The Gaping Hole in the Middle of Dodd-Frank

Backing the government out of housing finance will not be an easy task, but there are thoughtful suggestions about how to achieve it. If we pursue that policy, Americans won't all be living in homes they own, but they will be better off.

When President Obama signed Dodd-Frank into law four years ago, there was a widely acknowledged hole in the legislation-housing finance reform was left for later. Given the role that mortgages, Freddie Mac, and Fannie Mae played in the crisis, this omission was significant. But omitting housing finance spared an important issue from being tainted by Dodd-Frank's government-centrism. Alas, in the intervening four years, Dodd-Frank-style dysfunctions have worked their way into many housing reform proposals. Rather than relying on subsidies and regulations to counteract their effects, we should craft the new housing finance system around individual choice and financial institution responsibility.

Financing home purchases is a key service provided by the financial system. Many Americans want to own homes, but most cannot afford to buy a house outright. Banks and other financial firms stand to profit if they design products to meet Americans' home financing needs. A home purchaser with a strong credit history, a substantial down payment, a sufficient income, and an intention to live in the house is good credit risk.

Government involvement is not necessary on either end of that equation. People are quite capable of deciding whether they want to buy a home, can afford it, are prepared for the headaches of homeownership, and plan to stay in the home long enough to make it worthwhile. The decision to buy a home should be hammered out around the kitchen table, not in a government employee's cubicle. On the other side of the equation, financial institutions are quite capable of designing mortgage products that work for consumers and offer the lender sufficient return to make taking the risk worthwhile. A government lawyer does not have any special wisdom to offer the banker deciding whether to make a particular loan.

Politicians of every stripe, purported consumer advocates, and industry lobbyists seem to think that we would be a discontent nation of renters without the government's benevolent intervention. Each group actively seeks to increase the government's role in directing the decision-making of households and financial institutions. The reform they advocate includes subsidies for homeownership, one-size-fits-all mortgage terms, government backstops to cover losses on bad loans, inducements so lenders provide mortgages to people who otherwise would not qualify, and government-set underwriting standards.

If these groups get what they want, the housing finance system will just be another variation of the tried and failed approaches of the past. The government never charges enough for the backstop it provides (witness the Federal Housing Finance Agency's waffling on guarantee fee increases) and cannot stick to its guns when it comes to setting sensible underwriting standards (witness the regulatory caving on underwriting standards in the Qualified Residential Mortgage rule or the proposals). Over time, the government's exposure will grow and lots of people will get into homes only to lose them to foreclosure soon thereafter.

Such reforms also usurp private decision-making and entail a large government bureaucracy. People who would not otherwise buy homes respond to packages of home-buying incentives, including the mortgage-interest deduction which is essentially a subsidy for wealthy Americans. Their mortgages fit parameters (30-year, fixed-rate, no prepayment penalty) set by Washington bureaucrats who cannot possibly know the individual circumstances of the nation's homebuyers. Financial institutions, plied with subsidies and government promises to bear losses if the housing market takes a bad plunge, make loans they otherwise would not. Because these government incentives decrease firms' incentives to lend carefully and homeowners' incentive to borrow responsibly, regulators have to closely monitor the whole system-in theory anyway-to make sure that risk-taking doesn't get out of hand again.

A more sustainable housing policy would allow the parties with the requisite information and incentives to make choices unfettered by government preferences. Homeownership is a big, life-changing decision that is best made by individual purchasers without any government-provided inducements to buy. Lenders-if not seduced with government guarantees and swayed by regulatory directives-have the expertise and incentives to make an informed decision about whether to put their money on the line for a particular homebuyer.

Backing the government out of housing finance will not be an easy task, but there are thoughtful suggestions about how to achieve it. If we pursue that policy, Americans won't all be living in homes they own, but they will be better off.