The world post Fannie Mae and Freddie Mac, part two

In yesterday’s post I discussed the history and purposes of Fannie Mae and Freddie Mac, as well as the radical proposed changes to these two institutions as made by the administration of President Barack Obama.  In today’s post I want to talk about the world post Fannie Mae and Freddie Mac.

Here are the overriding concerns associated with this potential sea change:

1. Mortgage costs will increase for borrowers
2. The overall level of risk in the mortgage market will increase
3. Liquidity in the mortgage market will be diminished
4. Profitability at banks will change
5. There will be even more financial industry consolidation
6. Miscellaneous changes

Mortgage Costs Will Increase for Borrowers

I believe that one of the great myths associated with Fannie Mae and Freddie Mac is that they have somehow lowered borrowing costs for mortgagees.  I think that supporters of the two government sponsored entities (GSEs) are using the wrong scale when evaluating the supposed benefit of Fannie and Freddie.

Supporters have tended to focus on the individual borrower.  Yes, it’s true that costs are lowered for the individual borrower.  Yet, this observation ignores the proper context for evaluation.  Namely, this belief ignores what the mortgage market looks like in its totality with Fannie and Freddie.

If you look at the aggregate level of risk in the entire mortgage system, I think that Fannie and Freddie increase risks.

Mortgage rates increase as the riskiness of the borrower increases.  Fannie and Freddie artificially lower the individual risk of a borrower by ostensibly agreeing to backstop the failure of a borrower to pay his/her’s mortgage.  That means that borrowers on the margin – those that would not have normally qualified for a mortgage – get home loans.  So at the scale of the individual borrower rates are lowered.  If you aggregate all of these borrowers, the thinking goes, rates have been lowered.

However, what really happens is that the entire aggregate risk level of the mortgage system is increased.  The reason is that there are many mortgagees who ought not to have home loans.  After all, just because Fannie Mae and Freddie Mac have agreed to backstop these mortgages doesn’t mean that these borrowers have somehow become more financially responsible or solvent.

Before intervention of Fannie and Freddie, underwriters were more careful with whom they underwrote for a home loan.  That meant that mostly only folks who were financially able and ready got home loans.  That meant the whole system was less risky.  Less risk means lower mortgage rates.

Once you have established a proper legal and regulatory framework for the functioning of markets, you then need a lack of price and risk distortions for those markets to truly work.  Think about it.  What happens when sellers have more information about a product than buyers?

Think: the seller of a used car who knows that it needs transmission work.  This is an informational and risk distortion.  Enter CarFax.  The risk to the system is lowered by information eliminating the distortion of a lack of information.

Think: oil.  Oil prices have been subsidized by the Federal Government for decades.  How?  By giving massive tax breaks to drillers of oil.  That lowers the cost of production for these producers.  Those lower costs are passed on to consumers – so gas prices are lower.  But do these price distortions lower the risk that oil has on our overall quality of life?  Do these price distortions lower the risks of global warming?  Clearly not.

Fannie Mae and Freddie Mac are price distorters of colossal size.  They mask risks to the mortgage system.  When those risks are revealed for what they are – like when the real estate bubble burst – the entire mortgage system collapses.  Net: Fannie Mae and Freddie Mac do not lower borrowing costs when you use the proper scale for examining their impact.  That scale is over the long-term and at the level of the entire system, not at the level of the individual borrower.

The Overall Level of Risk in the Mortgage Market Will Increase.

It should be obvious from the points above that I think this is a ridiculous assertion.  The greatest risk is price and risk distortions created by artificial subsidies that obscure an accurate assessment of risks, and especially of total risk.  Therefore, the dissolution of Fannie Mae and Freddie Mac will lower the risk of the entire system.

One of the ways this will happen is that lenders, unprotected by the largess of Fannie and Freddie, will have to be more careful at the outset when underwriting a loan.  That will lower the overall risk level of the entire mortgage market, not increase it.

One of the arguments for Fannie Mae and Freddie Mac is that they facilitate greater home ownership in the United States.  So the concern is that sans the presence of the giant GSEs that somehow the level of home ownership in the U.S. will fall.  Yet, as I pointed out yesterday, since 1968 when Fannie received the “full faith and credit of the United States” backing from the Federal Government, home ownership has only increased by 3.5%!  That occurred during a time in which overall per capital gross domestic product (GDP) increased much more substantially.  So this concern on the part of backers of Fannie and Freddie is not borne out by the statistics.

