March 14, 2014 | Commentary on Economy, Financial Regulation

Housing Market Doesn't Need Government To Do Its Job

When Fannie Mae and Freddie Mac went into federal conservatorship in 2008, industry lobbyists leapt to save government guarantees in the housing finance markets.

The National Association of Realtors was particularly ardent, insisting the 30-year fixed-rate mortgage would disappear without government backing.

Put aside the question of whether public policy should favor any specific mortgage product. Does the housing finance market really need government guarantees to function well?

History suggests it doesn't. At least two major housing booms flourished long before "government sponsored enterprise" (GSE) entered the housing lexicon.

During the 1920s, U.S. homeownership increased more than during the previous 30 years. After the Great Depression, housing took off again. The homeownership rate increased from 44% in 1940 to 62% in 1960.

Fannie Mae and the Federal Housing Authority existed during this second boom, as did the Department of Veterans Affairs for part of that period.

But they were mere bit players. As late as 1968, the year that Fannie officially became a GSE, all government-backed mortgages never accounted for more than 6% of the market in any year. At those levels, it's hard to say the market wouldn't have functioned without government backing.

Government backing in general, and Fannie and Freddie in particular, continued playing a relatively minor role in the market until the S&Ls crashed in the 1990s. Within a fairly short period of time, the GSEs — with their line of credit at the U.S. Treasury (among other advantages) — began to dominate the market.

From 1990 to 2003, Fannie and Freddie went from holding 5% of the nation's mortgages to more than 20%. Of all the mortgages originated in the last three years of that period, the GSEs funded almost 70%.

Their dominance is even more pronounced if we count all the mortgage-backed bonds in the economy. Indeed, the year after the GSEs went into federal conservatorship in 2009, they still issued and backed 71% of all mortgage-backed bonds. Throw the Federal Housing Administration into the mix and the government backed nearly 97% of the U.S. mortgage market in 2009.

Few outside the financial and real estate industry fully grasp the role Fannie Mae and Freddie Mac play in our economy.

For over two decades, federal policies have encouraged consumers to take on more and more housing debt — and induced private lenders to give it to them by reducing their risk of loss.

The GSEs and their beneficiaries tout these policies as encouraging home ownership for everyone, but all the GSE system actually encourages is mortgage ownership. That is, it encourages borrowing large sums of money — an act that is inherently risky for both lenders and borrowers, especially over long periods of time.

So the government's solution was to socialize the costs of that risk. But that doesn't make the risk disappear; it merely shifts it to taxpayers. That's the core of the GSE model and it's what brought the system down.

Rather than let banks hold loans for 30 years, Fannie Mae bought the banks' mortgages, then packaged them into securities.

These were then sold on Wall Street, under the pretense that this was getting investors to share in the risk.

A nifty arrangement, but the same total risk was always present, and even though it appeared diffused it was always the taxpayers who bore the ultimate liability.

Everyone in these markets knew the government would step in if there was trouble, and that's exactly what happened.

Taxpayers are the ultimate "fall guys" under this system.

But the scheme has bred three large interest groups who, predictably, are lobbying hard to revive some form of the GSE system.

Banks loved the GSE model because they could earn fees for processing mortgages and then offload the risk. Realtors liked the process because it made banks want to sell more mortgages. (Collecting more fees with virtually no risk is a pretty good business model.)

And then there's Wall Street. Investment bankers and traders eagerly participated because the GSE system let them buy and sell billions in securities that featured the same government backing as U.S. Treasuries but with higher payoffs.

All of these groups still want their government guarantees, so they promote the notion that these pledges are necessary for widespread homeownership.

But government backing isn't necessary, and it hasn't led to pervasive homeownership, only to near-universal mortgage ownership.

After the 2008 financial crisis, the U.S. homeownership rate settled at 65%. This is essentially the same as the rate was in the mid-1990s — before the great GSE expansion.

It's also basically the same as in 1968, when Fannie Mae became a GSE.

But while ownership rates didn't increase, mortgage debt did. Adjusted for inflation, mortgage debt increased nearly sixfold, from about $1.8 trillion in 1968 to roughly $10 trillion in 2013.

Compare those figures to the post-World War II era.

From 1950 to 1968, the homeownership rate climbed from 55% to 64%, yet debt on the same class of single-family homes increased just fourfold. During that period, the U.S. government — through all of its agencies — never backed more than 6% of all mortgages in any year, yet the homeownership rate soared while the rate of the debt increase was only about two-thirds that of the GSE period.

GSE reform pits a large "at risk" population — U.S. taxpayers — against some very powerful vested interests. But policies that socialize the costs of debt while letting the profits remain largely private always end badly.

 - Michel is a research fellow in the Heritage Foundation's Thomas A. Roe Institute for Economic Policy Studies

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Originally appeared in Investor's Business Daily