crises in housing finance. First one was in the depression. Then the savings and loan crisis of the late 1980s, now the great recession. Being principally caused by problems in our housing finance system. So basically scaling back the government's involvement and targeting it is something that there's a lot of agreement on. Of the second thing is that from a financial risk standpoint, to have corporations as large as Fannie Mae and Freddie Mac, are over $5trillion, 1/3 the size the entire economy, they're two essentially monopoly companies that have that special status because of their government backing. And I think that we believe in competitive markets and let markets determine the allocation of capital. Let's get the government back out of that and reduce the systemic risk in the financial system.
CAVANAUGH: So if banks and other lenders made home mortgages, and they kept those mortgages, or at least they didn't sell them onto the government, what would that do to home buyers?
LEA: Well, I think that if necessarily wouldn't have really large changes because I think that mortgage lending is a profitable business for the banks. I think the two things that you would see is first of all, if there's less government guarantee, less government involvement, mortgage credit will be a bit higher priced. I'm not talking about several percentage points. Make 1quarter to a half a percentage point more. The second thing is we would probably have more expensive types of mortgage, mainly the long-term 30-year fixed rate mortgage. That's a type of instrument that really needs to be funded in the capital markets and guarantees really help doing that. And if banks held these mortgages on their balance sheet as they did try to the savings and loan crisis, they'd be more apt to do shorter term, fixed rates, or adjustable rate mortgages.
CAVANAUGH: Is there also the idea that this would give the basics more stability, more credibility when it comes to servicing not only mortgages but also not selling things on and actually having the money, the resources in the bank, so to speak? Because they still own there's loans?
LEA: That's an excellent point, and you're exactly right. I think we got away from the notion of incentive compatibility where the that makes the loan, services the loan, and bears the risk on the loan, when that situation occurs, they certainly have much more of a vested interest to make sure they create good loans and ensure that those loans stay current. We got away from that system with the widespread sale of mortgages, both to Fannie and Freddie, as well as other entities prior to the crisis. Because they were selling off the risk, they really didn't have any real incentive to create good quality mortgages because they effectively get paid on volume, not on the quality.
CAVANAUGH: Now, your research involves housing finance both in the U.S. and in other countries. Have you found any successful models in other countries that you'll be sharing in Washington, those countries that don't necessarily have the bulk of their home mortgages backed by the government?
LEA: Well, first, the U.S. is very unusual, it's totally unusual amongst developed countries in terms of the extent and the type of government involvement. Virtually no other developed country has the equivalent of Fannie Mae and Freddie Mac. You have some countries like Canada who have a version of FHA. But in the research I've done looking at about 15 or 16 countries, there's only three or four that have much government involvement, and nothing to the extent to which we do. Then you look at what kind of outcomes you get from your housing finance sector and you look at countries Australia and the United Kingdom that have virtually no government involvement in their system, home ownership rates are high are than they are in the U.S.. And they didn't go through the financial crisis that we had, at least as relates to housing finance. The Canadian system is more of a hybrid system. It has an FHA type framework. It also has dealty very well with housing bubbles and bursts without the widespread losses that we've seen here in the U.S. And the last country that I like to look it because it has some similarity to the US in terms of the long-term fixed rate mortgage, is Denmark. They fund it without specially charted enterprises like fanny and Freddy.
CAVANAUGH: And in some of the other countries you've researched, they allow homeowners to renegotiate their loans at certain intervals, in other words you get a 30-year mortgage, but you can renegotiate on interest rates as it goes along. And it's not necessarily an arm. It's just -- you can renegotiate a fixed rate!
LEA: And that's exactly what the Canadian mortgage is. So the typical Canadian mortgage will have a rate fixed for five years, though it kind of comes in 1, 3, 5, and 10-year fixed ret periods over a 30-year term that you pay off the mortgage. So the rate is adjusted, renegotiated periodically when that fixed rate period ends. Now, obviously there's some degree of interest rate risk that the borrower has because who knows what rates are going to be when that adjustment period comes up? The flexibility the borrower has is if rates are high, they can basically say, well, I'll just lock in for one year with the hope that rates will come back down. So you have a little bit of flexibility there. I come back and ask the question here in the U.S., why do rates have to be fixed for 30 years when the average person holds their loan for about 5? It's a luxury good that we don't necessarily need to -- and if people really want that protection, they can get it without a government guarantee.
