What to Do About Fannie, Freddie, and Mortgage Securitization?

There is a great article in this morning’s New York Times by Harvard economics professor Edward Glaeser that discusses mortgage securitization, and it dovetails nicely with the topic of reforming Fannie Mae and Freddie Mac.  As far as I can see, increased regulation of mortgage securitization should be part and parcel with Freddie and Fannie reform.

There are definite pros and cons to mortgage securities, at least as they are currently constituted.  Bundling mortgages into securities helps to keep the cost of borrowing lower than it otherwise would be.  It also protects smaller lenders from interest rate risk, and helps to more evenly distribute the risk of default.

There are, however, significant downsides to mortgage securitization.  Glaeser cites a study that demonstrates that securitized mortgages are more likely to default.  Securitization also makes it far more difficult to renegotiate with a borrower who defaults on a mortgage.  Lastly, it appears that securitization allowed/enabled mortgage originators to take risks with underwriting standards they probably would not have taken had they been forced to keep the loan themselves.

Glaeser does a pretty good job of laying out both sides of the argument.  From the article:

“The pre-2006, conventional narrative about the rise of securitization ran something like this. Once upon a time, local bankers — all of whom looked and talked like George Bailey — received deposits from their neighbors and then lent this money back to other neighbors who wanted to buy homes. These bankers had a lot of local knowledge, but they were vulnerable to swings in interest rates or the local housing market. We should never forget what happened to the savings and loan industry when it was ensnared by rising interest rates.”

As to the future of Freddie and Fannie, Glaeser says:

“That relatively positive view of securitization does not imply that the government should subsidize securitization, as it implicitly did through Fannie Mae and Freddie Mac. I didn’t like the Fannie and Freddie model before the bust, and I don’t like it any more today. If these agencies are to continue, they need to be far more conservative, charging high fees and taking few risks, and they need to be purely public agencies. Securitization has a role to play, but that role doesn’t merit vast public support.”

I think the last part is key, taxpayer dollars should not be used to encourage people to take significant risks knowing there are no real ramifications if they fail.