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Government Housing Policy: The Sine Qua Non of the Financial Crisis

Tuesday, July 26, 2011

How did the financial system accumulate an unprecedented number of risky mortgages?

David Min of the Center for American Progress continues to challenge my research on the origins of the housing and financial crises;1 research my colleague Peter Wallison relies on in part in his Dissent from the Majority Report of the Financial Crisis Inquiry Commission (FCIC).

In my research I find that the financial crisis resulted from an unprecedented accumulation of weak and risky Non-Traditional Mortgages (NTMs). NTMs are those with low or no downpayments, increased debt ratios, impaired credit, reduced loan amortization, and other changes in underwriting standards as compared to traditional loan standards that were commonplace in the early 1990s. The early 1990s was used as the benchmark since shortly thereafter government policies required the broad-based introduction of “flexible underwriting standards.”

Min's central criticism is that I have characterized as high risk some loans, most of which were acquired by Fannie Mae and Freddie Mac, which are not actually high risk when compared to mortgages originated for private securitization.

For starters, it’s worth noting there is no disagreement between Min and me that loans denominated as subprime were the riskiest of the NTMs. Indeed, this is a fact clearly set out in my Forensic Study.2

But just because some types of loans were less risky than others does not mean they weren’t also risky.

More importantly, Min’s “not as risky argument” ignores the leading role played by Fannie, Freddie, and government housing policy with respect to the mortgage market, including the private mortgage backed securities backed by subprime loans:

1. Fannie and Freddie were the largest investors in subprime private securities, having purchased about a third of all such issuances over the period 2004-2007. As the Wallison dissent demonstrates, these securities were rich in loans that met government mandated affordable housing goals.

2. The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the GSE Act) and HUD’s 1995 National Homeownership Strategy launched a classic race to the bottom based on credit flexibilities. HUD assured broad compliance by drafting virtually the entire mortgage industry. Most significant was the policy to largely eliminate downpayments for targeted borrowers. As the government demanded more and more such lending, particularly those with incomes below 80 percent of median and special target groups, virtually the entire industry responded by moving further and further down the demand curve and out the risk curve. FHA, Fannie, Freddie, banks, subprime lenders, Alt-A lenders, first-time buyers, repeat buyers, and cash-out refinance borrowers all became much more highly leveraged. Moral hazard became rampant as downpayments and initial equity disappeared throughout much of the housing finance system.

Other loan risk factors were magnified by the push to reduce equity. My Forensic Study documents that self-denominated subprime first mortgages traditionally had 20 percent or more initial equity. In 1989 cash equity of 20 percent or more was common on “A-” subprime loans, with several investors setting a maximum LTV of 75 percent.3 Maximum LTVs of 70-75 percent and 60-70 percent respectively were required on subprime “B” and “C” loans. In 1991, Fannie and FHA’s median LTVs were about 73 percent4 and 95 percent respectively.  The GSE Act mandated that Fannie and Freddie undertake an entirely new mission to compete with FHA and traditional subprime lenders. The government’s central role in increasing borrower leverage is documented later in this article.

3. Fannie and Freddie also led a second race to the bottom. Their charter privileges made them the leverage and moral hazard leaders. Treasury Secretary Tim Geithner recently observed that all financial crises are caused by too much leverage.5 Back in late 2009, in a private interview with the Financial Crisis Inquiry Commission,6 he enumerated six causes of the financial crisis, including moral hazard and the unique role played by the GSEs:7

“Moral hazard was everywhere and endemic. The biggest source was in the GSEs [Fannie and Freddie]. The GSEs were entirely moral hazard."

Below are his other five causes. Alongside in italics I have set out the starring role played by the GSEs:

1. “A long period of stability, including no history of a significant fall in house prices.” Note: as early as 2001 Josh Rosner and James Grant both noted ample credit provided by the GSEs was the source of this apparent stability;

 2. “Rates very low for too long.” Note: each period of low interest rates was an opportunity for the GSEs to use their charter advantages to gain market share. Their share of outstanding mortgages went from 41.1 percent in 2000 to 46.8 percent in 2003;

3. A parallel banking system, growing up alongside the traditional banking system,  funded short, and vulnerable to panics. Note: Fannie and Freddie were the largest and most leveraged part of this parallel banking system and suffered from a schizophrenic regulatory regime comprised of HUD and OFHEO;

4. Incentives to borrow and take advantage of regulatory arbitrage. Note: the GSEs were the biggest beneficiaries of regulatory arbitrage and incentives to borrow;

5. Inadequate regulation and lack of aggressive enforcement. Note: Geithner substantially dilutes this as a cause by noting that that “people don’t have perfect foresight” and “can’t be preemptive in this stuff.”8 HUD’s pro-active regulatory enforcement with respect to the GSEs’ affordable housing mandates has now been now broadly recognized as ill advised.

