Holding the Bag on Fannie and Freddie

A new earthquake hit world financial markets this weekend when the central U.S. mortgage market institutions were taken over by the Treasury. The nationalization of Fannie Mae and Freddie Mac under the conservative Bush administration marks the end of an era. A “public-private partnership” of mismanagement has led us to this fiasco. Housing markets never will be the same. How they will change, though, is far from clear.

Make no mistake: the Treasury did the right thing in taking over the assets and liabilities of the technically bankrupt mortgage giants. If Fannie and Freddie had been allowed to fail, many banks, both in the United States and internationally would have failed too. But now, their unmanageable debts have become the American taxpayers’ debt, and the basic model for home ownership in the United States is in shambles.

There are two central policy failures that have led to this sorry state. First, as un-American as it sounds, the longstanding federal policy that pushed for universal home ownership never made sense, and its implementation was a disaster. Second, the focus in financial intermediaries on making money from transactions has led banks and mortgage brokers to all but abandon one of their central functions, to assess risks and to turn down bad loans.

It is always and everywhere good for families to have more wealth. But, as every introductory course in finance emphasizes, a family’s assets should be diversified. Creating incentives for families to buy homes undermines this basic idea of wealth management. What is more, owning a home and borrowing against it not only put a family at great risk when real estate prices fall, but it hinders the family’s ability to move from one place to another. Homes are very illiquid assets. It often takes a long time to sell them, the sale price is unpredictable, and the transaction costs – points, inspections, brokers fees – are quite high.

The absurd idea that home prices can only get higher never made logical sense. Now it is manifestly crazy as an historical assertion.

Bending all the rules of sober lending in order to push up the rate of home ownership makes no more sense than pushing and subsidizing every adult to own an automobile. The central premise and goal of federal housing policy does not make sense.

More worrisome, the growth of sophisticated financial instruments has made it easy for someone to broker a deal – in housing sales just like in other asset sales and acquisitions – and then to pass the risk inherent in the deal on to someone else. As mortgages were bundled together and shares of the bundles were sold to asset owners throughout the world, responsibility for issuing sound mortgages gradually moved from bankers to brokers to nobody at all. A diversified portfolio of junk mortgages is still junk.

The combined pressure to increase home ownership and the removal of incentives to lenders to make sure loans were repayable created a disastrous combination. In 2004 and 2005, the requirements to buy a house were reduced to the ability to say what the lenders wanted to hear, whether it was true or not.

It is not easy to see how this problem will be solved in the long run. No politician will ever be elected for removing subsidies to home ownership. Therefore, various subsidies and institutions to advance this questionable goal will continue to be in every political party’s program. Within the financial sector, while the heads of some institutions will lose their jobs, the myriad loan officers, transaction brokers, and employees who made big bucks setting up housing deals and bundling mortgages will have no incentive to avoid bad lending in the future. Their money in is making the loans, not in the repayment. Many families will lose their homes and their wealth, but it is likely that a new feeding frenzy like the housing bubble easily will find a ready crowd of poor suckers who can be convinced to buy into the next sure thing.

Ultimately, what a market economy needs is rewards for those who do a good job managing resources and punishment for those who mess up, without creating collateral damage to innocent bystanders. The challenge of revising our present systems of housing policy and financial management to achieve this simple goal is not simple at all.

Comments

[Rick Cohen]

Thanks for the candor about the ideological push about homeownership. Both political parties pushed this as an ideological point, whether as a mechanism of increasing the economic position of lower income people or as an instrument of the "ownership society" (or simply the notion that homeowners are somehow better citizens and neighbors than renters), but the victims were all too often lower income people themselves. For lower income households, sinking such a large proportion of their assets into a house means that the first adverse dynamic--loss of job, health crisis, family break-up, etc.--means that they lose all of their assets, without a cushion to fall back on. The solution that I suspect TCF and others might not subscribe to is to promote social ownership alternatives. But fundamentally it is good to have people like you questioning the underlying contextual ideologies that have led the nation to the current housing policy/finance mess we're in, with little indication from either presidential candidate that they're willing to question the homeownership sacred cow.