Get comfortable with the new word of the day: deregulation.
The prominence of private equity barons in the incoming administration, however, cautions against optimism on a general halt to the spread of quasi-government guarantees with their troubling implications for the economy. They distort the flow of capital away from the real growth opportunities. The gates of hope, though, are still wide open for free market reforms of housing finance and the related government-sponsored enterprises including the end to guarantees there.
“Deregulation” conjures up a bonfire of the onerous rule books across many industrial sectors, decrees authored with scant or no congressional oversight. There is a second track of deregulation of equal, or even greater, importance which will boost prosperity: the scrapping of quasi-government guarantees applied to various forms of policy-favored credits, including the growing private-public partnerships active in infrastructure projects. The GSEs provide another prominent case of policy-favored credits in point.
Scrapping the GSEs would mean credit terms for housing finance could be differentiated according to quality. While mortgage costs would modestly rise compared to the present subsidized levels — many potential homeowners would find that cost more than offset by the cheaper price of their dwelling. Most importantly, general prosperity would gain from the better allocation of capital between housing and other investment opportunities.
During the long interest income famine generated by nonconventional monetary policy, bonds enjoying some degree of officially provided “comfort” albeit without explicit government guarantee have attracted a vast global demand at thin margins. GSE bonds are an example of this phenomenon.
In a world without quasi-government guarantees and financial engineering — occurring mainly through public-private partnerships like infrastructure projects — designed to produce securities that satisfy the hunger of those suffering from income famine, the demand for investment income would be more focused on risk assets with genuinely attractive expected returns. The higher prices for these (meaning lower cost of risk-capital) would boost capital spending in dynamic areas of the economy.
In effect, the squeezing of demand in the economy generated by government quasi-guaranteed finance would be more than offset overall by vibrant operation of market forces.
Protective, quasi-government guarantees have led to a diversion of capital to projects with poor productivity and low rates of return.
This has been done at the expense of investments whose underlying rates of return are considerably higher, such as with new, hot technological or entrepreneurial investment opportunities. Moreover, the ability of the private credit markets to make refined judgements about borrower quality — key to overall market efficiency — has been reduced. And our general prosperity has suffered, though some have individually gained.
The voracious hunger for yield among investors suffering from interest famine has meant that the financial packagers of fixed income streams have enjoyed buoyant demand for such products. For instance, the private equity groups who invest in businesses servicing new public-sponsored programs have created securities (mainly in debt form) based on user charges and other ostensibly steady streams of fee income.
In many cases it is unclear how far the state or federal government is guaranteeing any part of the income flow or the payment of interest and principal on the debt.
Meanwhile, the credit rating agencies in particular have grown whole new teams of experts to assess “the degree of comfort” in so-called structured finance deals. Securities packagers make clear, to potential and actual investors, that fee income may be boosted, via higher user charges, if returns prove inadequate to debt servicing.
Given the elasticity of demand, however, the height to which fee income can be boosted is often in doubt. The quality and reliability of government backstop is thus a key issue for buyers of these securities.
If there were neither understanding nor backstop, the scope to run the given program within a given budgetary constraint would be smaller.
These attributes are not absolute and so the private equity groups insert some slice of capital (equity participation) into the package alongside the debt-like securities. The widespread assumption is that yield-hungry investors overestimate the comfort to be gained from possible government protection, and so over-pay for the relevant securities.
In turn, household savings sunk into housing have run significantly above levels in a hypothetical guarantee-free market. There, house prices would be considerably lower on average (most of all in urban centers where the supply of land is tightly limited) without the prop of subsidized borrowing rates.
Today, there is little to be gained by borrowers seeking out lenders who have specific knowledge about their potential qualities as good payers. Private lenders cannot out-compete the finance terms offered by the official housing finance agencies. Scrapping the housing finance agencies would present the scope for mortgage lenders to develop respect (and a premium price) for the brand of securities which they offer to investors.
A typical security would be backed by mortgages of specified standard quality dimensions (based on credit scores, and the amount of borrowing relative to house value) on average and protected by a fixed element of equity cushion as inserted by the mortgage lender.
Institutions that earned the reputation for “making” better than average “product” (mortgages of given credit score and other standard attributes) would be able to sell their securities at a premium. This could mean lower costs for homeowner borrowers and higher returns for investors. Competition and better use of available information via decentralized markets is the best recipe for economic progress.
Brendan Brown is an executive director and the chief economist of Mitsubishi UFJ Securities International.