What to do about U.S. mortgage finance?

September 9, 2011

By Viral Acharya, Matthew Richardson, Stijn Van Nieuwerburgh and Lawrence White
The authors are guest columnists for Reuters Breakingviews. The opinions expressed are their own.

Americans should be outraged at the architecture of the nation’s mortgage finance system. It was a primary cause of the financial crisis and at the center of this system were Fannie Mae and Freddie Mac, the mortgage finance giants. With the implicit backing of the full faith and credit of the U.S. government and favorable regulatory treatment, Fannie and Freddie went from bit players in the early 1980s to controlling almost 50 percent of the mortgage market and $5 trillion of mortgage risk by the time of the crisis. With very little capital supporting this risk, U.S. taxpayers are now paying — literally — for this calamity.

Fannie and Freddie were, in effect, a dream entitlement program. The government subsidized housing through lower mortgage rates but never had to put up any money. Of course, like any pyramid scheme, this works well at first until it collapses upon itself. And unfortunately, the fall is almost always worse than the rise.

The problem is not just the $150 billion worth of losses already suffered by Fannie and Freddie or the future losses estimated to be an additional $100 billion more. The collateral damage from this mortgage finance system has caused considerable harm to the U.S. economy. Through the mortgage rate subsidies, people borrowed more than they could afford to buy houses bigger than they needed, leading to a house price bubble of epic proportions.

Buoyed by these high prices, American households doubled their debt from $7 trillion in 2001 to $14 trillion in 2007.  Today, the ratio of household debt to GDP is at its highest point since the Great Depression. For a consumer-based economy that is driven by household spending, this single fact foretells that the U.S. economy is a long way from a full recovery. What the United States is going through now is the typical aftermath of a severe financial crisis.

Given the state of the U.S. economy and the mortgage finance system’s obvious role, an overhaul of housing finance should be at the top of the political agenda. Yet it has been four years since the crisis first started in the summer of 2007 and almost three years since Lehman’s collapse in early fall of 2008, and still no comprehensive plan has been laid out. To rub salt into the wound, last year’s Dodd-Frank Act, the most important financial legislation since the 1930s, devotes only about two of the 850-odd pages in its final printing to the reform of Fannie and Freddie — and those outline a study and note the need for reform rather than specifying action.

Yet housing finance reform need not be an ideological battle to the death. It is not healthcare. Both the administration and the Congressional leadership basically seem to agree that the U.S. mortgage finance system should be private in nature. Government support should be greatly reduced or even ended completely.

The problem with making that happen is that no industry in the United States is as heavily subsidized as the housing sector. This is not just because of Fannie and Freddie, but also due to a variety of other handouts, including mortgage interest deductibility and preferential capital gains treatment. The last few years the Congressional Budget Office has estimated these annual transfers to be well over $150 billion dollars, 10 times the amount afforded to much-criticized farming or energy subsidies. Simply put, the housing industry wants the gravy train to continue. No wonder that several bipartisan bills being offered — Boxer, Campbell-Peters, Campbell-Ackerman, and Miller-McCarthy — would all essentially maintain the status quo.

But our housing finance system does not simply need an update. It is not even a fixer upper, but instead a tear-down. There should be no doubt that mortgage finance reform requires transformational action.

The common argument for not doing something dramatic is that it will impede the recovery of U.S. house prices. But recovery to what level? House prices went through a bubble, the bubble then burst, and prices came back to earth. Looking at economic fundamentals and technical trends, house prices are back in the right ball park. Government should stop trying to prop up house prices and instead fix the system that propped them up too generously in the first place.

In our book, “Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance,” we call for this to be completed in three stages:

First, Fannie and Freddie need to be wound down. We don’t know of an economist alive who sees these institutions as a positive force. If the concern is about what happens when they exit this world, then the focus should be on managing the transition.

Second, we need to wean mortgage finance off the U.S. government. To minimize the system-wide shock of closing Fannie and Freddie and removing government support, we envision a decade-long transition. We call for a partnership between the private sector and government, with the government gradually winding down its support. The transition might take place more quickly, but it would be hard-wired to end in 10 years’ time.

Third, in the end the U.S. mortgage finance system would be private in nature. The slow transition would ensure that it functions well. Of course, it needs to be well regulated, so that the systemic risk of Fannie and Freddie just does not get simply built up in other too-big-to-fail financial institutions. In other words, we cannot merely replace the Fannie and Freddie Godzillas with private market King Kongs.

This new mortgage finance system will change the U.S. economy. As the subsidies to the housing sector are removed, productive resources will shift from real estate to more productive sectors. The long run impact will be higher economic growth and a more stable financial system as households and financial firms take on less mortgage debt. A side benefit will be that removing all major housing subsidies — including not only those given to Fannie and Freddie but also tax expenditures like mortgage interest deductibility and capital gains relief — will also partially help solve the U.S. deficit problem.

Given the role of mortgage finance in our economic collapse, the time to act is now. Dramatic reform can be a win-win for U.S. taxpayers, a far cry from the “heads I win, tails you lose” business model of Fannie and Freddie. Americans deserve better.


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You are correct that government guaranteed mortgages by Fannie Mae and Freddie Mac did lower the mortgage rates and contribute to the bubble. People did spend excessively on homes instead of limiting themselves to the traditional 25% of after tax income for housing that was the stand a generation ago. You failed to mention the role of the Community Reinvestment act which mandated that borrowers with worse credit must receive loans as another cause of this crisis. Giving money to rich bankers did not help a bit but there is still a way out of the mess. Let the federal Reserve bail out the mortgage holders not the bankers. Let the Fed buy down the interest rate on all primary residencies to 3% or 3.5%. This stems foreclosures and looses the noose of huge monthly payments that keep consumers on the ropes. In exchange for the lower rates the loans can be converted to a maximum of 30 year fixed instead of interest only loans. I would not limit this help to trouble mortgages or lower incomes only because every layer of the economy needs help and lets face it, most consumer spending comes from those with higher incomes and bigger mortgages. This consumer spending creates 2 or every 3 jobs. Just stay out of the class warfare at least this one time. When the economy heats up and inflationary pressure builds then raise the reserve ratio on the biggest banks. These banks that hold 5% or more of total banking assets are those that are “too big to fail” . These are the banks that the tax payers bailed out. The same banks that are sitting on hordes of cash and will not loan you a penny. The taxpayers are guarantying 97% of their debt since the reserve ratio is a ridiculously low 3%. Finally, we do not want to repeat the same mistakes and have another crisis. Limit government backing to mortgages that have some sort of down payment, at least 5%. Limit the backing to mortgages that are less than 25% of the after tax income. One can still spend 35% of their income on their home but just don’t ask for a taxpayer guarantee. Finally, repeal the Community Reinvestment act. Good credit is earned, not decreed.

Posted by BillG111 | Report as abusive

You really do bring up a great point with limiting the loan amount as it relates to after tax dollars. It really does not matter what you gross if you do not bring it home it is not available for a payment to be made.

Posted by MortgageLou | Report as abusive