The recent barrage of bad housing numbers has highlighted the poor performance of President Obama's economic team in dealing with the aftermath of the housing bubble. A number of tax credits and refinancing programs have been attempted, but have only served to temporarily bump prices and sales by stealing future demand. Earlier this month, even more bad news came from Fannie Mae and Freddie Mac, who are still bleeding money and drawing from Treasury's unlimited bailout fund. The desperate need for housing finance reform could not be clearer.
With this in mind Treasury Secretary Tim Geithner hosted a half-day conference on August 17 to kick-start the reform process, including substantial changes to Fannie Mae and Freddie Mac. The following is a breakdown and analysis of the core thoughts in his opening speech:
Geithner: "Today we consider the challenge of how to build a more stable housing finance system. Fixing this system is one of the most consequential and complicated economic policy problems we face as a country. And I think it's worth stepping back and asking the basic questions: What went wrong over the past few years? And what are the most important flaws in the system that we have to fix?"
I agree. This is a critically complex problem that will prevent a full market recovery until it is fixed. However, we need to look beyond just the past few years, and see if there has been policy failure building up over the past few decades as well.
Geithner: "Alongside the broader failures that contributed to this financial crisis, there are several that directly involved the government sponsored entities, Fannie Mae and Freddie Mac.
Amid the general race to the bottom in standards across the private sector, Fannie and Freddie lowered their underwriting standards, providing guarantees for increasingly risky types of mortgages without charging nearly enough to cover the risk.
And Fannie and Freddie were allowed to build up substantial portfolios of mortgage-backed securities, which rose to a level of more than $1.6 trillion dollars at their peak, without the financial resources to cover potential losses."
Actually, the way Mr. Geithner framed the failures of Fannie and Freddie was a bit misleading. Not only were the GSEs caught up in the race to the bottom of underwriting standards, they encouraged the private sector to lower its standards by increasing its demand for subprime debt-which was spurred on by requirements from the Department of Housing and Urban Development (HUD). It wasn't just another player. It was a leader of the pack.
Furthermore, Fannie and Freddie weren't just "allowed to build up" toxic debt-they were essentially ordered to by HUD, which was aiming to expand homeownership. It is important to note that the lead up to failure at the GSEs has government fingerprints all over it.
Geithner: "These two strategies were pursued to maximize short-term returns to shareholders and senior management. They were possible only because of the toxic combination of a perceived guarantee by the government and an absence of effective oversight. They were not the sole causes of the crisis, but they made the financial crisis worse. And they resulted in huge losses for the taxpayer."
In general I agree, though the dual mission of trying to make a profit for shareholders and meet policy goals of the government contributed heavily to their problems too.
Geithner: "Now, these failures in our housing finance system were avoidable. And it is our responsibility to make sure that we create a system that is not vulnerable to these same failures happening again. Toward that end, earlier this year, we posed a set of key policy questions for public comment and we've received more than 300 responses covering a full range of opinion."
One of those responders was the Reason Foundation (see my letter to Secretary Geithner).
Geithner: "Some propose getting the government completely out of the business of supporting housing finance, while others propose reforms that would leave the current system largely in place.
Some suggest that, as a government, we have provided too much support for housing, while others suggest we provided too little support to promote affordability for lower income Americans.
It's safe to say there's no clear consensus yet on how best to design a new system. But this Administration will side with those who want fundamental change. It is not tenable to leave in place the system we have today."
Unsurprisingly, I believe there should be no government support of the housing finance system. And it is encouraging to hear Mr. Geithner stand strong for fundamental change. It is possible to change the whole system into something worse, so the belief in change does not necessarily mean Treasury will support a free market plan. However, there are many alternatives that would be better than the current system, so we are likely to make at least some positive steps forward.
Geithner: "I want to start the conference today by presenting what I think are the four key questions underlying reform and outline some of the key policy choices we face in answering them.
The first is the most fundamental. What role should the government play to provide stability to the housing finance system, both in times of prosperity and during downturns?
This question is really about whether the government - in order to make sure that Americans can borrow at reasonable interest rates to buy a house even in a downturn - has to provide a form of guarantee or insurance against losses."
I agree that the role of government is the most important question, because it defines everything else about what the most effective reform plan would be. However, Mr. Geithner assumes that ensuring "reasonable interest rates" is a good thing. The question is not "really about" ensuring low interest rates. The question is if the government's involvement in the housing finance system helps or causes problems. It is my belief that the housing market became unstable because of distortions in the system-caused by the government.
