The following is a letter sent to Treasury Secretary Timothy F. Geithner on July 21 in response to a public request from the Treasury Department for comment on housing finance reform. Click here to download the PDF version.
United States Department of Treasury
United States Department of Housing and Urban Development
Re: eDocket Number: TREAS–DO–2010–0001; eDocket Number: HUD–2010–0029
Public Input on Reform of the Housing Finance System
Reason Foundation Response to Questions 1 to 7
The government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac were significant contributors to the build up of the housing bubble and remain today, even while in conservatorship, a significant source of distortion in the housing market, preventing a real recovery in housing from taking hold.
Fannie Mae and Freddie Mac, by pursuing their federally mandated goal of expanding credit to finance housing, artificially distorted mortgage prices across the housing market and put unnatural upward pressure on the price of homes, bloating the bubble. The GSEs also impacted the market by artificially creating demand for an increasing amount of low quality, risky mortgages. The price of homes is directly related to the cost of a mortgage. The cheaper a mortgage is, the more demand for housing increases, driving up prices. This undermines the goal of affordable housing.
The federally chartered agencies set underwriting standards based on the housing goals given to them by the Department of Housing and Urban Development (HUD) which sought to expand homeownership by making it cheaper. However, the unintended consequence of this action was to attract a deluge of resources from the global economy to housing in America, building into a bubble. And with Fannie Mae and Freddie Mac able to purchase or guarantee billions of housing debt, the price of mortgages was pushed to unnaturally low levels, spurring artificially high levels of demand.
The debt that financial institutions and households took on during the growth of the housing bubble eventually became unsustainable and, through a confluence of other unfortunately timed policy decisions, led to the market meltdown that spilled over into the entire financial system.
With credit markets still largely frozen today, the main source of liquidity in the housing finance system is the GSEs. In fact, Mortgage Service News reported June 1, 2010 that Fannie Mae, Freddie Mac, or Ginnie Mae purchased 98 percent of all mortgages originated this year, with the jumbo market virtually nonexistent.
This dominance of the housing market means that any recovery in price or sales volume is completely dependent on federal government financing. Were the GSEs to cease buying mortgages or guaranteeing mortgage-backed securities, financing for buying homes today would be virtually nonexistent until the banks got back up on their feet. This would result in mortgage prices increasing, causing demand for housing to decrease, taking the value of homes even further down.
In essence, the government support for defunct Fannie Mae and Freddie Mac is unnaturally propping up the price of homes and with them, the housing market. This means that prices have not been allowed to reach their natural bottom, from which a sustainable recovery could begin. Washington has placed itself in a difficult position, desiring an increase in housing prices in order to ease pressures on bank and family balance sheets. However, this requires a continuous bailout of Fannie Mae and Freddie Mac, which is distorting the housing market and preventing a real recovery in housing
The main problem with delaying GSE reform is that the continuation of their model, which has been proven to be both bad business and problematic for the broader housing sector, is distorting the market and preventing a real recovery in housing. This is the most important reason the GSEs must be reformed sooner than later, as a part of a sweeping overhaul of the housing finance system.
In April 2010, the Treasury Department released a list of questions for public input on how the government should approach reforming the housing finance system. These questions have been grouped into three categories and are addressed with broad principles to govern reform of the housing finance system.
I. What is the Role of Government in Housing Finance?
Federal involvement and intervention distorts the market by placing unnatural upward pressure on home prices and downward pressure on mortgage yields. This distortion in the free market has led to a wide range of unintended consequences, most recently coalescing in the finance crisis, leading to taxpayer losses. The role for government in the housing finance system is to support a legal structure for private sector financing of mortgages, and to enforce laws and regulations that ensure the market is a fair field for competition. However, there should be no federal government (i.e., American taxpayer) dollars available to support housing finance on a market-wide basis. Furthermore, the government should not be collecting taxpayer dollars to bet in the financial markets, housing or otherwise. Using federal tax dollars to support housing
finance puts Americans unfairly and unjustly at risk.
- What role should the federal government play in supporting a stable, well-functioning housing finance system?
- What risks should the federal government bear in meeting its housing finance objectives?
- How should the federal housing finance objectives be prioritized in the context of the broader objectives of housing policy?
