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When Economic Policy Became Social Policy

Saturday, August 21, 2010

The recent Treasury Department conference is further proof we will never get out of this housing mess until we are ready to face facts.

Watching the Treasury conference on housing finance earlier this week, I was struck by the gloomy thought that we will never get out of this housing mess until we are ready to face facts. Treasury Secretary Tim Geithner’s remark that the demise of Fannie Mae and Freddie Mac was caused by their pursuit of short-term profits was not a constructive contribution to the resolution of the major issues before us. In reality, Fannie and Freddie were doomed by a badly designed government housing policy, and government efforts to disguise its responsibility with a false narrative will only make a solution more difficult.

In 1992, Congress gave Fannie and Freddie a “mission” to promote affordable housing, and directed them to study a few very new ideas to accomplish this goal: “establish a downpayment requirement for mortgagors of 5 percent or less; allow the use of cash on hand as a source of downpayments; and approve borrowers who have a credit history of delinquencies if the borrower can demonstrate a satisfactory credit history for at least the [most recent] 12-month period.”

The Department of Housing and Urban Development (HUD) took this for what it was—a direction to support affordable housing by reducing underwriting standards—and throughout the 1990s and 2000s it relentlessly raised affordable housing requirements for Fannie and Freddie, requiring them to buy increasing numbers of subprime and other risky mortgages. In 2004, as it raised goals again, HUD made its purposes clear with this statement: “Millions of Americans with less than perfect credit or who cannot meet some of the tougher underwriting requirements of the prime market … rely on subprime lenders for access to mortgage financing. If the GSEs [government-sponsored enterprises, i.e., Fannie and Freddie] reach deeper into the subprime market, more borrowers will benefit from the advantages that greater stability and standardization create.” Fannie and Freddie, with little choice in the matter, did exactly this, eventually bringing them to insolvency in 2008.

We should recognize that if the residential mortgage market of the future consists of good quality mortgages, we don’t need Fannie and Freddie.

This is important to understand because—as the Treasury conference showed—the debate over Fannie and Freddie, and whatever might succeed them, will be about two entirely different subjects. The first is what role the federal government ought to play in the financing of housing. The second is whether and to what extent the government should assist low-income borrowers to buy homes. If the two issues become intertwined, as they did in the case of Fannie and Freddie’s affordable housing “mission,” we will be back where we started—with one or more entities responsible for both, and another huge taxpayer bailout.

Geithner’s misstatement about the causes of the GSEs’ insolvency leaves open the possibility of continuing a government role for Fannie and Freddie. His implicit point is that if they are better regulated in the future they will not make the same mistakes. We should recognize, however, that if the residential mortgage market of the future consists of good quality mortgages—those with downpayments of 10 to 20 percent, from borrowers who have steady jobs and good credit—we don’t need Fannie and Freddie. They served their purpose years ago by standardizing mortgages and creating a national mortgage market. That market can now function without them, although as we work through the obstacles left by the financial crisis—in particular, a moribund securitization market—the transition from here to there will have to be slowly and carefully worked.

When in 1992 Congress dragooned Fannie and Freddie into lowering their underwriting standards, it confused the economic goal of creating a viable national mortgage market for good quality mortgages with the social policy of increasing home ownership by making mortgage credit available to low-income borrowers. The added benefit for Congress was that it could achieve the social goal without budgetary consequences; the operations of Fannie and Freddie were and still are off-budget.

Congress will be reluctant to abandon the idea of financing mortgages for low-income families off-budget.

That is not to say, of course, that achieving this social goal is illegitimate. There is much data to support the proposition that home ownership significantly benefits the housing stock, neighborhoods, and families. That was another theme in the Treasury’s conference. But we should recognize that this is a different question from whether there is a necessary government role in financing well-underwritten mortgages for people whose circumstances and creditworthiness already enable them to gain access to private mortgage credit.

There are risks in this social policy, to be sure, as shown by the enormous losses taxpayers will have to take on Fannie and Freddie. But if the American people want to keep this policy in place, there is an agency—the Federal Housing Administration (FHA)—that already has this purpose. The FHA is on-budget, so the taxpayers and their representatives in Congress can keep tabs on the costs it is running up. That is the honest way, without hiding the real costs by requiring profit-making entities like Fannie and Freddie, or insured banks, to cross-subsidize risks they would not otherwise willingly assume.

So the questions about how to structure housing finance in the future are not so hard if we keep our objectives straight. When the private securitization market revives, Fannie and Freddie can gradually be eased out of their secondary market role. This can be done by gradually reducing the size of the mortgages they are allowed to acquire. As this happens, the private market will take over financing in the areas Fannie and Freddie have left, just as the private securitization market effectively financed jumbo mortgages in the past. When Fannie and Freddie’s mortgage limit has been reduced to the level that the FHA insures, they can be liquidated or privatized, leaving a private market for well underwritten mortgages and a government insurer for those mortgages that can’t meet market tests.

Achieving this objective will not be easy. Advocates for government assistance to low-income families will deplore the loss of Fannie and Freddie’s largesse in this time of limited resources; Congress will be reluctant to abandon the idea of financing mortgages for low-income families off-budget; the housing industry will protest the loss of government backing for much of the housing finance market; and the huge government deficit will limit the appetite for expanding the FHA. These are the hard choices, to be sure, but they are practical and essential if we want to avoid repeating the costly mistakes we made with Fannie and Freddie.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

FURTHER READING: Wallison also describes “The Troubling Resolution Revolution” and the “New Plan, Old Fears” on bank bailouts. He offers “A Global Solution for Cross Border Financial Resolutions,” notes problems with financial reform regulations in “Missing the Point: Lessons from The Big Short,” and discussed housing policy in “Republicans and Obama’s New Deal.”

Image by Rob Green/Bergman Group.

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