Like the Orcas at Sea World, the mortgage market has been coddled by government support for more than half a century.  Having decided Orcas would be better off in the wild, Sea World has announced that it will no longer seek to capture Orcas or to breed them in the park.  However, due to concern over the viability of confined Orcas to successfully transition from the zoo to the wild, the current crop will live out their days at the park.

Transitioning to a government-free mortgage market would probably be quite stressful as well, but there are advantages to doing so.  Let’s think about what would happen if we made one major change – wind down the GSEs (Government Sponsored Entities, more familiarly known as Freddie Mac and Fannie Mae).  Fannie and Freddie have dominated the mortgage market for the past fifty years.  The GSEs were originally designed to improve liquidity in the market so that, for example, Savings and Loan Associations in rapidly growing California could fund more mortgages than allowed by their less rapidly growing deposit bases.

The GSEs basically had two businesses.  In the “Guarantee” business, for an annual fee the GSEs guaranteed timely payment of principal and interest to investors in qualifying mortgages (known as “conforming loans”).  This allowed the investor to use the loans or securities based on them as collateral for borrowings.  In the “Portfolio” business, the GSEs issued debt to finance acquisition of portfolios of mortgage loans or securities based on those loans (Mortgage Backed Securities, or MBS).  With the federal government effectively guaranteeing their liabilities, the GSEs were enabled to borrow large quantities of funds at very small spreads to Treasury securities.   Some of that funding advantage was passed along to mortgage borrowers in the form of lower mortgage rates.  The funding advantage also enabled the GSEs to provide very attractive returns to their public shareholders.  An unintended consequence was that downward pressure on the spread between mortgage rate and deposit cost drove the Savings and Loan industry out of business.

Lower mortgage rates and greater liquidity were widely perceived (at least, outside of the Savings and Loan industry) to be very positive.  They supported growth in the housing market and in the percentage of families that owned a home.  But they probably drew capital away from other uses, like supporting small businesses.  And in the end the GSE model proved non-viable in the financial crisis when both Fannie Mae and Freddie Mac were taken under conservatorship by the federal government.  Political pressures forced the GSEs to dramatically weaken their underwriting requirements, and no one thought to increase their minimum capital levels accordingly.  Thus, the GSEs were wholly unprepared for a widespread decline in housing prices as occurred between 2007 and 2010.

What would a privatized market look like?  The terms of the mortgage would have to change so as to appeal to private investors.  For example, the 30-year fixed rate mortgage with its huge consumer benefits (principally the ability to prepay the loan without penalty) might go the way of the dodo bird.  Following a proposal by economist John Cochran, perhaps we would see development of investment companies, somewhat like mutual funds, that would invest in portfolios of mortgage loans or securities just as mutual funds today invest in portfolios of stocks or bonds.  To avoid creation of what Cochran calls “run-prone” debt, these mutual funds would be allowed only minimal or zero leverage.  How high would mortgage rates have to be to entice investors?  Surely they would have to be higher than today, maybe by as much as 200 basis points (2% in yield).  Or, maybe not.  There is a small market today in so-called “Jumbo” or “non-conforming” loans that are ineligible for guarantee by the GSEs.  The Jumbo rate is only modestly higher than the conforming rate.  But then again there is only a small volume of lending done at these rates.  So, for the sake of our thought experiment let’s assume mortgage rates rise by 200 basis points.

At this higher level of mortgage rate there would be a significant decline in mortgage origination volumes and in housing activity.  Origination volume consists of two components – purchase business and refinance business.  Refinance business would largely go away, at least for a while, because market rates would be higher than rates on existing loans.  Purchase business is comprised of financing for new homes and sales of existing homes.  The new home component, which generally constitutes about twenty percent of total purchase business, would take the greatest hit.  Higher mortgage rates would directly and dramatically affect first-time buyer affordability, which historically is a key driver of the housing market.  Thus, we should expect to see a substantial drop in new home sales and in residential construction.  Since the housing sector leads the business cycle (some economists assert that housing “is” the business cycle), we should expect a slowdown in the overall economy and perhaps even a recession to follow from the hike in mortgage rates.

On the positive side, the decline in funds flowing to the mortgage market means greater availability of financing for other sectors, notably new business ventures.  The decline in housing is a one-time shock while the benefits of greater business investment spending would accrue, and perhaps accumulate, over time.  Best of all, we would be reducing government intervention and allowing private markets to allocate capital to the most productive opportunities.