The Agenda

NRO’s domestic-policy blog, by Reihan Salam.

The Coming Housing Recovery and America’s Dysfunctional Mortgage Market


Will the housing comeback be big enough to revitalize the broader economy or will it be too small to overcome sluggish global growth and abrupt fiscal consolidation? Neil Irwin surveys the evidence in a new Wonkbook column:

Policymakers have thrown a lot at the housing downturn, including ultra-low interest rates from the Federal Reserve and efforts to make lending standards more reasonable. Demographics would seem to favor a housing boom. For five consecutive years, homebuilders have been constructing fewer houses and apartments than the nation’s demographics would suggest are needed. Part of that was due to the overhang of homes built during the boom years, but part was likely due to fewer households being formed amid the weak economy—young adults living at home with their parents, for example, or retirees moving in with their children. As those people doubling-up find jobs and want to move out, it could signal more demand.

So the stars would seem to be aligned for housing to be a source of a new boom. Stock prices for homebuilders indicate investors are betting on a brighter future. Now we can all hope that the sector lives up to its potential and brings the rest of the U.S. economy along for the ride.

Meanwhile, Jesse Eisinger of ProPublica has a new article on the largely unacknowledged nationalization of the U.S. mortgage market:

Fannie Mae and Freddie Mac, the taxpayer-controlled housing giants, guaranteed 69 percent of new mortgages in the first nine months of the year, up from about 27 percent share in 2006, according to Inside Mortgage Finance. Meanwhile, the Federal Housing Authority and the Department of Veteran’s Affairs currently back another 21 percent of mortgages, up from just 2.8 percent in 2006. Altogether, 9 of every 10 new mortgages are backed by the U.S. taxpayer, up from three in 10 in 2006, when the government share hit a decade-low, according to the publication.

“It is creeping nationalization,” says Jim Millstein, an investment banker who worked in the Obama administration’s Treasury Department as the Chief Restructuring Officer.

The problem isn’t just that the market is nationalized. It was nationalized in a slapdash fashion so that now it is riven by conflicts of interest and competing goals. [Emphasis added]

And as Eisinger goes on to explain, the emerging bipartisan centrist consensus is that the mortgage market should return to something like the hybrid of public and private finance that existed pre-crisis. He offers a fair characterization of Phillip Swagel’s call for an explicit federal mortgage guarantee, on the grounds that the alternative is an implicit guarantee that will ultimately prove more expensive and crisis-prone:

Swagel argues, contra more hard-right Republicans, that a fully private housing finance market is an illusion. Housing is so important for the economy that the government will inevitably bail it out in a serious crisis. Therefore, even if the government was somehow removed from the market explicitly, the backing would be there implicitly. Conservatives have an interest in pushing for the government to charge the right price for its insurance and to minimize its role.

Yet Eisinger fails to explain that while Swagel’s proposal represents a hybrid of public and private finance, like the pre-crisis housing system, it is nevertheless substantially different than what came before, as Swagel and his co-author Donald Marron explained back in 2010 in a paper for Economics 21:

The firms’ collapse confirmed what many analysts had long warned: the traditional GSE structure is fundamentally flawed. The opportunity to pursue private profit backstopped by an implicit government guarantee was an invitation to excess risk-taking. Light regulation failed to reign in the resulting excesses. As a result, the firms amassed enormous balance sheets – with debts and mortgage guarantees rivaling the size of the market for U.S. Treasury securities – even as political pressures encouraged riskier home lending that put the enterprises – and taxpayers standing behind them – in danger.

Yet Swagel and Marron are sensitive to the virtues of a public sector role:

Whatever their flaws, Fannie and Freddie did boost liquidity in the secondary mortgage market. That liquidity made it easier for average Americans to get mortgages not only during normal economic times, but also in the depths of the financial crisis. Even as other sources of credit dried up, the agency mortgage market remained robust.

The challenge for reform is to establish an institutional structure for mortgage finance that maintains the best outcomes of the earlier system and corrects its flaws.

In Eisinger’s article, however, pride of place is given to critics of profit-seeking:

But some people, especially outside the Beltway and Wall Street, think twice about reverting to a large private-market role, given that profit-seeking led to the subprime debacle. While hardly anyone is pushing it, there is an Option 4: Expanding the government’s role in the mortgage market, perhaps by having the government back home loans more directly. It could be done by a government corporation, akin to the Federal Deposit Insurance Corporation, which has a measure of independence from congressional or executive branch interference, but wouldn’t seek profit. In that way it would avoid the conflicts inherent in the Fannie and Freddie public/private hybrid model.

“Profit-seeking is what gets banks and financial institutions into trouble. The government can get into trouble too, but it seems it gets into less trouble,” says Susan Woodward, the former chief economist of the U.S. Department of Housing and Urban Development under Presidents Reagan and George H.W. Bush. Moreover, “It’s very hard for government to do something that hurts consumers.”

Much depends on what we consider “getting into trouble.” Government is indeed reluctant to do things that hurt consumers; the trouble, however, is that this entails a large-scale transfer of resources from taxpayers to the consumers of the subsidized good in question.

Eisinger then quotes David Scharfstein of Harvard, who offers a political economy critique of the Swagel-Marron approach:

His fear is that private for-profit entities would want to grow and expand their market share. They would lobby to reduce the amount of capital they have to reserve for an emergency, and to lower the fees charged for mortgage insurance so they could compete on price. If another crisis hits, lower capital reserves and lower fees would make them far more vulnerable to going bankrupt, leaving the taxpayer to bail them out. “It should be a private market or the government. But the government backstopping private entities,” Scharfstein says, “is the worst possible combination.”

This resonates with Michael Greve’s idea of “one problem, one sovereign,” and Scharfstein favors a purer private market approach, in which the government plays a role only in a crisis. The concern, however, is that by leaving the door open for a public sector bailout, Scharfstein’s approach simply misprices the values of government guarantees. 

So what is the connection between the housing recovery and our dysfunctional mortgage market? If the housing recovery isn’t very robust indeed, the federal government is in even bigger trouble than we’ve come to understand.


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