Did Congress just settle for less than best plan to reform housing finance?

Published in The Hill.

House Financial Services Committee Chairman Jeb Hensarling (R-Texas) has long worked to move the American housing finance sector toward private and competitive markets and away from the distortions and disasters of government guaranteed debt with huge risks to taxpayers.

His previous policy direction, exemplified in his sponsorship of the Protecting American Taxpayers and Homeowners Act, was the correct one, both economically and philosophically. But up against the many well placed interests that feast on subsidies from the government dominated system, it could not succeed politically. The history of American mortgage lending should make us modest as a country. Our housing finance system has collapsed twice in the last four decades, first in the 1980s then again in the 2000s. We should certainly try to do better going forward.

Now Hensarling, working across the aisle with John Delaney (D-Md.) and Jim Himes (D-Conn.), has introduced a discussion draft of the Bipartisan Housing Finance Reform Act, which he hopes will prove a “grand bargain” to create a “sustainable housing finance system for the 21st century” after 10 years of a stalemate in Congress. But central to this new proposal is vastly increasing the government guarantee of mortgage backed securities by using Ginnie Mae, a wholly owned government corporation whose liabilities deliver the full faith and credit of the United States. Thus, the government and taxpayers would explicitly guarantee virtually the whole secondary mortgage market.

Has Hensarling given up on his principles? No, but he has decided that, with the best choice unavailable, he will settle for what may be the second best, arguing that it would be an improvement from where we are and where we have been stuck for a decade. The new bill requires private capital to bear a junior position in mortgage credit risk, taking losses ahead of Ginnie Mae, which is to say, ahead of taxpayers. It abolishes the federal charters of Fannie Mae and Freddie Mac, while allowing them to become private credit risk takers, among other such private institutions. It also allows the Federal Home Loan Banks to aggregate mortgage loans for their members. I especially like this last idea because my team developed it while I was running the Chicago Home Loan Bank.

Consider the following series of options. The best choice is a primarily private and competitive housing finance system, but it cannot happen politically. As a second best choice, a system is proposed that uses big government guarantees, but fits in as much private risk bearing and competition as it can. A third choice would be a bad decision to stay where we are now, with Fannie and Freddie perpetually in conservatorship but dominating the housing finance system nonetheless. Finally, the worst choice is to return to the old and failed Fannie and Freddie model.

Given where we are, is it better to wish for the best and never get it, or try to move toward a second best option, which might be politically feasible? This second best strategy is understandable and reasonable. But is the structure proposed in the new bill actually the second best available? That is debatable. For example, when it comes to the key idea of having private capital bear the principal credit risk, the bill unfortunately misses an essential principle that the best place for the junior credit risk to reside is with the institution that made the loan in the first place. That is the party with the most knowledge of the credit and the only one with direct knowledge of the borrower. Keeping the credit risk there provides by far the best possible alignment of incentives for a sound housing finance system. It also spreads the credit risk bearing across the country.

This is demonstrated by the unquestionably superior credit performance through the financial crisis of the mortgage portfolio built on this principle by the Federal Home Loan Banks in their mortgage partnership finance program, the first loan of which was completed by the Chicago Home Loan Bank in 1997. The risk principle in this program provides more than 20 years of instructive experience to draw on in moving toward a better housing finance system for the United States, even if, as Chairman Hensarling has concluded, we cannot attain the best.