The Fatal Conceit of the Government Mortgage Complex

COMMENTARY Housing

The Fatal Conceit of the Government Mortgage Complex

Jan 25, 2018 6 min read
COMMENTARY BY

Former Director, Center for Data Analysis

Norbert Michel studied and wrote about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.
Debate over housing finance reform has raged for ten years. iStock

Key Takeaways

Free-market conservatives loathe the idea of designing a housing finance system. They want to let one develop.

Expanding federal guarantees will worsen the dangers that such promises cause and lay the groundwork for more intrusive regulation.

Supporters of this type of planned housing finance system are promoting economic fantasies and denying the realities that caused the 2008 financial crisis.

Debate over housing finance reform has raged for ten years. A favorite argument of those wishing to preserve some version of Fannie and Freddie has been: Without Fannie and Freddie, there is not enough private capital to sustain the housing market.

This line puts free-market conservatives on the defensive. After all, who could possibly argue for getting rid of these two government-sponsored enterprises (GSEs) without first determining what will take their place?

It’s a trap, of course. Free-market conservatives loathe the idea of designing a housing finance system. They want to let one develop. Letting bureaucrats design the housing finance system is exactly what led to (among other problems) the 2008 financial crisis.

Free-market advocates also point out other salient facts that rebut the lack of capital hypothesis. For example, depository institutions are sitting on more than $2 trillion in excess reserves right now. And U.S. corporations have bought back nearly $4 trillion in their own shares since 2008 for lack of sufficient investment opportunities. Where’s the shortage in private capital?

The GSEs were a relatively small part of the housing market until President Clinton helped engineer a massive expansion. And what did that accomplish? The U.S. homeownership rate is virtually unchanged from its rate prior to the mega-expansion of the GSEs, homes are less affordable, mortgage debt has gone up more than threefold, and homeowners’ equity share has declined.

You’d think facts like these would temper the enthusiasm of those bent on preserving the GSE system and all the goodies that come with it. Think again.

Last week, the Federal Housing Finance Agency (FHFA) weighed in on housing finance reform, calling for (among other things) reincorporating Fannie Mae and Freddie Mac and providing an explicit federal guarantee to cover losses in the secondary mortgage market.

This proposal, detailed by FHFA Director Mel Watt, a former Democratic congressman appointed by President Obama, is hardly surprising. But the Treasury Department declared itself “broadly supportive” of the FHFA outline, and that is a major disappointment to conservatives. Nothing we’re not getting used to, though. A month earlier, Treasury had expressed support for federal guarantees in the mortgage market.

The FHFA proposal, as well as previous proposals in the U.S. Senate, seek to preserve and expand as much of the old system as possible.

If that system hadn’t been ground zero of the 2008 financial crisis, maybe this new FHFA/Treasury/Senate alliance wouldn’t be so scary.

But the implicit guarantees of Fannie Mae and Freddie Mac, along with their “affordable housing” mission, were a principal cause of the 2008 meltdown.

They made housing less affordableincreased risky private debt, and (predictably) failed to fulfill the goal of increasing homeownership.

Expanding federal guarantees will worsen the dangers that such promises cause and lay the groundwork for more intrusive regulation. The best course of action is to eliminate these guarantees, but special interest groups have been angling to maintain their piece of the federal-housing pie since the day of the crash.

History shows that the U.S. does not need pervasive federal guarantees in housing markets, but it also shows that proponents clearly want them. But no matter how badly people might want it to be true, governments cannot successfully design an economy (or even certain sectors) so that everyone’s needs are met and everyone stays safe. Few in power have learned the lesson.

The new FHFA plan is simply the latest exhibit. Here’s a sample of the plan’s design elements for implementing “a post-conservatorship housing finance system.”

  • Establish shareholder-owned SMEs [secondary market entities] operating as utilities with regulated, overall rates of return and appropriate capital requirements.
  • There should be at least two SMEs to operate in the market.
  • Any additional SMEs chartered by the regulator should likewise have a regulated rate of return and have the economies of scale necessary to provide liquidity to the national housing finance market and the standardization required for the TBA and CRT markets.
  • While at least two SMEs would ensure that the housing finance market benefits from multiple approaches to serving the market, having too many SMEs operating in the market could increase the potential for a race to the bottom in underwriting standards in pursuit of market share or the emergence of just one surviving SME.
  • Requiring a national footprint will minimize the risk of SMEs competing to cherry-pick the strongest markets, products, or borrowers thereby leaving others underserved, and will contribute to uniform pricing across the country.
  • The regulator should have the authority to set a regulated, overall rate of return that permits each SME to earn a “fair return” for its shareholders.
  • The regulator should have authority to disallow excessive compensation for SME executive officers.
  • Require the continued operation of the Common Securitization Platform (CSP) as a market utility that is mutually owned by SMEs and potentially other secondary market participants (similar to the Depository Trust and Clearing Corporation).

This list would make the most ardent Hugo Chavez supporter proud. It reveals the unrelenting desire to design an economic reality that does not exist, and to shape markets into something that might be nice.

One glaring problem is that there are, in fact, no SMEs.

The people who want to preserve Fannie and Freddie and set up an explicit guarantee simply decided the U.S should have these.

Another problem is that Fannie and Freddie, as well as all financial market companies (even the clearing firms), fail to fit the classic definition of a regulated utility. Yet the so-called reformers are bent on forcing SMEs into this mold.

Treating financial companies as public utilities makes little sense economically. It is anticompetitive and mistakenly implies that the financial industry cannot function unless the government grants monopoly privileges to select firms.

This special status will restrict competition, concentrate financial risk, and ultimately raise consumer prices. Forcing such a model on the U.S. financial sector is sure to crowd out private investment, thus shrinking opportunities.

Furthermore, nobody in particular has the knowledge to determine how many companies an industry needs, what a fair return to shareholders should be, what level of compensation is excessive, or what single financial security can best serve a market. Forcing these kinds of ideas on the market is destined to detract from growth and innovation.

Overall, the U.S. economy has been the antithesis of this type of planned market. Its free-enterprise system, with minimal full-fledged government support and meddling, has been an incredible engine of opportunity, growth, innovation, and prosperity.

Supporters of this type of planned housing finance system are promoting economic fantasies and denying the realities that caused the 2008 financial crisis.

Free-market conservatives are not the pie-in-the sky dreamers in this debate.

This piece originally appeared in Forbes https://www.forbes.com/sites/norbertmichel/2018/01/23/the-fatal-conceit-of-the-government-mortgage-complex/3/#694dcf7641d8