Proposal for US housing reform

Article Highlights

  • The Dodd-Frank Act imposed new, costly and growth-inhibiting regulations on the entire financial system, failing to reform the US government's housing policies.

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  • US government housing policies fostered the creation of 28 million subprime and otherwise weak loans by 2008.

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  • We must now concentrate on reforming the U.S. housing finance system.

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Chairman Johnson, Ranking Member Crapo, and members of the Committee.

Thank you for the invitation to testify before the Committee today, and to discuss the future of the US housing finance system.

Many have pointed out that the Dodd-Frank Act ignored the fundamental causes of the financial crisis it was supposed to address. They note that the act imposed new, costly and growth inhibiting regulations on the entire financial system, but it failed to reform the U.S. government’s housing policies. These fostered the creation of 28 million subprime and otherwise weak loans by 2008 and the development of a massive housing bubble between 1997and 2007. When the bubble began to deflate, weak and high risk loans began to default in unprecedented numbers, driving down housing values and weakening financial institutions in the U.S. and around the world. 

In this testimony, I will outline the major provisions of a proposal for housing finance reform that I and two AEI colleagues, Alex Pollock and Edward Pinto, developed in response to a white paper issued by the Obama administration in February 2011.  Although no specific action was ever proposed by the administration, the administration white paper advanced three options for housing finance reform. One of those options was what I would call a completely free market system. The proposal I will describe today was embodied in a much longer paper, entitled “Taking the Government Out of Housing Finance: Principles for Reforming the Housing Finance Market,” that we issued in March 2011. That paper was intended to fill out the free market option that the administration had proposed and respond to questions raised in its white paper. I respectfully request that the complete proposal I will summarize today be included with the records of this hearing.

Our proposal is based on four principles that we believe should be the foundation of U.S. housing policy in the future. If these principles had been in place for the last 20 years, we would not have had a financial crisis in 2008. But that is water over the dam. We must now concentrate on reforming the U.S. housing finance system so that we do not face another housing-induced crisis in the future. 

The four principles are the following:

I.    The housing finance market—like other US industries and housing finance systems in most other developed countries—can and should function without any direct government financial support.

Under this principle, we note that the huge losses associated with the S&Ls and Fannie and Freddie—as well as the repetitive volatility of the housing business—did not come about in spite of government support for housing finance but because of government backing. Government involvement not only creates moral hazard but sets in motion political pressures for further and more destructive actions to bring benefits such as “affordable housing” to constituent groups. 

Although many new ideas for government involvement in housing finance are being circulated in Washington, they are not fundamentally different from the policies that have caused the losses already suffered by the taxpayers, as well as the losses still to be recognized through Fannie and Freddie.

The fundamental flaw in all these ideas is that the government can establish a risk-based price for its guarantees or other support. Many examples show that this is beyond the capacity of government, and is in any case politically infeasible. The problem is not solved by limiting the government’s risks to mortgage-backed securities (MBS); the fact of the government’s guarantee eliminates an essential element of market discipline in this case—investors’ risk-aversion—so that the outcome will be the same: underwriting standards will deteriorate, regulation of issuers will fail, and taxpayers will take losses once again.

II.    To the extent that regulation is necessary, it should be focused on assuring mortgage quality.

This principle is based on the idea that high quality mortgages are good investments and have a history of minimal losses. Instead of relying on a government guarantee to assure investors as to the quality of mortgages or MBS, we should simply make sure that the mortgages made in the U.S. are predominantly prime mortgages.  We know what is necessary to produce a prime mortgage; these are outlined in our proposal. Before the affordable housing requirements were imposed on Fannie and Freddie in 1992, these were the standards that kept losses in the mortgage markets at minimal levels.

Experience has shown that some regulation of credit quality is necessary to prevent the deterioration in underwriting standards. The natural human tendency to believe that good times will continue—and “this time is different”—will always spawn bubbles in housing as in other assets. Bubbles in turn spawn subprime and other risky lending, as most participants in the housing market come to believe that housing prices will continue to rise, making good loans out of weak ones. Bubbles and the losses suffered when they deflate can be minimized by interrupting this process—by inhibiting through appropriate regulation the creation of weak and risky mortgages.

III.    All programs for assisting low income families to become homeowners should be on-budget and should limit risks to both homeowners and taxpayers.

Our proposal recognizes that there is an important place for social policies that assist low income families to become homeowners. But these policies must balance the interest in low-income lending against the risks to borrowers themselves and the interests of the taxpayers. In the past, affordable housing and similar policies have sought to produce certain outcomes—for example, an increase in home ownership—without concern for how this goal would be achieved. The quality of the mortgages made under social policies can be lower than prime quality—the taxpayers may take risks for the purpose of attaining some social goods—but there must be limits placed on riskier lending in order to keep taxpayer losses within boundaries set by Congress and included in the budget.

IV.    Fannie Mae and Freddie Mac should be eliminated as GSEs over time.

Finally, Fannie and Freddie should be eliminated as GSEs and privatized—but gradually, so that the private sector can take on more and more of the secondary market as the GSEs depart. The gradual withdrawal of the GSEs from the housing finance market should be accomplished by reducing the GSEs’ conforming loan limits by 20 percent each year, according to a published schedule embodied in statute so that the private sector knows what to expect. These reductions would apply to the conforming loans limits for both regular and the high cost areas. Banks, S&Ls, insurance companies, pension funds and other portfolio lenders will be supplemented by private securitization, but Congress should make sure that it doesn’t foreclose opportunities for other systems, such as covered bonds.

These principles are the underpinning of a plan that assumes that housing, like virtually every other sector of the US economy, can and should be privately financed, and that the private market will produce a low-cost and stable system for financing homes.



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