A Modest Proposal to Completely Restructure American Housing Policy
posted by Nate Oman
Among the hopeful things that Obama has done (other than his audacity and change that we can believe in and all the rest) is bring Larry Summers on to his economic team. I hope that he’ll heed Larry’s suggestion that we should ultimately privatize Fannie and Freddie. The half-way house of “publicly sponsored” institutions is, we have seen, a recipe for moral hazard and financial disaster. Anyone who thinks that we should simply nationalize these behemoths needs to spend some time contemplating François Mitterand’s France and the long-term gloire of the state-owned banking sector.
Of course, if Fannie and Freddie are ultimately chopped up and sold off, who will be in “the American Dream business”? How will the government continue to facilitate home ownership? The answer, of course, is that we can continue to do all sorts of things to subsidize home-mortgage debt. The death of Fannie and Freddie wouldn’t end the home-mortgage interest deduction or all of the other financial goodies that the feds hand out to indebted homeowners like myself. And this is why Larry’s privatization proposal doesn’t, in my opinion, go far enough.
Oddly enough, this is not the part of the post where I say “let the market take care of the housing market thank you very much.” (Although I sometimes have those moments as well.) I actually subscribe to the home-ownership-is-good-for-communities school of thought. There are positive externalities to home ownership that are, I think, worth subsidizing. I’ve lived in neighborhoods full of renters and I’ve lived in neighborhoods full of homeowners. There is a difference. On the other hand, I am increasingly convinced that our entire approach to subsidizing home ownership is fundamentally wrong.
To put it bluntly, we subsidize home ownership by subsidizing home mortgage debt. The result is more home debt in the economy, but also more leverage by homeowners and an accompanying brittleness in household finances and the performance of home mortgages. In other words, the government is in the business of increasing the amount of mortgage debt flowing through the financial system and in increasing the risk associated with that debt. It’s not such a great system, as we have seen over the last year or so.
The solution, if we want to subsidize home ownership, is to subsidize equity rather than debt. This would also help families into homes, but it would do so in a way that encouraged them to be less leveraged, making household finances — and incidentally the performance of home mortgage loans — less brittle in the face of outside shocks or drops in asset prices.
The problem with subsidizing equity, however, is that it would force both policy makers and home owners to fess up to what they are doing. Policy makers would have to put an actual line in the budget where they voted x billions of dollars in transfer payments to home buyers. There would be a stipulated sum of money for which they would be accountable to the voters. Tax exemptions and GSEs allow the government to goose up home purchasing in a way that is complex enough that most voters yawn. On the home owner front, subsidizing equity would require middle-class citizens like myself to fess up to the fact that when we recline under our vine and fig tree we’re on the government dole as well.
None of this will happen, of course, but as we shake our fists at the obfuscation and dishonesty of high finance, I can at least dream about a little honesty between politicians and the virtuous middle class.
December 5, 2008 at 11:10 am
Posted in: Contract Law & Beyond
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Responses (6)
Mark Edwards - December 5, 2008 at 6:19 pm
Hi Nate –
Interesting post. I agree that subsidies should be made express, but I disagree that Fannie and Freddie should be re-privatized. Fannie was created as a public agency, and it functioned superbly in that capacity for 30 years. Freddie was created only after Fannie was mostly-privatized, to provide competititon to offset the advantages Freddie took into the market through its GSE status. I think Freddie should be closed down, and Fannie should be tranformed into a fully public agency.
There are several advantages of making Fannie fully public. First, it would continue to encourage home-ownership by mainting a stable secondary mortgage market, with its attendant positive externalities, but it would do it in a direct and fully accountable way, rather than through the yawn-inducing tax regulations and convoluted GSE status you rightly lament.
Second, Fannie could (and once did) enforce quality in mortgages by purchasing only those that met it’s quality standards (20% down, generally fixed-rate, 31% debt-to-income ratio, etc.). Admittedly, that’s the big hand of government setting the boundaries for a market — but we do that all the time. The choice is not between free market and government control. It’s between ad hoc government bailouts and a functioning market system. I’d take the latter.
Third, Fannie can actually be a money-maker for the government, by re-packaging and selling mortgage-backed securities, where the mortgages backing the securities meet clear quality standards. In other words, it need not be a vehicle for government subsidy.
Usually, if an agency can turn a profit, that’s a very good argument that its function should be privatized. I think this industry is different. Home ownership has more than neighborhood-based positive externalities. It is the basis of stability for most participants in the economic system as a whole. Governments responsible to stakeholders can be motivated in their decisions to protect that function; private actors responsible to shareholders cannot. But that function is so important that when private markets falter, as they are faltering now, governments inevitably intervene in a triage fashion. I think that explains our schizophrenic relationship with housing finance entities (which we have nationalized, de-nationalized, re-nationalized, de-nationalized, etc. etc.).
A government function that can, without subsidy, make homeownership — and thus provide the basis of stability for particpiation in the economic system as a whole for many people — more available, based on quality standards enforced in the market, is a very worthy one. But more importantly: government particpation is inevitable. History has shown that again and again. The only question is whether we want it to occur in emergency, ad hoc fashion, or a more planned and stable way.
Thanks for an interesting post.
