Housing Policy Mistakes: How We Got Here

In my recent paper, Rethinking Homeownership, I noted that there were a number of policy mistakes that got us to this point. I wanted to expound on what was in the paper and note some of the ways that we got into this housing mess, focusing particularly on CRA and affordable housing goals. These were certainly not the sole cause of the housing bubble, but they did contribute.

The chartering of Fannie Mae (1938) and the passage of the 1977 Community Reinvestment Act (CRA) were both designed to provide liquidity and incentives for mortgage lending. And from the 1960s to the mid 1990s, the homeownership rate stayed in a relatively stable range of 62 percent to 64 percent. Housing policy took on a new form, though, under the guidance of HUD Secretaries Henry Cisernos (1993 to 1997) and Andrew Cuomo (1997 to 2001).

The result of their policies, which were continued by the Bush administration, was a radical jump in the homeownership rate from 64 percent to 69 percent between 1995 and 2005, which was the peak of the boom. This may sound like a positive outcome, but the rapid growth in homeownership would prove unsustainable and has ultimately led to the foreclosure epidemic currently besetting the housing market. (Just take a look at where homeownership rates are now in relative terms.)

One of the first major changes to promote this growth in homeownership was the Affordable Housing Initiative in the early 90s, setting out the goal of making alternative mortgage financing more readily available to low-income families. As a part of implementing the Affordable Housing Initiative, Congress passed a bill that completely updated the CRA, placing more emphasis on performance-based evaluations that allowed regulators to essentially blackmail certain banks into lending (often described as “quantifiable outcomes”).

In order for the banks under CRA to comply with new regulatory requirements they designed innovative lending options, such as interest-only mortgages, principal-only mortgages, and an array of adjustable-rate mortgages. Even the banks that weren’t regulated by CRA developed the same products in order to compete. Quickly, borrowers with unstable credit began to find it easier and easier to obtain a mortgage. The result was a greater proportion of the population entering the housing market than was previously possible or than would have been anticipated based on normal economic and population growth trends. And with that increase came a substantial rise in prices.

While the CRA was decreasing lending standards for certain banks in the private sector, HUD directed Fannie Mae and Freddie Mac to lower their lending standards as well. As a part of the Affordable Housing Initiative, HUD Secretary Cisernos began increasing the affordable housing mandates for Fannie and Freddie. At that time, the GSEs were required to have 30 percent of their loan purchases contain mortgages issued to individuals or families under the median income in their area. In 1996 this quota was increased to 40 percent. In 1997, Secretary Cuomo increased the number to 42 percent, and then to 50 percent by 2001. Under the Bush administration HUD continued increasing the affordable housing goals of the GSEs up to 52 percent in 2005 and 53 percent in 2006. By the time the housing bubble was beginning to pop in 2006, Fannie and Freddie were required by HUD to have 55 percent of the loans they bought be mortgages issued to low-income borrowers.

Since their inceptions, Fannie and Freddie have had specific guidelines as to what kind of mortgages they can buy from the private sector. Specific aspects of a loan’s down payment percentage, borrower credit history and other measurements determined whether a mortgage “conformed” to GSE standards. However, in order to meet the HUD affordable housing requirements, Fannie and Freddie had to lower their conforming loan standards. This meant the quality of mortgages the GSEs held on their books dramatically decreased at the same time that the growth of the housing bubble increased the number and dollar amount of mortgages they took on.

As Fannie and Freddie decreased their conforming loan standards, it created a market for mortgages with increasingly higher loan-to-value (LTV) ratios. Prior to the HUD rule changes and CRA update, a minimum loan-to-value (LTV) ratio of 80 percent at the time of the origination of the mortgage was typical. This meant that at the time of purchase, a homebuyer was putting up 20 percent of the home price as a down payment and borrowing the remainder. Loan-to- value ratios jumped an overall rate of seven percentage points during the housing bubble. LTV rates on second mortgages grew even faster.

I will take a step back and say that it is true the GSEs were loosing market share during the first part of the 2000s even with the affordable housing goals. However, this does not mean the GSEs had clean balance sheets. In fact, this was a time period with serious accounting fraud allegations at Fannie and Freddie. The simple facts are that the GSEs did take on toxic mortgages and those have led to an expensive taxpayer bailout. One of the goals of the FCIC report is to clarify just how much of a role the affordable housing goals had (the answer is not zero percent)—though I imagine that the report is not going to really do its job. We are likely to be debating the issue just as strongly after the commision has its say(s).