Eliminating government housing market subsidies will be painful

Government subsidies are like drugs. Once the market is exposed, the participants quickly become dependent, and like any addict that goes through detox, getting off the subsidies can be very painful. The housing market completely relies on government supports and subsidies with over 95% of the loans underwritten in the United States backed by either the FHA or the GSEs with explicit government backing for any losses. Politicians claim they want to reduce the government’s footprint in housing finance, but the various interest groups who make a living from residential real estate transactions (realtors, mortgage brokers, homebuilders) are united in their opposition to any reduction in the level of government support for housing.

Much has been made of the recent strength of the housing market, but as Mike recently asked on a weekend post If the housing market is doing so well, then why all the subsidies? It’s one of those common sense questions nobody else bothers to ask. The plain and obvious reason we have all the subsidies is because the market is completely and utterly dependent on them.

Why has Congress left housing to Fannie Mae and Freddie Mac?

Posted by Neil Irwin on March 5, 2013 at 10:09 am

Here’s how strange things have gotten in the world of housing finance. Fannie Mae and Freddie Mac, along with their regulator, are doing more to dismantle themselves than Congress can be bothered to do. Monday their regulator, Ed DeMarco of the Federal Housing Finance Agency, said that a new company will be formed that will do much of the back-office work of both firms, setting the stage for whatever Congress decides to do next to overhaul the mortgage sector. …

(see: DeMarco prepares for final shutdown of GSEs)

No legislation to overhaul the nation’s mortgage finance has passed either the Republican-led House or the Democratic-led Senate. The White House unveiled a plan for what to do—more than two years ago—that was less a plan than a menu of optionsfrom which Congress might choose in sculpting its own approach to reforming the government-sponsored enterprises, or GSEs.So what is going on here? How is this an area where seemingly everybody agrees there needs to be an overhaul, yet no actual legislative action?

The answer boils down to this: Too many people benefit from the current system, and too many people have something to lose in any overhaul.

The special interest groups and lobbyists will fight any reduction in subsidies. Right now they make the argument that the market is just starting to recover and any reduction in support would cause the recovery to fail. They are probably right.

Here’s a refresher on the situation, and the problem: In the pre-crisis days, Fannie and Freddie occupied a strange place in the American corporate landscape. They were private companies with shares traded on the New York Stock Exchange, dedicated to maximizing profits for shareholders. Their executives were paid well and they employed scores of lobbyists. But they also had the implicit backing of the U.S. government, ensuring that the millions of home mortgages they packaged were nearly as risk-free as lending to the government itself. Heads, we (Fannie and Freddie shareholders) win. Tails, you (the taxpayer) lose.

That created some bizarre incentives. For ordinary homeowners, it meant lower mortgage rates than they would have had otherwise. For politicians, it meant a steady stream of campaign donations and other support so long as they remained supportive. It meant that it seemed to the government like a free lunch, because there was no annual appropriation to the companies.

Of course it wasn’t free at all, and when the housing market collapsed in 2008, the bill came due for the U.S. government—the aforementioned $131 billion bill, to be precise. …

Of the various options available to Congress, privatizing the GSEs is the worst of them. Complete elimination would be my first choice, but some form of government insurance or market backstop is inevitable. That fact that the FHA and GSEs successfully prevented an much deeper drop in prices will be used as a justification for a market backstop. The privatization option has all the advantages the reporter mentioned above, but risk will be mis-priced again due to the implicit government backing, and the taxpayer will end up paying the bills when they come due. At least if it’s run as a government insurance policy similar to the FHA, the premiums can be adjusted to keep the fund solvent in the long term, and the profits won’t be absconded by the private sector.

They have also played a crucial role in the recovery. In 2009, when banks were in horrendous shape and had little ability or desire to make home loans, Fannie and Freddie filled the vacuum, acting as the key providers of funding for the housing sector. It is hard to even imagine how much worse the housing collapse would have been if, when the banking sector was in dire shape, there had been no federal backstop to keep dollars flowing to homebuyers. They now account for 90 percent of the mortgages issued in the United States.

The miniscule jumbo market is the only lending in the United States not specifically backed by the GSEs or FHA.

That’s why any serious proposal to reform the GSEs retains some government role in supporting mortgage lending. If legislation to overhaul housing finance stripped out the government role entirely, it would surely lead to a sharp spike in mortgage rates and shortages in the availability of loans, and even after things stabilized would leave the nation more vulnerable to collapses in home prices.

There is no question that a non-government backed loan will carry a higher interest rate than a government-backed loan. This increased cost will reduce loan balances and strip much of the current affordability out of the market.

More practically, it is hard to see how it could ever pass over vehement objections from all the industries tied to housing—homebuilders, realtors, banks. …

The pressure from those lobbying groups is intense. realtors are one of the biggest donors to politicians in the country, and it’s already well documented that the banks own Congress. With those groups opposed to any kind of reform because it would reduce their profits, it’s going to be difficult for Congress to protect the taxpayer from future looting from those powerful lobbies.

In effect, the GSEs have been one of the major ways the U.S. government subsidizes home ownership for generations (the other biggest one is the mortgage interest tax deduction). If lawmakers try to yank away that subsidy, they will face vigorous opposition.

There are any number of ways to do that (Here is an overview of the Obama administration’s three proposed options). Any of them will face opposition from industries that benefit from the status quo. But something will have to change to give the United States a system of housing finance that doesn’t leave taxpayers on the hook for everyone who wants a place to live.

The lobbyists couldn’t care less about the greater good or protecting the US taxpayer. Right now, realtors, banking interests, and homebuilders are enjoying their rich subsidies, and they won’t want to give them up.