Robert Rhee - December 5, 2008 at 7:00 pm
Interesting post. A quick comment on subsidization of equity. Of course, such a proposal would have a disproportionately wealth effect on wealthier people as they are in the best position to put more equity down.
As far as “dishonesty of high finance,” I think the discipline of finance is getting an undeserved bad rap during this crisis. We have to distinguish finance from financiers. At its core, this crisis is about the housing bubble. If home values had tapered off from 2006 levels and had remained there, we would not have this crisis (or at least to this levels). During a stock market bubble (say internet bubble), the bubble popped resulting in 50% decline in stock valuations in Nasdaq and probably 30-40% in NYSE. No one would say that the concept of the public common stock is inherently bad. Likewise, securitization is a beneficial financial tool that has inherent value. Essentially, it expands the pool of capital for an underlying activity, and funds that activity at a cheaper cost of capital. I think there is a legitimate argument on whether there should be so much capital that funds consumerism, but the concept of efficient use of capital is sound.
As far as the various derivative products, keep in mind that a derivative transaction is a zero sum transaction. The values “derived” from the residential mortgage back securities, and the derivatives simply allocated the risks among various counterparties. This is not to suggest that there is not a huge problem created by these instruments, particularly OTC derivatives. If the diminuation of RMBS values created the primary problem in this crisis (blowing out the balance sheets of financial institutions), then the derivatives caused a secondary effect of seizing up the credit markets by enhancing the counterparty risk in subsequent transactions (insurance is only good so long as the insurer can meet its obligation).
The real problem here is that systemic risk was created by systemic greed along the entire chain of commerce. Securitization is an innovation of value. As far as OTC derivatives, there is a strong argument to be made that there should be less of them, or at least they become more standardized in such a way that the systemic risk to the financial system can be better assessed.
Mark Edwards - December 5, 2008 at 7:23 pm
I would echo Professor Rhee’s comment that neither MBSs nor derivatives based upon them are inherently bad. If the underlying mortgages upon which they are based are of sufficient quality, they are an enormously valuable tool. Fannie Mae, as I discuss above, provided mortgage quality assurance during its tenure as a government agency, and for much of its tenure as a GSE. It’s obligations to its shareholders, and pressure from political interests that used its tenuous privileges as a GSE for leverage over it, eventually drove it to participate in the race-to-the-bottom of subprime lending.
Nate Oman - December 5, 2008 at 9:29 pm
I actually agree with you regarding the potential virtues of MBSs, CDOs, and credit derivatives. I think that most of the problem with derivatives in particular could be solved by a strong clearing house system of the kind that we have for commodity futures or stock trading.
I disagree with Mark, however, that we need to have Fannie in whatever mode to create a stable home lending market. Britain’s home mortgage market is roughly comperable to the U.S. market, as are their levels of homeownership and they don’t have the equivalent of Fannie or Freddie standing behind the market. At the end of the day, I don’t see that Fannie is doing anything that a private bank cannot do, and a private bank is less likely to become involved in politically motivated lending the way that Fannie did. Given the experience of the Asian financial crisis, I find it very strange that one has to make the case that political control of the financial sector is a bad idea. Many of our over leveraged financial institutions were sadly vulnerable to the drop in asset prices when the bubble burst in housing. On the other hand, we also know from the experience of banks in Indonesia, Thailand, Korea, and even Japan that when the financial sector is strongly responsive to political pressures that it is likely to load up on politically desirable but questionable loans. Another way of putting this is that political control of the financial sector in Asia loaded up its banks with “toxic assets” that made the banks very vulnerable when there was a bit contraction in the supply of capital, which in the Asian case was caused by the flight of “hot money.”
Finally, as to whether a subsidy for equity would have a disproportionate benefit to the wealthy it would depend on how one structured the subsidy, it seems to me. One could certain create progressive elements. I certainly don’t think that an across the board subsidy of home equity makes much sense. I do think, however, if we want to encourage homeownership we ought to do so through a clear, clean subsidy of equity rather than through the wholesale subsidization of debt.
Frank - December 6, 2008 at 9:58 pm
I like this idea, and it certainly is much better than the bizarre idea now floated to artificially lower the mortgage rate to 4.5%.
I think it may have to be phased in over a long period of time (e.g., in 2009 the equity subsidy is 5% of the total “tax break” available, and 95% is for the debt), but if government had the fortitude to credibly commit to it it would be a lot better than the current incentives to go into debt to buy a bigger house.
Brett Bellmore - December 7, 2008 at 3:21 pm
Here’s a bizzare notion: If we want to encourage home ownership without increasing debt, maybe we should attack zoning and building codes which artificially inflate the cost of homes, and their minimum size?
Seriously, when I set out to build my own home about 10 years ago, I discovered much to my dismay that the small, energy efficient home I had in mind, quite comparable in size to the one my parents first owned while raising three children, was illegal to build. The minimum home size for new builds was twice as large.
This was probably due to the incentives generated by the people crafting zoning and building codes getting their budgets from property taxes, and thus having a strong reason to desire that people build as expensive homes as possible.
Stop mandating that starter homes be so large, and people won’t have to go so far into debt to buy their first home.
A bit more freedom to use non-standard building techniques would be helpful, too: There’s no good reason that factory build homes, “mobile” homes, should be restricted to special ghettos.
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