Data Show Federal Policy Triggered Mortgage Meltdown
Despite mortgage interest rates falling to near all-time lows, America's homeowners are in a state of unease not seen since the Great Depression. In 2009, nearly 4 million foreclosure notices went out to homeowners unable to keep up with their payments, an increase of more than 20 percent from 2008. Many explanations lie behind this collapse, but arguably the most crucial, and underappreciated, has been excessive federal intervention in the housing market. Recent reports and articles from American Enterprise Institute (AEI) Senior Fellow Peter Wallison and AEI Visiting Fellow Charles Calomiris strongly suggest the pileup of bad mortgage paper has the words "Made in Washington" written all over it. In other words, rogue capitalism is partly to blame, but rogue government has played a central enabling role.
Our nation has over-invested in housing. To put the matter more simply, we've bought more housing than we can afford. According to the Irvine, Calif.-based RealtyTrac Inc., the number of U.S. homes seized by banks during First Quarter 2010 was 35 percent higher than for First Quarter 2009. And the number of owner-occupied homes in immediate danger of foreclosure was 16 percent higher than during the same three-month period a year earlier. "We're right now on pace to see more than 1 million bank repossessions this year," notes RealtyTrac Senior Vice President Rick Sharga. The Mortgage Bankers Association of America, meanwhile, estimates that during First Quarter 2010, 10.06 percent of all mortgage loans on 1-to-4-unit dwellings were delinquent and another 4.63 percent were in foreclosure. Thus, nearly 15 percent of all single-family dwelling homeowners with a mortgage are to some degree in danger of losing their home.
Want more evidence of a crisis? A report released late last year by First American CoreLogic, a real estate information company in Santa Ana, Calif., estimated that 23 percent of homeowners nationwide owe more on their mortgages than their properties are worth in the market, a condition popularly known as being "underwater." And a new study by Barclays Capital estimates that about 30 percent of all home sales in 2010 will be foreclosure-related, as opposed to the typical figure of around 6 percent. Moreover, says Barclays, U.S. home prices will tumble 3 percent to 5 percent over the next couple of years - on top of the 30 percent decline occurring since 2006.
Reckless mortgage lending fueled this fire. The research of Wallison and Calomiris, based on data supplied by former Fannie Mae Chief Credit Officer Edward Pinto, indicated that in 2008 - the year the mortgage industry imploded - roughly 26 million of the 55 million outstanding first mortgages in this country were in the high-risk "sub-prime" or (nearly as high-risk) "Alt-A" categories. The federally-chartered secondary mortgage market giants Federal National Mortgage Association ("Fannie Mae") and Federal Home Loan Mortgage Corporation ("Freddie Mac") held or guaranteed a combined 10 million of these mortgages. The companies had bundled about 7.7 million of them into mortgage-backed securities (MBS) for issuance by brokerage houses. The party ended soon enough. Default rates rapidly rose during 2007 and 2008, triggering a flight by investors from the MBS market and ultimately from all asset-backed securities. Fannie Mae and Freddie Mac were exposed to a combined $1.6 trillion in subprime and Alt-A mortgages, about a fourth of which became effectively uncollectible. Bonds could not be sold except at distress-level prices. Bear Stearns, Lehman Brothers, and Merrill Lynch imploded, as did Fannie Mae and Freddie Mac. The nation, and the world, fell into recession.
But the question arises: Why did this recklessness happen? As Wallison and Calomiris note, the federal government for years had applied intense pressure to primary and secondary lenders to lower credit standards in mortgage underwriting. Lax standards meant more applicants approved for credit. And more borrowers would translate into a higher homeownership rate, something presumably in the national interest. House price appreciation would serve as collateral in the event of foreclosure. It was optimism gone wild.
Banks and other primary lenders, for their part, created and/or shifted loan portfolios to exotic financial instruments such as sub-prime and Alt-A mortgages. They also focused more heavily on adjustable-rate mortgages, especially for subprime borrowers, in which payments typically reset at a higher level after the first two years. Lenders also promoted "cash-out" (loans exceeding the purchase price) and "interest-only" mortgages. Toward these ends, many banks acquired non-bank mortgage companies through which they could increase their volume of subprime loans.
