In a year when voters are demanding a reduced government role in the economy, it is remarkable that most of the ideas for supplanting Fannie Mae and Freddie Mac are just ways to keep government in the business of housing finance. Treasury Secretary Timothy F. Geithner has already signaled that the government will continue to have a role.
This is astonishing. One would think that something might have been learned from the spectacular failure of the savings and loan industry (S&Ls) and the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. It cost $150 billion to clean up the first and may cost more than $400 billion to resolve the second.
Old arguments are being trotted out: without government support there can't be a 30-year fixed-rate mortgage; interest rates in a nongovernmental system will make homes unaffordable; and inevitable disruptions in the credit markets may put a crimp in housing finance.
These bugaboos are myths. A Google search reveals offers of 30-year fixed-rate jumbo mortgages — loans too large to be bought by the GSEs and provided by private lenders without government support. Studies by Federal Reserve economists in 2006 found no significant reduction in mortgage rates because of Fannie and Freddie's low-cost funding.
As for market disruptions, insulating housing from financial downdrafts would be bad policy; it would eliminate incentives to be cautious in borrowing and investing and encourage the growth of bubbles. The recent financial crisis affected securities backed by prime jumbo mortgages in the same way it affected other high quality asset-backed securities like credit cards or car loans: a sharp drop followed by a gradual recovery.
The major losses on mortgage securities occurred among those backed by subprime and other nontraditional loans, and the widespread failure of these weak loans caused a housing price collapse.
If our mortgage system were used only for conventional prime mortgages — those with 10 percent minimum down payment to borrowers with good credit — there would be no need for government support. In the housing bubble that ended in 1979, when most loans were traditional mortgages, foreclosures peaked at just 0.87 percent.
In the next bubble, which ended in 1992 and primarily involved traditional financing, foreclosures reached 1.32 percent.
But after 1992, when government policy encouraged the creation of 27 million subprime and other nontraditional loans — half of all mortgages — that result became destructive. When this bubble deflated in 2007, foreclosures jumped to a record 5.37 percent in 2009.
The lesson is that where mortgages are of good quality, the deflation of bubbles will not cause a serious financial disruption — certainly not enough to warrant continuous government involvement in housing. But policy that degrades loan quality will eventually cause devastation in the housing market.
This leads to several conclusions:
Government involvement in housing finance invites disaster. As illustrated by the S&Ls and GSEs, government support hides real risks.
Arguments for government involvement are unpersuasive. The vast majority of our economy functions successfully without direct government support.
As long as the mortgage system creates high-quality assets, changes in credit availability can be handled without difficulty.
When Congress weighs alternatives to the GSEs, it should start with a fully private system.
The George W. Bush administration proposed a covered bond system: banks would issue debt backed by a pool of mortgages that they hold on their balance sheets but are separate from other assets. This has worked well in Europe. A House committee recently sent a bill to the floor that would create such a system.
The Danish housing finance system is also worth considering. Homeowners can buy back all or part of their mortgage debt at a discount when interest rates rise and they can refinance when rates fall. Only mortgages with loan-to-value ratios of 80 percent or lower are allowed into the system, a major reason for its long-term success.
A third option is securitization, which has provided low cost asset-backed financing for more than 30 years. While the GSEs are still in a government conservatorship, a transition to a fully private securitization system shouldn't be difficult.
As private investors return to the securitization market, government can limit the mortgages that Fannie Mae and Freddie Mac acquire. We can observe whether the market is supplying all the needed credit and stop the process if it isn't.
The important point is that the housing market will finally return to parity with other financial markets and cease to be a ward of the state.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. E-mail: [email protected].