Regarding this last cause, there are many examples of HUD’s role in fomenting the mortgage crisis. Here is one from a 2000 rule making which implemented vastly increased housing goals, HUD set forth its view as to how the GSEs would use their competitive advantages to reshape the subprime market:9

Because the GSEs have a funding advantage over other market participants, they have the ability to under price their competitors and increase their market share. This advantage, as has been the case in the prime market, could allow the GSEs to eventually play a significant role in the subprime market. As the GSEs become more comfortable with subprime lending, the line between what today is considered a subprime loan versus a prime loan will likely deteriorate, making expansion by the GSEs look more like an increase in the prime market. [Emphasis added.]

The above also helps explain why the NTMs acquired by the GSEs were not the riskiest (but plenty risky to sink them). For years, the GSEs had used their charter advantages to gain supremacy in the low risk prime market. As a result, during the 1990s, their competitors were increasingly relegated to the higher risk fringes of the market—subprime, ARMs, second mortgages, and Alt-A, along with the prime jumbo market where the GSEs had only a limited ability to compete.10 As the GSEs expanded their risk appetite for NTMs, their competitors were forced to step further out the risk curve.

The GSEs had another advantage over their competition. It has been well documented in the Wallison dissent and by FHFA11 that the GSEs used their pricing advantage on low risk prime loans to cross subsidize higher risk, affordable-housing-goals-rich loans.12 Their competitors had little ability to do the same. These advantages assured that the GSEs’ competitors would end up further out the risk curve.

HUD’s commentary exhibits a static view of markets. Each push by the GSEs would naturally be expected to elicit a response by the private sector. It also ignores the GSEs’ central role as leaders in moral hazard and leverage. They continued in this role throughout the run-up to the financial crisis. Moral hazard and excessive leverage became endemic.

The Collapse of Fan and Fred

Now, turning to what caused the collapse of Fannie and Freddie. What do the facts tell us regarding the NTMs acquired by Fannie and Freddie where Min objects to my risk characterization? What role did these NTMs play in the mortgage crisis and the GSEs’ spectacular failure and subsequent massive taxpayer bailout?13 Let’s examine the impact of NTMs on Fannie:

1. My NTM definition mirrors the seven categories of risky loans that Fannie (and Freddie)14 identified.15,16 These groupings are based on known high-risk characteristics rather than after the fact characterizations;

2. As of June 30, 2008, these seven risk categories comprised approximately one-third of Fannie’s credit guaranty portfolio;

3. Over 99 percent of these risky loans are categorized in the Mortgage Bankers Association delinquency survey as prime loans;

4. Fannie’s single-family credit related expenses from January 1, 2007 through March 31, 2011 total $143.6 billion.17

5. Based on experience to date, these seven categories of risky loans account for an estimated 70 percent of this total or about $100.5 billion18, representing an expected 10.4 percent cumulative loss rate compared to an approximate loss rate of 2.5 percent on the other two-thirds of Fannie’s credit guaranty portfolio.

6. Overall, Fannie had capital of about 0.50 percent backing its credit portfolio, yielding a leverage ratio of 200:1;

7. The $100.5 billion in losses on these risky loans substantially exceed taxpayer assistance to Fannie of $87.6 billion,19 making them the proximate cause of the bailout.

Min would have us believe that Fannie, Freddie, FHA, and other government lending bear little responsibility for the mortgage meltdown. In the first quarter of 2011 the number of seriously delinquent loans that are federally backed totals about 45 percent, close to the number held by banks and private label securitizations.20 The lion’s share of these delinquencies is from the groups of loans Min objects to my characterizing as high risk.

While Min may not consider these loans high risk, taxpayers and homeowners would beg to differ.

