Guarantees that Deliver the Equality Goods

By Basil N. Petrou and Karen Shaw Petrou

At a recent meeting with senior White House and Congressional budget experts, we revisited the benefits of using federal guarantees to drive private capital to public need.  Much of the discussion centered on taxpayer protection, a significant challenge due to risk-taking incentives baked into the federal budgeting process.  There are many reasons – billions of them in fact – to reject the budgeting approach mandated by the Federal Credit Reform Act (FCRA) in favor of a fair-value methodology.  Less known and not discussed is an issue of equal importance:  getting guarantees right not just for taxpayers, but also for the regulated financial companies from which the private capital for successful guarantees must come.  Here, we lay out principles for equality-enhancing guarantees that meet needs ranging from sound mortgage lending to translational biomedical research.

A Bit of Background

A blog post is not exactly the place to delve into the intricacies of FCRA and fair-value accounting.  Suffice it to say that FCRA is premised on a unique concept:  negative subsidies.  That is, no matter how great the potential risk to taxpayers or how GAAP would measure it, the federal budget assumes that any guarantee that isn’t losing money during each fiscal year’s calculation is a net revenue-raiser for the taxpayer.  This approach creates a strong – indeed almost always irresistible – incentive for Congress to   open the spigots for high-risk guarantees.  No matter the costs to future taxpayers, each Member of Congress is saved by the “negative subsidy” from politically-awkward decisions regarding a guarantee or coming up with offsetting spending or revenue to keep the gravy train rolling.

So, first fix the budgeting process.  This will ensure that guarantees really do not substitute for private-sector capital or – even worse –subsidize predatory lending at taxpayer expense.  However, this fix isn’t enough if underlying guarantees remain incompatible with regulatory capital and liquidity requirements and the new bank business model crafted by them after the great financial crisis.  First-loss tranches do not work because the capital rules demand prohibitive amounts of risk-based capital for these structures.  Complexity is also a game-killer.  To bring in billions, even trillions, from global banks, insurers, and institutional investors, loans with a federal imprimatur must be suitable for secondary-market securitization.

A Short How-To

A new paper from the Milken Institute’s Center for Financial Markets and the OECD is a useful guide even though its focus is on development – not equality – finance.  There is a lot of research on issues such as the proper way to budget guarantees to align their incentives better with those of the taxpayer, but almost none about what it takes to make a governmental guarantee a viable incentive for a profit-motivated financial institution.  The Milken paper takes this on after conducting a first-time survey  showing that guarantees are by far the preferred private-sector approach to “blended” (i.e., public-private) finance.  It demonstrates not only that successful guarantees must comport with regulatory capital and liquidity rules if banks are to play the role essential for sustainable policy success, but also that the overall guarantee under governing rules must then fit well into business models premised on prudent finance.

FHA:  The Mug Shot

You can find more about this in an in-depth paper on housing-finance equality and recent blog posts showing why big banks have abandoned FHA and the scope of the risks posed by non-bank replacements to them.  In short, FHA is a 100% guarantee protecting lenders from credit risk if the high loan-to-value (HLTV) loans insured by the government default.  A lot of them have, as the results of FHA’s efforts to grow its “market share” right before the crisis painfully proved.  Now, though, times are good, the FHA is backing lots of loans and, even though FHA loans have higher default rates than comparable mortgages, the FHA is earning money.  It thus enjoys a “negative” subsidy that keeps Congress at bay.

All of the budgetary incentives behind FHA are to keep as many 100% guaranteed loans flowing as lenders are willing to make.  When lenders are willing – and non-banks are because they lack the capital costs that constrain big banks – the loans are made and the deficit seems to drop and all is right with the world until it isn’t. 

Near-term reforms could cure this for, by example, raising the premiums FHA charges to encourage lenders to make its loans, but any drop in volume would undermine the “negative” subsidy and thus are deferred.  Risk-sharing with the lender – i.e., reducing the USG guarantee to less than a 100%  – would similarly protect the taxpayer, but not only cut volume from non-banks, but reduce a bank’s willingness to make these loans unless the risk tranches are well structured to comport with capital and liquidity requirements. A third option of reinsuring the guarantee with MIs or private reinsurers remains possible provided the pricing works out to maintain FHA’s net negative subsidy calculation – an iffy proposition given FHA’s current skinny premium.

The result of the current budgetary, regulatory, and business-model incentives is that FHA not only does not protect taxpayers, but also does not well serve its actual purpose:  promoting first-time home ownership and loans to low-and-moderate income households not otherwise eligible for private or GSE-backed loans.  Currently, loans on higher-cost houses for anyone unwilling or unable to put down more than three percent raises lots of FHA volume and thus the negative subsidy.  However, it also raises lots more taxpayer risk.

One way to solve for this and still keep banks making FHA loans would be to income target the mortgages as we recommended to Congress.  Income targeting means that only low-and-moderate households or, if you prefer, loans only for below median-price homes would carry a 100% guarantee.  The negative subsidy would drop since fewer loans would be made, but preserving the 100% guarantee and keeping premiums low ensures a steady flow of loans that keep premiums funneling into the Treasury. 

Income targeting would be a non-event for the negative subsidy if premiums dropped enough to boost volume, a move that would also enhance FHA’s pricing power without supplanting private capital.  It will still be hard to bring banks back to FHA lending, but a targeted guarantee backed by pricing advantages that is compatible with capital and liquidity rules would be very, very tempting.  A bit of False Claims Act relief, and our bet is that big banks will be back.

Equality-Enhancing Guarantees

Whether it’s for bringing the post office into retail finance or crafting a limited federal guarantee to promote treatments and cures for disease and disability, properly-structured guarantees can leverage private capital to tremendous equality effect.  The trick is getting the incentives aligned so that guarantees pose no more risk than necessary to the taxpayer and do as much good as possible with the private-sector dollars they bring in.  Fair-value budgeting would cancel the blank check proffered by negative subsidies, but on its own it does not craft guarantees that would really make a difference.  Complex structures such as the GSEs’ credit-risk transfers might work for the budget, but they don’t work under regulatory-capital standards – and for good reason.  Simplicity, discipline, and targeted use of the federal full-faith-and-credit stamp are the essence of effective federal-guarantee policy.