The upside of the housing crash is that the world now sees the folly of a system where private entities like Fannie Mae and Freddie Mac gamble with public money, earning huge profits in a boom but leaving the risks to taxpayers in a downturn. After almost five years of public conservatorship, our legislators are finally planning to wind them down, and replace them either with a new public mortgage insurer with too few safeguards (the Senate plan) or nothing (the House plan). A better option lies in between: a more limited public entity that charges high enough fees to be irrelevant in good times, but that remains as a backstop insuring the mortgage market against collapse.
During their heyday, the mortgage giants claimed that the insurance they provided lowered borrowing costs and increased homeownership rates, all at no cost to the American taxpayer. We now know better. Ultimately, taxpayers had to cover the costs of their risk-taking with an almost $190 billion bailout.
Over the years, I have talked with Obama administration officials about the way forward, but reform has only become real with the two legislative plans, both of which want to wind down Freddie and Fannie in five years. I share the House’s dislike for public mortgage subsidies. The public sector shouldn’t encourage people to borrow more than they can afford or to buy bigger homes or to leave urban apartments for suburban McMansions.
But we haven’t experienced an unprotected mortgage market since the 1930s. We cannot know what going cold turkey will do by formulating fancy models or studying Europe. And we don’t need to leap into the policy unknown awash in so much ignorance. We can move gradually, by slowly reducing the loans that can be insured and raising the fees charged by a public entity.
The House would do more good by engaging with the Senate — and reducing its plan’s potential for disaster — than by sticking with purist laissez-faire. Intransigence will only ensure that Fannie and Freddie keep chugging along.
The Senate plan needs work because it does little to reduce the potential for future abuse. It would establish a Federal Mortgage Insurance Corporation (FMIC) empowered to “develop standard form credit risk-sharing mechanisms.” That sounds impressive but here’s how it would work. Banks would keep making loans, then the loans would be serviced by someone else, subject to a few more safeguards. Then the loans would be bundled into government-insured securities by a third party. A private entity would cover the first tenth of losses, and original down payments could only go below 20 percent if the borrower has private mortgage insurance.
The FMIC would charge fees that are high enough to build up enough capital to cover 1.25 percent of the covered mortgages within five years and 2.5 percent within ten years — but that seems like too much protection against extreme downturns. The FMIC also would have an open mandate for financial innovation, which seems risky given past experience.
The FMIC would also charge additional fees on every mortgage annually to support a Housing Trust fund, which is spectacularly unwise. If the trust fund is a good idea, then it should be paid for by general tax revenues, not a narrow class of borrowers. More importantly, those payments would create an unhealthy constituency for a large federal insurance entity, just as Fannie Mae’s do-gooding induced lawmakers to overlook its larger problems.
Instead of hoping for nothing, the House should require that the FMIC charges high fees that rise when times are good, and does nothing but insure standard mortgages. The FMIC could insure a 2.5 percent reserve ratio by charging a 2.5 percent mortgage insurance fee up front. Public insurance with high fees should achieve the House’s objective of protecting taxpayers, but also ensure that housing prices fall no more than the fee level. An FMIC that is limited in scope by the high fee that it charges can wean the mortgage market off federal guarantees without risking a collapse of the housing market.
Edward L. Glaeser, a Harvard economist, is director of the Rappaport Institute for Greater Boston.