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View related content: Financial Services
Thought you might be interested in AEI’s latest Financial Services Outlook in which AEI scholar Peter Wallison discusses the government’s housing finance reform efforts:
I. NO GOVERNMENT INVOLVEMENT
Most of the current plans put forward for replacing Fannie Mae and Freddie Mac involve some sort of continuing role for the government in housing finance.
These proposals are built on incorrect assumptions about the benefits of government involvement.
They overlook recent experience which shows that the moral hazard–which causes business and people to take greater risks when they know that they are protected/insured from those risks–created in this case by the government’s presence in the housing-finance market, can produce catastrophic results for taxpayers.
II. THREE PRIVATE SECTOR SOLUTIONS
Wallison suggests, instead, that Congress should consider ways to withdraw the government from any role in financing prime mortgages and puts forward three private-sector solutions:
Covered bonds: Banks would be authorized to sell bonds backed by a specific pool of mortgages. The mortgages would remain on the banks’ balance sheets, segregated from other assets. The bank could use the bond proceeds for any banking purpose, but the principal and interest would flow to the investors. The key to this program would be an obligation on the part of the banks to top up the mortgage pool whenever defaults or delinquencies jeopardize the quality of the collateral backing the bonds.
The Danish mortgage system: There has never been a mortgage-bank default in Denmark in the past 200 years. In this unique system, mortgages are added to a pool of mortgages all issued at the same interest rate. Except for size, all the mortgages in the pool are identical. Interests in the pool are purchased by capital-market participants anywhere in the world. The specialized mortgage bank that arranges the mortgage pool is responsible only for the credit risk, and in effect functions like a mortgage insurer. The unusual feature of the Danish system is that homeowners can, in effect, buy back their mortgage obligation by purchasing, in the open market, some of the outstanding bonds that are backed by the mortgage pool.
Securitization of prime mortgages. The key to this solution is to make sure that the system securitizes mortgages of high quality. Securities composed of prime-quality mortgages, not subprime or Alt-A mortgages, performed as well as any other asset-backed security in the recessionary period that followed the deflation of the housing bubble. Through the use of proven technology and structures, and not subject to size limits, a soundly based securitization market should grow as the mortgage market grows. “This market has functioned satisfactorily for thirty or forty years,” notes Wallison, “[it] produces interest rates that Fed economists found to be competitive with those offered by GSEs, and is still working well for many types of assets.”
One of the benefits of securitization is that it is already a functioning system and thus–and while Fannie and Freddie are still under government control–it could be used for a transition to a fully private system. A gradual reduction of Fannie and Freddie’s conforming loan limit would allow the private system to take over areas that are no longer covered by these GSEs. Eventually, Fannie and Freddie’s area of activity would be reduced to zero, allowing the entire residential mortgage market to be privately financed.
III. AFFORDABLE HOUSING: FHA NOT FANNIE AND FREDDIE
Congress and most of the groups submitting plans for reforming the housing finance system do not cite affordable housing as a reason for government involvement.
There are sound policy arguments for low-income groups to have access to mortgage credit, even if they can’t afford prime mortgages, but the right decision is to do this through the Federal Housing Administration and not distort the private financial market with what is essentially a social policy.
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