- The role of government should be as regulator of the financial market, ensuring competition and compliance with the law, not a financier itself.
- There should be no risk to taxpayers.
- If it is impossible to fully remove government, then the government’s role as financer should be as limited as possible.
If we were starting from a blank slate, no one seeking a stable housing finance system would design what we have today. The government-sponsored enterprise system contributed heavily to the build up of housing investments that reached unsustainable levels. This toxic debt, mixed with poor banking practices, was spiked with irresponsible borrowing and spilled over catastrophically into the global economy when home prices imploded.
Understand the Damage of Distortion
The chartered mission of Fannie Mae and Freddie Mac is to increase financing available for homebuyers. This expansion of mortgage credit is by its very nature a distorting force in the market. Without the GSEs there would be less credit available for those who want to buy a home, so the natural level of financing is skewed by the GSEs, which were implicitly backed by the U.S. government, and now are de facto federal agencies. The government, when considering the future of its role in housing finance, must keep in mind the distortions of its involvement and interventions.
The intended consequence of government-backed housing finance distortions was to increase the percentage of homeownership in the U.S. by making mortgages more readily available. To some degree the GSEs have been successful in that regard, though studies have mixed findings when trying to quantify the exact benefit of Fannie Mae and Freddie Mac for homebuyers. Nevertheless, the GSEs played some role in encouraging the homeownership rate’s rapid rise from 64 percent to 69 percent between 1995 and 2005 (see figure 1).
Source: U.S. Census Bureau
However, the unintended consequence was to contribute to a housing bubble through the rapid expansion of mortgage credit. In 1993, as a part of the Affordable Housing Initiative, the Housing and Urban Development Department began increasing the affordable housing mandates for Fannie Mae and Freddie Mac. By 2006, the percentage of “confirming” loans the GSEs were required to purchase, based on certain standards of quality and affordability, grew from 30 percent to 55 percent.
At the same time, the GSE definition of quality for conforming mortgage underwriting standards decreased. The average loan-to-value ratio of a subprime mortgage for instance, increased from 79 percent in 1999 to 86 percent in 2006. These actions had the effect of expanding the available credit to homebuyers from mortgage originators who knew they could sell their low-quality mortgage to the GSEs. The homeownership rate increased, but a bubble was formed as well, ultimately collapsing and hurting those very same citizens the government intended to help. The drive for homeownership has now yielded a near doubling in the home vacancy rate in America (see figure 2).
Source: St. Louis Federal Reserve Bank
Today, the GSEs are continuing to distort the market. As virtually the sole providers of capital, they are keeping mortgage prices below their natural level, and pushing housing prices above their natural level. This is politically popular, as the government can use the GSEs as agencies to avoid populist anger at falling home prices. But this is having the unintended consequence of creating a false baseline for home values. The housing bubble inflated the cost of homes above their natural market worth, and the GSE support for the housing finance sector is preventing the market from falling to its natural level.
The government should not distort the housing market, or prevent American homeowners from losing value on their homes. Federal officials are not equipped to accurately price homes, or know through economic analysis, or any other means, an “acceptable” target range for homeownership in America. Market forces may be shifting more Americans to rental housing, and it is inappropriate to use the GSEs to artificially support the mortgage business. Furthermore, government-supported and directed distortion of the housing market to try to help homebuyers underprices the risks the market is seeing in the future of the housing sector, and this could lead to more problems down the road with a second (though smaller) bubble and burst.
Phase Out GSEs and Replace with Improved Regulatory Framework
Congress and the executive branch should work to phase out Fannie Mae and Freddie Mac over a short period of time in order to remove the distorting impact of GSEs while prudently giving the market time to adjust. The taxpayers should not bear any financial risk for federal housing objectives, and the market should be allowed to naturally price homes to avoid destabilizing booms and busts in the housing sector.
Many business interests and affordable housing proponents have proposed and will propose assorted schemes to have the government involved in the housing and mortgage markets, but there is no justification for this. Investors must fully bear the risks and consequences of the investments that they choose to make, as this is a quintessential component of a free and robust economy. A government-shared risk program will only subsidize unwarranted risk-taking because investors will be able to shift losses onto the taxpayers’ expense.
