No Real Housing System Exists Without Government Support
Government guarantees prevent bank panics from occurring
August 13, 2013
There are a great number of reasons to support a robust federal government role in the U.S. housing finance system; I will discuss three here.
First, the federal government already implicitly guarantees the "tail risk" in housing finance – the risk that mortgage markets will blow up, as they did recently. As former senior Treasury official Phillip Swagel has stated:
Here is one clear lesson from the economic meltdown of 2008: Any future U.S. administration will intervene directly and heavily if faced with a potentially devastating economic crisis. Market purists might not like it, but it is a fact I witnessed firsthand at the Treasury Department during the George W. Bush administration.
Why does Swagel come to this conclusion? Because it is clear that letting the mortgage markets (the largest and most important part of the broader banking system) collapse would be a far worse alternative than bailouts, leading to catastrophic economic consequences.
This is not some crackpot idea – the notion that financial crises wreak economic havoc has been clearly understood since the early days of modern capitalism, and has been repeatedly reaffirmed by historical experience. Whether or not the government decides to formally insure the tail risk of housing finance, the fact is that the American public already owns that risk. Why not make that guarantee explicit, limited and supported by an insurance pool paid into by the financial services industry (just as we do with the Federal Deposit Insurance Corp.)?
Second, we have yet to see the counterfactual – a successful housing finance system in an advanced economy that does not rely on high levels of government support. If we judge the efficacy of a housing finance system based on current policy priorities – maintain a broad and consistent flow of mortgage credit, offer it on fairly reasonable terms,= and don’t blow up into major financial crises every decade – there is not a single example of an advanced economy that achieves these goals without government support.
Some have pointed to Canada and Western Europe and claimed that these countries do not provide government guarantees to their mortgage markets, because these countries do not have government backing for securitization. As I’ve pointed out on a number of occasions, this claim is wrong and misleading. Outside the United States, most mortgages are not funded by securitization, but instead by bank deposits and other bank liabilities. Every advanced economy in the world, including Canada and the countries of western Europe, offers a number of government guarantees for these forms of funding, including deposit insurance (just like our own FDIC) and implicit guarantees against other bank liabilities (as evidenced by the massive bailouts, larger than our own, provided by European governments to protect investors in covered bonds and senior bank debt).
Third, government support appears to be critical for stability in housing finance. In the United States, we have had government guarantees in housing finance since the New Deal. For most of the post-War period, these guarantees came primarily in the form of federal deposit insurance for banks and thrifts. Beginning in the 1980s, we saw a shift, as government-insured deposits were displaced by government-backed mortgage-backed securities issued by Fannie Mae and Freddie Mac.
Prior to this time, the U.S. regularly experienced major financial crises every five to 10 years. It is worth noting that the only financial crisis we have had since the New Deal occurred following a period in which private non-guaranteed finance – the so-called "private-label" securitization of mortgages developed by Wall Street as an alternative to Fannie Mae and Freddie Mac – grew dramatically, briefly supplanting Fannie and Freddie as the largest source of mortgage finance in the United States. In other words, it is only when government support of mortgage finance has been non-existent or displaced that we have experienced financial turmoil.
One obvious reason for the correlation between financial stability and government guarantees is that such guarantees prevent banking panics from occurring by providing confidence to investors and thus preventing them from "running on the bank." It is well established in the banking and economics literature that government backstops prevent such runs from occurring.
Another important reason is that government support encourages the origination of loans with lower rates and more favorable terms for the consumer. Not coincidentally, these loans have been far less likely to default. For example, mortgages originated for Fannie and Freddie securitization performed roughly five times better than mortgages originated for private-label securitization, which suffered nearly a 30 percent delinquency rate following the collapse of the housing markets.
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