Acting director of the Federal Housing Finance Agency Edward J. DeMarco had some interesting things to say today in testimony before the House Subcommittee on Capital Markets, Insurance, and GSEs. While most of the written statement was focused on the conservatorship progress of Fannie Mae and Freddie Mac that DeMarco’s agency regulates, his comments on the future of housing finance were particularly interesting. Specifically his comments on three core problems with an explicit federal guarantee:
In the future design of our housing finance system, careful consideration should be given to targeting subsidies to specific groups that lawmakers determine warrant that benefit. For example, the explicit government guarantees that the Federal Housing Administration and Veterans Administration provide reflect policymakers’ judgment as to the public benefits from targeting certain borrowers with those programs. There may be other categories of borrowers for whom a direct form of government subsidy is appropriate, as determined by Congress.
It is reasonable to question whether all conventional mortgages warrant a government guarantee. Recently there has been a growing call for some form of explicit federal insurance to be a part of the housing finance system of the future. While such an outcome has certain merit and some attractive features, I believe that the potential costs and risks associated with such a framework have not yet been fully explored. To put it simply, replacing the Enterprises’ ―implicitâ€- guarantee with an explicit one does not resolve all the shortcomings and inherent conflicts in that model, and it may produce its own problems. I offer three observations in that regard for your consideration.
First, the presumption behind the need for an explicit federal guarantee is that the market either cannot evaluate and price the tail risk of mortgage default, at least at any price that most would consider ―reasonable,â€- or cannot manage that amount of mortgage credit risk on its own. But we might ask whether there is reason to believe that the government will do better? If the government backstop is underpriced, taxpayers eventually may foot the bill again.
Second, if the government provides explicit credit support for the vast majority of mortgages in this country, it would likely want a say with regard to the allocation or pricing of mortgage credit for particular groups or geographic areas. The potential distortion of the pricing of credit risk from such government involvement risks further taxpayer involvement if things do not work out as hoped.
Third, regardless of any particular government allocation or pricing initiatives, explicit credit support for all but a small portion of mortgages, on top of the existing tax deductibility of mortgage interest, would further direct our nation’s investment dollars toward housing. A task for lawmakers is to weigh such incentives against the alternative uses of such funds.
To sum up, the problems with the guarantee are 1) that the government is likely to under-price the tail risk of mortgage credit risk through their own guarantee program, 2) that the government’s program would distort the pricing of risk on political terms, and 3) that an explicit program would subsidize investment in housing and thus incentivize the direction of excessive resources towards housing, which was a key reason for the housing bubble.
See the whole testimony here (PDF).