Aug

22

More interest on interest rates

August 22, 2008 | 4 Comments | Joshua Gans

A grab-bag of stuff today on financial stability and interest rates:

  • Following up on nab’s announcement yesterday, an interesting article in Business Spectator about that bank’s political game — you know, arguing against intervention except where it might help the banks.
  • Chris Joye and I appeared before the House of Representatives yesterday. This was a much more informed and reasonable discussion than my FuelWatch time at the Senate the other week. Malcolm Turnbull pushed us hard on what the costs to the government might be (for which we gave our response that in the scenarios that would cause that cost, the government already bears the implicit risk). I was also pushed on bank switching costs. I expressed my skepticism that it would cost $500 million to put in bank account number portability and that, in any case, this is a good task to hand the ACCC for a complete review. They are used to dealing with situations like this.
  • At the House, I favourably talked about Sam Wylie’s AFR piece yesterday which he has kindly given to me to reproduce (over the fold). Contrast that thoughtful piece with some typical lunancy we get in the press.

Fannie, Freddie are not failures

by Sam Wylie (AFR, 21 August 2008)

Fannie Mae and Freddie Mac have received a lot of bad press lately.  If you read only those reports you might think that the American public wishes that Fannie and Freddie had never been conceived.  The truth is the opposite.  There is a great deal of goodwill among ordinary Americans towards these government sponsored enterprises (GSEs) because they have delivered low cost, fixed rate mortgages to middle income households for decades without being a drain on the public purse.

The value of Fannie and Freddie can be seen by comparing conforming mortgages, which go into the GSE system, to jumbo mortgages, which at more than $417,000 are ineligible for purchase by GSEs.  Rates on 30 year, fixed rate, conforming mortgages are currently 6.45%, and those on jumbo mortgages are 7.65%.
Low and middle income US households pay about 1.20% less than they would without Fannie and Freddie; hence the public goodwill in a country that has little appetite for government intervention in markets.
It is true that the GSEs have always had the funding advantage of implicit backing of the US Government, and now the US Treasury has explicitly stated that they will not allow Fannie and Freddie to fail.

Both GSEs claim that no Government bailout will be necessary, but the average expectation of industry experts is a bailout costing taxpayers $25 billion, which is about 0.5% of the total mortgages held in the GSE system.  Not so bad for a system that generates savings to households of over 1.0% per year.

So far the losses of the GSEs have been born by their shareholders with the combined market cap of the two firms falling from $114 billion to just $12 billion in the last year.  Fannie Mae shares have now underperformed the average stock in the US markets by about 2% per year over the last 25 years.  So much for the often quoted phrase “private profit and public cost”.  Thus far in the credit crisis: private loss to GSE shareholders $100 billion, public cost zero.

Clearly, parts of the Fannie and Freddie model are deeply flawed.   The main problem is that the GSEs have existed in the no man’s land of no explicit government guarantee, but general belief that they are too big to fail.  It is a mistake to have ambiguous or incomplete financial guarantees of any kind, as the Bank of England found with the Northern Rock debacle.

The US Government should guarantee the debt of the GSEs unconditionally and charge them 0.2% of insured debt per annum.  If the US Treasury had implemented such a policy since 1978 and used the proceeds to retire US Treasury bonds, then US Government debt would be $150 billion lower today and a $25 billion bailout would seem a natural payout on insurance already paid for.

The second problem is that the GSEs were not adequately regulated.  The Office of Federal Housing Enterprise Oversight (OFHEO) was hardly known outside government circles before the GSEs were caught in an accounting scandal in 2002.  Later the OFHEO allowed the GSEs, especially Freddie Mac, to make investments in subprime mortgages and CDOs that were outside their government mandate of providing low cost housing finance to well qualified borrowers.

It is now common to hear the GSEs incorrectly referred to as a “failed model”.  Yes, there are better mortgage agency models; the Canadian model is considerably better.  But, no, the Fannie and Freddie model has not failed, it just needs fixing.  The GSEs should be charged 0.2% for an explicit government guarantee and kept to their mandate by their regulator.

Australians who believe that the Fannie and Freddie model is a failure should ask themselves two questions. Firstly, why are prime mortgage rates consistently 1% or more lower in the US than in Australia, even after adjusting for the lower Treasury yields in the US?  Secondly, why do US households have access to 30 year fixed rate mortgages, which can be refinanced without penalty, when Australian households do not?  The answer to both of those questions is that US has effective government sponsored mortgage agencies and Australia does not.

Treasurer Wayne Swan has stated that he has reviewed the mortgage agency models of other countries and does not wish to introduce the “failed” model of the US GSEs into Australia.  It will be interesting to hear the Treasurer’s views on the utility of a mortgage agency if the banks do not decrease interest rates after the next RBA rate cut.

Sam Wylie is a Senior Fellow of the Melbourne Business School


Comments

4 Responses to “More interest on interest rates”

  1. Julian on August 24th, 2008 1:33 pm

    Its not entirely fair contrasting Sam’s writing to that lunacy. Compare it to reality.

    Over the last 6 years, FNM and FRE bought or insured 700 billion subprime and Alt A loans. The default rate on these is 30%. $210 billion.

    FNM and FRE have a claimed $60 billion in equity. Ignoring that this is also a lie involving creative accounting, we’re down to $150 billion. $25 billion?! A flat out lie from politicians, with obvious intentions.

    A closer look at the matter reveals much worse. Compared to historic values, the housing bubble (hmm what helped create this it…) has increased housing prices to an unprecedented 200% of their real, long run mean value.

    FNM and FRE have claims officially on $5 trillion in mortgages. A small mean reversion to the historical house price is going to put losses greater than $1 trillion.

    Putting your faith in numbers released by the Congressional Budge Office without examining their incentives or the validity of the numbers is folly.

    The $25 billion number is fiction. Its a number designed to minimise the amplitude of the problem in order to dilute the problem over time.

  2. Chris Hutcherson on October 3rd, 2008 3:26 am

    Now that the Senate has passed the 700 billon bailout has McCains destiny been sealed?

  3. CoreEcon » Blog Archive » Australian high horse? on October 7th, 2008 8:31 am

    [...] be sure, no one believes in implicit guarantees but as more informed commentators have noted, as an explicit guarantee, the government gets a great return from the activities of [...]

  4. Rick on December 1st, 2008 7:53 pm

    Why reducing official interest rates tomorrow will have little effect on the economy.

    1. There are now a lot of people out there who have collected houses – I know at least 3 people who own at least 6 houses each – and I don’t move in affluent circles. In other words there are a significant number of people who own and rent at least one house – so a rate reduction will help them immensely, but not increase available money in the average budget.

    2. A significant proportion of home loans are currently fixed. A year ago the trend was for an increasing rate, a lot of responsible people, fixed their home loan.

    3. There is now in Australia, due to the aging population, a large number of people who own their own home already. Changing the official interest rate will have very little effect on them.

    4. Credit cards – the personal debt level is the highest it’s ever been, until these rates come down there will be little extra spending money in the economy.

    Thanks and Regards

    Rick
    :o )