There are a number of possible ways to dissolve the GSEs. And while there is room to discuss details, the most important pillars of any plan are: first, that they are not replaced by another housing market distorting agency; and second, that the phase out take a clear, prudent path. Here is a five-step proposal for dissolving the GSEs:
- Step 1: Lower Conforming Loan Standards
The 2010 conforming loan limit for single-family houses is $417,000 and the “high-cost” limit is $729,750. First, eliminate the high-cost limit and put a ban on purchasing or securitizing second liens by December 31, 2011. Second, lower the conforming loan standard to the median home value on a state-by-state case and require that all new mortgages purchased or securitized after December 31, 2011 have a loan-to-value ratio of at least 80 percent.
These standards would not ban the private sector from issuing second mortgages or originating loans with higher LTV ratios. Fannie and Freddie would just not be allowed to buy or package them. None of these steps would hurt responsible low-income borrowers and they would create opportunities in the secondary mortgage market for private market participants to gradually enter the market and pick up the slack. This will effectively phase out most of the need for GSEs.
- Step 2: Restrict New Portfolio Holdings
First, ban the GSEs from retaining new, raw mortgages on their balance sheets for more than two quarters. (The term raw mortgage defines a mortgage that is not yet securitized. The GSEs buy “raw”
mortgages from originators, then package them into securities and sell them off to
investors.) All mortgages purchased, in conformity with the new standards, would have to be packaged into securities and pushed off the balance sheet within six months of the date of purchase. Second, require that the GSEs cease all new mortgage purchase activities by June 30, 2013. The GSEs would have the remainder of 2013 to securitize those, and any remaining mortgages, and shift them off their balance sheet.
Collectively, this will have the effect of opening the secondary mortgage market to investment from the private sector. Only the private sector would have the option to buy whole mortgages from their originator and hold them for cash flow. This gradual wind down will mitigate any severe shocks to the mortgage market. Furthermore, by only allowing the GSEs to operate by securitizing mortgages, you eliminate the problem of maturity mismatching with short-term liabilities and long-term asset holdings that contributed to the illiquidity of the two firms.
The management of the maturity gap exposed the GSEs to great risks regarding interest rate changes: when interest rates started to rise on longer-term assets, their prices dropped significantly more than the value of their liabilities (recalling that the market values of assets and liabilities are inversely related to interest rates) because longer-term securities are more sensitive, i.e., their prices change in greater proportion to shorter term securities, when interest rates change. Thus when interest rates increased, the value of their assets fell at a much greater rate than their liabilities, which wiped out their equity and provided the impetus for the federal government to nationalize them.
- Step 3: Divest Fannie and Freddie’s Securitized Mortgage Pools
Mortgage-backed securities (MBS) exist in two places on the GSEs books. First, their balance sheets contain recently securitized mortgages that have yet to be sold. This amounts to about 15 percent of the total GSE-issued MBS (as of June 2010). Second, the GSEs maintain offbalance sheet “Agency-and GSE-Backed Mortgage Pools” that serve as special purpose vehicles accounting for the majority of the GSE’s MBS. When Fannie and Freddie receive mortgage payments, those balances flow into the pools in order to pay off the investors of Fannie and Freddie’s MBS.
The GSEs should be required to divest as many of the mortgage-backed security pool assets as possible by December 31, 2015, selling off the securities in such a way as to not shock the prices in the market. The outcome of Step 2 of this plan is a shift of all mortgage debt off GSE balance sheets and into the pools by the end of 2013. The GSEs’ only purpose from that date would be to service the mortgages in the pools, which would likely be holding somewhere between $4 trillion and $6 trillion in mortgage debt, and to attempt to sell them all back to the private sector.
There are a few approaches to divesting the MBS by the end of 2015. First, the GSEs could target a certain percentage of their securities to be sold in a specific time frame, such as 12.5 percent per quarter of the 2013 balance. This could prove difficult, however, as many of the securities held by the GSEs contain undesirable assets. Second, in order to avoid a shock in prices, the MBSes could be sold off within bounded limits as they affect mortgage interest rates. These limits could be anchored to a benchmark such as the federal funds rate. If mortgage interest rates begin to rise over a certain specified limit, the volume of MBS
divestment activities would decrease so as not to place additional upward pressure on interest rates.
