Academic journal article Journal of Corporation Law

Housing Finance Reform and the Shadow Money Supply

Academic journal article Journal of Corporation Law

Housing Finance Reform and the Shadow Money Supply

Article excerpt


In a previous Article,1 I showed that government guarantees in the U.S. mortgage market have historically promoted financial stability, and argued that this stability was at least in part due to three effects of government guarantees: first, they prevent banking panics; second, they blunt procylicality; and third, they promote the origination of consumer-friendly loans that are less likely to default.

In this Article, I propose another complementary explanation for this phenomenon: housing finance naturally produces liabilities that function as money. Thus, government guarantees of housing finance liabilities create two positive externalities promoting financial stability-they facilitate greater linkages between the Federal Reserve's traditional monetary policy levers and the actual money supply, and they crowd out private forms of money (like the "shadow money" liabilities created by the shadow banking system), which are more prone than publicly backed monetary instruments to procyclicality and instability.

This hypothesis may have a great deal of importance, given the likelihood of major reforms to the housing finance system under the Trump Administration. In September 2008, the government-sponsored enterprises (GSEs)2 Fannie Mae and Freddie Mac were placed into conservatorship by their primary regulator, the Federal Housing Finance Agency (FHFA), a casualty of the financial crisis that was then brewing.3 Following their conservatorship, a wide array of commentators (including many influential legislators) have been clamoring for some form of "privatization" of the GSEs, wherein the two companies would be wound down, and the federal government would be removed from its longstanding role as the guarantor of last resort of most U.S. housing finance liabilities.4 President Donald Trump appears to be sympathetic to this view of housing finance, as his presidential transition team was made up of several leading advocates of housing finance privatization.5

Such reforms could potentially have a staggering impact on the mortgage markets in the United States, as the two enterprises provide a very large share of all residential mortgage financing. Since the 1990s, and particularly since 2008, Fannie and Freddie have been responsible for financing most American home loans.6 Thus, any such major structural changes to U.S. housing finance will likely have enormous implications for American homeowners and home buyers, and more broadly, the American economy. Unsurprisingly, legal and policy analysis of housing finance reform has focused almost entirely on the effects this may have on the mortgage markets.

But GSE reform would also have a major effect on global credit markets, a point that has been mostly overlooked to date. To finance their considerable mortgage finance activities, Fannie and Freddie have issued approximately $5.3 trillion in mortgage-backed securities, collateralized mortgage obligations (CMOs), and corporate debt.7 These liabilities, which are understood to carry an implicit federal guarantee against losses that is nearly as robust as the "full faith and credit" guarantee on U.S. Treasury obligations, are an important component of the supply of so-called "safe assets," making up about one-tenth of the estimated global supply of safe assets, and about one quarter of U.S. safe assets.8 As I discuss infra in Part I, safe assets vary greatly in form and function, but are generally thought to carry de minimis credit risk.9 In the absence of any countervailing measures, housing finance reform is likely to have a short-term contractionary impact, possibly a very severe one, on the supply of safe assets.

Any reduction in safe assets would in turn have important consequences for global money markets today, as safe assets, particularly government-backed safe assets like the liabilities of Fannie and Freddie, have come to play an essential role in the creation of "shadow money." Shadow money has become an important part of the overall money supply, but because it is a private form of money creation and does not carry any formal government guarantees behind it, it relies heavily on the use of collateral to help maintain its monetary attributes. …

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