When the U.S. government wanted people to settle the western frontier, it gave them land, not a loan. Today, when the government seeks to promote home ownership, it offers cheap debt. That creates bad incentives and risks financial instability. American history teaches us that the government should subsidize home equity, not mortgage debt.
The Homestead Act of 1862 specified that anyone over 21 could obtain a grant of 160 acres of public land. After living on and farming the land for five years, including building a home and paying a filing fee of $18 (about $425 in current dollars), the land would be theirs.
Mortgage subsidies through federal agencies are the modern-day version of the Homestead Act. But unlike the land grants of the 19th century, government loan subsidies have proven to be a rather bad idea. They drive up prices and increase the size of the average house, at the same time that they encourage people with little savings and highly variable incomes to purchase homes and shoulder the risks of house price fluctuations. The result -- as we saw in the "subprime crisis" -- was ruinous for the borrowers, the lenders and the economy as a whole.
Astonishingly, the Federal Housing Finance Agency (FHFA), the regulator of Fannie Mae and Freddie Mac, appears inclined to replay this disaster movie. It is working to provide government guarantees on mortgages where borrowers put down as little as three percent of the purchase price. In the face of competition from the Federal Housing Administration -- which also aggressively subsidizes housing debt -- Fannie's chief recently emphasized that it "wants this business."
Taxpayers and financial regulators should be appalled. Instead of lowering minimum down payments, the U.S. government should be raising them to reduce the probability of default and protect the financial system.
Naturally, many people would benefit from a return to the pre-crisis status quo. There are the federal agencies' own employees and managers; real estate brokers; mortgage originators and servicers; builders and construction workers; and finally, the homeowners who can borrow up to $625,500 (the current limit for loans in high-cost areas that conform to Fannie and Freddie's guidelines) at a below-market rate.
Collectively, the Congressional Budget Office (CBO) estimates that Fannie and Freddie subsidies for new mortgages over the period 2015-2023 will average around $2.5 billion per year. The recipients of these benefits are so numerous that is hard to imagine how you would start to organize effective political opposition.
One might hope (as policymakers did) that these housing subsidies boost U.S. home ownership. Yet, despite the massive federal interventions, the rate of U.S. home ownership currently stands at 65 percent, the lowest level since 1995.
Whether boosting home ownership further is a worthy policy goal is debatable. In Germany and Switzerland, two affluent nations, roughly half of the residents are renters.
But if U.S. policymakers insist, they should follow the example set by President Abraham Lincoln in 1862. First, to be effective in boosting home ownership, focus the subsidy on first-time buyers or on houses below the current median sales price of existing homes of $210,000. Second, to reduce the threat of financial instability, transform the subsidy from debt support to an equity boost of roughly equal aggregate size.
Call it a 21st century land grant.
Imagine, for example, if the federal government were to match $1 for $1 for low-income families that had saved 10 percent of the value of a starter home, giving them enough capital to put 20 percent down. Keeping the annual cost at the CBO's estimate of $2.5 billion, that would allow the government to subsidize 200,000 purchases of $125,000 homes every year. With a bigger equity cushion, the resulting mortgages would be less risky and easier to securitize. And the equity subsidy also would promote another key public goal -- namely, higher personal savings.
It's easy to see why politicians like debt subsidies. Measuring them is complex, making concealment easier. Debt also postpones the day of reckoning, transferring the eventual burden from current to future taxpayers. Yet, by now, we should all understand how risky and damaging this approach can be, even for the subsidized borrowers.
A Homestead Act for the 21st century that terminates mortgage subsidies can support U.S. homeownership and end the threat to our prosperity posed by today's system of housing finance. If we can't reach that goal today, the least we could do is to halt government moves to make the debt subsidy even riskier.
Note: Previous comments on the FHFA's plans appeared on the authors' blog here.