Deregulate Housing
by John Berlau
Issue 115 - September 10, 2008

Congress just got through with passing a multi-billion dollar bailout to the government-sponsored housing enterprises Fannie Mae and Freddie Mac, which own half of America's mortgage debt. Fannie was created as a government agency in 1937 as part of the New Deal, and despite it and Freddie's restructuring some 40 years ago, it still maintained government privileges and other implicit subsidies (which have now been made explicit.)

Yet amazingly, despite these two government-created behemoths at the center of the housing storm, many are gaining traction arguing that the housing mess somehow shows the failure of the "free market." What "free market?" The fact is that despite the partial deregulation of past decades, financial services remained one of the sectors most controlled by the state. The politicians now pointing their fingers at lenders making high-risk loans are the same ones who just a few years ago were chiding banks for not making enough loans to poorer borrowers who carried higher risks, and passing laws like the Community Reinvestment Act to pressure banks to chuck underwriting standards.

I delved into these issues a few months ago in an international online debate hosted by the Economist magazine. Against the backdrop of the Bear Stearns collapse in March, I had the task of arguing in favor of the proposition, "By intervening to regulate business and financial risks, goverments have made things worse." I ended up getting 49 percent of reader's votes, losing to my opponent's 51 percent by a wafer-thin margin. These are the closest results so far in the Economist's series of policy debates, and in the words of Economist Executive Editor Daniel Franklin, "there is no doubt that the clash of values and philosophies on view granted many of us a broader understanding of the issues at hand."

Here is my closing statement in the debate. I started by saying that I shared the antipathy toward bailouts and corporate welfare, which my boss, CEI President Fred Smith often calls the "privatization of profits and socialization of losses." I then pointed out that financial innovation during the housing boom did indeed produce tangible benefits that will outlast the bubble's bursting. Home ownership increased in all sectors, and it is still the case that "the vast majority of borrowers in all demographic categories do not face foreclosure." The foreclosure rate and number of foreclosures have certainly been on the upswing, as we all know, but the overall rate of U.S. mortgages in foreclosure is still around 2 percent.

In the three-part debate, I brought up government regulation that hindered private risk management, including the Community Reinvestment Act and the blocking of competitors to the two dominant credit rating agencies. The rating agencies had turned out to be spectacularly wrong about the soundness of many mortgage-backed securities, yet there was an over reliance on these ratings in substantial part because the federal government would not accredit rival firms that may have had differing assessments.

Another big factor in the mortgage mess was the limits on short-selling imposed on ordinary investment vehicles such as mutual funds. Hedge funds, by contrast, had this ability and many weathered the subprime storm and even prospered by shorting banks' mortgage securities. But regulators, ironically, considered this useful risk-management technique too "risky" for retail investment vehicles. So ordinary mutual fund and 401(k) investors lost out. That's why, in the essay, I call for "a second stage of deregulation" that would let mutual and exchange-traded funds engage in some of the same financial management techniques for ordinary folks that hedge funds do for their super-wealthy investors.

We don't want a world without risk, for that is also a world without opportunity. But eliminating market-distorting corporate subsidies and regulation -- not to mention preventing new ones being touted as "cures" -- could greatly reduce financial volatility.

These are trying times, to say the least. But I sense in the comments, both pro and con, a deeper and legitimate concern about equity in the world of risk. Do the poor and those outside the system really benefit from innovation? There is also an antipathy which I share towards corporate welfare—what is often referred to as the privatization of profits and the socialization of losses—which we witnessed last week in the bail-out of Bear Stearns’ creditors in the US (and which I opposed).

But the benefits of new financial products flow to the masses in the same way all innovation does, and government-imposed restrictions on this innovation risks limiting opportunities for precisely those it is trying to protect. And one does not have to be a political conservative or free-marketeer to see that this is the case. Writing recently on the housing boom and bust, the former senator George McGovern, forever a hero to the American political left for his spirited challenge to Richard Nixon in the 1972 presidential election, had this to say about what he calls the worrisome new trend of “economic paternalism”:

“With liberalized credit rules, many people with limited income could access a mortgage and choose, for the first time, if they wanted to own a home. And most of those who chose to do so are hanging on to their mortgages … If the tub is more baby than bathwater, we should think twice about dumping everything out.

One can believe, as Mr McGovern does, in progressive taxation policy and government spending on antipoverty programmes, and yet still be skeptical about governmental micromanagement of business transactions. I am pleased to see that even Mr Moore says he favours “a set of regulatory policies which allow for the taking of risk, innovation and flexibility”. But when in the next sentence of his rebuttal he calls for “constant and active governmental regulation and intervention”, I am afraid he is the one who is acting naively. It was the mortgage innovations spurred by the partial deregulation of banking in the US and the UK that led both countries to have record homeownership levels in many demographic sectors. This was a quintessentially progressive outcome that previous “progressive” governments had never achieved.

Indeed, when looked at in terms of distribution, the housing boom’s benefits may have been even more widely dispersed than those of the tech boom. Nearly 70% of US families and close to one-half of American black and Latino families now own the homes in which they live. And the vast majority of borrowers in all demographic categories do not face foreclosure. There have indeed been “record numbers” of foreclosures, but these correspond with a “record number” of homeowners. The overall rate of US mortgages in foreclosure, according to the latest National Delinquency Survey that tracks the last quarter of 2007, is 2.04%.

Cycles of innovation spur many inventions and technologies that will survive a boom and a bust and better everyone’s lives. Yet these cycles also undoubtedly cause pain that is often spread unevenly. While there will always be some dislocation in a dynamic economy, volatility can be much reduced through the introduction of what we should call a second stage of deregulation. Let us deregulate private risk management, as we have risk-taking, for ordinary investors as well as hedge-fund fat cats.

Take short-selling, for instance. In 2007, many hedge funds weathered the subprime storm and even prospered because they had shorted mortgage-backed securities and the banks that held them. Yet decades-old regulations in the US and European countries limited the ability of mutual funds or pension plans to engage in these same strategies on behalf of ordinary investors.

Had retail investment vehicles the same ability to use short-selling or other investment strategies as hedge funds, there likely would have been two results that would have made the mortgage crisis less severe. First would have been the immediate gains to the portfolios of ordinary folks that would have mirrored those which hedge-fund investors are realising now.

The second, and almost more important benefit, would have been that a larger number of short positions would likely have sent the market a stronger signal that something in the mortgage industry was wrong. As a New Yorker correspondent, James Surowiecki, observes in his brilliant book, The Wisdom of Crowds , if the price of a security “represents a weighted average of investors’ judgments, it’s more likely to be accurate if those investors aren’t all cut from the same cloth”. He adds that limiting short-selling increases vastly the chances that if a price “gets out of whack, it will really get out of whack”.

Here, I am pleased to report that the new European Union UCITS 3 (Undertaking for Collective Investments in Transferable Securities) directive greatly liberalises the ability of retail portfolio managers to utilise shorting strategies with financial products such as derivatives. The US should follow suit.

There is plenty of other deregulation that could bring the benefits of competitive risk management to ordinary homeowners, investors and savers. Lifting these barriers to risk hedging, rather than reinstating failed old regulations, would maintain the US and the UK’s prosperity while reducing volatility significantly.

John Berlau is Director, Center for Entrepreneurship at the Competitive Enterprise Institute