Housing Finance Needs Clean Break from Government Subsidy

It is no accident that doomed housing finance systems developed throughout history produce great results before failing. The government's grand designs on how to finance mortgages don't have much to show for its supposedly good ideas. And this is why the current focus on what to do about Fannie Mae and Freddie Mac is misdirected.

The current U.S. homeownership rate of about 63% is no higher than when it was previously achieved a half-century ago by a private savings and loan industry, before there was a Department of Housing and Urban Development. The thrift industry largely failed in the 1980s, replaced by the rise of government-sponsored enterprises Fannie and Freddie that produced record homeownership, before they too failed almost a decade ago and were placed in government conservatorships. While producing questionable homeownership gains, GSE dominance of the housing market is even more unprecedented. They fund about 90% of all mortgages — what The Economist recently labeled a de facto nationalization.

These systems and others like them have certain things in common. The U.S. financial system is, as Stephen Haber and Charles Calomiris described in their 2014 book "Fragile by Design." This is due to populist political measures sometimes benefiting borrowers, sometimes savers, but always politicians. Speaking to banking and thrift industry audiences in the 1970s, Preston Martin, a onetime chairman of the Federal Home Loan Bank Board and vice chairman of the Federal Reserve Board, used to tell a joke in which the ironic punchline always brought the house down: "I'm from the federal government and I'm here to help you."

At the heart of the failings of our government-backed housing systems is a political impulse to protect individual consumers and firms from failure — an impulse that is the primary cause of systemic failure. Federally sponsored enterprises require as justification a public mission inherently subject to populist political tinkering while at the same time are intrinsically too big to fail. That is a potentially lethal combination when tilted too heavily toward borrowers.

Federal chartering and deposit insurance for the savings and loan industry led to the perverse mandate of funding fixed-rate mortgages with short-term deposits to which the industry succumbed by the 1980s. But this failure didn't pose a systemic threat to the entire financial system. The subsequent shift of mortgage-related political risk to federally insured TBTF commercial banks in the form of Community Reinvestment Act requirements led to $4 trillion in commitments. That spread systemic risk to the real economy.

It was the combination of political risk in both banks, and with Fannie and Freddie, that made the crisis globally systemic. While markets would have shorted bank stocks early on, limiting their funding capacity, the ability of Fannie and Freddie to continuously borrow at or close to the Treasury's cost of funds regardless of risk or solvency kept the bubble inflating to systemic proportions. The ensuing bailout reinflated the house price bubble and led to numerous negative repercussions.

Yet it is clear policymakers still haven't learned their lesson about the consequences of a government-backed housing scheme. At times, they have appeared to be headed in the right direction. A 2011 paper released by the Obama administration outlined reform options that all envisioned phasing out and Fannie and Freddie. But the White House and other politicians continue to believe that some alternative federally sponsored facility remains necessary.

This is the case with legislative proposals to create a reinsurance agency to back private-market risk. The proposal by Jim Parrott, Lewis Ranieri, Gene Sperling, Mark Zandi and Barry Zigas — titled "A More Promising Road to GSE Reform" — represents an attempt to carefully craft an enterprise to consolidate catastrophic risk, securitzation and a "public mission" into a new privately capitalized government monopoly. Its corporate structure would be reminiscent of the pre-privatized Freddie Mac.

Fannie and Freddie, and the kind of securitization outlined in this recent proposal, are both anachronistic, politically expedient exemptions from since-repealed laws and regulations. They inhibit the emergence of a private mortgage market. Bank-issued covered bonds are the least risky way to tap the limited supply of capital market funds.

And the proposed seemingly innocuous public mission for the National Mortgage Reinsurance Corp. — envisioned by the "Promising Road" plan — "that broad access to sustainable mortgage credit for creditworthy borrowers is available in all communities in all economic conditions; provides equal access to the secondary market for lenders of all sizes; and minimizes taxpayer risk" is unnecessary and exposes the insurer to future populist political pressure.

A half century ago, home mortgages were almost entirely funded with household savings. But household savings plummeted from around 10-12% during the 1960s and 1970s to about 2% for the last decade, even as household debt levels doubled with implicit government guarantees that facilitated low or no down payments. That is never a good idea and is also no longer an option as direct Treasury borrowing already exceeds foreign demand and will for the foreseeable future. One alternative approach would be to consider bank-managed investment accounts — like an IRA — for the purpose of helping borrowers save for their down payment.

So let's stop subsidizing consumption. The current populist political promise — easy access to cheap government backed credit and painless default — is delusional and destructive, as any potential benefits no longer warrant the systemic risks.

Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He is the author of the book "Occupy Pennsylvania Avenue: How Politicians Caused the Financial Crisis and Why their Reforms Failed."