A Housing Reform Test Drive

U.S. housing officials are right to slowly reduce the government's large footprint in mortgage markets.

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Exterior view of home with a reduced price sign in Palo Alto, Calif., Tuesday, Aug. 21, 2012. Average U.S. rates on fixed mortgages fell for the week of Aug. 30, 2012, and are just slightly above record lows reached earlier this year. The low rates have contributed to a modest housing recovery.

U.S. housing officials are preparing to reduce the government's abnormally large footprint in mortgage markets, one of the most visible remaining legacies of the subprime lending crisis. It's the right move at the right time.

The Wall Street Journal reported Monday that the Federal Housing Finance Authority will order Fannie Mae and Freddie Mac to cut the size of mortgage loans they will guarantee. The idea is that with the government backing nine out every 10 loans, taxpayers are bearing too much risk, and it's time for private capital to step in and take on a greater share.

That's the right call, but it will meet resistance from the housing industry and consumer advocates who worry, quite reasonably, that it might mean even tighter credit for middle-income homebuyers in certain high-priced markets (typically found along the coasts), such as San Francisco, New York and Washington, D.C. Such advocates of maintaining the status quo say the recovery is still too shaky and investors are still leery about buying and making loans to any but the most affluent, low-risk borrowers.

[See a collection of political cartoons on the economy.]

But private mortgage investors, on the other hand, are likely to applaud the FHFA's move. Investors and securitization firms like Redwood Trust and Two Harbors have been eager for the opportunity to show what they can do when they don't have to compete with the federal government. They say there is plenty of appetite for private lending, so long as they aren't undercut by the ultra-low rates the government can offer.

At some point, we must move from the "recovery" phase of the housing crisis to the "reform" phase. Creating a sustainable mortgage finance model will entail some difficult choices, like when and how much to lower the guaranteed loan limits.

Congress is considering proposals for a radical overhaul and even the outright elimination of Fannie and Freddie. Instead of leaping into the unknown, however, why not test the premise on which any reform rests: that private capital is ready to resume its primary role in providing mortgage credit to U.S. homebuyers through a robust secondary market?

[Read the U.S. News Debate: Should the Federal Government Provide Support to the Mortgage Market?]

That's exactly what the FHFA seems to have in mind. The trick is to ratchet down the loan limits gradually. Too swift or large a retraction could re-freeze credit and destabilize the fragile housing recovery. For their part, private investors should consider themselves "on the clock" and move briskly to occupy space evacuated by Freddie and Fannie. That will give us a useful barometer of investors' real appetite for buying up loans not guaranteed by Washington.

The key threshold the FHFA should be looking for is a relative expansion, not a contraction of credit by the private markets. Simply swapping out pristine government loans for private capital on a one-to-one basis won't tell us much about whether the private sector is truly ready to meet the needs of all homebuyers. The government shouldn't replace what the private markets are willing to offer to be sure, but we know from the very recent past that if economic conditions turn, liquidity based on private funding can disappear instantly.

It's not often that Washington is faced with the opportunity to safely and appropriately take measures to let the market lead the way on reforms of significant consequence. If the appetite for investors is simply not there, and market conditions show signs of considerable deterioration, the FHFA can re-instate loan levels down the road.

The stabilizing presence of the GSEs should buttress any harmful market impact, proving their worth yet again. If that's the case, lawmakers, especially in the GOP controlled House, which is considering a bill based 100 percent on private capital, will have to face the reality that the government guarantee should be the keystone of a sustainable housing finance system.

Jason R. Gold is director of the Progressive Policy Institute's "Rebuilding Middle Class Wealth Project" and senior fellow for financial services policy. Keep up with his work at PPI here and follow him on Twitter at @PPI_JGold.

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