Why a GSE?

Last night I met a regular reader of this blog who said, “I like reading your blog but disagree with everything you say.” Fair enough. But he also suggested that I hadn’t made the case for a government-sponsored enterprise (GSE) like AussieMac or something related.

This surprised me because I had figured I was talking about this ad nausium. Anyhow, just in case the message isn’t clear, let me put it here in baby steps:

  1. Home lending is funded from two sources: deposits and securities.
  2. Thanks to the US subprime crisis, securities have dried up in Australia.
  3. The result is a contraction in supply, a rise in interest rates on mortgages, credit rationing of SME business lending and the major banks now having 90%+ of the home lending market (reversing a decade or more of competitive gains).
  4. Non-deposit taking institutions (and smaller banks) have been left out in the cold. Compared with the US and Canada that have GSEs where they are still operating competitively.
  5. An Australian GSE would bring back the securitisation channel. By using the government’s AAA-rating it would restore confidence to that market and so long as the GSE was not backing non-conforming (high risk or subprime) loans then there would be no cost to the government.
  6. The only risk would be a major housing meltdown (of the kind seen in the US recently) but in that situation the government is already carrying that risk by an implicit guarantee to the banks.
  7. There would be no moral hazard as loans backed by the GSE would have to be conforming.
  8. There would be no crowding out because supply is currently tight and the GSE could have a mandate to only ramp up activities in liquidity constrained times. (see also Paul Krugman today on this).
  9. At present, there is no other solution that offers to do all of this and back sustainable competition in home lending. (The spectre of re-regulation looms as a lack of a securitisation pathway removes the Wallis justification for de-regulation).
  10. And that is why we need a GSE.

7 thoughts on “Why a GSE?”

  1. That was a quick answer! As it happens, I agree there is merit in competition for mortgage business, but I still disagree with most of what you say here.

    Banks create debt out of thin air, limited only by regulation such as fractional reserve ratios. This is immensely profitable: the more debt you sell, the more profit you make.

    Both banks and non-ADI lenders can source wholesale funds, but banks pay lower spreads. Non-ADI lenders arose because of the flood of cheap wholesale funds, and have now been hurt primarily by the credit squeeze — they can’t afford the spreads or they can’t get money at all.

    Securitisation was a way to bypass regulation and make even more profit. The vehicles are opaque, non-standard, illiquid and nearly impossible to value. It’s dead and it should stay that way. Transparent, standardised, regulated, tradeable, securitised debt would be a different matter — maybe.

    The one thing we do NOT need is more easy debt, which has already caused massive run-ups in asset valuations, especially housing prices. De-leveraging has probably already started, and over about 5 years prices could return to something like normal.

    The single and sole role for an AussieMac would be to provide competition in mortgage finance for strictly conforming loans eg 25% deposit, 36% repayment/income limit. The best source of funds would probably be covered bonds (common in Europe). They should be highly competitive with the banks, even without an explicit government guarantee. Securitisation as currently practised is the wrong answer.

    And what of the people who don’t qualify for loans? They rent. Period.

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  2. I agree with dyork

    The problem is that it is too easy for banks to create debt with little risk. They do this by giving loans against the ability to pay not against the asset value of the house.

    There are other solutions to the problem. The first is to only allow banks to loan against the value of the house their loan pays for. Thus if you cannot continue the loan the bank gets back its proportion of the value of the house.

    A second and actually very simple one is to only allow money that is created to buy a house only ever be used to buy a house. If you pay me for my house then I have to use your loan part of the payment on buying or building another house. (I can show how this can be done for much lower cost than the current bank fees for loaning money)

    I suspect there are a dozen more solutions but they must address the fundamental problem of the ability of banks to create loans with little risk to them. An AussieMac does not address the underlying problem.

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  3. I have just realised that your first baby step is wrong. You say

    Home lending is funded from two sources: deposits and securities.

    As dyork says banks create loans for which they have no deposits. Ok they create the loan which is then put on deposit with them but they are allowed to create “new” money because of the fractional reserve ratio. That is the loan comes first then the deposit.

    The flaw in the thinking about the credit crisis is not understanding how money is created. Do people think that the Reserve Bank creates money? Money is created as a loan and then it is “destroyed” when the loan is paid back. Anyone theoretically can do it and it is called an IOU it is just that with regular money the IOU’s are created by people who have a franchise to create them in the name of the government – the banks. The problem arises when the IOUs created cannot be repaid because the assets they buy are not worth the IOUs. We get a credit crisis because we have too much money in existence that will not get repaid and so it becomes risky to create more money because we are awash in the stuff.

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  4. “An Australian GSE would bring back the securitisation channel.”

    Isn’t that (part of) what got us into this whole mess in the first place?

    Even if we accept that all the GSE-backed loans are conforming (a big ask), getting loans off the books will create extra capacity (as it’s supposed to do) for riskier loans (which is not what we want).

    Effectively you’re asking the government to get into the monoline business at precisely the moment the monoline business has imploded.

    It’s not politically plausible, in any case.

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