Thursday, December 29, 2011

Creating Bubbles

Bloomberg has an interesting story, suggesting a bubble in 30 year mortgage bonds. As usual, it's government rules that are largely responsible:
Because of the government guarantees, banks that hold these securities qualify for favorable capital treatment under risk- based-capital rules. Securities of Ginnie Mae, a government- owned entity that subsidizes affordable housing, carry a risk weight of 0 percent, meaning a bank doesn’t have to hold any capital against them. Fannie and Freddie securities carry a risk weight of 20 percent, meaning 1.6 percent capital is required rather than the normal of about 8 percent. These same capital rules allowed European banks to load up on the 0 percent risk- weighted debt of Greece and other countries on the periphery of the euro area.
This wouldn’t be the first financial crisis in which the 30-year fixed-rate mortgage played a large role. Twice in the last 20 years we have seen spectacular failures of U.S. housing finance, each at enormous cost to taxpayers. Both the savings and loan crisis and the Fannie-Freddie bailouts can be traced to congressional support for, and subsidization of, the 30-year fixed-rate mortgage.

The S&Ls invested in 30-year mortgages that they funded with short-term deposits. By 1981, when deposit rates soared as high as 15 percent, the thrift industry found itself insolvent due to portfolios stuffed with 9 percent mortgages.

Fannie and Freddie were set up to support the 30-year fixed-rate mortgage market, buying the loans from lenders, packaging them into securities and selling some of them to investors -- all with an implicit federal guarantee that helped to lower mortgage rates. In 2008, both were taken over by the government, costing taxpayers more than $160 billion and counting.

Freddie, and Fannie to a lesser extent, suffered a classic liquidity squeeze. In the late summer of 2008 as debt markets became concerned about the two companies’ solvency, yields on their debt relative to U.S. Treasuries ballooned. That imperiled their ability refinance hundreds of billions in debt used to back its huge mortgage portfolio.

The solution is to wean the housing market from its dependence on subsidized 30-year fixed-rate mortgages, starting with winding down Fannie and Freddie over a period of five to seven years. A private market focused on prime quality mortgages would offer borrowers a wider variety of loan choices. These loans would have varying amortization terms, prepayment options and periods of protection against changes in interest rates. In flush times, lenders should be required to build capital to better cover credit risk. Finally, risk weights should be increased to reflect price volatility inherent in securities backed by long-term mortgages.


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