A bipartisan Senate housing reform would double down on the mistakes that led to the financial crisis.

April 16, 2014 7:03 p.m. ET

In this era of partisan gridlock, any legislative proposal with significant bipartisan sponsorship should be praised and supported if it simply does not produce a policy worse than the status quo. Given current U.S. housing policy, that’s a six-inch hurdle.

Yet by politicizing the allocation of mortgage credit beyond the level that was possible with Freddie and Fannie—and using a new Federal Mortgage Insurance Corporation to force borrowers with good credit to subsidize those with bad credit—the bill proposed by Sen. Tim Johnson (D., S.D.) and Sen. Mike Crapo (R., Idaho) manages to make the affordable-housing provisions of current policy worse.

Under Johnson-Crapo, housing financial reform is held hostage to the political allocation of housing credit. In establishing the Federal Mortgage Insurance Corporation (FMIC), the bill broadens affordable-housing goals by requiring “equitable access” to mortgage credit for all eligible borrowers.

An “eligible borrower” is someone who meets the standards for a loan under the qualified-mortgage standard promulgated by the Consumer Financial Protection Bureau under Dodd-Frank. In an August 2013 proposal for a new risk-retention rule, six federal agencies noted that mortgages meeting the qualified-mortgage standard had a 23% default or serious delinquency rate between 2005 and 2008. Even Fannie and Freddie were never forced to set their mortgage standards that low.

Johnson-Crapo imposes an affordable-housing fee on the private securitizers who obtain federal guarantees for the mortgage-backed securities they issue. The FMIC collects these fees annually on the outstanding principal balance of all securitized mortgage loans it insures, and these fees will be passed on to the borrower.

The fees will be set based on the FMIC’s assessment of how well each firm is serving the “underserved.” Those judged to be meeting the needs of the underserved may pay as little as half the fees paid by other securitizers. In addition, some of the funds collected by the fee could be given to those judged by the FMIC to be performing “well,” further incentivizing subprime lending and discouraging prime lending.

The fee will average 10 basis points annually on all outstanding mortgage balances, or about $5,800 over the life of a $300,000, 30-year mortgage. The ability to subsidize favored securitizers and penalize those who are not allocating sufficient capital to borrowers deemed to be “underserved” gives the FMIC the power to force mortgage lenders to follow a political allocation of mortgage credit. This is a level of control that was never achieved even at the peak of affordable-housing goals set by the Department of Housing and Urban Development prior to the financial crisis and is beyond anything that Federal Housing Finance Agency director Mel Watt could impose under existing law.

Amazingly, the billions of dollars collected annually through these fees will not be earmarked for subsidized mortgages for low-income Americans. A significant amount will go to advocacy groups that pressure lenders to make subprime loans, creating what will almost certainly be the largest community-action slush fund in American history.

Under the bill, low-risk, prime borrowers will be forced to pay far more than the true cost of their mortgage insurance so that subprime borrowers, who defaulted five times more often than prime borrowers during the financial crisis, can pay far less than the actual cost of their insurance. Securitizers that cater to subprime borrowers will face much lower affordable-housing fees while securitizers that make prime loans will pay higher fees and in turn charge more to their prime borrowers. As the ratio of prime to subprime loans falls, the cost of insuring securitized mortgages will rise, further penalizing prime borrowers.

The resulting system, like ObamaCare, is rigged against the low-risk borrower. With ObamaCare being so unpopular, why would we want to use its redistribution system in the housing market?

A standard political argument for the federal guarantee of mortgage-backed securities is to help people who play by the rules and behave responsibly to obtain affordable 30-year, fixed-rate mortgages. But a close reading of Johnson-Crapo’s 442 pages makes it clear that much of the gain to the responsible, low-risk borrower coming from federal guarantees is taken away by a parasitic system in which the prime borrower overpays to fund subprime mortgages and community action groups.

If Congress wants to subsidize affordable housing it should authorize a subsidy program and fund it through appropriations instead of using housing finance as a slush fund. A transparent program to subsidize low-income housing might be a reasonable price to pay for a sound housing market that doesn’t contain the seeds of another financial crisis and doesn’t exploit prime borrowers through a program the public doesn’t understand.

Johnson-Crapo does kill Freddie and Fannie and affordable-housing goals, but it replaces them with a system that is dangerous to the economy and that exploits credit-worthy families seeking prime loans. Senators who don’t want a replay of the financial crisis should consider converting the affordable-housing provisions of Johnson-Crapo into an authorization to subsidize low-income housing. The debate could then focus, as it should, on safety and soundness protections and whether a federal loan guarantee is necessary. The outcome could be a better housing-finance system for America.

