Irrational exuberance in lending has ended. Countrywide, Bear Stearns and Merrill Lynch have been sold cheaply because of decisions they made during the never-never land period. Many overseas financial institutions (both private and public) have suffered dearly as well because of willful collective reluctance to assess risk and regulatory timidity. After all, a Credit Default Swap is a form of insurance committing the CDS holder to pay an investment note holder in case the borrower suffers an event that makes the note lose some principal, in exchange for an upfront payment! But I don't know how much of a bond, reserve or collateral a CDS holder is expected to purchase or make available...
Housing financing, however, leaks outside of high finance to affect all of us. The faith of investors domestic and foreign in the ability of the US government to guarantee quality of paper written under government programs has been seriously eroded.
Perverse incentives encouraged private industry to bypass underwriting requirements. 3 years ago, elected officials who would have pushed for Fannie & Freddy loan guarantee reserves to be reevaluated upwards based on bad news would have suffered from realtor/building industry backlash. Of course if the housing price increases of 2000-2005 had not been able to take place, deregulationists would have been complaining about those government busybodies interfering with the wealth-creating capacity of the great American free market... How many elected officials would allow the government to take measures that might reduce the short term saleability of high end houses in a place where 20% of total employment is somehow dependent on the idea that houses are always a safe investment and that their values are unconstrained by the buyers' ability to pay?
The initial purpose of government-backed private organizations was to be able to provide affordable loans to people who were considered poor risks by private lenders. The fact that lenders did not deem not-so-rich people credit-worthy in the 30's indicates that they saw excessive risk.
The risk assumed by a lender is tied to the capability of a borrower to pay, and the amount of principal that could potentially be lost by the lender. I think the Fannie and Freddie's current receivership management should keep backing loans, but that preference should be given to backing smaller loans over large loans. In my opinion, the cap for conforming loans covered by Fannie and Freddie should not be any higher than the largest loan that a household in the 65th or 75th percentile of a metropolitan area could qualify for based on their income. Private Mortgage Insurance would be required for any portion above this threshold. If there are too few people who can buy a house if the owners have to sell for whatever reason, it will increase the chances of a foreclosure or a very short sale vs those of a "slightly" short sale, which is less costly to lenders, note holders and guarantors.
One of the side effects of capping government loan guarantees based on mean household incomes percentiles would be an decrease in the price range of new homes that were being built! Smaller homes would also be cheaper to operate and less carbon-emitting. The biggest damage would be to the ego of the home buyers who are prevented from buying places they can't really afford anyway, and to the bottom lines of the builders since the margins on fancy homes are higher than those on homes with fewer bedrooms and without upscale trim. On the other hand, obtaining construction loans for house that can sell fast because of their wider clientele should be much easier! We can make the housing market more sustainable.
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