At Economics 21, my colleague Christopher Papagianis has written an important piece on the GSE reform effort. His basic argument is that while limiting the size of the maximum mortgage eligible for purchase or guarantee by the GSEs would represent a modest step forward, it doesn’t get at the heart of the GSE problem, namely the fact that the government guarantee offered by the GSEs has been badly mispriced:

Of the GSEs’ combined $226 billion in losses, over $166 billion (73%) came from the guarantee business. The investment portfolio accounts for just $21 billion (9%) of losses. Had the investment portfolios been eliminated in 2005, the GSEs would have still suffered losses from guaranteed mortgages that would have wiped out their capital base several times over. It would be disingenuous to therefore claim that just eliminating the investment portfolios now would protect taxpayers.
But, in seeing that over 70% of the losses came from mortgage guarantees, one might reasonably ask why wouldn’t better limits on the types of mortgages that are accepted be the right way to go to protect future taxpayers. This may be true in the short-term, but it’s important to acknowledge that even good steps in this direction now would not address the fundamental problem of how to accurately price the insurance – or what amounts to the cost of providing a government guarantee.

To address this problem, Chris suggests that our best option is shifting to something like the Canadian model:

In the end, it appears as though the most promising path for Congress is to commit to a credible strategy that puts the GSEs in receivership and liquidate their operations over a 5 to 7 year period. Any shortfalls would be covered by taxpayers so no creditor losses anything in a wind-down or is tempted to sell their securities. In the future, Congress would keep Federal Housing Administration (FHA) mortgages available for borrowers under certain income and mortgage loan thresholds and leave the rest of the market to the private sector. The likely result is higher mortgage costs, as the old guarantees would now be paid for by mortgage borrowers instead of taxpayers. If Congress wants to offset some of this cost increase, it does have options – even though some may not be popular with consumers. For example, mortgages could be made fully recourse to the borrower so homeowners’ assets would be at risk in the event of default. (For more information on this, take a look at Canada’s housing system.) Many would view recourse mortgages as anti-consumer and difficult to implement, but the change would help offset some of the cost increase. If Congress is particularly worried, it could also explore ways to explicitly subsidize low-income borrowers through mechanisms like interest rate swaps (See Charles Calomiris and Raj Date; Josh Rosner has other ideas regarding the mortgage interest rate deduction that are worthy of review).

This would represent a significant shift, and it would be politically contentious. But it’s not clear to me that there is another reform strategy that wouldn’t set us up for another crisis.