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.

In addition to these three reasons why AEI worries about government interference in the mortgage market, there are at least two others that they do not mention.

The Government Can't Keep Up With Innovation

There have been two housing-related bailouts in the last thirty years. In the late 1980s and early 1990s, the government had to bail out the Federal Savings and Loan Insurance Corporation, which cost taxpayers approximately $124 billion. More recently, of course, there was the bailout of Fannie and Freddie, with an even higher price tag.

These situations share a commonality: the financial industry was engaging in new techniques to profit from the housing market, and the government was behind the curve in realizing that the guarantees it provided would result in massive losses. This is mostly because the regulators who oversee such quasi-private corporations do not attract the right talent to see these problems arise.

Government regulators could raise salaries to be competitive with Wall Street -- but do we really want government employees earning huge salaries to regulate? Instead, it would be better to eliminate the moral hazard that government guarantees provide, and to allow firms to fail that engage in such shenanigans.

Future Losses Become Somebody Else's Problem

A very common problem in governments occurs when politicians satisfy constituents today at the cost of future generations. This problem describes the pension underfunding problems that a number of states are currently experiencing. But it also applies to government guarantees.

You can see this if you look back to Fannie and Freddie, in particular. Politicians encouraged them to broaden home ownership and never really worried about if the firms' underwriting was criteria deteriorating. Many likely focused on what was going well presently, without much concern about the future. After all, they may be out of office by the time the bubble popped anyway.

There are a number of factors that get in the way of the government supporting a market. In some cases, like depository insurance, it can be argued that there's an economic problem that forces a role for government. In that case, panic can cause bank failures can cascade into bank runs, and private insurers might not convince the public that their money is really safe, since they can fail.

But the mortgage market isn't as vital to all Americans as their bank deposits. After all, only relatively affluent people can afford to own a home, so the government guaranteeing mortgages amounts to a regressive program, where all Americans subsidize home ownership for the wealthier ones through cheap guarantees. In order for the government to back a market, it should be able to justify potential taxpayer losses to support a broad public good that would otherwise be lost due to an economic problem. That doesn't appear to be the case for mortgages.