Government's Role in the Crisis

Returning to the issue of the government’s role in the financial crisis, Min would also have us believe that government affordable housing policies did not force a systematic loosening of underwriting standards in an effort to promote affordable housing. These facts prove otherwise:

Facts:

In the late-1980s and early-1990s ACORN and other community groups claimed that Fannie and Freddie were standing in the way of their efforts to replace traditional underwriting with flexible underwriting. They lobbied Congress to force the GSEs to abandon their traditional underwriting standards. The goal was to force the GSEs to replace their conservative underwriting standards with flexible ones, knowing that this would spur the rest of the market to do the same.

Evidence:

1991: A community organizer tells the U.S. Senate Committee on Banking, Housing, and Urban Affairs:

“It is becoming increasingly clear that [Fannie and Freddie had] been a hidden loan officer at the loan origination table.”21

1991: HUD’s Advisory Commission on Regulatory Barriers to Affordable Housing reports:

“The market influence of Fannie Mae and Freddie Mac extends well beyond the number of loans they buy or securitize; their underwriting standards for primary loans are widely adopted and amount to national underwriting standards for a substantial fraction of all mortgage credit.”22

"Fannie Mae’s and Freddie Mac’s underwriting standards are oriented towards ‘plain vanilla’ mortgages."23

1991: Testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs:

"'Lenders will respond to the most conservative standards unless [Fannie Mae and Freddie Mac] are aggressive and convincing in their efforts to expand historically narrow underwriting.’ This point was reinforced over and over again by other [community advocacy] witnesses."24

Facts:

These groups were successful in convincing Congress to impose affordable housing (AH) mandates on Fannie and Freddie. This set in motion 14 years of ever looser loan standards:

Evidence:

1992: Congress passes the inaptly named “Federal Housing Enterprises Financial Safety and Soundness Act” (GSE Act). Instead of requiring safe and sound operations, ACORN and other groups successfully lobby for affordable housing mandates.25 As a result, Fannie and Freddie are forced to progressively loosen their underwriting standards and, for the first time, become competitors with FHA and traditional subprime lenders.

Facts:

Fannie embraced AH mandates in order to buy the political protection it would use to defeat any unwelcome changes to its lucrative charter benefits. To this purpose, it vows to “transform” the housing finance system. The strategy worked–Fannie was politically unassailable until 2008.

Evidence:

1994: “Fannie Mae Chairman Commits Company to 'Transforming the Housing Finance System;' Vows Company Will Provide $1 Trillion in Targeted Lending"26

Facts:

The government implements the National Homeownership Strategy with the goal of replacing traditional underwriting with flexible standards.

Evidence:

1995: President Clinton and HUD announce the “National Homeownership Strategy” (Homeownership Strategy):27,28

"[Having] forged a nationwide partnership that will draw on the resources and creativity of lenders, builders, real estate professionals, community-based nonprofit organizations, consumer groups, State and local governments and housing finance agencies, and many others in a cooperative, multifaceted campaign to create ownership opportunities and reduce the barriers facing underserved populations and communities."

The explicit goal was to draft the entire mortgage industry into making:

"Financing more available, affordable, and flexible [in order to]:

[Increase] ownership opportunities among populations and communities with lower than average homeownership rates;

Reduce downpayment requirements and interest costs by making terms more flexible, providing subsidies to low- and moderate-income families, and creating incentives to save for homeownership; and

Increase the availability of alternative financing products in housing markets throughout the country."

The mortgage meltdown and subsequent financial crisis were the result of these well-articulated government policies.

Facts:

Dissenting voices (Peter Wallison among them) predicted that these efforts to transform housing finance would end in disaster.

Evidence:

1998: "After the warm and fuzzy glow of ‘flexible underwriting standards’ has worn off; we may discover that they are nothing more than standards that led to bad loans. Certainly, a careful investigation of these underwriting standards is in order. If the ‘traditional’ bank lending processes were rational, we are likely to find, with the adoption of flexible underwriting standards, that we are merely encouraging banks to make unsound loans. If this is the case, current policy will not have helped its intended beneficiaries if in future years they are dispossessed from their homes due to an inability to make their mortgage payments. It will be ironic and unfortunate if minority applicants wind up paying a very heavy price for a misguided policy based on badly mangled data.”29

1999: “Fannie Mae Eases Credit to Aid Mortgage Lending:”30

"In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders. . . .

