Stabilizing the Economy through Housing Finance Reform

November 9, 2011
By Jennifer Nash, Mossavar-Rahmani Center for Business and Government

What role should government play in financial markets for housing? For the past several decades, a primary goal of federal housing policy has been to make mortgages available to more people. At a seminar organized by the M-RCBG Regulatory Policy Program on Nov. 3, David Scharfstein, Edmund Cogswell Converse Professor of Finance and Banking at Harvard Business School, argued for a different goal – to stabilize housing markets in periods of economic stress.

“Housing finance was at the core of the recent financial crisis,” said Scharfstein. “The main goal for housing finance reform should be to protect the financial system from adverse shocks to the housing market.”

At the seminar, Scharfstein offered a three-part proposal for stabilizing housing markets:

  • Federal policy should rely on private markets to supply mortgage credit without government guarantees.
  • Government should regulate private mortgage markets carefully in order to prevent boom and bust cycles to the extent possible.
  • Government’s role as a loan guarantor should only kick in as a last resort.

“Regulation is the most challenging part,” noted Scharfstein. “To prevent boom and bust cycles, regulation needs to be stringent.”

Scharfstein explained that his proposal faces stiff opposition. A broad-based coalition of the Mortgage Bankers Association, National Association of Home Builders, National Association of Realtors, as well as consumer interests would like the federal government to guarantee mortgage-based securities, much like the federal mortgage giants Fannie Mae and Freddie Mac have done in the past. Scharfstein maintains that approach is ill-conceived.

“The only way that government can lower interest rates is to take on risk that it’s not compensated for. Ultimately, taxpayers bare that risk,” said Scharfstein. Keeping mortgage rates low may actually drive up housing prices, since people take mortgage rates into account when they calculate what they are able to pay for a home, according to Scharfstein.

Scharfstein describes his proposal in detail in the paper, “The Economics of Housing Finance Reform,” co-authored by Adi Sunderam, also at Harvard Business School.

The seminar was part of a series offered by the Regulatory Policy Program (RPP) at the Mossavar-Rahmani Center for Business and Government. RPP serves as a catalyst and clearinghouse for the study of regulation across Harvard University. The program's objectives are to cross-pollinate research, spark new lines of inquiry, and increase the connection between theory and practice.

Joseph Aldy and David Scharfstein

Joseph Aldy, assistant professor of public policy (L) and David Scharfstein, Edmund Cogswell Converse Professor of Finance and Banking at Harvard Business School (R).

“Housing finance was at the core of the recent financial crisis,” said Scharfstein


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