Principles for Reforming the Housing Finance Market

We recommend that the U.S. housing finance market of the future should be governed by four basic principles:

I. 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.

Under this principle, we note that the huge losses associated with the savings and loan debacle of the 1980s and Fannie and Freddie today did not come about in spite of government support for housing finance but 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.

Although many schemes for government guarantees of housing finance in various forms have been circulating in Washington since last year, they are not fundamentally different from the policies that caused the failures of the past. The fundamental flaw in all 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 in any case politically infeasible. The problem is not solved by limiting the government's risks to MBS, as in some proposals. 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.

II. 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. We know the characteristics of a prime mortgage, which are defined later in this white paper. They do not have to be invented; they are well known from many decades of experience.

Read Pinto, Pollock, and Wallison's white paper, Taking the Government Out of Housing Finance.

Experience has also shown that some regulation of credit quality can prevent the deterioration in underwriting standards, although in the last cycle regulation promoted lower credit standards. The natural human tendency to believe that good times will continue-and that this time is different-will continue to create price booms in housing, as in other assets. Housing bubbles in turn-by suppressing delinquencies and defaults-spawn subprime and other risky lending; investors see high yields and few defaults, while other market participants come to believe that housing prices will continue to rise, making good loans out of weak ones. Future bubbles and the losses suffered when they deflate can be minimized by interrupting this process-by focusing regulation on the maintenance of high credit quality.

III. All programs for assisting low-income families to become homeowners should be on-budget and should limit risks to both homeowners and taxpayers.

The third 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.

IV. Fannie Mae and Freddie Mac should be eliminated as government-sponsored enterprises over time.

Finally, Fannie and Freddie 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 would be successive reductions in the GSEs' conforming loan limits by 20% of the previous year's limits each year.

These reductions would apply to conforming loan limits for both regular and high-cost areas. This should be done according to a published schedule so the private sector can plan for the investment of the necessary capital and create the necessary operational capacity.

The private mortgage market would include banks, S&Ls, insurance companies, pension funds, other portfolio lenders and investors, mortgage bankers, mortgage insurance companies and private securitization.

Congress should make sure that it facilitates opportunities for additional financing alternatives, such as covered bonds.

On Feb. 11, 2011, the Departments of Treasury and Housing and Urban Development released the administration's report to Congress, titled "Reforming America's Housing Finance Market." The paper outlined three options: a largely private system with government support only for low- and moderate-income housing (option 1); a government-backed standby system, necessary only in the event of a housing market crash (option 2); and a system for government backing of MBS issued by specially chartered companies (option 3).

No preference was expressed among them, and the report suggested deficiencies in all of them.

However, the areas of agreement between the administration's approach and our initial white paper draft suggest that housing finance reform based largely on private-market principles is possible.

For example, the administration's report accepts 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, then, there is a rough agreement between our four principles and the administration's option 1.

The administration recognizes the following advantages in a financing system that relies primarily on private financing:

The strength of this option is that it would minimize distortions in capital allocation across sectors, reduce moral hazard in mortgage lending and drastically reduce direct taxpayer exposure to private lenders' losses.

With less incentive to invest in housing, more capital will flow into other areas of the economy, potentially leading to more long-run economic growth and reducing the inflationary pressure on housing assets.

Risk throughout the system may also be reduced, as private actors will not be as inclined to take on excessive risk without the assurance of a government guarantee behind them.

And finally, direct taxpayer risk exposure to private losses in the mortgage market would be limited to the loans guaranteed by the FHA and other narrowly targeted government loan programs: no longer would taxpayers be at direct risk for guarantees covering most of the nation's mortgages.

Edward Pinto is a resident fellow, Alex J. Pollock is a resident fellow, and Peter Wallison is the Arthur F. Berns fellow in Financial Policy Studies at AEI.

Photo Credit: Bigstock SVLuma

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