Kyle Bean for Fortune
By Sheila Bair
September 18, 2014

My kids once dragged me onto a gut-wrenching amusement-park ride called Pharaoh’s Fury. It consisted of a large, Egyptian-style boat that swung on a 40-foot-long pendulum. It took about two terrifying minutes of swinging before the pendulum finally came to a rest. I stumbled out, swearing to cut off my kids’ cellphone service in retribution.

Over the past decade, the mortgage market has been on its own terrifying pendulum ride. Prior to the financial crisis, mortgages were available to just about anyone who could fog a mirror. (And some dead people too…) After the crisis, mortgages became primarily available only to those with gold-plated credit. That is a major reason housing has remained a laggard while other sectors like agriculture, energy, and autos have experienced decent growth in recent years. And prospects for improvement are dim: Home prices were down in the second quarter, and lending standards tightened even more last month.

To be sure, stringent loan requirements are not the only impediment to a housing rebound. Numerous studies show that millennials are much more inclined to delay home purchases than earlier generations. Gen Yers may prefer the greater mobility of renting (or living free for a while with Mom and Dad). Many also suffer from high student-debt loads, weak credit histories, a tough job market, and moribund wage growth.

CREDIT CRUNCH Before the financial crisis, just about anyone with a oulse qualified for a mortgage. Since then, bankers have tightened credit, slowing the housing market.

CREDIT CRUNCH Before the financial crisis, just about anyone with a oulse qualified for a mortgage. Since then, bankers have tightened credit, slowing the housing market.Graphic Source: Mortgage Bankers Association

The complex problems plaguing our housing market don’t lend themselves to easy solutions. However, there is one piece of low-hanging fruit. It deals with an arcane issue that bankers call “put-back” risk. When lenders make loans that the government guarantees—primarily through Fannie Mae, Freddie Mac, or the Federal Housing Administration—they must promise to adhere to certain underwriting standards. If the loans later default, the government can put back the loan by asking the lender to either buy it back or absorb the resulting losses.

The problem is that when the housing market tanked, government mortgage insurers were confronting major losses. The worst subprime lenders had gone out of business, so the insurers started aggressively putting back loans on the healthier lenders who remained. But these put-backs were not limited to instances of poor underwriting. They were also based on some seemingly contrived reasons, such as technical issues with paperwork or a borrower’s changed circumstances after the mortgage was issued. Some of the put-backs targeted mortgages of homeowners who had made timely payments for as long as 10 years. Predictably, mortgage lenders large and small reacted by cutting back on their lending, offering credit only to those who presented little, if any, chance of default. By aggressively pursuing put-backs, the government was understandably trying to protect taxpayers. But the long-term result was to chill credit availability and impede the housing recovery.

We need fundamental reform of housing finance. Fannie, Freddie, and the FHA guarantee over 80% of all mortgage originations in the U.S. Private lenders have few alternatives other than to deal with this government tri-opoly. But as long as government dominates, it should work to bring the credit standard pendulum back to equilibrium. Sensible people like Wells Fargo’s John Stumpf have suggested a simple fix. The government should assume that a fixed-rate loan has been properly underwritten if the borrower has made timely payments for three years. But while this approach has been publicly embraced by Fannie and Freddie, it has yet to be meaningfully implemented, and the FHA has not followed suit.

Common-sense rules like this are needed to revive housing. Until then, the market will resemble an Edgar Allen Poe horror story: a pendulum endlessly swinging while the housing recovery remains in the pits.

Fortune contributor Sheila Bair is former chair of the FDIC, and is an independent director of a European bank that has U.S. mortgage operations.

This story is from the October 6, 2014 issue of Fortune.

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