- Step 4: Establish a “Bad Bank” for Remaining GSE Assets
Given the likely possibility that the GSEs will be unable to divest all of their assets by December 31, 2015, it is necessary to develop a contingency plan. By January 1, 2016, all remaining, likely toxic, mortgage debt owned by the GSEs should be moved into a new entity on the federal balance sheet that would serve as a “bad bank.” Any securities that were not divested from the MBS pools would be transferred to this bad bank holding entity.
A private sector asset manager should be hired to service this pool for the government. This contractor would be selected through a competitive sourcing bid to service the holdings remaining from the mortgage pools. Hiring an asset manager would not be selling the servicing business, but keeping it on the books of the government and bringing in the private sector to manage the bad bank.
The exact details of the contract would depend on the bids received; however the value of an asset manager would be to leverage the operational quality and efficiency advantages of the private sector. The contract could be structured to have the private manager pay the government up front for the right to the servicing fees, thus transferring risk of losses away from the taxpayer, or the asset manager could simply take a portion of the servicing fees. In any case, any servicing agreements with investors in the pool of MBS would have to be honored. This asset manager would service the mortgages in the pool for the government until maturity. The asset manager would also be required to divest what holdings they could.
- Step 5: Dissolve the GSEs by the End of 2015
The GSEs should cease to operate as of December 31, 2015. By this time the private sector will have moved into the secondary and securitization markets for all loans above the conforming loan standard, which will only comprise a limited number of mortgages issued. All remaining mortgage holdings would be shifted into the bad bank holding vehicle to be managed by a private sector company. All affordable housing functions and operations would be transferred to Federal Housing Administration. There would be no more reason for the operating existence of the GSEs. All remaining assets of the GSEs would be liquidated.
This five-step process for dissolving the GSEs meets the goals of eliminating the price distortion effect of Fannie Mae and Freddie Mac while prudentially avoiding shocks to the market, and allows the government to continue its affordable housing policies.
The GSEs should also be formally put on the federal budget. They are in effect run by the federal government and meet the Congressional Budget Office standard for being included on the budget. Currently, the White House Office of Management and Budget does not include them. Adding them to the budget would not only be more honest, but it would add more transparency to the true drain the GSEs are on the fiscal stability of the federal government. If the GSEs were put on budget, then all cash flows from maturing mortgages or servicing fees on pools of loans would go into the Treasury to mitigate losses the taxpayers have taken on the GSEs. Also, adding the GSEs to the federal budget should also be accompanied by putting GSE on the federal payroll, thereby forcing it to conform to federal pay scales. An additional idea for reforming the GSEs would be to further lower the conforming loan standard to state-defined pricing for affordable housing standards (oftentimes a mortgage payment costing no more than 30 percent of a family’s income).
It is undeniable that immediately dissolving Fannie Mae and Freddie Mac would be damaging to the U.S. economy. But instead of replacing them with a new entity, a new regulatory framework that allows the private sector to efficiently allocate capital for housing finance should be established as the GSEs are phased out. The new regulatory framework will need to respond quickly to new ideas for housing finance, such as providing necessary legal support to covered bonds. It should also focus on enforcing regulations restricting fraud or predatory lending.
Embrace the New Market for Housing Finance
The new housing finance market will look much different with the elimination of the GSEs’ government-subsidized mortgage prices. The value of homes may not return to the heights Americans became used to for some time, if ever. This will mean more affordability in the shortrun, but potentially higher losses for current homeowners, particularly those who bought at the height of the boom. There will not be as much credit available in the system, and it is likely that more individuals and families will rely on rental housing, at least in the near term, as the market sorts out how much capital it wants to risk investing in housing.
This kind of change will likely also adjust the way lenders and individuals think about America’s standard 30-year, fixed-rate mortgages. The cost of these mortgages could increase as private sector sources of mortgage credit reassess how they want to lend in a market without a government guarantee. But other products would rise in their place, if the typical fixed-rate mortgage became unpopular. These products could be modeled on global mortgage models where long-term fixed-rate mortgages are relatively rare.
Higher standards for large loans will likely focus American homebuyers on building wealth and sounder financial practices. This would mean a shift in thinking about the economic and social value of homeownership. Whatever the changes, government officials and citizens alike will need to embrace a market without distortions and not fall into the trap of comparing it too much to the prior, flawed system.
