5 Ways the Government Screws Up Housing Finance

For all the debate surrounding the causes of the financial crisis, one thing is for sure: the government made a huge mistake guaranteeing mortgage financing giants Fannie Mae and Freddie Mac. These big pseudo-private firms were exposed to a huge number of bad mortgages, for which taxpayers are stuck with a still-growing bill of $150 billion. Advocates for a government role in housing finance say that the government can learn from Fannie and Freddie and do a better job in the future. Skeptics disagree, saying that, by its nature, the government can't succeed in accurately pricing mortgage risk.

This is the contention by American Enterprise Institute scholars Peter J. Wallison, Edward Pinto, and Alex J. Pollock in a new paper on housing finance policy reform. It urges that government exit housing finance, except for a small, on-balance-sheet effort to help promote home ownership to lower- and middle-income Americans. It contends that the government doesn't have the ability to accurately price risk, and the private market does. Therefore, it should no longer guarantee the bulk of U.S. mortgages.

The paper provides three main reasons for why the government fails to accurately price risk.

Government Has the Wrong Incentives

The AEI scholars write:

Unlike an insurance company, the government has no profit incentive to price for risk, and because risk pricing can seem arbitrary and unrelated to current conditions, the government has many incentives to avoid the political controversy that risk pricing entails

For a business, profit is the ultimate goal. So if it wrongly prices risk, it will fail. But the government is the definition of too big to fail. If it loses money, it can just borrow more or raise taxes (for a while anyway). Instead, its incentive is to please voters. Unfortunately, voters tend to have short attention spans, so long-term risk is often ignored for short-term political gain.

Politics Get in the Way

Another problem is that the government would have to pick winners:

If the government actually attempted to set a price based on risk associated with any particular mortgage, it would be discriminating among its citizens, since some present greater risks than others; this would inevitably bring the risk-pricing project to a halt

Businesses don't run into this problem. They can pick winners based on economics. For example, if one borrower is a high-risk candidate for a mortgage, a private lender might deny the loan. But the government could have convenient political advantages for providing that borrower a mortgage, despite the risk.

The Government Has No Discipline

Can the government be trusted not to engage in counter-cyclical policy -- to collect money in good times in order to cover costs in bad times when losses occur? AEI doesn't think so:

Successful insurance systems require the buildup of substantial reserves during good times to pay claims during the inevitable bad times, but the government lacks the discipline and incentives to follow through. During the good times, the government comes under political pressure not to increase a reserve fund by continuing to collect fees or premiums.

It uses as an example the Federal Deposit Insurance Corporation. When the economy was humming it collected too few insurance premiums and was forced to raise the rate it charges banks for its insurance during the crisis -- at the worst possible time. AEI fears the same problem will continue to occur if the government tries to provide insurance for mortgages.

Presented by

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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