When Is A Bailout Not A Bailout?

Dean Baker says it's bailout – of hedge-fund managers, no less. Tim Worstall says it's a bailout, which raises all manner of moral-hazard issues. Joanna Ossinger says it's a bailout. But it's not.

They're talking about the proposal to free up Fannie Mae and Freddie Mac so that they can buy a wider range of mortgages than they're currently allowed to, which would be a good first step to addressing some of the problems in the mortgage sector.

Why is it not a bailout? For one thing, no public money is involved. This is a regulatory change. At the moment, Fannie and Freddie are constrained from buying certain types of mortgage. If the proposal goes through, they won't be as constrained as they are presently. That's it.

There also isn't a moral-hazard argument (sorry, Tim). To understand why, it's worth looking at how we got to where we are today.

Most mortgages in the US are sold to Fannie and Freddie. But in order to sell a mortgage to one of those two GSEs, it has to be "conforming". It can't be too big ("jumbo", or more than $417,000). It can't be on something weird, like a New York City co-op, where you don't technically own your apartment, but only shares in a building. And it can't be subprime.

Now no one thinks that writing mortgages on big homes or New York City apartments is a bad idea. And although subprime has blown up now, most people don't think it's a good idea to prevent people with weak credit from buying houses altogether. In other words, all these mortgages must and should exist. But the market in these mortgages isn't as clean and efficient as the market in conforming mortgages.

This result has, historically, been bad for borrowers and good for lenders. Non-conforming mortgages are more expensive for homeowners, which means that they're more profitable for lenders. Which meant in turn that lenders were very happy with the fact that the GSEs didn't play in this particular sandbox.

It also meant that the lenders didn't need to ensure that their mortgages conformed to the GSEs' underwriting standards. Lenders could – and did – write all manner of nuclear waste to just about anybody. The paper might have been palatable to the bond investors who bought RMBS and CDOs, but it would never have passed muster with the GSEs.

So the GSEs' absence from the subprime market actually contributed to the weakness of its underwriting standards. And therefore if the GSEs are allowed to enter the subprime market, that will strengthen underwriting standards, both now and going forwards.

So there's no moral hazard: the next mistake is not more likely, as a result of this change, it's less likely.

So can we stop calling this a bailout, already?