Mr. Gramm, a former chairman of the Senate Banking Committee, is senior partner of U.S. Policy Metrics and a visiting scholar at American Enterprise Institute. Mr. Wallison is a fellow at AEI.

By PHIL GRAMM and THOMAS R. SAVING

With the Senate Banking Committee on Thursday approving Janet Yellen’s nomination to lead the Federal Reserve, her confirmation is virtually assured. Less certain is what Ms. Yellen ultimately intends to do with Fed policy on quantitative easing, now entering its 34th month. She is committed to maintaining QE for now, but does she have an exit strategy? The Fed needs one, because the economic stakes could not be higher.

If we listen to the Fed governors, the potentially explosive increase in the money supply inherent in the current $2.3 trillion of excess bank reserves won’t be allowed to occur. At the first sign of a real economic recovery, the Fed will sell Treasurys and mortgage-backed securities (MBSs) to soak up excess bank reserves, or achieve the same result through repurchase agreements and paying banks to hold excess reserves.

It sounds simple, but in a full-blown recovery the Fed will have to execute its exit strategy quickly enough to keep the inflation genie in the bottle without driving interest rates up to levels that would derail the recovery. And every month that the Fed’s monetary expansion continues, its exit strategy becomes more difficult and dangerous.

To maintain the money supply’s historic relation to GDP, once a real recovery begins the Fed will have to start to divest its $1.4 trillion of MBSs—about a quarter of all MBSs held outside Fannie Mae and Freddie Mac. This would send mortgage rates spiraling, even if the sales were spread over several years.

The challenge is even greater because, under existing regulations, Fannie and Freddie must annually divest 15% of their $1.1 trillion portfolio of assets, 50% of which is made up of mortgage-backed securities. If a real economic recovery is accompanied by a surge in housing sales and an increase in the issuance of new MBSs, the market would be further flooded.

Even if the Fed could sell its MBSs, absorb its losses and withstand the public outcry as mortgage rates soared, its work would not yet be finished. The Fed would still need to move about $600 billion of U.S. Treasurys off its books to reduce excess reserves in the banking system. The effect of these sales would be substantial, since the Fed now finances 62% of the deficit and holds 18% of all marketable Treasury securities. And as a legacy of its “Operation Twist,” the Fed now owns 36% of all Treasury securities with maturities between five and 10 years and 40% with maturities longer than 10 years. Selling this long-term debt would compound market disruption.

There is another complication. The Fed does not mark its assets to market. Every increase in interest rates drives down the market value of its Treasury and MBS holdings and requires the Fed to sell more and more of the book value of its portfolio to lower the monetary base by the required amount, depleting both the Feds asset holdings and earnings. For example, 30-year fixed mortgage rates have risen by 89 basis points since September 2012. Even if MBSs carried on the Fed’s books were worth $100 billion when they were purchased they would sell now for less than $80 billion. The same principles apply to Treasurys where 10-year notes bought at $100 billion in April would today sell for only $90 billion.

Further, in a strong recovery private demand for credit will rise rapidly, pushing up interest rates. A return of interest rates to their postwar norm of 5.9% on an average maturity of five years would over time force the Treasury to pay out an additional $440 billion annually in interest payments, nearly equal to the total amount of annual nondefense discretionary spending, dramatically raising Treasury borrowing.

As the Treasury borrows to meet its interest expense and the Fed sells assets to soak up excess bank reserves, private borrowing will be crowded out and the recovery will start to crater. The pressure on the Fed to stop selling will be immense, but if it does, banks will respond to rising interest rates by making more loans with their excess reserves. The money supply will spike, putting upward pressure on prices.

Fed Chairman Ben Bernanke tells us there is another way to stop the banks from lending out their excess reserves—by increasing the 0.25% interest the Fed now pays on bank deposits it holds. As the Fed pays higher interest on deposits, Fed earnings, the source of the $88.9 billion the Fed remitted to the Treasury last year, will begin to dry up. Treasury borrowing will increase as interest payments from the Fed decline. And interest paid to banks will add to the monetary base and can itself fuel a multiple increase in the money supply.

If the Fed uses its bond holdings as collateral to borrow (a reverse repo) it can lock up excess reserves for a given period of time, but the impact would be the same as paying banks not to lend. Paying banks not to lend or selling repos as rising interest rates choke off the recovery will create a political firestorm. Such a policy would be unworkable over any extended period of time.