II. How Should We Organize the Future System?
The future housing finance system should be free of government distortions in the market. Fannie Mae and Freddie Mac should be eliminated, and all mortgage distortions and fiscal policies favoring homeownership removed along with them. A preferable housing finance system would focus on protecting consumers by prosecuting fraud, providing the necessary legal approval for creative methods of mortgage lending, and changing the tax code to favor savings (rather than consumption) and investment broadly speaking, letting the market allocate capital to housing as is appropriate.
- How should the current organization of the housing finance system be improved?
- Should the government approach differ across segments of the market, and if so, how?
- End all government distortions and repeal all policies and regulations that seek to boost homeownership.
- The government approach should not favor any particular segment of the housing market over another.
The core problem of the current housing finance system is that government interventions are creating distortions in the marketplace. These distortions fueled an unsustainable housing bubble, encouraged banks to reduce underwriting standards, and have ultimately stuck a multi-hundred billion-dollar bill at the feet of the U.S. taxpayer to cover losses at Fannie Mae and Freddie Mac. Therefore, the future housing finance system should be organized without these distortions.
End the Distortions
The simple fact of the matter is that the government cannot know what is actually best for the market when it comes to determining how much financing should be available for mortgage lending. Officials in Washington have used the political priority of helping Americans achieve the nebulously defined American Dream of homeownership. But this ignores the broader, negative implications of picking this industry to support. The government does not have a positive track record of picking winners and losers in the marketplace, and housing is no exception. It lacks market signals that help drive effective investment, and operates as if the U.S. taxpayer is a backstop to any government investment failure.
The goal of making homes more “affordable” is essentially subsidizing homeownership, creating a dangerous cycle. The more affordable homes become with government-supported downward pressure on mortgage prices, the more expensive homes become, due to increased demand. This means each percentage point increase in the homeownership rate requires exponential subsidization. And the cycle simply spirals up until the artificially boosted prices reach an unsustainable height and come crashing down. Ending distortion, and creating a stable regulatory framework for housing finance, means ending the subsidies. There are two types of distortions the government uses to pursue its homeownership goals:
1. Mortgage Distortions
Mortgage price distortion generally comes from activities by the government-sponsored enterprises, including mortgage purchases and guarantees. Since mortgage prices directly influence the price of a home, this is a chief area of focus for government officials seeking to influence the homeownership rate.
The Federal Housing Finance Authority and the Federal Housing Administration (FHA) also influence mortgage prices by offering mortgage insurance at rates not always consistent with market prices. The FHA furthermore influences mortgage rates through direct subsidization of loans through qualified lending organizations. The Community Reinvestment Act also sets certain terms and limits for private sector investments in housing that encourage certain levels of mortgage financing for the low- and middle-income segment of the market.
The combined distortions put downward pressure on the interest rates for mortgages and, thereby increase the pool of potential homebuyers by lowering prices. This in turn triggers the exponential cycle of subsidization as federal agencies reach to meet affordable housing goals.
2. Housing Distortion
Housing distortions stem from a range of fiscal policies including tax credits for homeownership, mortgage interest deductibility, and selective capital gains taxes that sidestep residential investment. First, the government has taken to using tax credits to encourage citizens to become homeowners. The First-Time Homebuyer Credit program, first begun in 2008 and extended through April 2010, was essentially cash handed out to anyone who hadn’t purchased a new home in the past three years.
Second, the tax code incentivizes owning a home by making mortgage interest payments deductable. Interest on loans backed by up to $100,000 of home equity, no matter what the loan is used for, is also deductable from income tax returns.
Third, since 1997, home sellers have been able to largely avoid paying capital gains taxes. Regulations restrict this capital gain exemption to once every three years, but there are exceptions even for this rule. In theory, reduced capital gains taxes would be positive for economic growth. However, this is problematic because it creates an exemption that unnaturally incentivizes investments just in housing and distorts the natural flow of resources.
These combined distortions put upward pressure on the price of housing, increasing the value of homeowner investments in housing. However, the unnatural price support attracts resources away from other possible investments, creating bubbles and slowing the growth of other industries.
In order to end the distortions in the housing market that favor homeownership with federal subsidization, a number of steps are needed, including eliminating the GSEs, reforming the tax code to get rid of favoritism, and overhauling the whole federal housing finance system to change the way FHFA and FHA interact with the market. The more recent activities under Making Home Affordable programs are also distorting the market and would need to be wound down.
