The Next Housing Bust
The Supreme Court has determined that the Federal Housing Finance Agency (FHFA)—the regulator and conservator of the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—was unconstitutionally structured because its director could only be removed from office for cause. The Court held in its June 23, 2021 decision that the constitutional issue could be resolved by striking the “for cause” language—leaving the FHFA in place, but headed by a director who could be removed from office at any time by the President.
Immediately upon the Court’s decision, the White House fired the FHFA director, Mark Calabria, and replaced him with a temporary appointment. Calabria had been following a policy of increasing the capital of the GSEs in preparation for privatizing them and reducing their risk to the taxpayers; his temporary replacement forthwith reversed course. Said Sandra Thompson, Calabria’s acting replacement, “It is FHFA’s duty through our regulated entities to ensure that all Americans have equal access to safe, decent, and affordable housing.”
This means a sharp change in marching orders for Fannie and Freddie—from a future as privatized companies to a future of being used to accumulate the risk of the government’s housing policies and increase the risk to taxpayers.
This sets up the conditions for the next housing bust. We have seen this movie twice before and know the ending.
The first time began in 1968 when HUD developed a “10-year housing program to eliminate all substandard housing.” Since there were then, like now, very large budget deficits, this program was implemented off-budget. The answer was the 1968 Housing and Urban Development Act, which had FHA insuring the 10-year plans’ subsidized single- and multifamily loans and Fannie funding them. Fannie was up to then a government agency with its debt on-budget. The 1968 Act converted it to an off-budget GSE. Now it was in a position to fund the largest expansion of newly built and rehabilitated subsidized housing in the nation’s history with up to 40-year fixed-rate loans. There have been only two years where privately owned single- and multifamily housing completions exceeded 2 million: 1972 (2.00 million) and 1973 (2.10 million)—when the population was 210 million and the number of households was 67 million, 36% and 48% respectively and smaller than today. As a reference, in 2006, at the peak of the Housing Bubble, there were 1.98 million completions.
In just a few years, HUD’s program turned into a disaster for cities and their residents, as described in the book Cities Destroyed for Cash: The FHA Scandal at HUD written in 1973. Detroit, Chicago, Cleveland, and many other cities never fully recovered from the effects of HUD’s scheme. By the early 1980s, Fannie’s investment in these loans had suffered huge interest rate risk losses that left it effectively insolvent. It was only able to continue in business given its GSE status and backing by the Treasury.
The second time began in 1992. Over the following years, the government forced Fannie and Freddie to reduce their credit standards so as to acquire trillions in risky loans under the rubric of affordable housing. The first of many trillion-dollar commitments was announced by Jim Johnson, Fannie’s very politically connected CEO, in March 1994. He vowed to “transform the housing finance system.” He did, but not in the way he intended. In 1994, HUD followed with its National Homeownership Strategy, about which President Clinton claimed: “Our home ownership strategy will not cost the taxpayers one extra cent.” A poor prediction indeed!
This government policy was pursued until 2008 through HUD’s authority to impose what were called “Affordable Housing Goals” on the GSEs. To meet ever more aggressive HUD goals, Fannie and Freddie had to continually reduce their mortgage credit standards, especially with respect to loan-to value and debt-to-income ratios. Instead of HUD’s strategy promoting homeownership, it resulted in some 10 million foreclosures and once again devastated our cities.
The full extent of the catastrophic credit risk expansion that took place has now been documented in a detailed analysis that researchers at FHFA and AEI released in May 2021. This is the first “comprehensive account of the changes in mortgage risk that produced the worst foreclosure wave since the Great Depression.” By analyzing over 200 million mortgage originations from 1990 onward, they showed “that mortgage risk had already risen in the 1990s, planting seeds of the financial crisis well before the actual event.” Average leverage and average DTI (the debt-payment to income ratio) on both home purchase and refinance loans increased significantly over the decade. Since Fannie and Freddie accounted for about 50% of the total mortgage market over the period 1994-2007, their complicity in the ensuing disaster is clear. The bubble’s inevitable collapse brought down many banks and other financial institutions, creating the 2008 financial crisis. In 2008 Fannie and Freddie were bailed out by the taxpayers and put into conservatorship, where they remain today, 13 years later.
The Democratic Congress elected in the wake of the crisis adopted the Dodd-Frank Act of 2010. It reflected the Democrats’ view that insufficient regulation caused the crisis. But the most important culprits—Fannie and Freddie—were left untouched, insolvent, and still functioning. Because it has become entirely clear that the US government is effectively the 100 percent guarantor of the GSEs, with the taxpayers fully on the hook, the financial markets provide unlimited funds for their operations. Thus the GSEs are allowed to operate profitably in their government conservatorship by using the U.S. Treasury’s global credit card. Today their off-budget, taxpayer-backed debt totals nearly $6 trillion, with the Federal Reserve funding more than $2 trillion of their mortgage-backed securities.
As the saying goes, those who cannot remember the past are condemned to repeat it, and the U.S. has a history of catastrophic housing blunders to remember, also including the spectacular failure and bailout at taxpayer expense of the savings and loan industry in 1989. Three dramatic failures in four decades—not an enviable track record.
