Thursday, October 28, 2010

Introducing a New Column

Today we are introducing a new column by Martin Kennedy, who teaches economics at MTSU. He will be discussing business news and interviewing Jones College faculty experts on particular topics. Views expressed will not necessarily be those of the Jones College. We invite reader input. 

Residential Lending Reform

"The reform of residential lending is going to result in a massive overhaul of the government-supported entities."  That's Senator Bob Corker (R-TN) as reported by the Nashville Post during a symposium in Nashville.  Those government-supported entitites are Freddie Mac and Fannie Mae.  Such entitites were created by the U.S. Congress.  The idea behind such government-supported enterprises was to facilitate the flow of credit — to make housing more affordable.

Freddie and Fannie buy mortgages.  They hold some and bundle and sell the rest — Mortgage Backed Securities.  How do they make money?  Buyers of these securities pay a fee in order to get the GSEs to assume the credit risk; Freddie and Fannie agree to pay the principal and interest on the underlying loan even if the actual borrower fails to pay.  Though Freddie and Fannie are not backed explicitly by the government — they are private corporations — there is what is called an implicit guarantee.  Buyers of their securities believe that the Federal government would not allow them to fail — a good assumption, it turns out, as the Federal Government had to bail them out in September 2008.  Bundling mortgages is a form of diversification but still limited to one sector in this case — housing. 

Ironically, the development of this system made it more difficult for many marginal homeowners to work things out with their bank.  Their bank had sold their mortgage long ago.  The solution?    

Corker again:  "We've got to figure out a way to pragmatically move more of the market to the private sector."

That may be.  Historically we have pursued policies to make housing more affordable, and now policymakers are scrambling to prop up home prices, in other words to make housing less affordable. 

A look north might provide insight.  Housing prices in Canada are above pre-crash levels.  In the past decade, subprime mortgages accounted for just 5% of home loans originated in Canada, while in the U.S. they represented 20%.  There is no tax deduction for mortgage interest payments, and buyers typically put 20% down.  Canadian policy doesn't encourage speculation.  

Home ownership might be a noble social policy goal, but in the end housing prices will be driven by the fundamentals of supply and demand.  Failure to recognize and respect that won't get us any closer to nobility.

Martin Kennedy 

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