Monday, November 12, 2007

Is There Something About the Subprime Mortgage Mess the Federal Reserve Hasn't Told Us?

On Friday, November 9, 2007, the Wall Street Journal (page A2) reported that Federal Reserve Board Chairman Ben Bernanke proposed at a Congressional hearing that the federal government guarantee jumbo mortgages up to $1 million so that they can be resold into the secondary mortgage market. If you’re experiencing cognitive dissonance, you’re not alone.

Jumbo mortgages are mortgages greater than $417,000. Fannie Mae and Freddie Mac cannot, by law, purchase mortgages greater than this amount. Smaller mortgages (“conforming loans”) can be bought by Fannie and Freddie, and are readily resold because they benefit from the implicit federal government guarantee of Fannie and Freddie. Since the subprime mess and the ensuing credit crunch, jumbo mortgages have generally been shunned by investors and are now available only at significantly higher interest rates than conforming mortgages.

A federal guarantee of jumbo mortgages up to $1 million would be a subsidy for the upper middle class and the wealthy. Once enacted, it, like all government benefits for the well-off, would never be repealed. Although Chairman Bernanke said the government should impose a fee for the guarantee, do we really believe that it would be a fair amount? With the political influence of the well-to-do, might not the fee be set at a level that would warm the hearts of Lexus drivers everywhere?

This proposal includes moral hazard of the first degree. If a federal guarantee of jumbos becomes available, you can bet that lenders will require borrowers to pay for it, so that they, the lenders, can continue their business as usual of making loans and selling them to dodge responsibility if a loan goes sour. With federally guaranteed loans easily sold in the secondary mortgage market, lenders will have no incentive to enforce meaningful credit standards. Perhaps some federal agency somewhere will try to impose credit standards through the process of issuing guarantees. But what federal agency has the staff and resources to process trillions of dollars of loans to hundreds of thousands of people? The political pressure to process large quantities of loans very fast would be enormous. Eventually, ordinary taxpaying citizens could end up subsidizing the McMansion fantasies of the more fortunate in America.

Market based economies work well only if their markets are allowed to function properly. People who qualify for a jumbo mortgage can take care of themselves, even if they have to pay higher interest rates. Their creditworthiness, if properly packaged in transparent mortgage-backed securities, should be marketable in the secondary mortgage markets. There is private insurance for these securities, and for jumbo mortgages, if investors really want it. Why not let all these well-to-do people pay their own way for a product that they have the means to pay for? The federal government has enough burdens with Social Security, Medicare and Medicaid. Why should it now take on the housing needs of the upper middle class?

More important than this being bad policy, though, is the suspicion that something really scary must be going on. This idea is right out of the European Social Democratic play book. A really big bogeyman must be out there in the subprime world to make a free market Republican like Chairman Bernanke even think of federal guarantees of jumbos, let alone say it out loud at a Congressional hearing. Is the subprime mortgage mess and credit crunch worse than anyone is admitting publicly? Is the banking system so bedeviled with real estate losses that the entire U.S. housing market--conforming loans and jumbos--has to be federally guaranteed? Are there an enormous number of jumbo loans out there that are likely to default, and can only be refinanced with federal guarantees? Is the U.S. banking system insolvent, or likely to become insolvent shortly?

The lack of transparency about the subprime mess is one of the reasons why the financial markets are so unsteady. Yes, if the picture is really bad and everyone finds out, there is a risk of a run on U.S. banks and the dollar. But runs can, and have been, precipitated by uncertainty. Chairman Bernanke’s proposal only adds to the uncertainty. Before U.S. taxpayers become liable for every upper middle class mortgage issued in America, perhaps they should be given the full picture of what’s going on.

Crime News: a Robin Hood banker. Was he helping subprime borrowers?

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