February 11, 2011

Treasury report fails to examine the fundamental questions

Arnold Kling

Senior Affiliated Scholar

Overall, I am disappointed to see that the report is heavily waited toward strategy and tactics, without adequate consideration of objectives.  Nobody seems to want to step back and ask fundamental questions about housing policy.  In particular, the questions I would want to see asked include the following:

What public policy is served by supporting mortgage loans that do not encourage the accumulation of equity in the home by households, but instead foster speculation and consumption?  These are loans with one or more of the following characteristics: non-owner-occupied homes; low down payments; cash-out refinancing; negative-amortization loans; second mortgages

If the housing market went on a bender earlier in this decade, then these loans were the booze.  Staying off the booze is the most critical need for housing policy going forward.  That is, the government must make sure that, if it stays in the market at all, it only supports owner-occupied first mortgages for purchase, with significant down payments (I favor 20 percent, but even 10 percent would be much better than the way that the market has evolved) and scheduled amortization of principal.  One virtue of the book by Acharya, et al that I just reviewed is that it makes the "stay off the booze" point clearly.

Freddie and Fannie went onto the booze in part because of pressure to meet affordable housing goals mandated by the government and in part as a way to expand the basic model of privatized profits and socialized risk.  Going forward, if their regulators were to focus on keeping the GSEs off the booze rather than forcing them to go on it, the GSE model could work.  Instead, the report proposes a new form of government guarantee.  Without a mandate to stay off the booze, this gives us the worst of all possible worlds:  a bubble-prone housing market, a new and untried government-guaranteed institution, with a new and untried regulatory mechanism.

The larger question is how much taxpayer risk is justified in order to channel capital into thirty-year fixed-rate mortgages.  The report alludes to this issue, but it requires much more attention.  It requires fundamental rethinking.  Is the thirty-year fixed-rate loan so precious that it is worth risking catastrophic financial crises in order to keep it?