Pros and Cons of the Treasury's Housing Finance Options

Now that we finally have the much-anticipated housing policy plan authored by the Obama administration, we can begin to evaluate the options it provides. Most of the report (.pdf) is fairly uncontroversial. It explains problems with the government-sponsored entities Fannie Mae and Freddie Mac that we have known about for years now. It provides straightforward ideas for making the housing market safer, like requiring higher down payments. There really isn't a whole lot of room for debate until you get to the end of the report -- when the Treasury lays out three options for the future of housing finance policy. What are their pros and cons?

As explained earlier, all three plans would provide government support for affordable housing initiatives through programs within the Federal Housing Authority, USDA, and Veterans' Affairs. So the following options would affect the other 85% or so of mortgages. In what follows, I'll briefly explain the three options, and then lay out several of the potential pros and cons of each plan.

Option 1: Go Private

The first option provides a truly private framework. There would be no government guarantees or other support in place for mortgage financing. It would be entirely up to the market to step in and take on all mortgage risk.

Potential Pros

  • The taxpayer has no exposure to the market.
  • Since the government won't be standing behind mortgages, moral hazard should be limited. That should make for less severe housing bubbles, if any. 
  • The potential for losses should prevent overinvestment in residential real estate and provide more investment for other sectors of the economy instead.

Potential Cons

  • It's unclear if banks and investors alone will be willing to support as robust a mortgage market as the U.S. has enjoyed over the past few decades.
  • The availability of the 30-year fixed mortgage may decline. For some, it will be replaced by adjustable rate products. 
  • Mortgage interest rates will rise, possibly by as much as or more than 100 basis points. 
  • If the government hasn't solved the "too big to fail problem," then a housing market downturn could wreck the economy again and bailouts would ensue. 
  • Home ownership levels may decline. 
  • In times when poor economic conditions cause a credit crunch, mortgage funding may be difficult to get.

Option 2: Crisis Funding Mechanism

Here, the government will offer mortgage guarantees, but the premiums will be so expensive that they won't be competitive with the private market in normal times. But at times when the housing market struggles and private sources of credit dry up, then the infrastructure will be in place for the government to continue to provide guarantees. That will make funding easier to get in a credit crunch, while private mortgage guarantors will likely be sitting on the sidelines.

Potential Pros

  • The private market will be responsible for mortgage risk under normal circumstances, protecting taxpayers.
  • Moral hazard should be limited during those times, since the government guarantees will be rarely used, which should prevent severe housing bubbles. 
  • Again, overinvestment in residential real estate should be avoided.
  • When a poor economy threatens credit, the government guarantee option can ensure that mortgages keep flowing.

Potential Cons

  • Again, it's unclear if the private market will support as robust a mortgage market in normal times.
  • Again, the availability of the 30-year fixed rate mortgage will decline. 
  • Again, mortgage interest rates will rise. 
  • Again, bailouts could ensue if banks and investors' mortgage-related losses threaten the economy. 
  • Again, homeownership levels may decline.
  • If banks find a way to game the system, then they can use the expensive government guarantees for only the very risky mortgages, threatening taxpayers.

Option 3: The Catastrophic Guarantee

Through this proposal, the government would provide a backstop to some, probably large, universe of mortgages through reinsurance for private mortgage guarantors. Banks, investors, or whoever else hold mortgages as assets would endure some first loss when mortgages lose value. The government would then absorb any additional loss. That loss would theoretically be paid for by the government dipping into an insurance fund, which will be created by the reinsurance premiums it charges to the mortgage guarantors, similar to deposit insurance.

Potential Pros

  • The government's catastrophic guarantee should keep mortgage funding moving in times of poor credit conditions.
  • The private market won't have to bear the full burden of mortgage losses, so the mortgage market won't be as resistant to this change.
  • The availability of the 30-year fixed rate mortgage will still likely decline a little, but not by as much as it would in the other two scenarios. 
  • Mortgage interest rates would rise a small amount, probably less than 50 basis points -- which is a smaller rise than what's expected in both of the other two options. 
  • Homeownership levels will still likely decline, but again by a smaller amount than in either of the other two options.

Potential Cons

  • Taxpayers may escape mortgage losses if the government manages to price the reinsurance it offers accurately. But if the government doesn't charge enough, Fannie/Freddie style losses could again occur.
  • Overinvestment could potentially flow to real estate, since investors wouldn't have to worry about very severe losses. 
  • Moral hazard may be somewhat limited, since mortgage holders will sustain the first loss. But those banks and investors might still take undue risk if there is a larger profit to be gained then their potential loss through a severe stress scenario where the government steps in.

It's important not to interpret the above lists in a purely quantitative fashion. Some of the potential pros are much more significant than the potential cons, or vice versa. There's also some subjectivity involved in the list. Although most people likely view fewer 30-year fixed-rate mortgages as a con, others may argue that the product isn't perfect and Americans will learn to live with other products instead without much trouble.

Ultimately, these plans should be evaluated with a mix of philosophy and practicality. If you believe that taxpayers simply shouldn't be allowed to potentially be on the hook for mortgage-related losses, and you believe that the government simply can't accurately price guarantees, then all the pros in the world for option #3 probably won't convince you of its merit. Similarly, if you see no problem with the government maintaining a limited role in the housing market when that means a small potential loss to taxpayers but more mortgage availability, then you probably think the cons of option #1 are far too great. These are the sorts of issues that will be debated in the months, and possibly years, to come.