Thursday, February 17, 2011

Mark Zandi and Christian DiRitis on the Moral Hazard of a Hybrid Mortgage System

One potential weakness of a hybrid system involves moral hazard: If private investors believe the government will bail them out if things go badly, they will take inappropriate risks. Such concerns were illustrated by the recent experience with the two government-sponsored mortgage finance agencies, Fannie Mae and Freddie Mac. These institutions took on too much risk, holding too little capital for the kinds of investments they held in mortgage securities. While their private shareholders were effectively wiped out, bondholders were made whole when the federal government put Fannie and Freddie into conservatorship.
Moral hazard cannot be eliminated in a hybrid model, but it can be significantly mitigated. The system we support would require enough private capital to withstand losses associated with a 25% decline in house prices. Before the crisis, Fannie's and Freddie's capital levels were designed to withstand only a 10% decline. The hybrid system's catastrophic insurance would not kick in until losses reached levels consistent with a 25% price drop, providing significant financial incentive for private investors to make sound lending decisions. 
It is also important to recognize that moral hazard exists even in a fully privatized system. Investors in such a system are likely to assume that in extreme circumstances, the government would still step in, congressional pledges to the contrary notwithstanding. Recent experience has only reinforced this belief, as the government stepped in during the financial crisis to bail out the system. In the hybrid system plan, the government's backstop is explicit and paid for by private investors.