How to avoid the next housing bust

The boom-and-bust in the housing market has ruined lives, wiped out vast amounts of wealth and taught some hard lessons - including at least one that Congress has seen fit to ignore: Fannie Mae and Freddie Mac have got to go.

These huge, government-sponsored companies buy mortgages from lenders and bundle the loans into securities for sale to investors. They guarantee the underlying loans, and their guarantee is backed, in effect, by the full faith and credit of the U.S. Treasury.

Fannie and Freddie played a leading role in setting up the housing market for its big fall by encouraging lending to unqualified borrowers. In essence, Fannie and Freddie helped set up many families to fail.

When home prices collapsed, the two companies collapsed too. Uncle Sam put them into public conservatorship and pumped in nearly $200 billion to keep them operating.

The continued existence of Fannie and Freddie still gives lenders an incentive to make riskier loans than they would if the government weren't providing guarantees. It also discourages the innovation, efficiency and accurate pricing that would result if the free market were allowed more influence.

Fannie and Freddie are profitable today, producing so much cash that some of their private investors have sued to redirect to themselves money that now goes to the government: The key to these companies' success is that they still operate with the federal backing they had before the crash. Lawmakers on both sides of the aisle agree in principle that it makes no sense for taxpayers to bear a risk that should be borne by private enterprise. Yet legislation aimed at reforming Fannie and Freddie has languished on Capitol Hill.

Why? We can think of one big reason:

In January, the federal agency that oversees Fannie and Freddie got a new boss straight off the Hill: Former U.S. Rep. Melvin Watt, D-N.C., quit Congress to accept a presidential appointment as head of the Federal Housing Finance Agency.

Before Watt arrived, the agency had proposed scaling down the size of mortgage loans eligible for the government guarantees, from the current $417,000 ($625,000 in New York and other high-priced markets). His agency was on the brink of raising the fees it charges for its loan guarantees.

Watt has backed off those plans, which indirectly would have made lenders less likely to let homebuyers take out mortgages they can't afford to repay. Watt instead has committed to making more credit available for prospective homebuyers.

Under Watt, Fannie and Freddie also eased the rules that govern "putbacks" - when lenders who unload mortgages on the government-backed companies are forced to buy them back if the loans go bad. After the housing bust, Fannie and Freddie required lenders to repurchase billions of dollars in defective loans.

The putback rules have acted as an important deterrent to the wild lending practices that brought on the housing bust. Lenders concerned about getting stuck with their own bad loans have tightened standards. As a result, very few mortgages made in recent years have gone delinquent or into default.

Isn't that how it's supposed to be? If loan officers decide applicants won't be able to make their payments, they're not supposed to make the loans. That may frustrate prospective homebuyers who can't borrow as much as they'd like, but it also helps insulate them from the misery of subsequently losing their homes in foreclosure.

Giving people access to easy credit so they can buy homes they cannot afford to purchase is a terrible public policy. It especially victimizes inexperienced or unsophisticated borrowers who get in debt over their heads, as many of them discovered during the Great Recession.

The government should reduce - not inflate - the federal incentives for overinvesting in homes. The House and Senate have considered legislation that would help by reforming Fannie and Freddie, yet no bill gained momentum.