Correcting James Kwak
By Arnold Kling
This post about Freddie Mac and Fannie Mae does not reach a fundamentally unsound conclusion. However, along the way, I think he gets a number of things wrong.
First, a minor correction. He writes,
Although they had been private, profit-seeking companies for forty years
Freddie Mac was still a government agency when I started there in 1986. They were under the Federal Home Loan Bank Board and their shares were held by savings and under non-tradable status. The shares became publicly tradable a couple of years later.
If thirty-year fixed-rate assets are bad, that means no one would buy thirty-year U.S. Treasury bonds, yet people do (at 4.53 percent). A bank could originate a thirty-year fixed-rate mortgage and just buy an interest rate swap to hedge the interest rate risk.
Yes, there are 30-year Treasuries. But the volume is miniscule compared to the volume of 30-year fixed-rate mortgages. Without Freddie and Fannie willing to hold 30-year fixed-rate mortgages in portfolio, the market would not be as deep. I think that those who worry that the 30-year fixed-rate would be more expensive without Freddie and Fannie have a point.
So let’s think about what might happen if Fannie and Freddie didn’t exist. People would still want thirty-year fixed-rate mortgages, so some bank would try to originate them. That bank might just hedge the interest rate risk with interest rate swaps and hold onto the credit risk. This is what banks did during the postwar boom.
Um, no. Banks and thrifts retained the interest rate risk during the postwar boom. And those that did so (mostly the thrifts) were insolvent when rates moved against them in the 1970’s. As for interest-rate swaps, (a) they did not exist back then, (b) they are not sufficient to hedge the interest-rate risk, which includes prepayment risk, and (c) they only transfer the risk–it does not disappear into thin air.
The way I look at it, 30-year fixed-rate mortgages give borrowers are very valuable option. If rates go down, the borrower prepays and refinances at the lower rate. If rates go up, the borrower keeps the mortgage and somebody else takes a loss. If the “somebody else” is not the original lender because the lender has executed a swap, then the counterparty to the swap becomes the “somebody else.” And chances are that “somebody else” will be the taxpayers, once push comes to shove.
Taking bailouts as a given, the 30-year fixed-rate mortgage is a time bomb that is bound to blow up in the taxpayers’ face. If by some miracle the regulators locate the interest-rate risk and force those who take that risk to hold sufficient capital to make a bailout unlikely, my guess is that the 30-year fixed-rate mortgage would cost a lot more, and eventually fewer borrowers would go that route.