Fannie Mae and Freddie Mac, each officially a "Government-Sponsored Enterprise" (GSE), also found themselves on the receiving end of federal heat. Starting in 1993, pursuant to new federal statutes, Fannie Mae and Freddie Mac's regulator, the U.S. Department of Housing and Urban Development's Office of Federal Housing Enterprise Oversight (OFHEO), established new "affordable housing" goals. Each GSE now would have to expand their purchases of mortgages made to low- and moderate-income households, especially members of racial minority groups. Civil-rights leaders such as Jesse Jackson, nonprofit radical activist groups such as the Association of Community Organizations for Reform Now (ACORN), and congressional allies such as Rep. Barney Frank, D-Mass. (see photo), were adamant about using the Community Reinvestment Act of 1977 to punish primary and secondary lenders who allegedly "redlined" (unjustly denied credit) black and Hispanic neighborhoods. They found willing accomplices in the Clinton administration. In 1999, HUD Secretary Andrew Cuomo announced a historic "agreement": Fannie Mae and Freddie Mac would buy $2.4 trillion in mortgages over the next 10 years to create affordable housing for 28.1 million low- and moderate-income households. At least 50 percent of all mortgages would have to meet affordability standards of such borrowers, up from 42 percent.
The Bush administration also coaxed Fannie Mae and Freddie Mac into operating as virtual adjuncts to HUD. President Bush, his top political adviser Karl Rove, and other key officials saw creating an "ownership society" as priority number one. In a June 18, 2002 speech, Bush made clear his intent:
The goal is, everybody who wants to own a home has got a shot at doing so. The problem is we have what we call a homeownership gap in America. Three-quarters of Anglos own homes, and yet less than 50 percent of African-Americans and Hispanics own homes...So I've set this goal for the country. We want 5.5 million more minority homeowners by 2010.
This statement unfortunately ignored the fact that creditworthiness long has varied by race as well as income, and that studies show blacks in particular have higher rates of default. By 2007 HUD stipulated that at least 55 percent of loans acquired by Fannie Mae and Freddie Mac had to meet low- and moderate-income affordability standards. The two GSEs complied rather than lose advantages contained in their respective congressional charters, such as exemption from state and local taxes and a $2.25 billion credit line from the Treasury Department. In addition, Congress and OFHEO (superseded in 2008 by the Federal Housing Finance Agency, or FHFA) allowed them to be undercapitalized. The GSE figure averaged about $1 in capital for every $20 in assets, whereas the commercial bank standard was $1 per $12. Safety and soundness took a back seat to raising the homeownership rate among minorities to the level of "Anglos." And if the risk of failure was higher, the unwritten rule of "too big to fail" still applied. Washington would come to the rescue in a pinch.
And so it did. As the blitz of high-risk lending by banks, thrifts and mortgage companies of varying repute tailed off, the profitability of Fannie Mae and Freddie Mac, despite intense lobbying of and generous political contributions to Capitol Hill lawmakers, was now in jeopardy. Each company already recently had become embroiled in accounting fraud scandals. "Affordable" mortgages - more accurately, mortgages for people who can't afford them - became a balance-sheet disaster for major investors as well as banks. With mortgage and capital markets interwoven, mounting defaults and foreclosures during the course of 2007 and 2008 were putting the economy in harm's way. The inevitable collapse occurred in September 2008. Spurred by Treasury Secretary Henry Paulson, FHFA hurriedly placed the companies under federal conservatorship. Congress, as part of the July emergency legislation that created FHFA, granted the Treasury Department an 18-month window of authority to raise indefinitely the Fannie Mae and Freddie Mac credit lines. Soon enough, the department raised the limits to $100 billion and then to $200 billion. In December 2009, Obama Treasury Secretary Timothy Geithner lifted them altogether. It was the logical culmination of years of social control over homeownership. As AEI's Wallison puts it:
The fact is neither political party, and no Administration, is blameless; the honest answer is that government policy over many years caused this problem. The regulators, in both the Clinton and Bush Administrations, were the enforcers of the reduced lending standards that were essential to the growth in homeownership, and ultimately, the housing bubble.
