The US government’s housing finance policies in recent decades can be summarized by one simple phrase: quantity over quality. The implicit goal was to increase the quantity of housing finance by keeping mortgage rates low and promoting wider home ownership. For several decades, the system worked. But if we view the long-term stability of home prices as one measure of the quality of housing finance, those policies now don’t look so successful.
In our view, this prioritization of quantity over quality has had unacceptable consequences. Taxpayers have been saddled with losses at Fannie Mae and Freddie Mac, and the price of a house—the biggest store of value for the vast majority of American families—has fallen nationwide for the first time since the Great Depression.
So what’s the answer? As argued in my last post on this topic, a housing market without any government involvement at all is not a realistic option. Nonetheless, it is clear that the private sector needs to take the reins, going forward. My colleagues Michael Canter and Matthew Bass argue in their recently released white paper, Increasing the Role of Private Capital in the Mortgage Market, that there are two key principals that should govern the transition.
First, to protect taxpayers, private capital needs to provide a significant buffer against losses before a government guarantee kicks in. Second, to reduce volatility in housing prices, this capital should be unleveraged. Let’s look at each of these principles in turn.
Historically, the US government underwrote 100% of the risk in agency mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae. Although this government backstop may have helped keep mortgage rates low, it subjected taxpayers to risk, since the government had no way of pricing this “insurance” correctly.
In our view, a better approach would be to require that private investors price and invest in the “first loss” risk in mortgage securitizations—the first piece of the transaction that is at risk of loss when homeowners default on loans in a mortgage pool. The government guarantee would come into play for the rest of the securitization only after private investors’ first-loss capital is completely wiped out. If the first-loss piece is appropriately sized relative to the underlying quality of the mortgage loans, the first-loss capital should be wiped out only in extreme stress scenarios.
Transparent, market-based pricing of the first-loss capital provided by private investors would help the government price its catastrophic insurance appropriately, reducing the risk to taxpayers.
But perhaps most importantly, in order to minimize volatility in the housing market, the private capital should come from a stable base of long-term investors, such as pension funds and sovereign-wealth funds, as opposed to leveraged investors, which tend to be more flighty because their investment decisions are largely driven by the availability of financing. A strict prohibition on investors’ ability to leverage the first-loss piece would help facilitate this change.
This would also effectively end “credit tranching” of the first-loss risk in mortgage securitizations. In the years leading up to the recent financial crisis, nonagency (or private-label) securitizations were commonly tranched, or sliced up into different classes of securities that had a differing order in the priority of claims on interest and principal repayments. Often, some of the “subordinated” tranches, which are inherently leveraged, were further repackaged into collateralized debt obligations (CDOs), magnifying the leverage even further. The end result of this system was that when home prices declined and mortgage losses escalated, the availability of credit became volatile and leveraged institutions became fragile. The ultimate impact was extreme housing price volatility.
Although low mortgage rates are an admirable goal, we believe that price instability for housing is too high a price to pay—for individual homeowners as well as taxpayers. Under the privately led system that we propose, mortgage rates are likely to rise somewhat, but in our view, this would be an acceptable tradeoff for a more stable housing market. How could the transition to a privately-led system actually happen? I’ll have more to say about that in a future post.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams
Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income, Michael S. Canter is Director of Structured Asset Research and Portfolio Management and Matthew D. Bass is VP— Structured Assets, all at AllianceBernstein.