The fiscal and regulatory issues still awaiting solutions are monumental: generating new living wage jobs to bring down unemployment; addressing the budget shortfalls at all levels of government; repairing and upgrading our physical infrastructure, especially for transportation and the electric power grid. But for a couple of reasons, fixing the mortgage market may be particularly contentious. More than any other problem, proposed solutions tend to fall along ideological lines in accordance with what you think caused the collapse of the banking system.
The US Treasury and Housing and Urban Development Departments held a Conference on the Future of Housing Finance this past August 17 as part of policy development for this process.
The Treasury conference tried to adhere to its title and stick to the future. But it’s hard to separate cure from diagnosis with this disease. Participants tried to characterize what the solutions should look like while avoiding the blame routine
The “takeway”
Conference consensus seemed to form around the conclusion that, for the time being, we are stuck with a large federal role, but that will eventually be phased out, (or not, if you are Bill Gross of PIMCO). (See summary conference notes thanks to: http://www.thinkglink.com/blog/2010/08/17/live-blogging-conference-on-the-future-of-housing-finance)
I’d like to focus on three ideas about which most if not the entire panel, shared their opinion (not agreement).
1. Federal housing subsidies have been excessive, they have been overwhelmingly in favor of middle and upper middle class homeownership; their market distortions have been harmful, and should be diminished.
2. Government policies forced banks and the GSEs (government sponsored enterprises - Freddie Mac and Fannie Mae) to abandon traditional high credit standards and inspired the banking crisis
3. Lightly regulated private financial institutions were not responsible for the crisis, and remain the salvation for the future of the credit markets.
First, where does all this subsidy come from and more important, where does it go? The Congressional Budget Office published “An Overview of Federal Support for Housing” in November, 2009. The three figures below excerpted from the report show the bias toward homeownership and away from renters. You can see a 4-to-1 ratio of support for homeowners over low income renters in the first graphic. It’s a peculiar arrangement that gives the most subsidies to those who need it least. It’s even worse when you see how much more difficult and bureaucratic the subsidy is to get the poorer you are - more on that in a different installment. It’s shouldn’t be a surprise that there was a bubble in middle class housing and a shortage of low income rental housing once you see how the subsidies were distributed.
Federal Support for Housing, 2009 (Billions of dollars)
Federal Support for Homeownership, 2009 (Billions of dollars)
Federal Support for Rental Housing, 2009 (Billions of dollars)
The second is a favorite libertarian theme that the federal government forced the lowering of lending standards. The key word is “force”.
The specific federal actions held responsible were the 1990s enforcement of the Community Reinvestment Act of 1977(CRA) and the HUD affordable housing guidelines applied to the federally chartered government sponsored housing enterprises (GSEs- Freddie Mac and Fannie Mae). In short, the CRA said that, in exchange for federal deposit insurance, banks were obligated to lend to families and businesses in their branch neighborhoods, including low income customers, or else their bank merger applications might get stalled. Incidentally, turning down some of those requests may have prevented some of these banks from becoming “too big to fail”.
The HUD guidelines restricted new business for the GSEs unless growth included increased home loans to low income families. The motivation for this was that despite the great advantages that the federal government had given to the GSEs in the mortgage market, the beneficiaries were predominantly middle class suburban single family home owners. Although this had been Fannie Mae’s target market from its inception (1938), there was every reason to believe that urban, rural and renting Americans should also benefit from some version of the “American Dream”. The guidelines merely said that if you are going to continue growing you have to include these neglected markets as part your expansion. The simplest alternative was to slow the growth.
By the late 1990s, observers were noticing the increased risk of a rapidly growing and increasingly leveraged Fannie Mae and Freddie. Peter Wallison of American Enterprise Institute (AEI), points this out on several occasions well before the 2007 crisis. He warned in “Nationalizing Mortgage Risk; The Growth of Fannie Mae and Freddie Mac” with co-author Bert Ely that having fully penetrated the prime market, Fannie could only meet its growth targets by expanding into home equity, multifamily, and inevitably, the sub prime market. These risky departures from their traditionally safe product mix grew from following their own corporate growth strategies, not from HUD coercion.
Between 2002 and 2005, FNMA increased their purchases of sub prime mortgages from non-bank originators because they were concerned about losing market share in the mortgage-backed securities (MBS) business to the large investment banks and their affiliated originators.
The point is that both the banks and the GSEs had alternatives to making bad loans. They could slow their growth - which doesn’t sound like “forcing” unless you have no alternative but to grow. Unfortunately, some firms, including the “too big” banks and Fannie Mae never seriously considered slowing down. They were dedicated to their growth strategy. Their stock price, along with their stock options, depended on it.
Third, is the for-profit private sector always the preferred alternative to a politically driven public agency? “Free enterprise” gets a lot of unchallenged praise for efficiency, and innovation, especially when compared to government. But what happens when the interests of the shareholders, senior management and the customers are not the same.
Conveniently enough, only a few days after the housing finance conference, a Wall Street Journal article appeared, The Case Against Corporate Social Responsibility by Aneel Karnani, an associate professor of strategy at the University of Michigan School of Business. His most relevant observation to private sector involvement in housing finance, especially low income housing comes early in the piece: “Very simply, in cases where private profits and public interests are aligned, the idea of corporate social responsibility is irrelevant: Companies that simply do everything they can to boost profits will end up increasing social welfare. In circumstances in which profits and social welfare are in direct opposition, an appeal to corporate social responsibility will almost always be ineffective, because executives are unlikely to act voluntarily in the public interest and against shareholder interests.”
The mismatch between the interest of senior management, shareholders and homeowners could explain at least as much of the credit market collapse as government housing policy. When a “growth company” encounters a traditional, mature, moderately profitable industry like residential mortgages, stability is not likely to continue. See the next article on inappropriate corporate models (Shouldn’t we be careful with what we feed to growth stocks?).
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