All this has cleared the decks for a rolling bailout. As of mid May, Fannie Mae and Freddie Mac had received a combined $145 billion in taxpayer-funded aid to cover their losses. And rest assured, more assistance will be needed. A few weeks ago Fannie Mae, the larger of the two companies, announced an $11.5 billion loss for First Quarter 2010 and asked for an extra $8.4 billion in assistance. Freddie Mac announced an $8 billion loss for the quarter and requested another $10.6 billion. The Congressional Budget Office projects the 10-year cost of the combined Fannie Mae/Freddie Mac bailout at nearly $390 billion. Too big to fail, indeed.
Yet this is small change compared to the value of mortgages held by the Federal Reserve System, pressed into service as the investor of the last resort. In a first-time-ever move, the Fed from January 2009 through March 2010 purchased $1.25 trillion in mortgage-backed securities in the hopes of eventually unloading them to well-capitalized investors. True, the purchases have kept interest rates down and maintained high rates of homeownership and property values. But they have done so at the risk of creating another overheated housing market and an even worse recession.
The financial services overhaul sponsored by Sen. Christopher Dodd, D-Conn., and passed by the Senate last Thursday (the House passed its own version in December) ostensibly would end the financial abuses that led to these and other bailouts (e.g., Troubled Asset Relief Program, or TARP). An amendment to the bill affirms its intent to "prohibit taxpayers from ever having to bail out the financial sector." Yet lawmakers have refused to address the twin assumptions that caused the bailout: 1) homeownership is a right; and 2) government should subsidize lenders that lose money on loans to high-risk borrowers. As such, the legislation won't extricate taxpayers from Fannie Mae, Freddie Mac and other fiscal sinkholes.
Neither will the government's $75 billion Home Affordable Modification Program (HAMP). The program, $50 billion of which is funded by TARP and the other $25 billion by Fannie Mae and Freddie Mac, is intended to modify mortgage payments for qualifying troubled homeowners, first on a temporary and then on a permanent basis. Yet HAMP, formally launched last April, initiated less than 80,000 trial modifications this March, less than half the peak figure of last October. A growing number of loan modifications, moreover, are being cancelled, as many borrowers have proven unable to make scheduled payments even on more favorable terms; Goldman Sachs estimates about 68,000 cancellations of trial modifications took place in March.
The best way to ensure against future bailouts is to terminate the federal government's too-big-to-fail guarantees. That's right: End them, don't mend them. So long as guarantees are in place, primary lenders, Fannie Mae, Freddie Mac and every other mortgage industry player will continue making loans to large numbers of people unable to pay them back. Risk must be driven by market rather than political forces. Writing on the mortgage meltdown, Barron's columnist Gene Epstein recently noted, "Crony capitalists love to take foolish risks, dependent as they are on government's rigged markets, often to the point that they would not be able to cope with free markets if they do." This rigging inevitably moves credit allocation away from risk-based approval criteria, making future bailouts likely.
Many political leaders, under the guise of "reform," prefer assigning to government the role of underwriter-in-chief. Frankly, it's hard to imagine the federal government getting much more involved than it already is. During First Quarter 2010, Fannie Mae, Freddie Mac and various mortgage insurance agencies (e.g., the Federal Housing Administration, itself beset with rising default rates) owned or guaranteed a combined 96.5 percent of all new home loans. This compares with about 40 percent for each of 2005 and 2006; 60 percent for 2007; 80 percent for 2008; and 85 percent for 2009. The government can't walk away from these commitments without severely compromising investor confidence. Even if the bill included an overdue privatization plan for Fannie Mae and Freddie Mac, we're locked in for a long time.
The persons instrumental in creating this crisis seem to have learned nothing. Example: Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, stated back in 2003: "These two entities - Fannie Mae and Freddie Mac - are not facing any kind of financial crisis." Unable to make that claim anymore, he wants the two GSEs to continue taking on high levels of risk. In June 2009 he and Rep. Anthony Weiner, D-N.Y., sent a letter to the CEOs of Fannie Mae and Freddie Mac, urging them to reverse the firms' recently tightened standards for condominium mortgages. Early this year, Rep. Frank called for "a whole new system of housing finance" to replace Fannie/Freddie. Given his long track record of misguided advocacy, whatever "reform" bill emerges from his committee is almost certain to involve far more federal control. In the era of the bailout, being wrong means never having to say you're sorry.