GSE Reform and Tail Risk
By Arnold Kling
The Wall Street Journal reports that the Administration is going to release its overdue white paper on Friday.
The administration’s proposal to Congress is likely to assess the merits and drawbacks of each of the three options. The most conservative would propose no government role in the mortgage market beyond existing federal agencies, such as the Federal Housing Administration.
The two others would create a way for the government to backstop part of the secondary mortgage market, a role long- filled by Fannie and Freddie. Under one, that government backstop would kick in primarily during periods of market stress; under the other, the government would play a role at all times.
I suppose that they are going to push the second option as a “middle ground.” It sounds like the government would promise to take what in Wall Street jargon is known as “tail risk,” which is the risk of some extreme events, such as a large nationwide decline in home prices.
One can argue that it is realistic to presume that when extreme events occur, the government will step in and force the taxpayers to take tail risk. So, why not make it explicit? I can think of several reasons.
1. Having an explicit formula for the government to conduct bailouts creates a roadmap for private firms to figure out the best way to exploit the guarantee. That is, it allows them to maximize the risk that gets shifted to the government.
2. Chances are, the extreme events that you include in your formula will not be the ones that cause the next blow-up. To the extent that the government decides to bail out companies for these unexpected extreme events, the taxpayers end up taking unspecified tail risk, regardless.
3. Someone might argue that under my preferred approach, of no explicit promise to take tail risk, private firms will have to hold more capital in order to be able to fund mortgage loans. To me, that is a feature, not a bug.
I will have more to say in the coming days and weeks.