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A Guaranteed Disaster

Tuesday, September 20, 2011

Why the government shouldn’t guarantee mortgages or mortgage-backed securities.

One of the arguments occasionally put forward by proponents of a government housing market guarantee is that the government will always come in and rescue the housing market—so we might as well start with a government guarantee and charge for it. That way, it’s argued, the taxpayers will at least be compensated for the costs of the inevitable government intervention.

This idea is so flawed on its face that it wouldn’t seem to require a response, but since I have now heard it from two scholars whose views I generally respect—Adam Levitin, who writes for the Center for American Progress, and Phil Swagel, whose paper on this subject was published in July by the Milken Institute—I thought I should explain why I think the proposal lacks any logical basis.

Putting the government into the position of guaranteeing mortgages or mortgage-backed securities is not something that should be done lightly. Congress and the president are currently struggling with how to reduce the country’s debts, and blithely saying that the government should guarantee a substantial part of the $11 trillion housing market adds to the problem of an overextended government that we haven’t even begun to address effectively. Yet those who are pushing this notion are proposing to burden the government and, ultimately, the taxpayers, for what seems to be a completely frivolous reason: because they believe the government is incapable of avoiding a foolish mistake.

The argument seems to be circular: the government should back the housing market in the future because it has always had to step in when the housing market it was already backing has fallen apart.

Is this a reasonable standard? The government recently rescued Bear Stearns, an investment bank, and AIG, an insurance holding company. Even more to the point, the government also rescued two automobile manufacturers, General Motors and Chrysler. This was the second rescue for Chrysler, which was also rescued in the late 1970s. Does this mean that the government will always rescue financial institutions and auto manufacturers, and if so should we now authorize a government guarantee for the obligations of firms of this kind so that the taxpayers will be compensated for the losses they are going to incur in any event? Surely not. Then why does it make sense to assume that the government will always step in to rescue the housing market?

Anyway, what would be the circumstances in which the housing market—or some part of it—might require a rescue? Certainly, the government rescued Fannie Mae and Freddie Mac, but that was probably for two reasons: (i) they were government-sponsored enterprises, performing a government mission, and many foreign central banks had bought their debt securities without any cavil from the Treasury Department; and (ii) they so dominated the housing finance market—largely because of their perceived government backing—that their rescue was essential in order to keep the market functioning. If in the future there is no government involvement in the housing market, and consequently no dominant firm or firms, what exactly should make us so confident that the government will step in? The Levitin-Swagel argument seems to be circular: the government should back the housing market in the future because it has always had to step in when the housing market it was already backing had once again fallen apart.

Finally, how is it possible to believe that the government, and ultimately the taxpayers, will actually be compensated for the major financial risks that the government will assume? Has there ever been a government insurance program in which the government has charged a fee or a premium that has proved sufficient to compensate it for the risks it insured? Certainly not the FDIC, which consistently runs out of insurance funds when large numbers of banks get in trouble. Not the Federal Flood Insurance program. Not the Pension Benefit Guarantee Corporation. All these agencies are suffering losses—meaning that they did not charge enough for the risks they were taking.

How is it possible to believe that the government, and ultimately the taxpayers, will actually be compensated for the major financial risks that the government will assume?

We even know why these programs did not charge enough. The successful operation of an insurance system requires the building of a substantial reserve—enough to cover the potential losses. The insured parties, the ones that are funding the reserve, decide at some point that the reserve is large enough that—from their point of view—it can cover any conceivable loss. They pressure Congress to impose a restriction on the size of the reserve; Congress complies; and when the losses arrive the reserve is far too small. The taxpayers, then, have to make up the difference. This happens so often that it can be stated as a general rule: the government never gets compensated for the risks it insures, and the taxpayers will always get the bill.

In summary, then, the notion that the government should insure mortgages or mortgage-backed securities because eventually it will do so anyway seems deeply flawed. If that’s the standard, the government should be guaranteeing the liabilities of auto companies and nonbank financial institutions like AIG. The circumstances under which the government might step in to rescue the housing finance system are not even clear; in fact, the only time the government has had to rescue that system was when the government had already been backing some of the participating institutions. The S&Ls, Fannie, and Freddie come to mind. Finally, the whole idea rests on the assumption that the government will be adequately compensated for the risks it will be taking, and this—given the history of government insurance programs—is an obvious fantasy.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

FURTHER READING: Wallison also writes “An 'Unusual' Mortgage Coalition Reassembles,” “The Error at the Heart of the Dodd-Frank Act,” “Government-Sponsored Meltdown,” and “How the TBA Market Would Function for Privately Issued Mortgage-Backed Securities.”

Image by Rob Green | Bergman Group

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