Corker-Warner Improves on GSE Model … Barely

The new Corker-Warner housing finance bill admirably would dissolve Fannie Mae and Freddie Mac and bring the GSE era to an end. But in their place, the government would explicitly guarantee most of the securitized mortgage market. This will be much to the satisfaction of all parties who walk away with their cash at the closing and leave all the credit risk and house price risk to somebody else, especially taxpayers. It will appeal to foreign and domestic investors and to mortgage-backed securities traders who don't want to be bothered with any credit risk.

We can agree with most observers that an explicit government guarantee with an explicit price is better than the implicit, but real, guarantee Fannie and Freddie got for free. Still, before we sign on, there is a dilemma about the pricing of the government guarantee and an irony of the effects of such guarantees on catastrophes which must be addressed.

The Pricing Dilemma: We are assured that the government's risk will be fully paid for by an "actuarially" sound insurance premium or price which the market actors will have to pay to get their MBSs guaranteed. The price should build up an insurance fund, which will cover the credit risks involved. This is simply the theory of creating an insurance company to pool risks. But:

1. If you think the price is correct, then the government guarantee is unnecessary.
2. If you think the government guarantee is necessary, then you think the price is wrong.

And if the price is wrong, it will be wrong for the entire country.
It's all too easy to think of government insurance plans in which the prices have not covered the real risks: all the historical state deposit insurance funds that went broke, the Federal Savings and Loan Insurance Fund, which went broke, the Federal Deposit Insurance Corp. whose fund went negative in two banking crises, the National Credit Union Share Insurance Fund, which needed a Treasury bailout, the Federal Housing Administration fund, which is about to need one, federal flood insurance, the federal pension guarantee fund, which is deeply insolvent, Social Security, Medicare—did they ever get one right? Yet all are billed as government "insurance," which seems to have a magical political aura combined with a predictable financial outcome.

The Catastrophe Irony: The Corker-Warner bill intends that the government guarantee is only there to cover "catastrophic" situations and losses. But what if, as it doubtless does in every case, the guarantee makes the catastrophe more likely?

Catastrophes in financial markets are not outside, exogenous events that just happen, beyond any human control, like hurricanes or earthquakes or tornados. Financial catastrophes are caused by human financial behavior—they are endogenous to the financial system. That is why so-called "100-year floods" in financial markets happen about once every ten years. The much-discussed "tail risk" of financial systems is not an objective, stable parameter: the tail risk is created by optimistic behavior and by moral hazard. As any credit-driven financial bubble inflates, the tail risk of a collapse finally becomes 100%. 

Government guarantees induce excessive debt in the favored sector. It has been understood since the 19^th century that catastrophe-causing behavior is encouraged by government guarantees, which, thereby, increases the "tail risk." So:

1. If you believe the government guarantee will not make catastrophes more likely, your under-pricing of the insurance premium will without doubt be worse.
2. If you do think that the government guarantee will make catastrophes more likely, you may wish to drop the guarantee.

The Corker-Warner bill would require private capital to cover the first 10% of the outstanding credit risk before an MBS could acquire the government guarantee. Serious private skin in the credit game is definitely a good idea. The bill's sponsors suggest the required amount would have covered all of Fannie's and Freddie's losses. In addition, the insurance fund would build up a sizeable reserve. But then, it must be asked: why do you need the government guarantee on top of all that?
It seems more logical to simply drop the guarantee, and rely on the spacious protections of the skin in the game and on the insurance fund itself. But this alternative does have a problem: the insurance fund, being government sponsored, always will enjoy an implicit government guarantee!

A more fundamental approach is to demand that the financial actors internalize and capitalize the risks themselves. This is known as a private market. 

The Corker-Warner bill requires a study in eight years, long after Fannie and Freddie would be gone, of whether the ideal of a private housing finance market is feasible. Let us praise the bill for proposing the end of Fannie and Freddie, but in the meantime, does what would replace them move us more toward the private market or further away from it? This depends on how we assess the pricing dilemma and the catastrophe irony.

Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington.