Bernanke and Paulson express strong cautions about raising loan limits

Both Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson cautioned today that steps to raise conforming loan limits for Fannie Mae and Freddie Mac to address the mortgage crisis could reduce market discipline further and increase risk, unless such an action would be “explicitly temporary” and be done quickly.

Both officials specifically noted the downside of such an action, but left it open for Congress to take that step.

Here’s an excerpt from Bernanke’s testimony before the U.S. House Financial Services Committee:

Some have suggested that the GSEs could help restore functioning in the secondary markets for non-conforming mortgages (specifically jumbo mortgages, those with principal value greater than $417,000) if the conforming-loan limits were raised. However, in my view, the reason that GSE securitizations are well-accepted in the secondary market is because they come with GSE-provided guarantees of financial performance, which market participants appear to treat as backed by the full faith and credit of the U.S. government, even though this federal guarantee does not exist. Evidently, market participants believe that, in the event of the failure of a GSE, the government would have no alternative but to come to the rescue. The perception, however inaccurate, that the GSEs are fully government-backed implies that investors have few incentives in their role as counterparties or creditors to act to constrain GSE risk-taking. Raising the conforming-loan limit would expand this implied guarantee to another portion of the mortgage market, reducing market discipline further. If, despite these considerations, the Congress were inclined to move in this direction, it should assess whether such action could be taken in a way that is both explicitly temporary and able to be implemented sufficiently promptly to serve its intended purpose. Any benefits that might conceivably accrue to this action would likely be lost if implementation were significantly delayed, as private securitization activity would likely be inhibited in the interim.

Sec. Paulson echoed those points:

Some have suggested that the GSEs should be permitted to inject some liquidity into the jumbo mortgage market. There is little question that allowing the GSEs to securitize jumbo mortgages would give a short term lift which would be helpful to a segment of the housing market that has shown some recent improvement but is not functioning as normal. GSE entry into this sector would improve liquidity. The jumbo mortgage market traditionally has been a very profitable part of the mortgage market, with low default rates. For that reason it seems logical that this market will right itself in the weeks and months ahead. Therefore, consideration of this issue should be limited to a provision that is temporary and is part of legislation strengthening the regulatory structure. If it goes beyond that, it raises difficult public policy issues and could be seen as detracting from the GSEs’ affordable housing mission and displacing private sector participation, which the Administration does not support.

. . .

Anything the GSEs do to provide liquidity in this area, then, would mean taking on more risk. Therefore, such steps, and any additional authority permitting such steps, must be contemplated only in conjunction with legislation that addresses the inadequate regulatory structure of the GSEs.

Both Bernanke and Paulson also noted that broader public policy issues relating to Fannie and Freddie will need to be addressed relating to the moral hazard question, “longer-term market distortions,” and possible reductions in “market discipline, competition, innovation, and efficiency.”