REQUIRED READING: The housing finance market, like other U.S. industries and housing finance systems in most other developed countries, can and should principally function without any direct government financial support. The Fannie Mae and Freddie Mac bailouts did not come about in spite of government support for housing finance, but rather because of that government backing.
Government involvement not only creates moral hazard, but also sets in motion political pressures for increasingly risky lending, such as affordable loans to constituent groups. Some people may justify direct support in the form of the government-sponsored enterprises (GSEs) by pointing to slightly lower interest rates. However, this is an illusion when compared to the GSEs' numerous market distortions and bailout costs.
Others may justify the need for a guarantee in order to make mortgage-backed securities (MBS) attractive to private investors. This, too, is an illusion. The Federal Reserve's flow of funds data show that, contrary to what Congress is being told, private institutional investors are not particularly interested in government-guaranteed assets.
These same supporters also neglect to point out that government-backed MBS are primarily acquired by government entities, such as state and local general and pension funds, foreign central banks, the GSEs themselves and entities already benefiting from a government guarantee – including banks, thrifts, credit unions and foreign banks with U.S. government deposit insurance.
Although many schemes for government guarantees of housing finance have been circulating in Washington since last year, they are not fundamentally different from the policies and institutions that caused the failures of the past. The fundamental flaw in all of these ideas is the notion that the government can successfully establish an accurate risk-based price or other compensatory fee for its guarantees. Many examples show that this is beyond the capacity of government and is politically infeasible.
The problem is not solved by limiting the government's risks to MBS, as some proposals suggest. The government's guarantee eliminates an essential element of market discipline – the risk aversion of investors – so the outcome will be the same: Underwriting standards will deteriorate, regulation of issuers will fail and taxpayers will take losses once again. Further, with the potential establishment of new too-big-to-fail GSEs, the market will be the subject of moral hazard, because since it will once again correctly conclude that the heirs to Fannie Mae and Freddie Mac are implicitly guaranteed by the government.Â
Ensuring mortgage quality and fostering the accumulation of adequate capital behind housing risk can create a robust housing investment market without a government guarantee. This principle is based on the fact that high-quality mortgages are good investments and have a long history of minimal losses.
Instead of relying on a government guarantee to reassure investors in MBS, we should simply ensure that the mortgages originated and distributed are predominantly of prime quality. Experience has also shown that some regulation of credit quality can prevent the deterioration in underwriting standards, although in the last cycle, regulation actually promoted lower credit standards.
There is a natural tendency to believe that good times will continue – and that this time is different – which will continue to create price booms in housing and in other assets. Future bubbles and the losses suffered when they deflate can be minimized by focusing regulation on the maintenance of high credit quality.
Despite their underlying quality, prime mortgages with loan-to-value ratios (LTVs) higher than 60% require some form of credit enhancement to be attractive to investors. Mortgages pose two types of credit risk, and adequate capital must be accumulated to survive both risks: sufficient capital for what one would call ‘normal loss experience’ on prime mortgages with an LTV greater than 60%, and sufficient capital necessary to address catastrophic conditions, such as a housing-price decline of as much as 35%. This, again, focuses on the risks posed by prime loans with an LTV greater than 60%. Private mortgage insurance, with its statutorily mandated catastrophic premium reserve, is capable of providing such credit enhancement.Â
There is also the question of using federal housing policy to rectify perceived social imbalances. All federal housing programs for assisting low-income families to become homeowners should be on budget and limit risks to both homeowners and taxpayers.
This principle recognizes that there is an important place for social policies that assist low-income families to become homeowners, but these policies must balance the interest in low-income lending against the risks to the borrowers and the interests of the taxpayers. In the past, affordable housing and similar policies have sought to produce certain outcomes – such as an increase in homeownership – which turned out to escalate the risks for both borrowers and taxpayers. The quality of the mortgages made in pursuance of social policies can be lower than prime quality – taxpayers may be willing to take risks to attain some social goods – but there must be quality and budgetary limits placed on riskier lending to keep taxpayer losses within known and reasonable bounds.
The party's over
Ultimately, GSE reform needs to involve GSE closure. Fannie Mae and Freddie Mac should be eliminated as GSEs and privatized – but gradually, so the private sector can take on more of the secondary market as the GSEs withdraw. The progressive withdrawal of the GSEs from the housing finance market should be accomplished in several ways, leading to the sunset of the GSE charters at the end of the transition.
One way of accomplishing this would be to reduce the GSEs' conforming loan limits each year by 20% of the previous year's limits. The private mortgage market would include banks, thrifts, insurance companies, pension funds, other portfolio lenders and investors, mortgage bankers, mortgage insurance companies and private securitizers.
On Feb. 11, the Department of the Treasury and the Department of Housing and Urban Development released the administration's report to Congress titled ‘Reforming America's Housing Finance Market.’ The paper outlined three options: (1) a largely private system with government support only for low- and moderate-income housing; (2) a government-backed standby system, necessary only in the event of a housing market crash; and (3) a system for the government backing of MBS issued by specially chartered companies.
The administration offered no preference among these options, and the report suggested deficiencies in all of them. Nonetheless, housing finance reform based largely on private-market principles is possible. For example, the administration's report accepts the following as a viable option: a privatized housing finance market as the primary source of mortgage credit, with private capital playing the predominant role in housing finance; robust oversight in support of strict underwriting standards; government assistance to low-income borrowers as a limited adjunct to a largely private financing system; and the need to wind down and privatize or eliminate Fannie Mae and Freddie Mac.
In effect, there is a rough agreement between the four principles set out above and the administration's first option. All that is necessary now is for the mortgage lending industry to ask Congress to define the terms of a prime mortgage and how Fannie and Freddie can gradually be withdrawn from the market.
Edward Pinto is a resident fellow at the American Enterprise Institute, based in Washington, D.C. He can be reached at (240) 423-2848.
