How much is Treasury’s housing guarantee worth?

By Felix Salmon
August 18, 2010
Arnold Kling is incredulous when it comes to Pimco's Bill Gross, who said yesterday that "without a government guarantee, mortgage rates would be hundreds -- hundreds -- of basis points higher, resulting in a moribund housing market for years".

"The standard estimate in the literature is that Fannie and Freddie reduce mortgage rates by 25 basis points or less," says Kling, and he's correct: that is indeed the standard estimate. But the standard estimates were all calculated back in the day, when no one worried much if at all about mortgage default risk. Here's Gross again:

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Arnold Kling is incredulous when it comes to Pimco’s Bill Gross, who said yesterday that “without a government guarantee, mortgage rates would be hundreds — hundreds — of basis points higher, resulting in a moribund housing market for years.”

“The standard estimate in the literature is that Fannie and Freddie reduce mortgage rates by 25 basis points or less,” says Kling, and he’s correct: that is indeed the standard estimate. But the standard estimates were all calculated back in the day, when no one worried much, if at all, about mortgage default risk. Here’s Gross again:

It’s an $11 trillion secondary mortgage market. Agencies are about a half of it. The other half, or a good portion, were financed when people thought housing couldn’t go down in price. We know that’s not the case now. So to suggest there’s a large place for private financing in the future of American housing finance is unrealistic.

The 25bp figure dates back to the time when Frannie accounted for roughly half of all mortgages: back then the best estimate was that Frannie-conforming loans were about 25bp cheaper than private-label loans, all other things being equal. That 25bp wasn’t only a function of the government guarantee, so much as it was a function of the fact that Frannie’s capital requirements were much lower than banks’ capital requirements, and the fact that Frannie had huge economies of scale when it came to things like managing the risks associated with prepayment and negative convexity.

Now, however, everything has changed: Frannie accounts not for half of the market, but for essentially all of it. And while private money is happily pouring into corporate bonds and other credit instruments, it’s still shying away from mortgages, partly because no one really knows how to price them any more.

In order to price a mortgage, lenders and investors need to have an idea of what the borrower’s default risk is. And right now, they haven’t got a clue. We know that default risk is highly correlated to house prices, but we don’t know whether or when or by how much house prices might fall. We also know that default risk is a function of societal norms: historically, people paid their mortgage first, before other debts like credit cards, or other household expenses. That’s changing dramatically.

And beneath it all is the fact that the US housing default rate isn’t something that any lender can calculate: rather, it’s something controlled mainly by US government policy. The government has a huge range of ways in which it supports the housing market, and it can remove those supports at any time, sending defaults spiking. Alternatively, it can throw even more support at the housing market, as Gross would like to see:

Gross, speaking at a Treasury forum on the future of housing finance giants Fannie Mae and Freddie Mac, said a massive refinancing program to slash monthly mortgage payments could boost consumer spending by $50 billion to $60 billion and boost home prices by 5 to 10 percent.

“Policymakers should quickly re-engineer a refinancing opportunity for all mortgagees that are current on payments and are included in GSE-securitized mortgages,” said Gross, PIMCO’s co-founder and co-chief investment officer.

This is a crazy idea: the last thing we want is to send large checks to anybody lucky enough to have a conforming mortgage. Nor do we want house prices to rise even further away from the market-clearing level which we’d see were there no artificial government support. To the contrary, we want houses to become more affordable and to account for a much lower proportion of households’ budgets than they did during the housing boom.

But the point is that if it wanted to, the government could throw so much money at the housing market that defaults would no longer be much of a problem. And so the key analysis of anybody trying to price mortgages has to be primarily political rather than economic or financial.

Bond investors are by their nature very cautious folk, and they hate massive uncertainty about something as important as future housing default rates. So they simply avoid the housing market altogether, absent a government guarantee. That’s why Gross says that the guarantee is worth hundreds of basis points. I don’t know whether he’s right, but I’m sure the number is more than Kling seems to think.


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The very next thing Kling wrote in that post was

“What Gross is saying might be true if you are an unqualified borrower buying a house with little or no money down. But once upon a time we had a mortgage market in which borrowers with documented income and assets took out loans for 90 percent or less of the price of the house they were buying. If we went back to those types of mortgages, a typical borrower would not save hundreds of basis points by having Uncle Sam as a co-signer. If the guarantee is worth that much, then there is something fishy about the loans that are being guaranteed.”

The point is that private money would not make the loans that the GSEs are making. IF they did, they would charge massively higher rates because of the risk these loans carry. And Gross is using this as an argument to keep the GSEs around? As I understand it, he owns large amounts of GSE bonds. That is a very large bet that the government will not allow GSE debt holders to bear any losses. I hope and expect that that is a bet he will lose; when the Federal backstop of GSE losses ends in 2012, anyone who holds GSE debt will own the losses in that debt.

The GSEs account for essentially all of the market in large part because they are making loans that make no economic sense. They are doing so to protect the banking system from bearing the losses they incurred by making bad loans.

Posted by MattJ | Report as abusive

Yes, the 25 bp GSE effect was for conforming loans, so we’re talking about some of the best credits.

Also, the 25 bp GSE effect was for a time when there were plenty of banks and thrifts that would hold 30-year, fixed-rate mortgages. I think Gross may be thinking that, without some sort of government inducement, there will be far fewer investors interested in holding such loans in the future, so we may find the U.S. moving towards shorter-term, variable-rate loans. The reduced opportunities to leverage into housing could well result in a “moribund housing market for years.” But that might be a transition we should go through.

Posted by Eric_H | Report as abusive

Aren’t jumbo loans in effect priced by the market without a government backstop? Mr. Gross seems to be looking to sustain the high leverage that homebuyers have been able to obtain over the last ten years. I am sure that there would be a market for loans made with real underwriting standards to people with actual, you know, equity in their houses. That might mean that housing prices still have to decline in some areas but I think that a housing financing market that is totally reliant on government leaves us vulnerable to the same boom and bust cycle we went through as it will be in the politician’s interest to push loans out and mbs buyers have less incentive to police the value of loans going into those securities.

Posted by JohnOmeara | Report as abusive