Housing is consumption. What the United States needs is a greater ability to produce.
Our ability to produce determines the quantity and quality of meaningful jobs in the United States. Shifting resources from investment to consumption (housing) lowers our long-term standard of living.
Fannie Mae, Fraddie Mac, and the Federal Housing Administration currently control more than 90% of the housing finance market in the United States. The reason that they have this large market share is that they are taking irrational risk. They are taking risks that market participants will not take. Because Freddie and Fannie have a government guarantee, these risks are passed to the taxpayers.
Freddie and Fannie are taking an extraordinary amount of interest-rate risk. The FHA is taking a significant amount of credit risk with 3% down payments. These are ultimately the taxpayers' risk. We might get lucky, but these are not risks that a rational investor would take.
The best strategy would be to simply announce that in one year, Freddie, Fannie, and the FHA will quit making home mortgage loans. After they wind down their origination busi-ness, they will liquidate or sell their existing mortgage portfolios. Unfortunately, the taxpayers will assume the losses (which already exist anyway), but at least this liquidation will eliminate future losses.
Market participants will quickly fill the home finance gap. Financing homes is an excellent business. The S&Ls were successful in this market for 50 years before they were destroyed by government policy.
The government should not in any way interfere in the market process, especially by subsidizing the originate-and-sell mortgage model that Freddie and Fannie created. The investment banks and mortgage bankers make substantial profits from their relationship with Freddie, Fannie, and the FHA.
As typical crony capitalists, they will argue strongly for government subsidies via credit guarantees and other such supports for the originate-and-sell model. Of course, the investment banks will capture most of the value of the subsidies as profits for themselves. A purely market-based originate-and-sell model will evolve. The model will deal with the fraud issue and will underwrite to rational credit-risk standards.
Not only Freddie and Fannie but also the FHA must be eliminated. The FHA is a huge distorting factor in the low-end home finance market. If Congress wants to subsidize housing, it should do so directly, where taxpayers can clearly see the cost and where all of the benefits flow to the low-income home purchasers.
A major component of the solution will be provided by existing commercial banks that retain home mortgages in their portfolios the way the S&Ls did. One of the few major economic systems to have limited problems as a result of the financial crisis is Canada. One reason the Canadian banks did relatively well is that they portfolio home mortgages. While there are some housing subsidies in Canada, the banks do not have to compete with the government, that is, Freddie, Fannie, and the FHA. Also, since the banks were holding the mortgages on their books, they cared about the credit risk and underwrote the risk rationally.
Having commercial banks make and hold home mortgages using rational underwriting standards (that is, appropriate down payments, debt-to-income ratios, and so on) would reduce the risk in the commercial banking industry. Properly underwritten home mortgages are low-risk assets.
Life insurance companies will also reenter the market, as home mortgages are a natural fit for their long-term investment portfolios. However, it is critical that the regulators adjust capital requirements.
Many life insurance companies and other investors like having government guarantees on their assets (via Freddie, Fannie, or the FHA). However, this is very destructive public policy because it pushes the risk to taxpayers and not market participants.
John Allison is the president and CEO of the Cato Institute and the former chairman and CEO of BB&T. This article is adapted from his forthcoming book, "The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy's Only Hope."