GSE conforming limits

One option for dealing with the subprime problem is to raise the GSE conforming limit. My understanding is that Freddie Mac and Fannie Mae, two nominally independent private companies that are viewed as extensions of the government, and therefore backed by governmental guarantees, were set up to enable the government to give an arms length subsidy to low-income homeowners by having these entities back cheap home loans. "Cheap" means loans of $417K or less. Fed chairman Ben Bernake seems to want to have it both ways with these entities

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.

I'm not sure how Ben manages to both claim that 1) GSEs are not backed by the government, and 2) the government wants to step in and let the GSEs cover more loans because loans are doing badly. It would be easier for him to simply say "GSEs are backed by the government, which is why I don't want them to get even bigger than they already are".

I also think that it's rich that states like California are agitating for GSEs to cover larger mortgages because every house in California costs more than $417K. If GSEs started backing jumbo loans ($417K+) in California, the interest rates for those loans would fall. The last time interest rates on mortgages fell, the market response was to bid up the home price so payments stayed exactly where they were, but houses became expensive. This was great for people who owned houses, but bad for people who wanted to buy houses. If GSEs start backing jumbos, then there will be another one time transfer from non home-owners to home-owners. Since home-owners have just enjoyed the greatest burst of residential price appreciation in the past 100 years, I'm not sure why it's a priority to goose things a little more.

I would also add that if California is concerned about the price of homes, it could try making home construction legal again. While it's true that they are not making any more land, there is still acres of sky free and clear, just waiting for that second story.