Guest Op-Ed to by "Banker with a Conscience"

February, 2011

These weekly pieces are written by a very influencial "Banker with a Conscience," and submitted to my Blog as Guest Op-Eds. Gets you into the mind of someone at the very top of the financial services sector; how they see the current global economic crisis (the mess), as well as various government and private sector solutions to get us out of it.  Hope you enjoy reading them.   


Just read through the Administration’s presentation on the long term “solution” to the GSE mess.  I think you can sum the whole thing up in a single word—Privatization.

For those of us that have been plowing these fields for a few decades, this is an ironic outcome.  The solution is almost exactly what Dick Kovacevich, the former CEO at Wells was ranting about to anybody that would listen throughout the 90’s and early part of this century.  I guess all ideas eventually come into fashion.

My guess is that the Republican Congress will eat this up.  Sure, there will be some fringe battles, but this is certainly in the sweet spot of the Republican agenda.

Let’s take a minute and with the advantage of 20-20 hindsight ask “what problem are we trying to fix” and “does this solution fix that problem”.

Obviously, the problem being addressed are the eye-watering losses taken by the GSEs as they guaranteed the performance of billions of dollars of terrible retail residential loans.  What caused the problem was that the brilliant management teams at the GSEs (spurred on by ridiculous pay packages) successfully and dramatically increased their market share of a mortgage market that had gone completely off the deep-end from a quality management perspective.  They were a private company with the full faith and credit of the US Government standing behind them.  The accounting rules allowed them to post ever greater profits on ever more dangerous loan guarantees and they paid huge bonuses to their staff out of these (phantom) profits.  Along the way they paid huge amounts to their lobbyists and those lobbyists donated huge amounts to the Congress that was supposedly overseeing them.  By the way, the regulators never benefitted a whit from this.  They just enjoyed their usual uninterrupted snooze.

The original idea of the whole GSE concept was to provide a liquid market for loans made by the mortgage industry because it was obvious (and became more so with the demise of the S&L industry in the late 80s and early 90s) that the banking industry could not possibly hold all of the American mortgage debt on its balance sheet.  It was believed that the best way to keep the lenders lending was to provide a simple solution to getting the loans off their books after they were made.   There was another reality—even if the banks had the balance sheet capacity, they could not safely hold 30 year loans (with no prepayment penalty) when their funding sources were generally limited to a few years at best.  So the GSEs bought up the loans, packaged them into securities and “recycled” the money the originators lent.

It all worked pretty well except for two things:  (1) the government was effectively in the business of guaranteeing the performance of America’s homeowners and (2) there were no effective controls on the increasing stupidity of some members of the industry and certainly of the GSE management teams.  In other words—the government proved to be both ineffective at regulating business entities and equally inept at running them.

The question then becomes, will privatization solve the problem.  It would be good to be skeptical at this point.   Here are the potential outcomes and the consequences of this:

  1. The proposal carves out a role for the government, assuring the market is open to low and moderate income Americans by keeping FHA alive and (we hope) well.  As long as the risk premium charged by the FHA (a quarter percent back in the day) reflects the actual risk of this pool of borrowers, this should work out pretty well.  The one fly in the ointment is that the losses on this pool of borrowers have been extraordinary over the last few years, so the appropriate risk premium (measured by recent history) is in the mid to high single digits (not fractions of a percent) so we have to have a road map to get through that.
  2. The elimination of the GSEs as an outlet for loans made by originators, means the originators will have to develop the ability to package up their loans into securities and sell those securities to interested individual and institutional investors.  Given the less than sterling track record of mortgage backed securities developed by Wall Street and sold independent of the GSEs over the last three years you can imagine how the yield demands might be a bit higher than for mortgage backs with full faith and credit of the US Government standing behind them.  In the long run, the yield will settle down to reflect the actual risk, but in the short run the yield requirements will reflect the recent history of losses.  It would not be irresponsible to suggest that a 30 year, no prepayment mortgage could be priced up by 200 to 300 bps if this change were implemented overnight, right now.
  3. The whole idea rests on the idea that the regulators, who have accomplished nothing of value through this entire journey, will somehow grasp the subtlety of overseeing a market by carefully preventing excesses while simultaneously letting the amazing strength of the market system work.  Don’t take any major bets on that success. 

The consequences of these fairly dramatic price increases for mortgages (read interest rates) that will be borne by people borrowing money (until the market settles down) is that payments will be higher, therefore buyers will be able to spend less on the purchase price than they otherwise would have.  If you dive back into your college Econ 101 text, you will realize that this instantaneous drop in the demand curve means that residential real estate prices will take another downward spiral—good for home affordability, bad for the wealth of American homeowners and bad for their propensity to spend on everything else—therefore, bad for the economy in the short run. 

Conclusion:   the proffered solution by the Obama administration is probably the only politically viable solution.  What we can only hope is that they work hard on the transition and try to ease these changes in over time so we don’t shock the economy into a longer period of economic malaise.  Until we get back to “normal” in the mortgage industry and market (which is to say what we experienced for the entire post war era until early in this century when laissez faire capitalism took over the mortgage business and regulators went into deeper sleep than usual) the economy can’t build more houses and that means we can’t provide the homebuilding jobs that drove the economy for so many successful years.


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