You may have seen the news that the Federal Housing Finance Agency has given an initial thumbs-up to a plan to allow Freddie Mac, the government-sponsored entity, to buy second mortgages.
Early indications are that the plan will consist of Freddie buying second-lien mortgages such as home equity loans from banks and pooling them together to create asset-backed securities. These securities will then be sold back to banks and other investors. On the surface, this plan is being touted as a low-risk, novel idea that will help homeowners access hundreds of billions of dollars of equity in their homes to improve their finances and begin new life endeavors. The idea is neither novel nor low risk, and it raises numerous alarm bells.
For almost two decades before the administration of President Barack Obama instituted burdensome bank regulations in 2010, banks would regularly make loans for second-lien mortgages, then sell them to loan aggregators that pooled them and sold them back to banks as asset-backed securities. This provided a stable source of financing for banks that made these loans without directly putting the taxpayer at risk because there was no government guarantee at any stage. During the financial crisis, these types of securities were hit hard with losses, and regulators clamped down on banks’ ability to hold both the direct loans and the pooled asset-backed securities. In the decade and a half that followed, homeowners saw the cost of tapping home equity soar as banks became reluctant to make these loans, and homeowners began to use more-expensive methods of financing lifestyles and home improvements: credit cards and personal loans. The difference in borrowing costs to homeowners between credit cards and home equity loans is astounding; around 25% for credit cards today vs about 9% for home equity loans. This has created a situation where today, homeowners are seeing credit card balances grow like never before as they continue to outspend their incomes.
Enter Freddie Mac, which is proposing to put taxpayers at risk again by guaranteeing these mortgages. But this time, instead of being an indirect backstop in a crisis, the taxpayer will be on the hook directly, every day, as some of these loans regularly go into default.
So why is Washington doing this when enormous energy was spent in 2010 to demonize taxpayer backstops for financial markets?
Because it’s an election year, and the economy is slowing, and households are running out of options to continue to spend beyond their incomes. This highlights the second concern with a taxpayer-backed home equity loan pipeline: It encourages households to continue to borrow money to spend beyond their means, but now by putting their families’ homes up as collateral. To say that this is shortsighted of both politicians and borrowers is an understatement. Home equity loans serve a vital role in financing small businesses, home improvements and college educations, but they come at a cost that not all homeowners want or can really afford to take on. And putting your home up for lenders to take in the event that a business goes under is risky to families and is a point that wasn’t lost on borrowers when banks were driving this business. But it could be lost if the government is the ultimate lender.
So encouraging households to put their homes up as collateral so they can continue to spend on leisure and entertainment seems unjustifiable. Yes, there will be short-term benefits to households, and the economy, with some economists expecting tens of billions of dollars of extra household spending per year over the first few years. But the cost will be homeowners finding that their financial hole has grown deeper over time, with their homes now up for grabs, and the taxpayer now directly on the hook for any shortfalls that follow.
Thomas Tzitzouris is director at New York City-based Strategas Research Partners. He lives in Rhode Island.