If the government has actually "helped" borrowers and not hurt them, then maybe they have a role in providing stability. But if the government's distortions merely gave homes an artificially high value for a short period of time while separately giving a boost to uncreditworthy borrowers in homes that they now can't afford and are being evicted from, then maybe they haven't helped and shouldn't be involved.
Geithner: "The second question is what role should the government play in providing financial support to improve access to affordable housing? ...The choices here range from whether we should provide more support or less; whether we should realign our incentives for owning or renting a house; and how we delineate our support for affordable housing from the mechanisms we use for general housing finance."
Again, the answer to this question is that over incentivizing capital investment in housing can only lead to bad outcomes. The prevailing policy of the past few decades has been to try and push mortgage rates down and increase capital available for borrowing. However, in the short-term, lending standards will have to be lowered in order to find enough borrowers for all the available capital, since there are a limited number of well-qualified borrowers. In the long-term, all of the available capital will artificially boost demand for housing that might not otherwise be there, and that demand in turn drives up the value of homes, pricing many out of the housing market and eventually leading to a burst bubble.
If an individual or family qualifies to get a loan to build a house, then they will find the capital to do so. But capital can be put to many good uses beyond housing, and if it is better invested elsewhere, why should federal authorities interfere with that system? More individuals and families will turn to renting, but at the same time will be able to pursue wealth building instead of rushing unprepared into homeownership. This view runs counter to what has guided policy over the past few decades, so the question here is really about whether not increasing homeownership should be a policy goal of the United States.
Geithner: "The third question is what should we do about the securitization market more generally? The Dodd-Frank reforms require very substantial changes to the securitization markets -- markets that are so important to how we finance housing in America. Among other things, these reforms require a level playing field in terms of constraints on risk taking across financial firms -- whether banks or non-banks -- operating in the housing finance market, stronger consumer protections, new disclosure requirements, reforms of the credit rating agencies, and risk retention thresholds for specified mortgage products."
Restarting the securitization market is important for the return of capital to housing, but it is not the only option. Covered bonds and private mortgage insurance are also tools available to restore the housing sector. In general, the best thing the government could do to help the securitization markets is to help restore certainty in the marketplace by ending talk of increased business taxes, rolling back the populist rhetoric against investment success and profits, and basing financial services reforms in a proper analysis of what actually caused the crisis instead of in a series of political aims.
Geithner: "The fourth and final question is how do we best manage the transition to a new housing finance system? Here we face several different imperatives. We need to begin the process of weaning the markets away from government programs and make room for the private sector to get back into the business of providing mortgages. We need to continue working to keep overall mortgage rates low. As we go through this transition, it is important that consumers maintain access to credit at attractive rates. The planned wind down of the GSEs' portfolios should be done in a careful way. And we need to make it absolutely clear that we will make sure the GSEs have the resources to meet their financial commitments."
Here, I again agree with Mr. Geithner in principle: we need to transition in a prudent way to the new housing system. But that doesn't mean a focus on keeping mortgage rates low. It means avoiding shocks to the system and ensuring that all interested parties are well aware of how the transition process will work to avoid market uncertainties.
Because a properly reformed system would be devoid of the government subsidies that distorted in the first place, it is likely that mortgage rates will be higher. This must be accepted up front. That doesn't mean, though, that we have to jump to the higher rates over night. Allowing time for the market to adjust and adapt will be difficult to manage, but a prudent and responsible task nonetheless.
Geithner: "It is important to note that reform, as Barney Frank has said, is about more than designing an elegant funeral for Fannie and Freddie. It requires a broader reassessment of how much support the government should provide for housing finance. The failures that produced the system we have today were bi-partisan. The solution must be as well. This is a test for Washington. The stakes are high. For many Americans, their home is their largest financial asset and the housing industry supports millions of jobs. We must take this opportunity to build a more stable housing finance system that that better protects American taxpayers."
I couldn't agree more. And in my assessment, the support level from the government should be: none. But it is good to know that we have the same goal: a stable housing finance system. How we get there will be a challenge in working out the differences in policy focus. I think if we can agree up front that the policy aims of the federal government should not include expanding homeownership, then much of the rest of the discussion will be less contentious. However, there are many who believe we should try to get more people in homes they own. Given the failure of this policy over the past few decades, I believe the impetus should be on them to prove why homeownership policy goals are such a good idea.