Liquidity in the Mortgage Market Will be Diminished

Okay, now we are to a real concern.  Fannie Mae and Freddie Mac, by creating a market for mortgage backed securities, have tremendously increased the liquidity in the mortgage market.  Prior to the creation of these GSEs mortgages were a highly illiquid asset.  After all, they were secured by an asset, a house, that was tough to sell relative to the nearly pure liquidity of a stock.

If Fannie Mae and Freddie Mac go away there is no doubt that there will be fewer purchasers of mortgages and mortgage backed securities.  However, my question is: and of what benefit is liquidity in the mortgage market?  Isn’t okay if you cannot turn around and sell a mortgage?  Well maybe.

It is certainly nice if you are a bank that you can underwrite a mortgage, then have it bought by Fannie Mae and Freddie Mac.  You take the cash handed over in that purchase and reinvest it in another mortgage.  So profitability at banks will certainly be lower based on a reduced volume of transactions.

However, remember that the percentage ownership of houses in the United States has barely changed under the Fannie and Freddie regime.  Isn’t it just as possible that sans the GSEs that the major commercial banks pick up the slack?  Or that those very big banks fulfill a purpose similar to Fannie and Freddie in terms of creating a liquid mortgage market?

Profitability at Banks Will Change

Notice that I didn’t say that profitability at banks will be reduced by lower volumes of mortgage transactions.  I am not sure what will happen to the profitability of banks.  There has been lots of speculation that if the liquidity provided by Fannie and Freddie disappears that transaction volumes for mortgages will be lower.  Lower volumes equals lower profitability…supposedly.

But isn’t it just as possible that the big commercial banks, like Bank of America and Well Fargo begin fulfilling a similar function like Fannie Mae and Freddie Mac have provided for almost half a century?  I think so.  Without the artificially advantageous, almost monopolistic qualities of the GSEs, isn’t it possible that the big commercial banks will step in and fill the vacuum?  That vacuum is a highly profitable vacuum isn’t it?

That’s because without the artificially low mortgage rates provided by Fannie and Freddie, spreads for banks between the cost that they borrow at (which will stay relatively fixed) and at which they then turn around and lend at, should widen.  So perhaps profitability lost on volumes may be gained on fatter profit margins.

I think, at the outset of the post-Fannie and Freddie frontier, that it is difficult to assess just what the effect will be on bank profitability.  There will certainly be more competition.  Usually in capitalistic markets, unfettered by the b.s. of a Federal government subsidy, there is usually a reduction in the costs to consumers and an increase in profits to the low cost providers of goods and services.

There Will be Even More Financial Industry Consolidation

While the last thirty years has seen tremendous consolidation in the banking industry, sans Fannie Mae and Freddie Mac there will be even more.  Why?  In order to compete in the mortgage underwriting, mortgage-backed-securities, higher profitability market, banks will need to have scale.  That scale is already in place for some of the larger national banks.

However, there are a number of smaller, regional banks, that have competed on great service and knowing their local markets that will either be subsumed by the national players, or they will buy up other regional banks in order to get big.  Only with scale can you enter a market as a national underwriter of mortgage backed securities.

The world will increasingly be dominated by fewer and fewer banks post Fannie Mae and Freddie Mac.

Miscellaneous Changes

While it may seem as if financial institutions like Fannie Mae and Freddie Mac, once emasculated, would have only a financial industry affect, this is naïve.  For example, more mortgages equals more houses.  More houses means a greater need for real estate.  A greater need for real estate equals a greater need for land.  A greater need for real estate has meant greater development where land was cheap.  That cheap land has been in the suburbs.  Greater population in the suburbs equals greater commutes.  Greater commutes equals more pollution.  Greater pollution equals more global warming.  Yes, really.  This is the cause and effect chain – sorry to say.

Fannie Mae and Freddie Mac have created a whole host of problems for the world (in addition to their benefits).  Unfortunately, if Fannie and Freddie go away, it’s my feeling that the slack will be taken up by other institutions, private institutions.

There are a whole host of other possible ramifications – but I just wanted to highlight that nothing exists in isolation in the world.  Indulge me.

In conclusion, I think the ultimate benefit, net, of the dissolution of Fannie Mae and Freddie Mac, when all factors are considered, is that there is less risk in mortgage markets.  This is a good thing.  No, actually it is a very, very good thing.  Que sera, sera.

Jason