Obama’s next housing boom and bust

WhiteHouse.gov

President Obama speaks at Desert Vista High School in Phoenix, Ariz., Aug. 6, 2013, on his plan to promote government mortgage guarantees for homeowners while eliminating Fannie Mae and Freddie Mac.

Article Highlights

  • When low-quality mortgages made #Fannie and #Freddie insolvent, investors were paid. Taxpayers were handed the bill

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  • Under new finance formulas, there will be a huge housing bubble, and when it deflates, there will be a crash

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  • The only way to end the bubble-crash cycle is to get the government out of the business of housing finance

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It would be funny if it weren’t so serious. The president has proposed to eliminate Fannie Mae and Freddie Mac, while at the same time proposing to put in place the same policies that caused the two government-sponsored enterprises to fail.

At some point, we have to choose. Either we will have a government-controlled market or a private market. The president says he wants the government to have a limited role — mostly, it appears, providing what he called “catastrophic guarantees.”

Even if you’re the president, you can’t square the circle. Once the government is providing catastrophic guarantees, it means that the investors who buy mortgages or mortgage-backed securities will be protected against loss. Either they will be paid by the private sector, or they will be paid by the government’s catastrophic guarantee. That means they won’t be interested in whether the mortgages are good quality: Even if they’re not, these investors will be paid.

"Once the government is providing catastrophic guarantees, it means that the investors who buy mortgages or mortgage-backed securities will be protected against loss. That means they won’t be interested in whether the mortgages are good quality." -- Peter Wallison

That’s where we started with Fannie and Freddie. They were known to be backed by the government, so investors didn’t care whether the mortgages they acquired were safe and sound. Investors knew this didn’t matter, since the government would bail them out. When low-quality mortgages made Fannie and Freddie insolvent, sure enough, all the investors in their mortgage-backed securities were paid. The taxpayers were handed the bill.

Now, the White House fact sheet goes on to explain that private capital would take most of the burden, to protect the taxpayers. However, if the private sector is going to take most of the burden, it will want to be sure that the mortgages are of good quality, made to people with good credit records, who can make solid down payments and will not be stretched financially after they have assumed the obligation of the mortgage.

Once again, the issue is the quality of the mortgages. We have now established that because of the government’s catastrophic guarantees, the holders of the mortgages or the mortgage-backed securities will not care whether the mortgage is of good quality. So, if the private sector is going to take responsibility in some way for the quality of the mortgages, how will it do that?

The obvious way is to charge for the risks that the mortgage creates. In other words, if the borrower does not have a good credit score or a down payment, the mortgage would cost more. But here’s where the scheme runs into trouble. The data shows that if a mortgage is not a prime mortgage — that is, if the borrower doesn’t have a good credit score or a down payment, or both, those mortgages have high rates of default. That’s what put Fannie and Freddie under. Some of the mortgages they were buying had rates of delinquency between 13 percent and 17 percent. To protect against that, the private sector will have to do one of two things: refuse to make those mortgages or impose hefty finance charges.

Congress is not likely to stand idly by while a mortgage system that the government is backing is turning down low-income borrowers — the very people who frequently have low credit scores and cannot afford substantial down payments. So Congress will come up with a way to make sure that as many people as possible have access to this government program.

With Fannie and Freddie, it was easy. Since they were chartered by the government, Congress simply ordered them to buy unsound loans. The deal was simple. If you acquire these subprime loans, we (Congress) will continue to allow you and your managements to profit from the low-cost funds you are getting as government-backed firms. For almost 10 years, that was a good deal for Fannie and Freddie — until the government’s increasing demands made them insolvent.

What will happen in this case? Congress can’t force the private sector to back unsound loans unless they can charge high rates, and Congress won’t stand for either the high rates or for turning down loans to people Congress wants to help.

So Congress will do what it always does — find a way to subsidize the private sector to take the risks or reduce its own insurance charges so the government isn’t getting adequate compensation for its catastrophic guarantee.

Then what happens is exactly what happened with Fannie and Freddie: A large number of low-quality mortgages will be made, because now the government has found a way to pay for them.

There will be a huge housing bubble, and when it deflates, there will be a crash. Many families will lose their homes, a recession will cost many people their jobs and once again, the taxpayers will be handed the bill.

The only way to end this cycle is to get the government out of the business of housing finance.

Peter J. Wallison is a senior fellow at the American Enterprise Institute.

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