A Way Forward for the Mortgage Market

Last week the Obama administration offered a vision of a future U.S. housing system in which Fannie Mae and Freddie Mac will eventually be wound down and eliminated. That in itself is not remarkable; even Rep. Barney Frank (D., Mass.) said last year that he hoped the two government-sponsored enterprises (GSEs) would be abolished. What was remarkable was that the proposal outlined by Treasury Secretary Tim Geithner included, as one of its options, a future housing-finance system that would rely almost entirely on the private sector.

Starting with the savings and loans crisis in the late 1980s, and continuing through Fannie and Freddie and the Federal Housing Administration (FHA), taxpayers have been or will be called upon to pony up more than $500 billion to pay for losses that the government has suffered in an unsuccessful effort to help people buy homes. The reason is simple: The government never receives adequate compensation for the risks it assumes. As a result, government backing always appears to confer a benefit--and members of Congress want to push as many of their constituents as possible into that favored category.

Here is a rare chance for the GOP to make common cause with the president and relieve the taxpayers of an unwarranted and unnecessary burden.

Exactly this happened with Fan and Fred. In 1992, we got affordable housing requirements that required the GSEs to extend their subsidy to low- income borrowers who couldn't meet the standards for prime loans. And in 2008, we got higher loan limits that enabled Fannie and Freddie to buy mortgages for million-dollar homes. In the end, both low-income and high- income borrowers got to benefit from the GSEs' subsidy.

The costs were all heaped on the taxpayers. And for what? Destructive housing bubbles and a home ownership rate that is No. 17 among developed countries.

Much of the Obama administration's proposal for a private housing-finance system follows a white paper issued in January by the American Enterprise Institute. That paper argued that the U.S. can build a sound mortgage system without public backing by ensuring that most mortgages are prime loans.

Prime loans are good investments and will be bought by insurance companies, pension funds and other institutional investors without government backing. Even in the worst downturns of the past, prime loans as a group have never suffered serious losses, and the losses that did occur were limited to local markets.

What made the recent financial crisis distinctive was that because of affordable-housing requirements and other policies, half of all mortgages in 2008 were subprime or otherwise risky loans. When the bubble deflated, they began to default in unprecedented numbers. If government policy had not encouraged the origination of these mortgages, we would not have had a financial crisis.

Yet most candidates for home ownership would be eligible for prime mortgages. More than 85% of U.S. homeowners have FICO credit scores higher than 660--the dividing line between a prime and a subprime borrower.

As both the administration and the American Enterprise Institute plans acknowledge, this still leaves room for social programs to assist low-income borrowers--working families who have demonstrated the ability to meet their financial obligations. Such a program, run by the FHA or a newly designed similar institution, would have to be on budget, contained in a way that protects taxpayers from excessive loss, and insulated against leakage from the prime market.

In a properly functioning private market, ease of entry and competition will produce low costs and innovation. Securities regulation to enforce mortgage standards will assure that the mortgages entering the securitization system are of good quality. Both the administration plan and the AEI plan suggest ways of withdrawing the GSEs from the secondary market--either through gradually reducing the size of the mortgages Fan and Fred are allowed to buy, or by raising their guarantee fees. In either case, private secondary market intermediaries could begin to service the markets from which the GSEs have withdrawn.

Now that these ideas are on the table, perhaps the new Republican House will look favorably at the administration's approach. Here is a rare chance for the GOP to make common cause with the president and relieve the taxpayers of an unwarranted and unnecessary burden.

Peter J. Wallison is the Arthur F. Burns Fellow in financial policy studies at AEI.

Photo Credit: Flickr user respres/Creative Commons

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