Finally, the Fed could simply raise reserve requirements and force the banks to hold the expanded monetary base. However, it’s hard to imagine that reserve requirements could be increased anything like the more than 25 times current levels that might be required to absorb the existing level of excess reserves, without crushing any recovery.

The last time the Fed tried to absorb the excess reserves of the banking system by dramatically raising reserve requirements was in 1936. Then, a less than doubling of reserve requirements helped send the economy back into the depression.

The weakest recovery in the post-war period was bought with a fiscal policy that doubled the national debt held by the public and a monetary policy that expanded the monetary base at a rate not approached in the modern era. The monetary expansion that started as a response to the subprime crisis has evolved into a prolonged and largely unsuccessful effort to offset the negative impact of the Obama administration’s tax, spend and regulatory policies.

Never in our history has so much money been spent to produce so little good, and the full bill for this failed policy has yet to arrive. No such explosion of debt has ever escaped a day of reckoning and no such monetary surge has ever had a happy ending.

Mr. Gramm, a former chairman of the Senate Banking Committee, is senior partner of U.S. Policy Metrics. Mr. Saving is professor of economics and the director of the Private Enterprise Research Center at Texas A&M University.

Simply put, the financial crisis of 2008 was caused by a lot of banks making a lot of loans to a lot of people who either could not or would not pay the money back. But this explanation raises two key questions. Why did private lenders, whose job it was to assess credit risk, make those loans? And why did the army of financial regulators, with massive enforcement powers, allow 28 million high-risk loans to be made?

There’s a strong case that the answers can be traced to Sept. 12, 1992. On that day presidential candidate Bill Clinton proposed, in his campaign book “Putting People First,” using private pension funds to “invest” in government priorities, such as affordable housing, to “generate long-term, broad based economic benefits.” Seldom has such a radical proposal been so ignored during a campaign only to later lead to such devastating consequences.

After his election, President Clinton tapped Labor Secretary Robert Reich to lead the effort to extract, as Mr. Reich put it in 1994 congressional testimony, “social, ancillary, economic benefits” from private pension investments. Mr. Reich called on pension funds to join the administration’s “Economically Targeted Investment” effort. Housing and Urban Development Secretary Henry Cisneros assured participants that “pension investments in affordable housing are as safe as pension investments in stocks and bonds.”

Six pension funds ultimately agreed to invest in public housing that was backed by $100 million in federal grants and guarantees, but the program never took off. In the end, even unions and their pension funds rejected the effort to direct any part of their retirement savings toward someone else’s welfare.

The Clinton administration lost the battle to use pensions to fund low-income housing, but it succeeded in winning the war by drafting Fannie Mae, Freddie Mac and the commercial banking system into the affordable-housing effort. It did so by exploiting a minor provision in a 1977 housing bill, the Community Reinvestment Act, that simply required banks to meet local credit needs.

Bank regulators began to pressure banks to make subprime loans. Guidelines became mandates as each bank was assigned a letter grade on CRA loans. Banks could not even open ATMs or branches, much less acquire another bank, without a passing grade—and getting a passing grade was no longer about meeting local credit needs. As then-Federal Reserve Chairman Alan Greenspan testified to Congress in 2008, “the early stages of the subprime [mortgage] market . . . essentially emerged out of the CRA.”

Effective in January 1993, the 1992 housing bill required Fannie and Freddie to make 30% of their mortgage purchases affordable-housing loans. The quota was raised to 40% in 1996, 42% in 1997, and in 2000 the Department of Housing and Urban Development ordered the quota raised to 50%. The Bush administration continued to raise the affordable-housing goals. Freddie and Fannie dutifully met those goals each and every year until the subprime crisis erupted. By 2008, when both government-sponsored enterprises collapsed, the quota had reached 56%. An internal Fannie document made public after the financial crisis (“HUD Housing Goals,” March 2003) clearly shows that by 2002 Fannie officials knew perfectly well that these quotas were promoting irresponsible policy: “The challenge freaked out the business side of the house [Fannie] . . . the tenseness around meeting the goals meant that we . . . did deals at risks and prices we would not have otherwise done.”

