The American Enterprise Institute has come forward with its proposal for reforming the housing finance system which advocates taking the government totally out of the picture and implementing a system reliant on credit quality to attract investors.

In a White Paper titled Taking the Government Out of Housing Finance:  Principles for Reforming the Housing Finance Market, authors Peter J. Wallison, Alex J. Pollock, and Edward J. Pinto fault the Dodd-Frank Act for ignoring government housing policies which "caused the recent financial crisis it was supposed to address." 

The report dismisses the assumption that institutional investors will not buy mortgage backed securities (MBS) unless they are issued by a government sponsored enterprise, government agency, or backed with a government guarantee.   Instead, it suggests a system in which only prime quality mortgages are allowed into the securitization system.  "The very low delinquency and default rates on prime mortgages will be attractive investments for institutional investors and enable the housing finance system to function effectively with no government support."  This, the authors say, will eliminate potential taxpayer losses in the future and allow the eventual elimination of Freddie Mac and Fannie Mae.

The paper advances four principles to support its argument, saying that these principles, if in place for the last 20 years, would have averted the financial crisis of 2008 and the savings and loan meltdown in the late 1980s. 

  1. The housing finance market can and should principally function without any direct government financial support. The paper maintains that the losses in the both of the housing crises referenced above did not come about in spite of government support for housing finance but because of it.  The reform proposals being put forward now have the fundamental flaw of supposing that the government can successfully establish a risk-based price or other compensatory fee for its guarantees or other support.  The problem is not solved by limiting the government's risk to MBS because a guarantee eliminates an essential element of market discipline, the risk aversion of investors.  This will lead again to deteriorating underwriting standards; regulation of issuers will fail, and the loss will again fall on taxpayers.
  2. If regulation is necessary it should be focused on ensuring mortgage credit quality.  Rather than relying on a government guarantee to make MBS more attractive to investors, the quality of mortgages should be primarily prime mortgages.  We know what is necessary to produce a prime mortgage, the paper states, and in pre-GSE days "these were the standards that kept credit losses in the mortgage markets from affecting the entire economy."  The authors allow that some regulation of credit quality is necessary or the natural tendency to assume that good times will continue will always cause bubbles in the housing market and these in turn spawn risky lending.  The government can interrupt this process by inhibiting the creation of weak and risky mortgages through appropriate regulation.  The authors propose using the Securities and Exchange Commission to ensure that MBS be issued only using prime loans and appear to welcome regulation that would limit subprime lending in both the public and private sectors. Government regulation is also welcome when it comes to restraining exuberant markets.  The report suggests that countercyclical leverage requirements should come into play when housing prices rise.  This would mean raising required LTVs and CLTVs and requiring lenders to build loan-loss reserves during good times rather than bad.  The report also suggests that appraisers be required to use both comparable sales and rental value in estimating value.
  3. All programs for assisting low-income families to become homeowners should be on-budget and limit risks to both homeowners and taxpayers. The authors acknowledge that there is room for social policies that assist low-income families to be homeowners but say that these policies must balance the interest of the low income with that of taxpayers.  While the quality of the mortgages made under social policies can be lower than prime quality there "must be quality and budgetary limits placed on riskier lending in order to keep taxpayer losses within reasonable bounds."
  4. Freddie Mac and Fannie Mae should be eliminated as government sponsored enterprises over time. The report recommends privatizing the two GSEs gradually to allow the private sector to take on more of the secondary market as the GSEs wind down.  This should be done by reducing the conforming loan limit by 20 percent each year in both regular and high-cost areas.  Banks, S&Ls, insurance companies and other portfolio lenders would be supplemented by private securitization but "Congress should make sure that it does not foreclose opportunities for other systems, such as covered bonds."

To put these recommendations into some context, the American Enterprise Institute, which generally bills itself as "non-partisan" research entity, does have a strong conservative bent and, while it does not reveal its sources of funding it does acknowledge substantial corporate support.  Among its most notable current personnel are former Supreme Court nominee Robert H. Bork, former VP Cheney's wife Lynn, former Speaker of the House Newt Gingrich, actor and presidential candidate Fred Thompson, and Iraqi war architect Richard Perle.