Think tank lays out plan for private housing system

That report contained three options for the future of housing finance, each of which called for a reduced role for the government and larger responsibilities for the private sector. But the first option, which calls for the least government support, has attracted the attention of AEI.

That option would limit the government's role to targeted assistance for lower- and middle-income borrowers with good credit, as the private sector steps in to handle the majority of the nation's mortgages.

Such a proposal would represent a dramatic departure from the current arrangement, in which government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac back roughly nine out of every 10 new mortgages.

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In its paper, AEI suggests that only high-quality prime mortgages, which it says constitute the majority of U.S. mortgages, be allowed to be packaged and sold as securities.

"The very low delinquency and default rates on prime mortgages will be attractive investments for institutional investors and will enable the housing finance secondary market to function effectively with no government support," the paper says.

Limiting securitization to low-risk mortgages will eliminate additional future taxpayer losses, reduce the severity of housing booms and busts driven by rapidly expanding bubbles and allow for troubled mortgage giants Fannie Mae and Freddie Mac to be eliminated, AEI argued.

The authors, all resident experts at AEI, go on to argue that government backing created a moral hazard that exacerbated the sub-prime mortgage crisis, and that any plan in which the government plays a major guiding role is fundamentally flawed.

"The government's guarantee eliminates an essential element of market discipline — the risk aversion of investors — so the outcome will be the same: Underwriting standards will deteriorate, regulation of issues will fail and taxpayers will take losses once again," they said.

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But by focusing on high-quality mortgages as the backbone of the housing system and ensuring adequate capital is backing those mortgages, a robust housing market driven by private parties could exist, they claim.

A common concern aired by Democrats about a private housing finance system is that it could make homeownership inaccessible to lower-income borrowers; they argue government support is needed to assist homeowners who might struggle to meet more stringent borrowing requirements imposed by the private market.

In the paper, the authors acknowledge "there is an important place for social policies," but argue that excess in those areas puts taxpayers at risk. They call for any affordable housing assistance to be included in the federal budget, and be limited to protect against potential taxpayer losses.

While the White House might disagree with AEI over how far the government should go to assist lower-income borrowers, the two groups agree that the GSEs need to be wound down and eliminated. Both have called for it, saying that a gradual wind-down will be needed in order to accommodate the slow return of private investors to housing finance.

AEI's new report is an update to an earlier paper released in January, before the administration unveiled its paper.

The paper comes as House and Senate lawmakers gear up for what is expected to be a lengthy debate on a housing market overhaul. House Republicans are poised to unveil several bills next week that would modify the organizations' policies and speed up their closing. The Senate Banking Committee has scheduled a March 29 hearing on various proposals.