This coming Tuesday, 8/17/2010, the Treasury will host a conference on GSE reform entitled "The Future of Housing Finance."  In evaluating the opinions and commentary that this event is sure to generate, taxpayers and voters should focus on three issues:

1.  How much housing is too much?  US policymakers have long promoted housing as a component of the "American Dream," arguing for example that homeownership helps form stronger communities.  No doubt these policies reflect voter preferences: it's no accident that Fannie and Freddie were formed to help maintain liquidity in the secondary mortgage markets, that mortgage interest is tax deductible, and that the FHA helps low-income borrowers buy homes.  However, the Great Recession was sparked by the collapse of the mortgage and housing markets.  Somehow housing became an "American Nightmare."  We've seen that trying to encourage too much housing becomes counterproductive, so we might want to think about scaling down governmental subsidies to more realistic levels.

2.  What's the right amount of government involvement in housing?  Today the government, acting through Fannie Mae, Freddie Mac, and the FHA, produces something like 9 out of 10 new mortgages.  Shouldn't the private sector play a bigger role? 

3.  How much cost and risk should we take on in promoting homeownership?  Fannie, Freddie, and their cousin the Federal Home Loan Bank System have issued almost $3 trillion in debt, but it is considered "US Agency Debt," not direct obligations of the US government.  In the old days, when the companies were profitable and had solid (albeit thin) equity cushions, their debt could be considered "off balance sheet."  But not today.  Fannie and Freddie's equity capital was -$3 billion as of second quarter 2010, and that's not counting some $80 billion in preferred stock owned by the Treasury.  Any accountant would consolidate their debt on the US balance sheet, which would push the ratio of US debt to GDP from approximately 100% to 115% .  As I point out in "Stalking the Black Swan," off-balance sheet debt (and other forms of hidden leverage) increase risk, making Black Swan-type volatility all the more likely.  If we don't want this volatility, it would make sense to run down Fannie and Freddie's large portfolios and pay off this debt.

4.  How do we transition from the current model to something new?  Unfortunately, the US housing market is addicted to government subsidies right now.  If we went "cold turkey," i.e., shut down Fannie, Freddie, and the FHA, which are currently producing 9 out of 10 new mortgages, then the housing markets would essentially collapse.  Rather than cold turkey, we need the equivalent of methodone, something to ease the addict off of his habit, without killing him in the process.  One idea would be for Fannie and Freddie's useful function (that of guarantying mortgages) to be transferred to the private sector, so that the mortgage market does not lose the benefits of having highly liquid securities in the secondary markets.