Phasing Out The GSEs

Abstract:

We develop a new model of the mortgage market where both borrowers and lenders can default. Risk tolerant savers (risk takers) act as intermediaries between risk averse depositors and impatient borrowers. The government plays a crucial role by providing both mortgage guarantees and deposit insurance. Underpriced government mortgage guarantees lead to risky mortgage origination and excessive financial sector leverage. Mortgage crises frequently turn into financial crises and government bailouts due to the fragility of the intermediaries’ balance sheets. Increasing the price of the mortgage guarantee crowds in the private sector, reduces financial fragility, leads to less and safer mortgage lending, lowers house prices, and raises mortgage and risk-free interest rates. Due to a more robust financial sector, consumption smoothing improves and aggregate welfare increases. While borrowers only incur a small welfare loss, both types of savers are substantially better off, with depositors benefiting the most.