Taking the government out of housing finance: Principles for reforming the housing finance market

Article Highlights

  • The 4 basic principles that should guide the US housing market

    Tweet This

  • Fannie and Freddie should be eliminated as GSEs over time

    Tweet This

  • The housing finance market should principally function without any direct government support

    Tweet This

Taking the Government Out of Housing Finance: Principles for Reforming the Housing Finance Market

Download PDF
Executive Summary

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

Principle I: The housing finance market can and should principally function without any direct government financial support.

Principle 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.

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

Principle IV: Fannie Mae and Freddie Mac should be eliminated as government-sponsored enterprises (GSEs) over time.

With the release of the Obama administration's thoughtful report1 on housing finance reform (February 2011), which was broadly consistent with these ideas, a bipartisan agreement on the future of housing finance has become possible.

The administration's paper outlines three options, the first of which is a largely private market. By including this idea as a key option for a Democratic administration, the report was a game changer: whether most housing in the United States should be financed in a private market is now open for consideration. In its paper, the administration raised some reasonable concerns about this option and suggested two alternatives. We address these concerns and show how to produce a robust, stable private system for originating and financing mortgages, while protecting the taxpayers.

There are two theories about the financial crisis of 2007-2008. One holds that it was caused largely by a lack of effective government regulation;2 the other that government housing policy was primarily at fault.3 Whether one looks at this debacle as a failure of regulation or a failure of housing policy, it is undeniable that large parts of the previous US housing finance system were guided and guaranteed by the government and that once again the taxpayers will bear the immense costs of government failure.

Many of the proposals for reforming the US housing finance market reflect the belief that institutional investors will buy securities backed by US mortgages (MBS) only if they are somehow guaranteed by the US government. To the contrary, we propose a superior alternative to government guarantees--remembering that such government market interventions have led to large-scale taxpayer bailouts twice in the last generation.

Our alternative is to ensure that only prime-quality mortgages, which comprise the vast majority of US mortgages, are allowed into the securitization system. The very low delinquency and default rates on prime mortgages will be attractive investments for institutional investors and will enable the housing finance secondary market to function effectively with no government support. This will eliminate the potential for additional taxpayer losses in the future; reduce the likelihood and severity of housing price booms, busts, and attendant bubbles; and allow the eventual elimination of the GSE charters of Fannie Mae and Freddie Mac.

The four basic principles we recommend (initially outlined in an earlier draft of this paper issued in January 2011) line up remarkably well with Option 1 in the report issued by the administration. This provides an opportunity to replace Fannie Mae and Freddie Mac and adopt other housing finance reforms that will protect the taxpayers against further losses and significantly reduce the chances of another financial crisis.

The following explanations summarize our four central principles:

I. The housing finance market--like other US 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 (S&L) 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 3 defined later in this white paper. They do not have to be invented; they are well known from many decades of experience.

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 (GSEs) 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 percent 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 (MI) companies, and private securitization. Congress should make sure that it facilitates opportunities for additional financing alternatives, such as covered bonds.

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

1 Department of the Treasury and Department of Housing and Urban Development (HUD), Reforming America's Housing Finance Market: A Report to Congress (Washington, DC, February 11, 2011). 2 Financial Crisis Inquiry Commission, Financial Crisis Report (Washington, DC, January 2011). 3 Peter J. Wallison, Dissent from the Report of the Financial Crisis Inquiry Commission, (Washington, DC: American Enterprise Institute, January 2011), www.aei.org/paper/100190.

Also Visit
AEIdeas Blog The American Magazine
About the Author


Peter J.


Alex J.


Edward J.

What's new on AEI

AEI Election Watch 2014: What will happen and why it matters
image A nation divided by marriage
image Teaching reform
image Socialist party pushing $20 minimum wage defends $13-an-hour job listing
AEI on Facebook
Events Calendar
  • 20
  • 21
  • 22
  • 23
  • 24
Monday, October 20, 2014 | 2:00 p.m. – 3:30 p.m.
Warfare beneath the waves: The undersea domain in Asia

We welcome you to join us for a panel discussion of the undersea military competition occurring in Asia and what it means for the United States and its allies.

Tuesday, October 21, 2014 | 8:30 a.m. – 10:00 a.m.
AEI Election Watch 2014: What will happen and why it matters

AEI’s Election Watch is back! Please join us for two sessions of the longest-running election program in Washington, DC. 

Event Registration is Closed
Wednesday, October 22, 2014 | 1:00 p.m. – 2:30 p.m.
What now for the Common Core?

We welcome you to join us at AEI for a discussion of what’s next for the Common Core.

Thursday, October 23, 2014 | 10:00 a.m. – 11:00 a.m.
Brazil’s presidential election: Real challenges, real choices

Please join AEI for a discussion examining each candidate’s platform and prospects for victory and the impact that a possible shift toward free-market policies in Brazil might have on South America as a whole.

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.