The 2010 Dodd-Frank Act was sold as a reform bill that would reduce risk in financial markets, yet it barely touched the single biggest source of that risk: the government-sponsored enterprises Fannie Mae and Freddie Mac.
Several GSE reform proposals have since surfaced in Congress, but those that have garnered the most political support still would perpetuate the old GSE system. In particular, key financial and housing industry representatives have supported bipartisan Senate proposals that would convert implicit taxpayer backing to explicit government guarantees.
As economist and investment genius Fischer Black pointed out almost two decades ago, the source of systemic risk in financial markets is the government. Seeking to mitigate risk, investors pressure Washington to take some of it off their hands. When lawmakers comply, taxpayers wind up shouldering systemic risk. Exhibit A: the U.S. mortgage market.
As Black noted, mortgages can be structured so that both interest and principal allocations vary, but monthly payments remain constant. This type of mortgage presents much less financial risk to either borrower or lender than, say, the 30-year fixed rate mortgages that now dominate the U.S. market. The downside is that it lowers the chance for a substantial buildup in equity.
Borrowers would have absolute certainty regarding their monthly housing costs, but it’s less likely they could sell their homes for fat profits a few years down the road.
But, as real estate and financial industry lobbyists point out, people like to purchase homes as investments. They want to take the chance that their home prices will rise, giving them a windfall.
That’s fine. But treating a home purchase like this makes it a speculative activity — one that generates financial risk. Which is why borrowers and lenders are so keen to shift the risks to taxpayers.
Government-sponsored enterprises also try to spread the risk by repackaging mortgages they’ve bought from banks and selling them off as mortgage-backed securities, with guaranteed interest and principal payments.
But that risk still exists, and if Fannie or Freddie gets into trouble, it’s the federal government that has to make good on those mortgage-backed security guarantees. In 2008, that was exactly what happened. The government-sponsored enterprises couldn’t meet their obligations, so taxpayers started doing it for them.
Housing lobbyists claim these guarantees are necessary to expand homeownership. They are wrong.
The U.S. experienced at least two major U.S. housing booms long before anyone ever uttered the term “GSE.” During the 1920s, homeownership increased more than during the previous three decades. After the Great Depression, the homeownership rate soared from 44 percent of households in 1940 to 62 percent in 1960.
Fannie Mae, the Federal Housing Authority, and the Department of Veterans Affairs were mere bit players in this second boom. As late as 1968, when Fannie officially became a government-sponsored enterprise, all government-backed mortgages had never accounted for more than 6 percent of the market in any year.
Yet in 1968, the homeownership rate stood at 65 percent — the same as it is now, when government-sponsored enterprises completely dominate the market.
Originally appeared in The Washington Times