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February 14, 2011

End Federal Wealth Insurance

We need to cure a national addiction to government-guaranteed debt. Proponents of government loan guarantees for things like mortgages, nuclear power plants, college loans, and small businesses tout the worthiness of the projects that are being encouraged. IMHO, the main beneficiaries of these programs are those who get to make loans which are risk-free to the lender because the rest of us are absorbing the cost of defaults. Like TARP, federal loan guarantees are a form of wealth protection.

There is now a healthy discussion of the proper role of government in the residential mortgage market. The argument for government insurance of mortgages is that, without such insurance, banks would have to charge more because they would be taking more risk and housing would be less affordable. Sounds right but it's probably wrong.

Except during housing bubbles, people decide how much they can pay for a house by calculating the monthly payments. When the price of mortgages goes up relative to wages, the prices of houses come down (again relative to inflation) as the market brings buyers and sellers into balance. Subsidizing the mortgage rate means that the price of houses goes higher because people can afford to pay more. That makes it easy to see why realtors are in favor of mortgage insurance but not nearly as clear why the rest of us should be - except if we happen to be selling a house and not buying a new one.

A huge part of the fuel for the recent housing boom was the artificially low cost of credit caused by the twin evils of the federal reserve flooding the market with liquidity and the government trying to make housing more affordable to more Americans (sounds good, doesn't it?) by subsidizing and/or guaranteeing mortgages including, of course, the activities of Fannie Mae and Freddie Mac. Housing got more expensive, of course, as mortgages became cheaper and more available; less people could afford to buy houses to live in because prices went up faster than interest rates came down. That ratcheted up the pressure for even more government assistance (you can't make this stuff up), which was forthcoming; so housing prices went even higher – until they crashed.

Moreover, absent government intervention, the mortgage market is also competitive. When government guarantees are available, lenders like to make profit without risk (to them). They can afford to charge more for unguaranteed loans because they have the opportunity to put their money to work without risk. If no guarantees were available, lender margins and the price of unguaranteed loans would probably come down since there would be no risk-free (subsidized alternative).

So, even if you believe that government should use your tax dollars to weigh in on the decision of whether you ought to use the rest of your money to buy a house or a car or nothing at all, in the end subsidizing and guaranteeing loans only makes houses more expensive. Now, if your loan is not guaranteed and your neighbor's loan is, you ARE at a disadvantage. When people think of losing the mortgage subsidy; they think that they'll still have to pay just as much for a house and more for a loan; this logic makes the politics of getting rid of subsidies difficult. Some politician has to be brave and articulate enough to explain that, if all the subsidies go away, the total cost of housing will stay the same (or go down because speculation won't be subsidized). It may help politically that we have the horrible examples of Freddie Mac and Fannie Mae and that we can't afford the subsidies; but look for plenty of arguments – some sincere – about how Americans will be shut out of the housing market or how the housing market will collapse (can't both be true at once) if lenders are not subsidized and protected from risk.

A post on federal wealth gurantees for lenders to and investors in nucler plants is here. More on other forms of federal wealth protection coming up.

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We’ve Been T*RPed

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