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High Stakes Battle in Credit War

e21 | 10/11/2011
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The latest battle in the ongoing war for the future of financial intermediation is currently unfolding in the high balance mortgage space. As of October 1, the Federal government’s agencies – the Federal Housing Administration, Fannie Mae, and Freddie Mac – are unable to guarantee or purchase loans with unpaid principal balances in excess of $625,000. This means that households seeking to borrow more than this amount will be thrown to the mercy of the market. The outcome of this battle will be telling because if the private sector cannot be trusted to set the terms and conditions for collateralized loans made to high income households, it’s not much of a leap to suspect the war will end in the full socialization of credit risk.

Since passage of the 2009 Stimulus Act, the top mortgage balance that would qualify for purchase from government agencies was $729,000. To put this in perspective, the median price of existing homes sold in the second quarter of 2011 was $171,000, according to the National Association of Realtors. This means a maximum loan eligible for public subsidy could buy more than four of the median homes in America. The new maximum balance of $625,000 is only sufficient to buy 3 of the median homes, with $112,000 left over for remodeling.

The reduction in the balance of loans eligible for purchase by Fannie Mae and Freddie Mac affects a small number of housing markets. According to an analysis of the change from Genworth Financial, only 86 of 3,143 U.S. counties (2.7%) had pre-October borrowing limits in excess of $625,000. Those that did were concentrated along the coasts – New York, New Jersey, the San Francisco Bay Area, and Washington, D.C. – and playgrounds for the rich like the ski resort towns of the Colorado, Utah, and Idaho, as well as Honolulu and Key West, Florida. The proponents of an extension of the old loan limits – aside from the obvious special interest groups who depend on government support for homebuilding and mortgage finance – are generally Members of Congress that represent these high cost areas.

The argument for extension generally focuses on the plight of firemen, teachers, or other public service professionals who happen to live in a high cost area. Yet, even in the New York metro area, the median house price is $448,000. San Jose and San Francisco are slightly higher, at $610,000 and $515,000 respectively. Even in these markets, a loan balance of $625,000 is sufficient to buy a home well in excess of what’s typical. Subsidizing the borrowing of the highest income households in the most exclusive locales seems like an odd function for government, especially in the wake of a financial crisis where the cost of previously invisible credit subsidies became all too apparent.

Prior to the 2008 housing act, there was a vibrant “jumbo” market for mortgages too large to be purchased by Fannie Mae and Freddie Mac. This purely private market was actually quite large even when viewed as a share of all mortgages. According to the Federal Housing Finance Administration (FHFA), “jumbo” loans accounted for nearly one-fifth of all mortgages originated between 2003 and 2006. According to a 2001 Congressional Budget Office (CBO) study, the interest rates on these mortgages were 18 to 25 basis points (0.18% to 0.25%) more than for “conforming” mortgages eligible for purchase by Fannie and Freddie. This was thought to be the subsidy government sponsorship of Fannie and Freddie generated for mortgage borrowers.

In the wake of the financial crisis, mortgage credit risk looks a bit different than it did in 2003. Initial estimates suggest that absent taxpayer subsidies, a borrower assuming a $700,000 loan for a $800,000 house will face incremental annual interest expense of more than $5,000 and a tripling (or more) of required down payments. An increase in the required down payment from 12.5% to 30% would increase the required down payment in this case by $140,000. This is a huge increase, but most households seeking to buy a $800,000 home are sufficiently liquid to execute this transaction. And if they are not, why is it of any concern to the taxpayers who’d otherwise be asked to backstop this transaction? A mortgage of $700,000 is more than three-times the average unpaid principal balance of the average loan originated in 2010 and, according to FHFA, this average includes $30 billion of purchases of ultra high-balance mortgages during the year.

Even worse than the increase in Fannie and Freddie loan limits has been the expansion of FHA lending. To get an FHA loans, only a 3.5% down payment is required. This means that prior to October 1, a borrower in Los Angeles County with as little as $27,000 in cash would be eligible to buy a $750,000 home through a taxpayer-guaranteed loan. If a private sector lender funded the same loan with discretionary risk capital, a homeowner would be asked to put down roughly $150,000 to $225,000 in equity. This means that the upfront subsidy to the borrower under the government channel is over $123,000. Since California is a non-recourse lending state, smaller down payments make strategic default more attractive since the borrower does not need to worry about losing other assets in the event of foreclosure. What public interest is served by ensuring that a borrower has to commit less upfront cash to buy what amounts to a call option on a $750,000 home?

Reduction in loan limits is the first place to start phasing out taxpayer support for mortgage finance. There is simply no sound public policy rationale for asking taxpayers to stand behind the mortgage loans of the affluent. At some point, subsidizing everyone means subsidizing no one, as the credit support simply drives up the cost of buying a home, canceling out the benefit it was meant to provide.

In a recent interview, Senator Charles Schumer of New York made the reasonable point that President Obama’s proposed tax increase treats households differently based on their location. “$250,000 makes you really rich in Mississippi,” Schumer said, “but it doesn’t make you rich at all in New York and there ought to be some kind of scale based on the cost of living on how much you pay.” The fact that there are a large number of households making more than $250,000 is precisely what makes New York’s median house price nearly three times higher than Mississippi. A “scale based on the cost of living” would generate very little revenue because it is the density of high income residents that drives up the cost of living.

The debate on taxes is interesting to consider in the context on mortgage finance because of the large number of elected officials who would increase taxes on the same households they wish to subsidize through below cost mortgage loans. In 2009, the Obama Administration embraced both higher taxes on “the rich” through the FY2010 Budget and lower mortgage rates for these same households through the stimulus. The policy approach seems to be ensuring that these households receive their “fair share” as much as it is about them paying it.


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