Thomas  M. Hoenig, president of the Federal Reserve Bank of Kansas City, characterized the recent housing collapse as a classic asset-price bubble spurred by low interest rates, easily accessible and often-unsound financing, over-optimism about housing price trends, and a high - and difficult to control - level of subsidies that flowed into housing.  The few exceptional years of housing activity, he said, do not come close to making up for the economic recession, foreclosures, erased wealth and slow recovery that we are now experiencing.    In remarks to the National Association of Realtors (NAR) at its annual meeting in New Orleans on Friday, Hoenig called for a new housing policy that requires greatly reduced governmental intervention and public subsidies.

There are several factors that argue for this approach, he said.  First, the crisis clearly shows that a mortgage finance system based on encouraging the ratio of debt to equity places households at significant risk and creates unsustainable trends in housing expansion.  Such policies also create harmful distortions in the economy and are enormously expensive to both homeowners and taxpayers, especially when things go wrong.  Many housing subsidies are structured to allow parties other than homeowners to capture most of the benefits. Finally, the growing budget deficits and numbers of interests competing for funds make it unrealistic to think housing can continue to command the same portion of public funds and taxpayer support.

The first step in changing housing policy should be reform of Fannie Mae and Freddie Mac.  Hoenig cited the $170 million the two government sponsored enterprises (GSEs) spent on lobbying in the decade before they were placed in receivership where they have and will cost taxpayers hundreds of billions.  "Given the costs and market distortions these (GSEs) brought with them, we should be confident that they should not be allowed to operate in the future as they have in the past."

Hoenig suggested two basic options for GSE reform.  If it is decided that some public support is needed, the government could establish public entities that focus solely on the securitization of well structured conventional conforming loans and with balance sheets limited to amounts necessary to warehouse loans for securitization.  This would limit government's role to that of a conduit; facilitating the flow of capital but not providing any guarantees.  The market would remain the final arbiter of standards and funding.     

A second option would allow private entities the sole authority to securitize conforming mortgages with a federal guarantee given to some securities backed by mortgages meeting strict standards, but only where the loans fill a special need or purpose.  This option, Hoenig said, would promote greater market discipline and insulate the process from political influence and control.

Apart from reforming the GSEs, the nation must insist on a return to sound real estate lending standards Hoenig said.   Other countries did a better job of maintaining debt and loan to value ratios, but there was a tendency in the US to also establish standards that encouraged high household leverage.  It is necessary that we take a closer look at the loan-to-value guidelines followed by depository institutions but we should also make sure that these guidelines are applied equitably to other lenders as well. 

Other lending provisions, subsidies and public policies also need to be examined including risk weights for mortgage loans and mortgage-backed securities under the Basel capital requirements, state and federal tax deductions for mortgage interest, credit agency assessments of MBS, and other public housing policies.  The key to reviewing policy is to consider whether each policy encourages homeownership in a cost effective manner without putting homeowners at high risk.  He cited a presidential panel's findings in 2005 that the federal tax deduction for mortgage interest provided "an incentive to take on more debt" and encouraged overinvestment in housing and was a benefit not shared equally among all taxpayers.

Hoenig concluded by stating that "many countries have achieved higher homeownership rates without - and perhaps because they don't have - many of the special privileges of U.S. housing finance, such as GSEs, minimal down payments, 30-year fixed-rate loans and mortgage interest tax deductions.  To this list we could also add non-recourse debt instruments, government promotion of 'creative and flexible financing,' the ability to prepay loans, affordable housing goals, and similar government housing programs."

Hoenig said he is not suggesting we do away with all support for housing, he is saying it is time for a change.    

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