When the Government Can Interfere in Housing Finance

As the housing policy debate heats up this year, there will be two relatively clearly delineated sides. Those who think the government's presence in the mortgage market is a good idea will fight to keep a federal guarantee in place for most mortgages. Those who prefer a free-market approach will assert that the government should exit the industry. Libertarian-leaning think tank American Enterprise Institute (AEI) is likely to be one of the loudest voices in that latter group. It published a policy paper (.pdf) on housing finance on Thursday. You might be surprised to learn, however, that it does allow for the government to have some presence in the housing market.

Of course, AEI generally wants to do away with government guarantees. So most of the paper predictably advocates for less government. It offers four main principles that it says should be followed:

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

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

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

IV. Fannie Mae and Freddie Mac should be eliminated as government-sponsored enterprises (GSEs) over time.

Its first section is probably the paper's most important; it argues that the mortgage market can survive without a government backstop. To support this claim, it provides evidence from studies and examples of nations with successful mortgage markets that lack government guarantees. But in its second section, AEI begins to explains some ways that the government can still play a role in housing.

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Promote Quality, Not Quantity

Up to now, government housing policy has focused on expanding the quantity of mortgages, largely ignoring quality concerns. The desire to expand home ownership through Fannie and Freddie went too far, and is partially responsible for the severity of the housing bubble and the crisis that followed. Instead, AEI thinks the government should be in the business of encouraging better quality mortgages.

It offers a couple of different ways to do this. Some of these proposals would serve to strictly define and expand the percentage of prime loans in the market, while minimizing non-prime loans. For example, the paper suggests forbidding securitization of non-prime loans, essentially saving investors from themselves.

One of the most interesting concepts in this section is to promote countercyclical policies. For example, banks' loan loss reserves should be increased during times of easy credit and economy prosperity. Then, if a bubble is forming, those institutions will be better able to withstand the market's coming hiccup.

Protecting Consumers Protects the Economy

Something that shouldn't conflict is consumer protection and economic stability. Yet conservatives worry that the newly formed Consumer Financial Protection Bureau will expand credit to unsafe levels in an effort to promote fairness, which could harm economic stability. After all, too much credit is one of the main reasons why the recent recession was so severe.

One part of the AEI paper shows that consumer protection and economic stability can coincide, however. It includes the following proposed simple, one-page mortgage disclosure to ensure that borrowers understand what they're getting themselves into (click to enlarge to full size):

AEI mortgage disclosure 2011.png

This disclosure does seem pretty straightforward. Considering that the newly formed Consumer Bureau is actively working to create such a disclosure, perhaps it should take note. Not only would such a disclosure better prepare borrowers for their loan, but by ensuring that they understand what they'll owe, there's a lower likelihood that they will have trouble paying their mortgage in the future.

The FHA Is Okay

Finally, AEI even says that there is a circumstance when it's okay if the government is involved in guaranteeing mortgages -- when doing so is clearly geared towards assisting low-income families to broaden homeownership. This is essentially the sort of thing that the Federal Housing Authority (FHA) has been doing successfully for many years through its low-income homeownership initiatives.

AEI does find some need for reform within the FHA's underwriting practices, but the think tank acknowledges that there might be some inescapable political need to provide some support for such initiatives. If the government does decide to do so, however, the program needs to be on budget, so any subsidies can be easily accounted for. It also needs to limit these initiatives to only Americans who can't get loans in the private market, which probably makes it exclusive to low income applicants with relatively prime credit.

In general, the AEI paper is pretty reasonable. There are only a few places where it gets a little extreme -- like its unrealistic timeline for winding down Fannie and Freddie in just five years. But perhaps even that proposal is meant to serve as a bargaining chip. Then, when progressive groups demand 15-20 years, they can meet somewhere in the middle at 10 to 12 years. Stay tuned for the Treasury's proposal, which is expected to be released in a few weeks. It will likely call for a much broader role for the government in housing policy, but as the examples above show, there might be some aspects of easy compromise.