CAVANAUGH: You were formerly the chief economist for Freddie Mac in the early '80s. And you are going to be heading to watch watch next week to specify specifically what to do about Fannie Mae and Freddie Mac. What types of questions are you anticipating from Congress?
LEA: Well, I think they're going to have two different lines of questioning. The first is going to be related to the research I've done. And I think that's the reason that they've asked me to come there, are to say, well, are let's imagine a world without Fannie Mae and Freddie Mac. What would you it look like? And the answer that I would give is that we can look around in the rest of the world and see how housing finance is structured and has performed over the course of the last couple of decades. And that's going to give us a pretty good idea about how housing finance with much less government involvement would look.
CAVANAUGH: Another aspect of the housing reform that the House is looking into involves loosening some of the provisions of the Dodd frank oversight law, that was passed after this crisis in 2008. It oversees hedge fund, banks, and derivatives. If we move to privatized, more housing finance, don't we need more strict oversight laws?
LEA: Well, we actually had fairly well-developed oversight and mechanisms prior to the crisis. Unfortunately, it just didn't work very well. And it wasn't necessarily that we lacked a lot of the laws. It was really that either they weren't enforced properly or as you pointed out earlier, the incentives were all screwed up. So I think we're moved in the direction of trying to get these incentives more in place starting with the fact that borrowers should have some equity in their property. Entities that sell their loans should keep a portion of the risk to again give them the incentive to create good loans and to service those loans properly. I think those are good things. I hope they don't go away.
CAVANAUGH: You're saying if the entity itself, the bank, the lender actually assumed more of the risk themselves, some of what was in the system before the housing crisis, the real shaky loans that we heard about, they wouldn't exist because it would be the lender that would be assuming that risk.
LEA: Absolutely. You wouldn't have made loans to people who clearly had falsified income or made loans to people that were subprime. They had demonstrated that they couldn't meet their financial obligations, and we give them a 100% loan for the value of the loan.
CAVANAUGH: Fannie Mae and Freddie Mac, even though they have been the subject of a major bailout, they seem to be pretty much a fixture in the way we do our home loans in this country. What do you expect the outcome of these hearings? What do you expect to see Washington do about reform?
LEA: Well, I think the path they have been on is probably the one that's most likely to continue, which is to try to scale back fanny and Freddy slowly. And they're doing is that in a couple different ways. One is is that they have been raising the fees that they charge for their guarantee operations. And as those fees raise, then we're going to get more competitiveness from private capital. And that will begin to shrink their market share. Second thing is that we're trying to shrink their portfolios to not have them hold as many mortgages, and that will be another way to reduce their size. Unfortunately, the process has been very slow so far.
CAVANAUGH: The people who do not want to see this reform, who want to see Freddie Mac and Fannie Mae keep their big position in American mortgage life, what are their concerns?
LEA: Well, I think the first concern is if they take them away too rapidly, what is there to replace them? And it's always a fear of the unknown. This is the market most people that are in it today have been in for the last 20, 25, 30 years. Fanny and Freddy and ginny have been the dominant factors in the market. So it's difficult for a lot of operators who are day to day making loans, securitizing loans to think of a world without fanny and Freddy. That's why I think the change has to be gradual, to let other options to come in, more bank lending on their balance sheet, more private label securitization, and gradually move the market away from the government domination.
CAVANAUGH: And you don't see interest rates just taking a really dramatic rise if indeed Freddie Mac and Fannie Mae went away?
LEA: No. Private capital would step in. Of the investors that buy fanny and Freddy securities are going to buy those securities without the government guarantee. The loans that are being purchased and created now are pristine, they're really good quality. So once Fannie Mae and Freddie Mac are not as major competitors, private capital will step in.
CAVANAUGH: Let me ask you in closing about something that you're doing here in San Diego. What is this panel discussion?
LEA: Well, we're having an event on Wednesday, May 29th, 7:30 in the morning at the alumni center here. Discussing the future of redevelopment in San Diego. So we have the past and present members of the redevelopment teams, now called Civic San Diego, as well as the former director of CCDC. And then we also have a prominent developer downtown as well as the president/CEO of the Jacobs family foundation in in southeast. So we're going to have a really interesting discussion about the challenges and opportunities for urban redevelopment here.
CAVANAUGH: When and where?
LEA: Wednesday the 29th of May, at the alumni center at 7:30 in the morning, and breakfast is served!
CAVANAUGH: Okay! And good luck in Washington!
LEA: Thank you, Maureen.