JAN 12, 2012

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Risky Business

Twelve Steps to Improve U.S. Housing Finance

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What thoughts should guide ongoing Congressional consideration on housing finance?

Let's start with this one: “It is increasingly clear that the Fed and the U.S. government's entwinement with the housing market is one of the greatest economic distortions on earth” (as the Lex Column of the Financial Times wrote).

In the days when Fannie Mae and Freddie Mac were still in their pride, I participated in a meeting in Denmark. Our hosts presented the highly interesting Danish mortgage bond system, in which 100% of the credit risk is retained by the original lender, and 100% of the interest rate and option risk is passed on to the bond investor, with no government guaranty on either side. 

After their presentation, I described the then-celebrated GSE-centric housing finance system of the United States.  When I had finished, the chief executive of a Danish mortgage bank made the following unforgettable statement: “In Denmark, we always say that we are the socialists and America is the land of free markets.  But now I see that in mortgage finance, it is the opposite!”

Congress might reasonably ask: In exchange for this massive government intervention or “entwinement” in the mortgage market, so striking to my Danish colleague, did the U.S. achieve the highest home ownership rate in the world?  No, we didn't, although this has often been claimed by those who do not know the numbers.

In a list of 25 economically developed countries, the U.S. ranks 17th in home ownership (see accompanying table).  Decades of government promotion of mortgage debt notwithstanding, we are in the lower part of the middle of the pack on this measure.

American housing finance was truly unique in one way, however: having a GSE-centric system and relying on the “implicit” government guaranty to keep the government's obligations off the federal balance sheet.

Indeed, the GSEs were in effect the government's SIVs: vehicles to achieve highly leveraged, off-balance sheet financing with the claim that the sponsor was not liable, although it fact it was.

Congress might also wonder why the American housing finance system has in recent times failed twice:  the savings and loan collapse of the 1980s, and the GSE collapse of the 2000s—the former costing the taxpayers about $150 billion, and the latter costing some greater number, variously estimated in some hundreds of billions of dollars.  That's two strikes.  How can we avoid strike three?

Here are twelve steps Congress could consider in order to create a better housing finance market for the future:

  1. Put Fannie and Freddie formally on the federal budget.  This would be honest accounting and also a strong incentive for Congress to proceed with fundamental reform.  It would be analogous to bringing a busted SIV onto the balance sheet of the sponsoring bank, now that the liabilities are obvious and indubitable.
  1. Create a private secondary market for prime, middle class mortgages.  The 21st century does not need GSEs to have securitization and bond market funding for prime mortgages, the largest portion of the mortgage business.  There may have been, decades ago, a case for using GSEs to overcome the geographical barriers to mortgage funding, which were themselves created by government regulation.  But no longer.
  1. Design a five-year transition to having no GSEs.  Like the collapse of the savings and loans, the GSEs are an expensive lesson about the government's yearning to promote loans on housing.  Even the previously most fervent political supporters of Fannie and Freddie now realize that the GSE form is a failure.
  1. So over five years, divide Fannie and Freddie each into three parts.  The first part must be a liquidating trust containing the deadweight losses, which will unjustly, but at this point unavoidably, be borne by taxpayers.  The second part should be the privatized intellectual property, systems, human capital and goodwill formed into a private company and sent out in the world to compete.  The final part should be the subsidy programs which should be become an explicitly governmental function, merged into HUD.
  1. Stop using the banking system to double-leverage GSEs.  Every investment in GSE equity by a bank should have a 100% capital requirement: equity investments should not be leveraged in bank balance sheets.  GSE debt obligations should be subject to the same limitations on risk concentrations as all other debt securities.
  1. Facilitate credit risk retention by mortgage originators, even where it is not required by regulation.  We should encourage the invention of structures in which significant credit risk is retained by the original lender, in addition to those mandated by the Dodd-Frank Act.  Creating a statutory basis for U.S. covered bonds would be a good contribution to this goal. 
  1. Develop counter-cyclical LTVs.  Mortgage loans should be made against the sustainable, underlying value of the property, not just the current price.  Countercyclical policy would reduce LTV ratios as house prices escalate sharply over their trend line.
  1. Create much bigger loan loss reserves in good times.  Bad loans are made in good times, while they seem good.  They should be matched by bigger, old fashioned loss reserves.  The lean years inevitably follow the fat years.
  1. Implement the Pollock one-page mortgage information form.  Clear, straightforward key information should allow borrowers above all to answer the question, “Can I afford this loan?”
  1. Confront the banking system's overconcentration in real estate risk.  We have not even begun to address this huge problem.
  1. Transition the Fed out of being the world's largest savings and loan, with its nearly $1 trillion of long-term mortgage assets, funded short.
  1.  Rediscover savings as an explicit goal of housing finance.  The original idea was to create savings through the retirement of the mortgage loan over time, so the borrower ended up being a real equity owner of the property.  A good idea to stress once again.

All of that together is a big order—but we are dealing with the biggest credit market in the world, and it is certainly worth the effort.

Alex J. Pollock is a resident fellow at the American Enterprise Institute, Washington, DC.

Comments (1)
Fureralz? That's marvelously good to know.
Posted by NDagTOCgHmJAIQFz | Monday, January 23 2012 at 10:52PM ET
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