Housing policy must be set on sustainable basis

By Hank Paulson

The financial reform bill enacted last week is a significant step toward a much-needed modernization of our regulatory structure. It will provide tools to help mitigate and manage the next financial crisis. But the job remains unfinished until Congress addresses the housing policies that fueled the crisis -- a big part of which requires reforming and dramatically scaling back Fannie Mae and Freddie Mac, the two government-sponsored housing enterprises that brought our nation's financial system and our entire economy to the brink of collapse.

A significant root cause of the crisis was the combined weight of government policies promoting homeownership; these are apparent in the housing GSEs, the Federal Housing Administration (FHA), the Federal Home Loan Banks, the federal tax deduction for mortgage interest and various state programs. Homeownership was overstimulated to the point that it was unsustainable and dangerous to the broader economy.

The GSEs, now placed in conservatorship, and the FHA still provide a massive subsidy to our housing market, touching more than nine out of 10 new mortgages. When the housing market is clearly recovering -- and it is still far from robust -- we must have the fortitude to create a more level playing field between housing and other productive investments.

Fannie Mae and Freddie Mac should not be allowed to revert to their old form, crowding out private competition and putting taxpayers on the hook for failure while shareholders benefit from success. Reform should address the systemic risk they pose and should wean our mortgage finance system from its dependence on these institutions.

Any entity that Congress creates to serve a public policy goal of reducing mortgage costs cannot also be driven by shareholder returns. We must eliminate the inherent conflict between public purpose and private ownership that was destabilizing to the GSEs. Congress could eliminate that tension by restructuring Fannie and Freddie to create one or two private-sector entities that would purchase and securitize mortgages with a credit guarantee explicitly backed by the federal government and paid for by the new entity. These privately owned entities would be set up like public utilities and governed by a rate-setting commission that would establish a targeted rate of return.

Regulation for fiscal soundness would be essential, as would oversight to ensure that the quality of conforming loans remained high.

The best way to address the systemic risk posed by Fannie and Freddie is to shrink them by eliminating their investment portfolios -- and their huge debt loads that put the financial sector at risk and necessitated a costly public rescue.

We should go further and reduce the subsidy for homeownership that helped create the crisis. The central place of homeownership as part of the American dream reflects a bias of our society that is unlikely to simply end. Policymakers may well decide that we should continue to facilitate lower-cost mortgages through a subsidy to mortgage credit guarantors. Even so, the scope of the subsidy should be reduced by rationalizing and reducing the missions of the FHA and the successor(s) to Fannie and Freddie. I would recommend limiting the availability of the subsidy to smaller mortgages or lower-income buyers or both. And the price the government charges this new private-sector entity for its credit guarantee must be high enough to leave room for a robust private-sector mortgage market that serves taxpayers and homeowners equally.

The benefits of a reduced subsidy for homeownership are clear. But we cannot move toward this model until the housing market is stabilized and housing prices are likely to rise.

The GSEs are providing an enormous stimulus to the economy. Placing Fannie and Freddie in conservatorship was, in my view, the most effective of the stimulus efforts undertaken in the past two years. This stimulus was aimed squarely at the driver of our financial and economic crisis: the decline of home prices. Without public support, ensuring that mortgage financing was available during the worst moments of the financial crisis and the ensuing 22 months, the housing market would have ground to a halt, home prices would have spiraled downward, foreclosures would have skyrocketed, and financial institution balance sheets would have suffered greater losses, leading to a prolonged downturn and the loss of millions of additional jobs.

Home sales are still suffering despite record-low mortgage rates, and the availability of low-cost mortgage credit is vital to avoid a further housing decline that tips the economy back toward stagnation. It will take time to reach consensus on the government's proper role in subsidizing housing and how to replace the GSEs with a more stable construct that reduces risk to taxpayers and the economy. Given today's political climate, this will not be easy. And it will take real leadership from both parties to get it done. But this is vital, and the discussion must begin now.

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