‘Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,’ said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ‘Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.’ . . .

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

'From the perspective of many people, including me, this is another thrift industry growing up around us,’ said Peter Wallison a resident fellow at the American Enterprise Institute. ‘If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.'"

Facts:

As flexible lending expands, the volume and risk characteristics of so-called prime loans increases markedly, yet these loans were still called prime. For example, loans with no downpayment acquired by Fannie are called prime merely because Fannie is now willing to acquire them. The same logic applies to loans with impaired credit. HUD acknowledges this in a 2000 rule making.

Evidence:

"Because the GSEs have a funding advantage over other market participants, they have the ability to under price their competitors and increase their market share. This advantage, as has been the case in the prime market, could allow the GSEs to eventually play a significant role in the subprime market. As the GSEs become more comfortable with subprime lending, the line between what today is considered a subprime loan versus a prime loan will likely deteriorate, making expansion by the GSEs look more like an increase in the prime market. Since . . . one could define a prime loan as one that the GSEs will purchase, the difference between the prime and subprime markets will become less clear. This melding of markets could occur even if many of the underlying characteristics of subprime borrowers and the market's (i.e., non-GSE participants) evaluation of the risks posed by these borrowers remain unchanged."31 [Emphasis added.]

Facts:

The United States, alone among developed countries, turned its prudential regulation of underwriting standards over to a social welfare agency, namely HUD. In 2004, HUD extols its “revolution in affordable lending.”

Evidence:

2004: “Over the past ten years, there has been a ‘revolution in affordable lending’ that has extended homeownership opportunities to historically underserved households. Fannie Mae and Freddie Mac have been a substantial part of this ‘revolution in affordable lending.' During the mid-to-late 1990s, they added flexibility to their underwriting guidelines, introduced new low-downpayment products, and worked to expand the use of automated underwriting in evaluating the creditworthiness of loan applicants. HMDA data suggest that the industry and GSE initiatives are increasing the flow of credit to underserved borrowers. Between 1993 and 2003, conventional loans to low income and minority families increased at much faster rates than loans to upper-income and non-minority families.”32

Facts:

The National Homeownership Strategy resulted in the substantial elimination of downpayments.

Evidence:

2007: From only 0.5 percent of home purchase loans in 1990, the proportion of loans with down payments of 3 percent or less steadily increased so that by 2007 they accounted for 40 percent of all home purchase loans. (See graph.)

Estimated Percentage of Home Purchase Volume with an LTV or CLTV >=97% (Includes FHA and Conventional Loans*)

Pinto 7.25.11

*Fannie’s percentage of home purchase loans with an LTV or CLTV >=97% used as the proxy for conventional loans.

For the year 2006, the National Association of Realtors reports that 43 percent and 19 percent of first-time buyers and repeat buyers respectively nationwide put down no money. The average first time buyer put 2 percent down.33 An estimated 30 percent of home buyers put no money down.

The major cause of the financial crisis in the United States was the collapse of housing and mortgage markets resulting from an accumulation of an unprecedented number of weak and risky NTMs. These NTMs began to default en masse beginning in 2006, triggering the collapse of the worldwide market for mortgage-backed securities and in turn triggering the instability and insolvency of financial institutions that we call the financial crisis. Government policies forced a systematic industry-wide loosening of underwriting standards in an effort to promote affordable housing, compounded by moral hazard spread by Fannie and Freddie.

Edward Pinto is a resident fellow at the American Enterprise Institute.

FURTHER READING: Pinto has written extensively on the topic of mortgages. He warns of “How the Government Is Creating Another Housing Bubble” and proposes solutions to the housing crisis in “Taking the Government Out of Housing Finance: Principles for Reforming the Housing Finance Market.” He further elaborates on these principles and reforms in, “How the TBA Market Would Function for Privately Issued Mortgage-Backed Securities” and “Government Must Jettison the 30-Year Mortgage.

 

Footnotes

1. See Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study and Exhibits to Government Housing Policies in the Lead Up to the Financial Crisis: A Forensic Study (Forensic Study).

