The Economics of Housing Finance Reform

This paper analyzes the two leading types of proposals for reform of the housing finance system: (i) broad-based, explicit, priced government guarantees of mortgage-backed securities (MBS) and (ii) privatization. Both proposals have drawbacks. Properly-priced guarantees would have little effect on mortgage interest rates relative to unguaranteed mortgage credit during normal times, and would expose taxpayers to moral-hazard risk with little benefit. Privatization reduces, but does not eliminate, the government’s exposure to mortgage credit risk. It also leaves the and financial system exposed to destabilizing boom and bust cycles in mortgage credit. Based on this analysis, we argue that the main goal of housing finance reform should be financial stability, not the reduction of mortgage interest rates. To this end, we propose that the private market should be the main supplier of mortgage credit, but that it should be carefully regulated. This will require new approaches to regulating mortgage securitization. Moreover, we argue that while government guarantees of MBS have little value in normal times, they can be valuable in periods of significant stress to the financial system, such as in the recent financial crisis. Thus, we propose the creation of a government-owned corporation that would play the role of “guarantor-of-last-resort” of newly-issued (not legacy) MBS during periods of crisis.