When Treasury Secretary Tim Geithner announced the Obama Administration's plan to revamp the housing finance system, I would have thought they would have learned the important lesson of the Great Recession: financial markets fail without strict regulation. But instead of applying that lesson by proposing strict controls on mortgage securitization and trading, Treasury's plan appears to offer more of the same sort of market-is-god ideology that got us into this mess in the first place.
Under our plan, private markets – subject to strong oversight and standards for consumer and investor protection – will be the primary source of mortgage credit and bear the burden for losses. Banks and other financial institutions will be required to hold more capital to withstand future recessions or significant declines in home prices, and adhere to more conservative underwriting standards that require homeowners to hold more equity in their homes. Securitization, alongside credit from the banking system, should continue to play a major role in housing finance subject to greater risk retention, disclosure, and other key reforms.
At the very top of Treasury's agenda is to wind down Fannie Mae and Freddie Mac. According to the received, mostly conservative ideology, Fannie and Freddie played too large a role in the mortgage finance market. Therefore, the functions that Fannie and Freddie performed, adding liquidity to the mortgage market, should instead be performed by what they call "private capital," which means Wall Street. Treasury notes that "private capital" has recently retreated from housing finance, leaving Fannie Mae to cover 90% of new mortgages. But Treasury fails to address the central reason why private capital has retreated from the market: nobody trusts these securities, mainly because the complexity by which they are constructed leaves investors open to risks they cannot properly ascertain.
It would seem to me that the most simple thing to do is not get rid of a New Deal-era institution like Fannie Mae, but to go back to the basics. Make Fannie Mae promulgate simplicity and clarity throughout the mortgage finance market. Fannie Mae can impose strict underwriting standards and simple and clear regulations on the kinds of securities they will purchase. Using the government guarantee of mortgage securities need not pose a massive risk to taxpayers so long as the standards for what they will and will not guarantee are simple, high, uniform and clear. That was the case for the first 50 years that Fannie Mae operated with nary a single housing crash. The administration also proposes moving FHA out of the market more aggressively and leaving its role to Wall Street as well. The plan to is decrease the FHA loan limit and increase the interest rate on its loans. After which, the thinking goes, Wall Street will then rush into these markets to take up the slack.
Which brings us back to the central idea in Treasury's plan: belief that the problem in the housing finance market originated with the federal housing programs created under the New Deal, and that Wall Street should be doing this job instead of the federal government. To be fair, Treasury officials believe that all they need to do is regulate the private market better and that will be that. The problem is, they don't seem to understand how things work on Wall Street. Or maybe they do. In any case, no regulator will be able to keep up with the sort of financial creativity that Wall Street uses to "spread risk," which means gambling. Furthermore, Treasury's idea of strict regulation of housing finance basically amounts to a prayer:
Our plan is also designed to eliminate unfair capital, oversight, and accounting advantages and promote a level playing field for all participants in the housing market.
Notice the "level playing field" jargon. The idea is that once left to Wall Street, there will be a heavy amount of fair and open competition, and that this, subject to "strong oversight" (ha!) will provide enough capital to lead to a recovery in the housing market. This idea must be a joke. I can almost hear bond traders chuckling with derision.
Treasury's plan really has nothing to do with fixing the central problem in the economy—housing—and more to do with adhering to a market ideology that is clearly wrong. The problem with the housing market was not that there was too much government. It is that there was far too little. Fannie Mae and Freddie Mac's relaxed standards of the late 1990s did not cause the crisis in housing. The crisis was caused by complex, sometimes fraudulent creation of mortgage securities by an unregulated derivatives market. Instead of focusing fire on the cause of the problem, Treasury appears to have accept the conservative argument that it is the New Deal housing programs that are at fault. Wrong. The very people Treasury wants to turn the housing market over to are at fault. Certainly Fannie Mae and Freddie Mac had problems, for sure. But both institutions performed their roles very well until unstable and unregulated markets began to offer up unstable, unregulated, sometimes downright fraudulent securities for those institutions to purchase. That is where the problem lies.
The meager reforms of Dodd-Frank, while certainly helpful in some ways, do not go far enough to deal effectively with the ever-increasing complexity of financial instruments. With Treasury basically saying "more Wall Street in the mortgage market," we no doubt will encounter the very same sorts of high-risk gambling that ruined the market in the first place.