The mortgage market shows the dramatic results of this shift in policy. According to the nonprofit National Community Reinvestment Coalition, total CRA lending rose to $4.5 trillion in 2007 from $8 billion in 1991. The American Enterprise Institute’s Ed Pinto found that in 1990 80% of the residential mortgage loans acquired by Fannie and Freddie were solid prime loans with healthy down payments and a well-documented capacity by borrowers to make mortgage payments. By 1999 only 45% of their acquisitions met this standard. That number fell to 15% by 2007. By 2008, roughly half of all outstanding mortgages in America were high-risk loans. In 1990, very few subprime loans were securitized. By 2007 almost all of them were.

Everything appeared to work fine as long as accommodative monetary policy and capital inflows from developing countries continued to fuel the upward float of housing prices. Home ownership grew to 69% in 2006 from 64% in 1993, but when monetary policy tightened the housing bubble broke and the mortgage-default rate soared.

It is stunning that, to this day, no one has explained how 28 million high-risk loans (the number calculated by the American Enterprise Institute’s Peter Wallison) got around the “safety and soundness” rules that dominate federal and state banking laws. What happened to the enforcement army, with its laws and regulations, its power to investigate and mandate corrective action, and its ability to fine and imprison violators?

The people who destroyed lending standards by driving subprime lending blamed banks, greed and deregulation for causing the financial crisis. But a review of the banking laws adopted since 1980 reveals that not one single safety and soundness measure was repealed.

Whatever went on inside the various agencies, financial regulators—whose job it was to enforce safety and soundness regulations—in the end deferred to government affordable-housing goals. Conflicted laws created conflicted regulations and conflicted regulators. Safety and soundness considerations required that regulators step on the brake. Affordable-housing goals required them to step on the gas. Government policy tried to make private wealth serve both government and private purposes. But wealth cannot serve two masters, and in the end the government was the dominant master.

Mr. Gramm, a former Republican chairman of the Senate Banking Committee, is senior partner of US Policy Metrics and a visiting scholar at the American Enterprise Institute. Mr. Solon, a former economic policy adviser to Senate Republican leader Mitch McConnell, is a partner at US Policy Metrics.

If the cause was an unsustainable boom in house prices and irresponsible mortgage lending that corrupted the balance sheets of the world’s financial institutions, reforming the housing credit system and correcting attendant problems in the financial system are called for. But if the fundamental structure of the financial system is flawed, a more profound restructuring is required.

I believe that a strong case can be made that the financial crisis stemmed from a confluence of two factors. The first was the unintended consequences of a monetary policy, developed to combat inventory cycle recessions in the last half of the 20th century, that was not well suited to the speculative bubble recession of 2001. The second was the politicization of mortgage lending.

The 2001 recession was brought on when a speculative bubble in the equity market burst, causing investment to collapse. But unlike previous postwar recessions, consumption and the housing industry remained strong at the trough of the recession. Critics of Federal Reserve Chairman Alan Greenspan say he held interest rates too low for too long, and in the process overstimulated the economy. That criticism does not capture what went wrong, however. The consequences of the Fed’s monetary policy lay elsewhere.

In the inventory-cycle recessions experienced in the last half of the 20th century, involuntary build up of inventories produced retrenchment in the production chain. Workers were laid off and investment and consumption, including the housing sector, slumped.

In the 2001 recession, however, consumption and home building remained strong as investment collapsed. The Fed’s sharp, prolonged reduction in interest rates stimulated a housing market that was already booming — triggering six years of double-digit increases in housing prices during a period when the general inflation rate was low.

Buyers bought houses they couldn’t afford, believing they could refinance in the future and benefit from the ongoing appreciation. Lenders assumed that even if everything else went wrong, properties could still be sold for more than they cost and the loan could be repaid. This mentality permeated the market from the originator to the holder of securitized mortgages, from the rating agency to the financial regulator.

Meanwhile, mortgage lending was becoming increasingly politicized. Community Reinvestment Act (CRA) requirements led regulators to foster looser underwriting and encouraged the making of more and more marginal loans. Looser underwriting standards spread beyond subprime to the whole housing market.

As Mr. Greenspan testified last October at a hearing of the House Committee on Oversight and Government Reform, “It’s instructive to go back to the early stages of the subprime market, which has essentially emerged out of CRA.” It was not just that CRA and federal housing policy pressured lenders to make risky loans — but that they gave lenders the excuse and the regulatory cover.

Countrywide Financial Corp. cloaked itself in righteousness and silenced any troubled regulator by being the first mortgage lender to sign a HUD “Declaration of Fair Lending Principles and Practices.” Given privileged status by Fannie Mae as a reward for “the most flexible underwriting criteria,” it became the world’s largest mortgage lender — until it became the first major casualty of the financial crisis.

