In the aftermath of the subprime lending bubble of 2005-2007 and subsequent freeze-up of global credit markets, the U.S. housing finance system remains on government life support.

The current policy question is what sort of housing finance system should the U.S. have in the crisis' aftermath?

Though contemporary housing finance systems evolved differently and vary significantly among countries, they fall into two broad categories: "market-oriented" or "government-driven." Not surprisingly, highly developed market economies have market-oriented systems whereas many developing countries have government-driven systems.

Political and economic experts draw very different inferences from the facts of the subprime lending debacle, but two conclusions are indisputable. First, the U.S. system was a unique market-government hybrid. Second, it caused the near-collapse of the global financial system. Some view the failure of the hybrid model as resulting from deregulation, but others view it as simply inevitable. The former propose more regulated variants of the hybrid model, and the latter, a return to an updated market-oriented model.

Few propose maintaining the current government-driven system because such systems impose huge economic costs, mostly in opaque ways. As the Obama administration poses the question, "What should be done about Fannie Mae and Freddie Mac?", the more fundamental question is, "What are the presumed advantages of a hybrid system that other market-oriented systems are missing out on?"

Treasury Secretary Tim Geithner indirectly gave an answer with his guest list for a meeting on this topic last August sponsored by the Treasury Department and the Department of Housing and Urban Development. A new system should keep the "benefits" of the old hybrid system but avoid the "costs," he said. The list of political constituents invited to comment on the future system was dominated by advocates of "affordable housing," "inner-city reinvestment" and the like. This selection revealed that the perceived benefits of our system are the implicit subsidies to selected groups, the costs of which are not reflected anywhere in the Treasury's budget.

Implicit unbudgeted subsidies in the form of implicit (or explicit) guarantees have produced short-term benefits for some, but the costs have always been paid in the longer term and generally far exceed the benefits. The attempt to do it off-budget within an otherwise private financial system distorts and undermines the stability of the financial system and was the root cause of the subprime lending debacle.

The U.S. made the transition to a hybrid model in the 1970s with the introduction of various lending targets (for example, through the Community Reinvestment Act) for publicly insured private lenders and social lending goals for the three government-sponsored enterprises — Ginnie Mae, Fannie Mae and Freddie Mac. Portfolio lending savings and loan associations, the traditional backbone of the U.S. housing finance system, were forced to compete at a major disadvantage. Federally chartered S&Ls had to fund fixed-rate mortgages with short-term deposits. This system collapsed in the 1980s and was replaced with an even more government-oriented hybrid GSE system.

Publicly insured banks are here to stay, but prudential regulation should not be undermined by social lending goals. Capital market financing will remain necessary, but the opportunities for "regulatory arbitrage" that drove private securitization off a cliff must be eliminated. Market participants can figure out the rest, for example, whether covered bonds work better than securitizations. This is the core of a market-oriented model.

The problem with all of the proposed capital market hybrids that seek to limit and/or price government backing is that policymakers have always done just that! Investors conferred "agency status" ex post facto in spite of the prior ill-conceived privatizations of Fannie and Freddie and would probably do so for the various proposed hybrids as well, especially when they inevitably grow too big to fail. GSEs in any form are no longer necessary and arguably never were.

Once the commitment to separate subsidy from finance is made, the design issues become fairly straightforward. Governments play a substantial role in market-oriented housing finance systems by providing a legal and regulatory framework for both retail and capital market mortgage finance and administering it in predictable ways that provide a balance of protection for savers and borrowers.

The transition back to a market-oriented system is more problematic precisely because the GSEs continue to deliver massive unbudgeted subsidies to home borrowers as the major instrument of current housing policy. This is compounded by today's Federal Reserve policy that is keeping mortgage interest rates at artificially low levels. In addition, the litigious attempts to shift the cost of the subprime mortgage debacle have created legal and regulatory ambiguity that further discourages any private mortgage finance. In short, the perceived political risk is currently too great to attract sufficient investors.

A competitive, private, market-oriented system serves qualified home borrowers and lenders best but has few political constituents. Qualified borrowers have no political advocacy comparable to that of subsidy petitioners. Investors benefit from earning higher yields but have historically been split on this issue; Wall Street investment banks have profited handsomely on GSE business.

Restoring investor confidence in housing finance will not be easy, given the history of political risk, post-crisis demagogic attacks on mortgage lenders, the accusatory legislative thrust of the Dodd-Frank Act and the wave of litigation trying to undermine investor rights. Many investors may prefer government-guaranteed securities to mortgages, seeking comfort in aligning their interests with those of Chinese investors.

Lacking sufficient political commitment to a competitive, market-oriented model with transparently budgeted subsidies, political forces are likely to align for a hybrid model. A transparently budgeted, government-directed model would be a giant leap backward but preferable to recurring global financial crises.

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