With a ‘Memorandum on Housing Finance Reform’, issued by the US president in March, the Trump administration has begun to outline how it will address the status of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.
These two government-backed companies, which dominate the US housing market, have been in a US government conservatorship since September 2008, when they were declared insolvent. During this 10-year period, the central question about their future has been whether they will be released from the conservatorship and restored to their original role in the US housing finance system, or whether their dominance in the housing finance system will gradually be reduced and their position taken over by the private sector.
The president’s memorandum is a major disappointment to those who had hoped that the Trump administration would begin to reduce the government’s role in the US housing finance system. Instead, it appears that the administration is planning to restore the GSEs to their original role in the US housing finance market. This will mean that the taxpayers will remain on the hook for over $7 trillion in mortgage debt today, with likely more in the future.
The best thing to say about the administration’s approach is that it is unlikely to be enacted, but it is troublesome nevertheless because it means US housing policy, through which the government controls one-sixth of the American economy, will remain unresolved at least through the end of President Trump’s first term. Meanwhile, the risks inherent in the GSEs’ policies will continue to increase, leaving the US economy open to another 2008-like financial crisis in the years to come.
The president’s memorandum directs the Treasury to develop a plan for a housing finance system that roughly replicates what existed before 2008. The key elements of that system were government backing for the obligations of the GSEs, together with affordable housing requirements that led the GSEs to engage in and encourage risky mortgage lending.
These elements are included in the president’s memorandum, but their ultimate effects are well-known because of the sad history of the US housing finance system. The president’s memorandum seems to acknowledge these dangers, but suggests that they will be mitigated by better regulation, more capital for the GSEs, and some form of compensation for the US taxpayers who will have to assume the risks of another GSE financial collapse – brought on, as it was in 2008, by the risky lending policies that GSEs will be expected to pursue.
Past experience with these “protections” has shown them to be worthless; Congress, responding to the demands of the housing lobby, will push the GSEs take increased risks, intimidate their regulator, and encourage the GSEs to lower their capital levels. The administration then in office will concur, realising that a strong capital position makes their mortgage loans too expensive for homebuyers. Investors in their debt securities will not be troubled, because they will be relying on the government guarantee and not on the GSEs’ capital position.
It is not as though a better policy was difficult to achieve. With its control over the Federal Housing Finance Agency, the regulator and conservator of the GSEs, the administration could have gradually withdrawn them from the housing finance market through administrative action alone, without consulting Congress.
This would be done by gradually reducing the size of the mortgages the GSEs could purchase and guarantee, opening larger and larger portions of the housing finance market to the private sector. At the moment, only US banks are significant private sector investors in whole mortgages, holding roughly $3 trillion in private mortgage debt. The GSEs hold most of the balance, about $2.4 trillion, through mortgage-backed securities they have issued and the portfolios of mortgage debt and whole mortgages that they still retain. FHA has insured the balance, which were securitised through Ginnie Mae.
As a result, there is little space in the US today for the development of a robust private securitisation market. However, if the GSEs were to be gradually removed from the market, a private securitisation market would be able to develop. Eventually, as the GSEs are withdrawn, most of the market would be managed by the private sector.
The traditional argument against private securitisation is that it could not supply the 30-year fixed rate mortgages that American home buyers want. But this is false. Contrary to the housing lobby’s claims, private lenders and securitisers offer 30-year fixed rate loans at rates competitive with the GSEs, and in some case rates that are even lower.
After the GSEs’ withdrawal, the government’s remaining role would be carried out through a reformed FHA, which would offer mortgage insurance only to lower income first time home buyers who need government assistance and have the credit scores to show that they meet their obligations.
It is difficult to understand why an administration that claims to believe in deregulation and reducing the government’s footprint in the economy would find this policy difficult to conceive and implement. Most of the US economy – food production and distribution, retailing, construction, manufacturing and services – is open to the innovation and competition of the private sector. To this we owe the vigorous economy we have today.
Yet the US housing market, for no discernible reason, is and has been historically controlled by the government to an extent far greater than in any other developed country. The low down-payment and high debt ratios that the GSEs have followed over many years produced a highly volatile market, subject to massive booms and busts, finally culminating in the 2008 financial crisis.
That debacle had disastrous political as well as financial consequences. It resulted in the 2008 election of Barack Obama and the subsequent enactment of the Dodd-Frank Act, which stifled the US economy for the eight years of the Obama administration. Now that the US is finally throwing off the consequences of this period, we are in danger of authorising another housing finance structure that will reproduce the same effects.
Although they remain in a government conservatorship, the GSEs are pursuing the same housing finance policies, low down-payments and high debt-to-income ratios for borrowers, that caused the 2008 debacle. It should not be a surprise, then, that current market data clearly show that housing prices for low- and moderate-income families are increasing at roughly the same rate as they did before the 2008 collapse. This is the inevitable result of the government’s intervention, using the GSEs and the Federal Housing Administration (FHA), to pursue the misconceived idea that low down-payments and high borrower leverage will make homes more affordable.
In reality, the opposite is true. These policies increase credit leverage and drive up home prices. And when these families do buy an overpriced home, with little equity in the transaction, they will again find themselves unable to sustain their ownership when the government-induced boom reverts to the mean and collapses.
During the Trump administration, the Treasury has consistently argued that reform should be achieved through negotiation with Congress, and not through administrative action. This is a prescription for political failure, especially when the House of Representatives is now under the control of the Democrats. Affordable housing, as much as possible, is the sine qua non of the Democrats’ caucus and of House Financial Services Chair Maxine Waters. It is unlikely that they will settle for less before the 2020 election.
Another stab at affordable housing will be a nonstarter for Republicans, especially in the Senate, who will almost certainly oppose a government guarantee that requires the taxpayers once again to bear the resulting losses of the GSEs. They are unlikely to be fooled again by promises of adequate compensation for this risk or better regulation to prevent failure. With assets equal to the nation’s three largest banks combined, the GSEs are too big to fail, and will always be saved. The result: legislative stalemate.
Thus, the most serious problem is that, at the end of President Trump’s first term, the opportunity to substantially privatize one-sixth of the US economy will have been squandered, and policies will remain in place that will lead ultimately to another housing market bust – all to be blamed, for good reason, on President Trump.
Peter J. Wallison is a senior fellow at AEI and co-director of its programme on financial market deregulation. His most recent book is ‘Judicial Fortitude: the Last Chance to Rein in the Administrative State’.