Wednesday, September 3, 2008

The Law of Unintended Consequences

Sometimes the attempt to fix a problem actually creates more difficulties than the original problem itself.  This is especially true when Congress gets involved.  As Ronald Reagan quipped, “The nine most terrifying words in the English language are, ‘I’m from the government and I’m here to help.’”

Expensive jumbo loans have proven to be a drag on the current housing markets.  Until recently, these loans were for amounts greater than $417,000.  If your mortgage was less than this and you had good credit, you went with what is termed a conventional loan.  This is a loan guaranteed by the GSE’s (Government Sponsored Enterprises), Fannie Mae and Freddie Mac.

The GSE’s didn’t buy home loans greater than $417k.  Federal law set this limit for two main reasons.  Congress originally set the GSE’s up for common people to afford homes, not rich folk.  Secondly, higher loan amounts created greater risk for the financial institutions backing them.  And Congress wanted the GSE’s to remain safe and solvent.

Consequently, jumbo loans are generally more expensive than conventional loans.  They can be up to 1.5% higher in rate.  With higher rates, these homes become less affordable.  And less affordable homes puts downward pressure on housing prices. 

But in some markets, insane housing prices have left few shacks (Think California, or more closely to home, Northern Virginia) that could be had with loans less than $417,000.

And so Congress decided to fix this problem.  In last February’s housing rescue package, the House and Senate raised the limit of what Fannie and Freddie could guarantee to nearly $730,000.  The actual amount varied by locality, depending on the median price of homes.

In the Charlottesville area, this limit climbed to only $425k as the cost of homes in Albemarle was diluted by relatively cheap abodes in the surrounding counties.  So it has been of little help to the central Virginia market. 

In fact, it may be hurting us, as well as the rest of the country.

In forcing Fannie and Freddie to buy riskier loans, Congress pushed them into more uncertain financial health.  Investors reacted by turning more reluctant to buy any of the bonds guaranteed by the agencies.

The only way the GSE’s can make their bonds more attractive is to offer a higher premium.  They have to increase what the mortgage backed securities will pay investors.  Of course, their greater costs get passed on to the consumers obtaining the mortgages.

So the law has not worked, neither as intended or expected.  Instead of making jumbo-sized homes more affordable, it has actually driven up the cost of conventional mortgages. 

This makes conventional sized homes less affordable.  This puts downward pressure on housing prices, leaving us in a worse place than where we began before government tried to fix the problem.

CNN Money offers more detailed analysis here.

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