2. Id. See Chart 53.

3. Thomas LaMalfa, “The Market for Non-Investment Quality Loans,” Wholesale Access, Vol. 1, No. 7, p. 6, December 1989.

4. Fannie Mae Random Sample Review, prime loan characteristics are from a random sample review of Fannie Mae’s single-family acquisitions for the period October 1988-January 1992, dated 3.10.1992.

5. Timothy Geithner, “The Dodd-Frank Retreat Deserves a Veto,” Wall Street Journal, July 20, 2011.

6. FCIC interview. http://www.bloomberg.com/news/2011-02-22/lehman-insider-trading-allstate-cftc-sec-compliance.html

7. Id.

8. Id.

9. http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=2000_register&docid=page+65093-65142

10. Combination 1st and 2nd loans were used to extend the GSEs competitive range. The GSE would acquire a conforming 1st and a 2nd would be made by another lender for the amount in excess of the conforming limit.

11. http://www.fhfa.gov/webfiles/14700/GFees72009.pdf

12. A point little appreciated is that Fannie and Freddie were wholesale buyers of loans. If a particular risk category (say low FICO or high LTV) averaged 60 percent of the loans meeting a particular goal, the other 40 percent in high risk loans were also acquired.

13. Most commentators focus on the taxpayer cost of the bailout. The bailout took place because the systemic risk posed by the GSEs was massive. The GSEs were themselves highly leveraged. However, many of the investors in their securities were also highly leveraged and therefore in danger of failing if the GSEs were not bailed out. For example, banks, thrifts, and credit unions held well over $1 trillion in agency mortgage-backed securities, most of which were guaranteed by Fannie and Freddie and were leveraged at over 60:1 on these securities.

14. Freddie’s disclosures are insufficient to permit a similar analysis, however I would expect the results to be similar.

15. I further subdivided NTMs into subprime and Alt-A. Subprime loans are generally characterized by weak credit, and Alt-A loans are generally those with one or more features that were outside of traditional agency guidelines.

16. The seven categories are: FICO <620, FICO >= 620 and <660, LTV greater than 90%, interest only, negative amortization, Alt-A, and (denominated) subprime. I also included loans with combined LTVs great than 90%.

17. Sources: Fannie’s 2008, 2009, and 2010 10-Ks and Q.1:2011 10-Q.

18. An additional $10 billion in losses are attributable to Fannie’s investments in private securities backed NTMs.

19. This figure is net of dividends on senior preferred stock. But for the bailout, these dividends would not have been incurred. Source: FHFA.

20. Based on author’s review of FHFA, FHA, MBA, and Loan Processing System data.

21. Allen Fishbein, “Filling the Half-empty Glass: The Role of Community Advocacy in Redefining the Public Responsibilities of Government-Sponsored Housing Enterprises,” Chapter 7 of Organizing Access to Capital: Advocacy and the Democratization of Financial Institutions, 2003, Gregory Squires, editor.

22. “Not in My Back Yard: Removing Barriers to Affordable Housing,” Chapter 5, page 3. http://www.huduser.org/Publications/pdf/NotInMyBackyard.pdf

23. Id. Chapter 3, page 13.

24. Supra, Fishbein.

25. Id.

26. Press release: http://www.thefreelibrary.com/FANNIE+MAE+CHAIRMAN+COMMITS+COMPANY+TO+%27TRANSFORMING+THE+HOUSING...-a014899678

27. http://www.huduser.org/publications/txt/hdbrf2.txt

28. See my Forensic Study for details on the role played by the Community Reinvestment Act (CRA).

29. Theodore Day and Stanley Liebowitz, “Mortgage Lending to Minorities: Where's The Bias?” p. 25, January, 1998. http://www.utdallas.edu/~liebowit/mortgage/mortgages.pdf

30. “Fannie Me Eases Credit To Aid Mortgage Lending,” New York Times, September 30, 1999. http://www.nytimes.com/1999/09/30/business/fannie-mae-eases-credit-to-aid-mortgage-lending.html

31. http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=2000_register&docid=page+65093-65142

32. Final Rule, Federal Register, November 2, 2004,  p. 63645.

33. http://www.usatoday.com/money/perfi/housing/2006-01-17-real-estate-usat_x.htm

Image by Darren Wamboldt/Bergman Group.

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