Anything short of completely eliminating any GSE model, even simply keeping a limited government guarantee in the housing finance sector somewhere, will inevitably lead to more taxpayer losses. The likelihood of another, smaller, housing bubble would be high. Catering to pleas for the government to guarantee mortgages would require establishing hybrid agencies with similar troubles as the GSEs, putting the taxpayer back at risk of bailing out the housing market again.
Create a Single Framework for Housing Finance Regulation
As part of a commitment to avoid distorting the market, the government’s approach to regulating housing finance should be from a single perspective, not favoring one segment of the housing market over the other. There are different forms of housing—ranging from single family housing to multifamily structures to various forms of renting. And within homeownership, there are different types of mortgages—fixed rate mortgages (FRM), adjustable rate mortgages (ARM), and a range of terms, the most popular being the 30-year FRM.
As previously mentioned, the government is not good at picking winners and losers, and favoring one segment in this market over the next would create distortions eventually leading to unintended consequences. The Treasury Department, HUD, FHFA, and Congress should avoid favoring homeownership over rental housing; single-family home over multifamily units; or, 30-year FRMs over any other mortgage model including 15-year FRMs and 1-year ARMs.
One of the main reasons the government should not favor one mortgage type over another is that changes in the market influence the desirability of various housing models. The Cambridge Winter Center for Financial Institutions Policy argues that high rates of employment volatility combined with the increased rate of divorce have made homeownership more volatile and the 30-year fixed rate mortgage and other long-term loans less desirable. Such loans are also unfavorable for banks without a government guarantee. It is likely that, with the move to private sector housing finance, mortgage terms and structures will look much different and need to change over time as the market ebbs and flows. Having the government favor one or two types with its regulatory structure would defeat the purpose of trying to end distortions.
The Exception for the Very Poor
It is unlikely, in the modern political climate, that political leaders would be willing to completely remove financial assistance from the very poor in society. The government could feasibly engage the market well below the poverty level to help develop multi-family housing opportunities without significantly distorting the market.
One option would be to have the FHA offer lump-sum payoffs of the down payment for very low income families that have high underwriting standards, and careful monitoring of the homeowner’s success in making mortgage payments. This would minimize taxpayer risks, relative to FHA loans, and provide the new homeowners with wealth to build on. Alternatively the FHA could provide temporary rental housing units to very low-income families and seek to transition the care for these individuals to state and local governments. Anyactivities by the FHA to help very low-income families should be done within a clearly defined, fixed portion of the market the government would be allowed to operate within. This would signal to the market that the government is not going to come again with the power of their ability to get cheap credit and take market share.
III. How Should Consumers Be Protected?
A reformed housing finance regulatory structure should result in a market that aligns business and consumer interests more acutely, instead of restricting certain business practices and products ad hoc. This alignment would best come with a combination of changes including promoting transparency, forcefully prosecuting fraud, and creating incentives for consumers to better educate themselves about their mortgage purchases.
- How should the housing finance system support sound market practice?
- What is the best way for the housing finance system to help ensure consumers are protected from unfair, abusive or deceptive practices?
- Promote transparency.
- Make the consequences of criminal behavior clear, prosecute fraud, and incentivize consumer relations best practices.
From claims of widespread predatory lending to the successful push for a consumer financial protection agency in one form or another, there has been an increased call for more consumer protection in the wake of the financial meltdown. Housing finance is an area of particular concern for consumer advocates, as homeowners taking on unaffordable mortgages were at the center of the crisis.
Some have argued for increased consumer protection standards, such as requiring mortgage products to list repayment procedures under various economic scenarios, requiring contracts be limited to a certain number of pages in plain English, or asking for caps on interest payments. However, this would be the wrong approach, as it continues to treat consumers like children and has the effect of restricting their options. It would be preferable to use a reformed housing finance regulatory structure to align business and consumer interests more acutely.
In many respects, the consumer problems that developed during the bubble period were a matter of education. Homebuyers were not always sophisticated enough to understand their mortgage or did not want to take the time to learn about the details of what taking out a $750,000 loan with a ballooning interest rate in three years would mean for their ability to pay the bills. Nevertheless, simply demanding consumers become better educated would not solve the problem. Instead, the new housing finance regulatory framework should provide a range of changes, including promoting transparency, forcefully prosecuting fraud, and creating incentives for consumers to become more informed.
