Dec262016

Subprime loans are a government subsidized entitlement

Should everyone really own a house? Are renters so much less a part of their communities that the government must spend billions of dollars subsidizing home ownership?

These are important questions. How we answer them will guide how we remake our housing finance system which was destroyed with the collapse of the housing bubble. The current system of government props with the taxpayer insuring more than 80% of the mortgages in the US is not tenable or desirable.

Is there a balance between public and private sector appropriate to the housing market?

Overzealous Intervention Dooms the Market

Edward J. Pinto

Those who want government guarantees for mortgages see them as a path to encourage homeownership and market stability, but instead guarantees pose needless risks to homeowners and taxpayers. Government guarantees suffer from three flaws: the inability and unwillingness to price for risk, asset allocation distortions, and the politicization of lending.

Let’s take these one at a time:

the inability and unwillingness to price for risk

Subprime borrowers default in larger numbers than prime borrowers do. That’s why they’re subprime. At a FICO score of 640, there is a 15% chance of default. The percentage of defaults rise as the FICO score drops. Banks must make enough on the 85% of borrowers who don’t default to cover the losses on the 15% that do, and make a profit. This forces banks to charge higher interest rates to subprime borrowers than prime borrowers who default less frequently.

With government mandates put on the GSEs, the risk of subprime borrowers was spread over all borrower classes. This under-priced the risk and caused them to underwrite more subprime loans than they would in the ordinary course of business. This is what politicians wanted, but it does create the inability and unwillingness to properly price for risk. Ultimately, that exposes the underwriting entity to large losses when economic conditions deteriorate.

asset allocation distortions

Any time risk is underpriced or subsidized by the government, capital flows into that asset class. Again, this is what politicians wanted, but it’s also economically inefficient as resources are diverted from other, more productive uses.

politicization of lending

Anyone who watched the advocates for the GSEs on Capital Hill would agree that lending becomes politicized when government subsidies are involved.

At a recent conference on housing finance reform, community and industry advocates called for a replay of the failed government “affordable housing” experiment begun in the early 1990s. That experiment cost America’s homeowners trillions as loose lending drove the homeownership rate and home prices to unsustainable levels.

Proponents of Subprime 2.0 say a government centric housing system is necessary to assure flexibility, accessibility, affordability and stability. We know from the last experiment that “flexibility” means subprime lending, “accessibility” means entitlements, “affordability” means subsidies, and “stability” means increasing leverage during boom times.

Further, affordability is an illusion. Each subprime borrower who is subsidized by the government crowds out another borrower who does not qualify for the subsidy. There is a finite number of houses, and although builders may respond by building more, the crowding out effect always occurs on the margins. The equilibrium state of a subsidized market is a higher price level. Affordability cannot be permanently increased by subsidy.

For example, achieving flexibility would require the widespread use of subprime loans with low down payments, low credit-score requirements and high debt-to-income ratios.

We know how that turned out.

I am in favor of a national housing market insurance fund like the FHA. If it properly prices risk, it can sustain itself indefinitely without government support. Its market share would shrink in good times as private lending takes a larger role, and if we ever have another disaster, it will serve as a backstop. It would lend when private money would not. The FHA would be a good model if it didn’t have the 3.5% down payment. This puts too much risk on the taxpayer. An insurance fund like the FHA that mandates 20% down payments could serve as a positive part of a new mortgage landscape.