Monday, March 31, 2008

The Real Value Added of Fannie and Freddie?

Mark Thoma has a nice post on adverse selection and mortgages. Adverse selection can only happen, of course, in the presence of unobserved heterogeneity.

Fannie and Freddie, owing to their market power, could require loan originators to collect a long checklist of information and documentation about borrowers: everyone who obtains a conforming, conventional, prime mortgage fills out the same forms. Much of the information on these forms is not particularly useful for estimating probit or logit models of loan default; however, they are filled out only by borrowers who are willing to reveal a lot of information about themselves. This alone will reduce unobserved borrower heterogeneity, and therefore reduce adverse selection problems. Borrowers once were willing to fill out the forms (along with associated documentation) because they HAD to do so in order to get a mortgage. Now they fill them out is they want to get the pass-through benefit of the of the Fannie-Freddie subsidy. I think one of the lessons of the current crisis is that we need to return to the day when only well-documented borrowers get loans.

This doesn't mean we need to go back to a rationed market (which i what we had in the pre-subprime days). In fact, by requiring borrowers to disclose sufficient information, the market might be able to price mortgage risk better in the future.


Uncle Billy said...

Can you point me (us?) to any articles that justify well the existence of fnma and fhlmc? And if we need them, why do we need *both* of them? I took a look at their webpages, and couldn't find fundamental differences.

"by requiring borrowers to disclose sufficient information, the market might be able to price mortgage risk better in the future"

Adversus solem ne loquitor!

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