First, promoting transparency should be a plank in any new housing finance system. The more consumers know about the firms they are borrowing from, the better consumers will be in selecting quality products and the more businesses will seek to provide quality service. Instead of limiting the length and wording of contracts, the regulatory framework should simply require that all standard contracts be made available online or on request from a firm’s physical location so that consumer simplicity would become a competitive advantage. The more accessible standard product contracts are, the more likely private consumer advocate institutions will set up simplicity comparing websites where consumers can judge for themselves, which firm would be the easiest to do business with. This system would reward action, instead of punishing inaction.
Second, the government should take more seriously its role as mediator of justice and forcefully prosecute fraud. Regulators should be tougher on mortgage lenders who don’t uphold their fiduciary duties, or cheat their clients. Claims of fraud or dishonesty should be pursued with greater vigilance to create an expectation of enforcement. Regulators should leverage the importance of business reputation. If a particular firm were constantly under investigation for fraudulent businesses practices, that would certainly hurt its profit margin and thus create incentives to be more honest with high service quality.
Regulators shouldn’t, however, punish negative outcomes that stem from uncertainty in the market. It is one thing to prosecute a firm that lies or deceives its clients. It is another thing to prosecute a firm because the market took a dip resulting in losses for its client. Firms offer services and products all the time that allow a consumer to take a risk in the market. Investing in a home when the market is on an upswing will appear to be an attractive investment to both client and firm. But there will always be uncertainty about the direction of the market, and businesses should not be punished simply because the market turned and the product they offered caused their client to lose on the investment.
And third, incentivizing consumers to educate themselves would go a long way to avoid a host of problems in the future. Buying a house is a big deal, and consumers should take the time to understand what they are buying. It is not unreasonable to believe that if a consumer does not want to take the time to understand his mortgage, he may not be ready for homeownership. Firms cannot deceive or abuse prepared consumers.
Perhaps the best way to do this would be to remove safety nets for consumers by reducing their recourse to prosecute lenders. If consumers knew their options would be limited if their investment went bad, they would have more incentive to learn about the mortgage they are taking out. Homebuyers, for instance, shouldn’t have much recourse after purchasing a home unless they can prove malicious intent to deceive. Businesses would be incentivized to make education easier, with consumers trying harder to educate themselves, as a competitive advantage. Combining this with more transparency and harsh prosecution of real cases of fraud and abuse could profoundly increase consumer protection without any heavy-handed requirements of businesses directly restricting their practices or products they offer.
The U.S. government needs to change the way it thinks about homeownership. From departments in the executive branch to members of Congress, the policy goal of increasing homeownership has ultimately led not to a better standard of living for all but a catastrophic meltdown of the housing sector in America. The main goal of reform should be to shift the mindset of policymakers from promoting affordable housing to promoting real wealth-building.
Building wealth is not an easy thing to do. It requires hard work, discipline, thrift and personal responsibility. Homeownership may or may not be a good tool for building wealth. With a society that is growing increasingly mobile, perhaps the homeownership model of wealthbuilding should change. Ultimately, with an economy and nation as dynamic as the United States the government should realize it should not try to use policy as a means of promoting any societal aim—even homeownership.
The role of government should be to support a sustainable regulatory structure for the private sector financing of mortgages. Federal involvement in housing finance ultimately distorts the market by placing unnatural upward pressure on home prices and downward pressure on mortgage yields. This isn’t a stable system that benefits taxpayers in the long run. A reformed housing finance regulatory structure should be used to align business and consumer interests more acutely, prevent fraud, and ensure the market is a just field for competition.
A key step in the process of reform will be dissolving Fannie Mae and Freddie Mac without replacing them with another market distorting housing agency. The resulting change will require a significant change in the way of thinking about housing finance. The new market will be different than yesterday or today’s housing market. The availability of mortgage debt may not be as readily available as before, and prices will likely be different. But the goal shouldn’t be to return to the market conditions of the bubble. That is unsustainable. Instead, the focus should be on building stable wealth over a long period of time while avoiding policies that distort the market and lead to calamitous results.
Director of Economic Research
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