Dodd-Frank's missing pillar, housing finance reform, has finally found its way into the halls of Congress and the speeches of the President. But this pillar will be rotten from the start if it is built around the fallacy that undergirds the current housing finance system-the notion that Americans cannot purchase and finance their homes without the help of Uncle Sam.
The government gets involved even before a family decides to purchase a home. It starts with the government's perpetual advertising campaign for home ownership. A White Housewebsite typifies this nudge towards homeownership with its assertion that "Owning a home has always been at the heart of the American Dream." The American dream is not reflected in homeownership, but in the ability to decide for oneself whether the positive aspects of homeownership outweigh the costs and headaches of it. Americans who bought houses at the height of the market, lost their jobs, and lacked the flexibility to move to a new state for a new job because they were tied to a home may prefer to rent in the future. Individuals are uniquely qualified-based on a keen understanding of their own temperaments, dreams, and realities-to make their own rent/buy decision without advice or subsidies from the government.
Once a family has decided to buy a home, Uncle Sam has some ideas about how the home should be financed. The government's favorite mortgage is the thirty-year, fixed-rate mortgage without prepayment penalties. President Obama, in his Phoenix speech, called for continued "access to safe and simple mortgage products like the 30-year, fixed-rate mortgage." Senator Warner, co-sponsor of the Senate bill to reform housing finance, touted the bill's "thoughtful reforms that will protect taxpayers from future downturns while responsibly preserving the availability of the 30-year fixed-rate mortgage for homebuyers."
Thirty-year, fixed rate mortgages cost more than other types of mortgages, because lenders take on more interest rate risk than they would with a shorter-term, variable rate loan. Restrictions on prepayment penalties make mortgages even pricier, because lenders know that homeowners will refinance when rates go down. Professors Michael Lea and Anthony B. Sanders in a Mercatus Center compendium on housing finance reform explain that "all borrowers pay a substantial tax" in the form of higher interest rates for the thirty-year, fixed-rate, prepayable mortgage. Some homeowners might be willing to pay for the benefits that go with this type of mortgage, but others might prefer to bear some of the interest rate risk. A family that knows it is likely to move in five years, for example, might be happy with a mortgage that adjusts after five years.
Once a mortgage loan has been made, Uncle Sam doesn't stand idly by, but rushes in to take the credit risk. Fannie Mae and Freddie Mac, which are now in government conservatorship because of their reckless behavior in the lead-up to the crisis, have come to dominate the mortgage market. Along with the Federal Housing Administration, they insure or guarantee nine out of ten mortgages. Knowing that the government stands ready to back mortgages makes private lenders a lot less careful about the types of loans they make and purchasers of mortgage-backed securities a lot less discerning about the types of mortgages that back their securities. The problem is exacerbated by the fact that the government never charges enough for the risk it takes in providing these guarantees. Some of the plans for reforming housing finance would get rid of Fannie Mae and Freddie Mac and put private capital on the hook for the first losses, but the government would still be there to absorb the remaining losses.
Remarkably, the United States has distinguished itself by the level of government involvement in housing. As President Obama put it last week, "we are fairly unique in the sense that most advanced developed countries don't have such a large government presence in the housing market." That presence has not gotten us very far. As Professor Dwight Jaffee points out in his piece in the Mercatus compendium, "Western European residential mortgage and housing markets have outperformed the U.S. markets" with less government involvement. Effective housing finance reform would let the markets function to serve the needs of renters and homeowners without forcing taxpayers to have their skin in the game.