Seven steps needed to improve housing finance

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  • If we get Biblical sum of seven lean years, the housing and related debt markets will bottom in 2013--not a bad forecast

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  • It is high time to consider what steps we should be taking now to do things better in the next #housing cycle

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  • We've already experienced two expensive lessons on #housing. Here's how to avoid strike three:

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"Out of the river there came up seven cows, sleek and fat, and they grazed among the reeds. After them, seven other cows, ugly and gaunt, came up out of the Nile.... And the cows that were ugly and gaunt ate up the seven sleek, fat cows." - Genesis 41

This is of course Pharaoh's famous troubling dream, which Joseph correctly interpreted as meaning there would be seven good years followed by seven bad years -a dream highly relevant to 21st century housing finance.

The fat years of the housing bubble lasted from 1999 to 2006 - seven years. The bubble was deflating by the beginning of 2007 and collapsed into the panics of 2007-09. Since then we have been struggling in its deflated wake. If we get the Biblical sum of seven lean years, the housing and related debt markets will bottom in 2013 - not a bad forecast. This would be similar to the historical average duration of housing busts: six long years, as found by and Reinhart and Rogoff in This Time Is Different.

"As we are finally approaching the bottom, it is high time to consider what steps we should be taking now to do things better in the next cycle." -Alex PollockAs we are finally approaching the bottom, it is high time to consider what steps we should be taking now to do things better in the next cycle.

As we do, keep this in mind: "Pride goeth before destruction, and a haughty spirit before a fall." It is essential to remember that in the days of Fannie Mae's overweening pride and exceptionally haughty spirit, mortgage lenders and politicians alike were fearful of Fannie's hardball tactics. Their representatives and apologists used to frequently trumpet that "American housing finance is the envy of the world!" It really wasn't, as was displayed when Fannie and Freddie Mac had their fall. They lost all the combined aggregate profits they had made in the 35 years from 1971 to 2006, plus losses of another $150 billion or so.

It was also often claimed (by Americans) that the U.S. had the highest home ownership rate in the world. We didn't. We were on the low side of the middle of the pack: 17th out of 25 advanced economies in one international ranking.

So we need insistently to ask: in exchange for the massive government interventions and subsidies of housing and housing finance, what did we get? Well, we got two expensive lessons about the government's yearning to promote loans on housing. In recent times, the government-promoted American housing finance system has failed twice: first the saving and loan collapse of the 1980s, and then the Fannie and Freddie collapse in the new century. The former cost the taxpayers about $150 billion and the latter will cost some greater amount. That is two strikes. How can we avoid strike three?

Here are seven steps to take:

1. Not counting the taxpayers' investment, Fannie and Freddie are hopelessly insolvent. Even their previously most fervent supporters now admit that the "Government-Sponsored Enterprise" ("GSE") form was a failure. They should forthwith be put into receivership, with their common and non-government preferred stock wiped out and their boards removed. They would then formally be what they already substantively are: 100% Treasury-owned government housing corporations.

2. They should then be formally on the federal budget. This would be honest accounting and a strong incentive for Congress to proceed with further fundamental reform. It would be analogous to bringing a busted SIV onto the balance sheet of the sponsor, when the liability of the sponsor is obvious and indubitable.

3. Over the next five years, Fannie and Freddie should be divided into three parts. The first part should be a liquidating trust for the existing government-guaranteed debt and related mortgage assets. As these run off, their imbedded losses will consume the Treasury's preferred stock. The second part should be the intellectual property, systems, customer networks, human capital, and goodwill formed into two private companies and sent out into the world to compete. The final part should be the subsidy and non-market loan programs, which should be explicitly part of the government, merged into HUD and subject to normal Congressional oversight and disciplines.

4. We need to encourage credit risk retention by the originators of mortgages. This both creates the best alignment of incentives and takes advantage of the maximum amount of knowledge about the loans, since they are themselves the lenders. This should be a profit-making business of pure credit risk management by the originators, at which they have a natural competitive advantage. Regulations and accounting rules should be made to facilitate this superior credit structure.

5. We should set a formal goal of creating a private secondary market for prime, middle class mortgages. The U.S. has not had this before, because of the government-sponsored duopoly given to Fannie and Freddie. Creating a U.S. covered bond market would be part of this project.

6. We need to rediscover savings as an explicit goal of housing finance, including stressing the old and true idea that you want to pay off the mortgage loan over time, so you end up the real free-and-clear owner of the property.

7. We should inject countercyclical factors into housing finance, instead of the current procyclical ones. These should include: loan-to-value ratios which fall as house prices escalate rapidly over their trend; and the establishment of much bigger loan loss reserves in good times, while the fat cows are still grazing, to get ready for when the lean cows arrive, as they always do.

None of this is easy, but it's definitely worth a try.

Alex J. Pollock is a resident fellow at AEI.

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