Why the Johnson and Crapo “Taxpayer Protection Act” will not protect taxpayers

The draft bill released on Sunday, March 16 by Senate Banking Committee Chairman Tim Johnson (D-S.D.) and Ranking Member Mike Crapo (R-Idaho) will not protect taxpayers from future bailouts. 

• It will replace the implicit federal guarantees enjoyed by Fannie and Freddie with explicit guarantees enjoyed by their successors. 
• It will replace the single-family affordable housing mandates with a new set of affordable housing provisions that will also lead to debased underwriting standards. 
• It will raise taxes on the middle class by imposing a new tax on homeownership that will be used to provide billions annually in furtherance of a misguided policy to promote risky lending to lower income homebuyers.

Experience has shown that any bill which includes an explicit guarantee of an insurance program will fail to protect taxpayers.  The proposed Federal Mortgage Insurance Corporation (FMIC) will be no different. 

{mosads}The bill, as was the case with Fannie and Freddie, assumes the government would be better at pricing risk than the market.  The examples of the government’s mispricing of insurance risk are legion—flood insurance, Medicare, and pension guarantees to name but a few.  Supporters point to the 10 percent requirement for private capital.  Deposit insurance is based on a similar concept, yet it has failed not once but twice.  The savings and loan deposit insurance bailout (FSLIC) of the early-1990s and the FDIC bailout by the Troubled Asset Relief Program (TARP) in 2008.   And lest we forget, Fannie Mae at one point had a similar capital requirement which was whittled away over time by Congress.

The bill, as was the case with Fannie and Freddie, would encourage too much of the wrong kind of debt for our economy—debt that bids up existing housing assets and the land they sit on, creating a temporary wealth effect and a crowding out of capital investment needed for a productive and growing economy and jobs growth.  Worse, the result will be another artificial housing boom and consequent bust. 

The bill, as was the case with Fannie and Freddie, would require politicized credit standards–once again putting lower-income families into housing they can’t afford, with the same disastrous results. 

Supporters are quick to point to its bipartisan support.  The inaptly named “Federal Housing Enterprises Financial Safety and Soundness Act of 1992” (1992 Act) passed the Senate on a voice vote without objection.  Like the Johnson-Crapo bill, the bi-partisan 1992 Act was enacted to protect taxpayers, but contained the infamous single-family affordable housing mandates which led to debased lending standards.  Less than 16 years after its passage, taxpayers were forced to bail out Fannie and Freddie.

Yes, this bill would sunset the affordable housing mandates.  However, the bill’s drafters went to great lengths to create a “duty to serve the entire market” without using these words.  Instead we have a Byzantine set of lending mandates that would again result in risky lending for those least able to cope. 

Lending mandate 1: define an eligible single-family mortgage loan to include very risky loans (Section 2 (27).  Unfortunately, the bill uses as its template FHA’s minimum loan standards—standards that have led to 3.25 million or one in eight families suffering a foreclosure over the last 37 years. For example, a 3.5 percent down loan with a 580 credit score, and a 43 percent or greater debt-to-income ratio (DTI) is eligible. Freddie Mac experienced a 43 percent default rate under economic stress for this type loan, 18 times riskier than for an 80 percent LTV loan with a 35 percent DTI, and a 725 credit score. 

Lending mandate 2: require the FMIC to make sure high risk eligible loans continue to be made at all times no matter what (Sections 201 (b) and 210).  

Lending mandate 3: make sure entities benefiting from FMIC’s insurance have the capacity to offer high risk eligible loans (Sections 311, 312, and 313).

Supporters will point to the bill’s provision that the FMIC will not interfere with the exercise of business judgment by regulated entities.  The 1992 Act demonstrates this is no more than fig leaf.  The 1992 Act was not to be construed as obligating the Federal Government to provide any funds to Fannie or Freddie or guarantee any of their obligations or liabilities.  It provided that Fannie and Freddie were to be allowed to earn a reasonable economic return on its mandated low- and moderate-income lending.   The taxpayers are still waiting for these protections.

The bill would impose a 10 basis point tax payable annually on outstanding guaranteed securities.  This amounts to $200/year on the average mortgage and, after a few years, would grow to $5-7 billion annually as millions of homebuyers are forced to pay this stealth tax. This is in addition to paying fully priced insurance premiums to be collected by the FMIC.   This is not a user fee since it is unrelated to the cost to the government for providing the service. It would siphon off much needed capital that should be used protect our housing finance market–a $9 trillion market with virtually no equity capital backing it today.  And for what purpose?  To further misguided policies promoting risky lending to lower income homebuyers.

What is clear is that we have learned nothing from the flawed 1992 Act and subsequent financial crisis.

What is needed is a privatized housing finance market—like other U.S. industries and housing finance systems in most other developed countries—that principally functions without any direct government financial support.   For low-income borrowers, there can be a government role.  However, instead of increased leverage used to bid up the price of existing housing thereby making it less affordable, we need to provide a straight, broad highway to debt-free ownership for working class families with the ability, desire and discipline to become homeowners. 

Pinto is a resident fellow at the American Enterprise Institute where he is co-director of the International Center on Housing Risk.