The 1992 Housing Bill set quotas or “targets” that Fannie and Freddie were to achieve in meeting the housing needs of low- and moderate-income Americans. In 1995 HUD raised the primary quota for low- and moderate-income housing loans from the 30% set by Congress in 1992 to 40% in 1996 and to 42% in 1997.

By the time the housing market collapsed, Fannie and Freddie faced three quotas. The first was for mortgages to individuals with below-average income, set at 56% of their overall mortgage holdings. The second targeted families with incomes at or below 60% of area median income, set at 27% of their holdings. The third targeted geographic areas deemed to be underserved, set at 35%.

The results? In 1994, 4.5% of the mortgage market was subprime and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and 81% of those loans were securitized. The Congressional Budget Office now estimates that GSE losses will cost $240 billion in fiscal year 2009. If this crisis proves nothing else, it proves you cannot help people by lending them more money than they can pay back.

Blinded by the experience of the postwar period, where aggregate housing prices had never declined on an annual basis, and using the last 20 years as a measure of the norm, rating agencies and regulators viewed securitized mortgages, even subprime and undocumented Alt-A mortgages, as embodying little risk. It was not that regulators were not empowered; it was that they were not alarmed.

With near universal approval of regulators world-wide, these securities were injected into the arteries of the world’s financial system. When the bubble burst, the financial system lost the indispensable ingredients of confidence and trust. We all know the rest of the story.

The principal alternative to the politicization of mortgage lending and bad monetary policy as causes of the financial crisis is deregulation. How deregulation caused the crisis has never been specifically explained. Nevertheless, two laws are most often blamed: the Gramm-Leach-Bliley (GLB) Act of 1999 and the Commodity Futures Modernization Act of 2000.

GLB repealed part of the Great Depression era Glass-Steagall Act, and allowed banks, securities companies and insurance companies to affiliate under a Financial Services Holding Company. It seems clear that if GLB was the problem, the crisis would have been expected to have originated in Europe where they never had Glass-Steagall requirements to begin with. Also, the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived, like J.P. Morgan, were the most diversified.

Moreover, GLB didn’t deregulate anything. It established the Federal Reserve as a superregulator, overseeing all Financial Services Holding Companies. All activities of financial institutions continued to be regulated on a functional basis by the regulators that had regulated those activities prior to GLB.

When no evidence was ever presented to link GLB to the financial crisis — and when former President Bill Clinton gave a spirited defense of this law, which he signed — proponents of the deregulation thesis turned to the Commodity Futures Modernization Act (CFMA), and specifically to credit default swaps.

Yet it is amazing how well the market for credit default swaps has functioned during the financial crisis. That market has never lost liquidity and the default rate has been low, given the general state of the underlying assets. In any case, the CFMA did not deregulate credit default swaps. All swaps were given legal certainty by clarifying that swaps were not futures, but remained subject to regulation just as before based on who issued the swap and the nature of the underlying contracts.

In reality the financial “deregulation” of the last two decades has been greatly exaggerated. As the housing crisis mounted, financial regulators had more power, larger budgets and more personnel than ever. And yet, with the notable exception of Mr. Greenspan’s warning about the risk posed by the massive mortgage holdings of Fannie and Freddie, regulators seemed unalarmed as the crisis grew. There is absolutely no evidence that if financial regulators had had more resources or more authority that anything would have been different.

Since politicization of the mortgage market was a primary cause of this crisis, we should be especially careful to prevent the politicization of the banks that have been given taxpayer assistance. Did Citi really change its view on mortgage cram-downs or was it pressured? How much pressure was really applied to force Bank of America to go through with the Merrill acquisition?

Restrictions on executive compensation are good fun for politicians, but they are just one step removed from politicians telling banks who to lend to and for what. We have been down that road before, and we know where it leads.

Finally, it should give us pause in responding to the financial crisis of today to realize that this crisis itself was in part an unintended consequence of the monetary policy we employed to deal with the previous recession. Surely, unintended consequences are a real danger when the monetary base has been bloated by a doubling of the Federal Reserve’s balance sheet, and the federal deficit seems destined to exceed $1.7 trillion.

Mr. Gramm, a former U.S. Senator from Texas, is vice chairman of UBS Investment Bank.  This op-ed is adapted from a recent paper he delivered at the American Enterprise Institute.