Features Australia

Dirty dancing with Fannie and Freddie

18 May 2019

9:00 AM

18 May 2019

9:00 AM

You don’t need a crystal ball to see that whoever wins our federal election, the taxpayer is going to be the biggest loser. Up to now, the threat came mostly from the Opposition, but the Coalition’s plan for the government to guarantee 15 per cent of the deposit of first home buyers is proof that no side of politics is immune to subprime economic policy. That Labor copied the initiative within three hours simply illustrates the adage that you can’t keep a bad idea down. As the British Liberal Sir William Harcourt said wearily in 1888, ‘We are all socialists now.’

You would think that after the meltdown in high-risk mortgages in the US triggered the global financial crisis, the Australian government would be wary of forcing the taxpayer to gamble with the banks on a heads-they-win, tails-we-lose basis. The US government has been meddling in mortgage markets since the Great Depression, when it founded the Federal National Mortgage Association, known as Fannie Mae, as part of the New Deal. Its sibling, Freddie Mac was created in 1970.

The intention was to make mortgages available to moderate- and low-income borrowers by guaranteeing bank loans in a pooled secondary mortgage market.  Yet although the ambition was only to help out the needy, nowadays nearly 80 per cent of US residential mortgages are backed by these behemoths because they can source capital, implicitly backed by the government, at rates that are far lower than for other financial institutions.

The banks have been happy with this arrangement as it allows them to sell the mortgages they originate to Fannie and Freddie and free up the capital to lend to others. But once banks could pass on the risk of mortgages to Fannie and Freddie at little cost, there was far less pressure for them to worry about whether the borrower could repay the loan.

Couple this with the fact that banks had been pressured to lower their lending standards to make loans available to people from disadvantaged backgrounds who had poor credit records, and you had a recipe for disaster. The massive default on loans in the US in 2007 was triggered by only a tiny hike in interest rates but it was enough to force borrowers who had no financial buffer to default, bursting the US housing bubble and forcing US taxpayers to bail out Fannie and Freddie to the tune of around $US187 billion.

Could it happen here? Australia was able to avoid the worst of the GFC precisely because its banks have always been forced to bear the full cost of the risk of lending. Unfortunately, despite this sterling performance, Australian banks have been forced to tighten their lending standards probably far more than was necessary. It’s been a principal cause of the slowdown in the housing market, along with the prospect of Labor’s proposed punitive tax hikes on housing investors. Now, rather than adjust the regulations governing lending criteria, a government-created entity, the National Housing Finance and Investment Co., will get a $500 million equity injection to guarantee the mortgages of low to middle-income borrowers. We don’t know whether this is going to be HECs debts for first home owners with no interest charged and no incentive to repay, but it sounds like it, as the government has said that the scheme will help first home buyers save around $10,000 by not having to pay lenders mortgage insurance.

That’s nice for borrowers but that’s $10,000 that the taxpayer would have earned if the scheme were based on a commercial rate of return. It’s also $10,000 that mortgage insurers won’t earn, meaning that taxpayers are seemingly going into the business of undermining the private sector. That would violate the principle of competitive neutrality, a commitment enshrined in law by the Howard government in June 1996, based on an agreement of all Australian governments in 1994 to ensure that governments did not take advantage of their powers to compete unfairly with the private sector. So, mortgage insurers look like losers, as do taxpayers, while the banks, or at least smaller lending institutions, look like winners, as the government has said that it will prioritise them to boost competition. But it probably won’t be doing them any favours. Yes, these lenders will be able to write more mortgages, but they will be to more risky borrowers. It’s a textbook case of moral hazard; the lenders will increase their exposure to risk because someone else — the taxpayer — will bear the cost. Alas, in the event of a downturn, it is those borrowers who will be most likely to default on their loans, so they may not be such a blessing to the small banks, who are, by virtue of their size, inherently less stable.

Almost certainly, the small bank will have first recourse to the funds after the home is sold in a distressed sale when the market has crashed because the government will not want to risk a bank collapsing and the taxpayer will be forced to pay out on the downside without getting a return on the upside. The proposal has been warmly greeted by the property sector, of course. They are not going to have to bail anyone out and the measure will stimulate the housing market unlike Labor’s proposed tax hikes.

So, are we on the road to Fannie and Freddie down under? Maybe not but as the song says, ‘From little things, big things grow.’ One of the most damaging policies of the last 20 years — the Renewable Energy Target — was introduced by the Liberals in 2001 with the aim of sourcing 2 per cent of the nation’s electricity from renewable generation. That morphed into Labor’s 50 per cent RET by 2030 which the Greens will try to ramp up to 100 per cent and would pauperise the nation. Similarly, in 2017 the government passed the Major Bank Levy which raises 6 cents for every $100 of specified liabilities per annum, to raise $6.2 billion over four years. Labor has already promised to increase it by $640 million over the next four years but that’s likely to be just the start, if a Labor government is unable to raise as much money as it hopes from other taxes, such as franking credits, as individuals change their behaviour to try to protect themselves from the new imposts.

The real danger of this foray into a New Old Deal is that if Labor wins the election, it will have carte blanche to write worse policy, with more deleterious effects in the event of a downturn, which its other policies are far more likely to precipitate.

What a time to be taking a gamble with taxpayers’ money. Just when the US and China are teetering on the brink of a trade war that could send the global economy into a tailspin.

But like the taxpayer, the government and the opposition don’t need a crystal ball to see that whatever it costs in the long run, it’ll be all upside on the way to the ballot box.

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