Any president, thanks to the Supreme Court decision, now has direct control over most of the mortgage finance system. This includes Fannie and Freddie through FHFA; and the FHA and Ginnie Mae through HUD.
While the Supreme Court’s decision about the governance of FHFA is correct on its merits, the main problem is that we have a nationalized and socialized housing finance system. The American Jobs Plan proposes spending $318 billion to construct, restore, and modernize more than two million affordable homes. It is almost certain that the government will use its new control over the GSEs to once again make them the central elements of its plan with another weakening of credit standards. Thus we face the prospect of combining some of the worst features of HUD’s 1968 subsidized housing debacle with the GSEs’ disastrous foray into high-risk lending. Given this, can another mortgage debt crisis be far behind?
However, the government does not have to follow the fatally flawed policies of the Johnson, Clinton, and Bush administrations. If instead the following four principles were implemented, the United States would have a robust, successful housing finance system it needs and its citizens deserve.
I. The housing finance market—like other US industries and housing finance systems in most other developed countries—can and should function principally as a private market, not a government-dominated one.
The foreclosures and financial losses associated with the 1968 Housing Act, the savings and loan (S&L) debacle of the 1980s, and the actions of Fannie, Freddie, and HUD did not come about in spite of government support for housing finance but because of that government backing. Government involvement not only creates moral hazard but also always generates political pressures for increasingly risky lending such as “affordable loans” to constituent groups, which in the end harms both these groups and the taxpayers.
Although many schemes for government guarantees of housing finance in various forms have been circulating in Washington ever since the GSEs entered receivership, they are fundamentally the same as the policies that caused failures in the past. The flaw in all these ideas is the notion that the government can successfully guarantee increasing risk and will establish an accurate risk-based price for its guarantees. Many examples show that this is politically beyond the capacity of government.
First, the government’s guarantee eliminates an essential element of financial discipline—it removes credit risk from the investors. Second, the seemingly free-lunch nature of the off-budget guarantees creates the lure of the “affordable housing cookie jar”—cross-subsidies, “free money,” FHA and the GSEs competing for high-risk borrowers, and the perennial weakening of underwriting standards—all of which are backed by a government guarantee. So the outcome will be the same: underwriting standards will deteriorate, regulation of issuers will fail, and taxpayers will take losses once again.
II. Ensuring mortgage credit quality, and fostering the accumulation of adequate capital behind housing risk, can create a robust housing investment market without a government guarantee.
This principle is based on the fact that high-quality mortgages are good investments and have a long history of low losses. Instead of expanding government guarantees to reassure investors in MBS, we should simply ensure that the mortgages originated and distributed are predominantly of good quality. The characteristics of a good mortgage do not have to be invented; they are well known from many decades of experience. These are loan characteristics that, taken together, are highly predictive of loan performance. They include the borrower’s credit score, the debt-payment to income ratio (DTI), the combined loan-to-value ratio (CLTV), loan type (fixed or adjustable mortgage rate), loan term, loan purpose, whether the borrower’s income is fully documented, and whether the mortgage has a feature that modifies the amortization of loan principal. We know that mortgage lending must limit risk layering. We know how to apply a summary measure of default risk. The Stressed Mortgage Default Rate (MDR) is a simple, straightforward way to do this.
Regulation of credit quality could help prevent the deterioration in underwriting standards, although in previous cycles regulation promoted lower credit standards. The natural human tendency to believe that good times will continue—and that “this time is different”—will continue to create price booms in housing. Housing bubbles spawn risky lending; investors see high yields and few defaults, while other market participants come to believe that housing prices will continue to rise. Future bubbles and the losses suffered when they deflate can be minimized by focusing regulation on the maintenance of credit quality.
Stressed MDRs have demonstrated their efficacy. Calculated solely on the basis of loan characteristics present at origination, Stressed MDRs are highly predictive of default rates both in a non-stress delinquency environment (R-squared is 96%) and in a stress delinquency environment (R-squared is 99.9%) for all types of mortgage loans. By using MDR to risk rate loans at origination and regulate loan risk, we can control the accumulation of future losses which result from deteriorating underwriting standards.
III. All programs for assisting low-income families to become homeowners should be on-budget and should limit risks to both homeowners and taxpayers.
The third principle recognizes that there is an important place for social policies that assist low-income families to become homeowners, but these policies must explicitly balance the interest in low-income lending against the risks to the borrowers and to the taxpayers. In the past, implicit “affordable housing” subsidies through weak credit standards turned out to escalate the risks for both borrowers and taxpayers. The quality and budgetary trade-offs of riskier lending should be clear and on-budget.
The boom-bust cycle that low-income homebuyers have been subjected to for decades under the guise of making homes more affordable by escalating risk with weak lending standards should be broken. This result could be accomplished with the 20-Year Wealth Building Home Loan combined with an interest rate buy down provided by the federal government to an income-targeted group of first-time buyers. This would materially reduce defaults in low-income neighborhoods and sustainably foster generational wealth building.
If the federal government wants to subsidize low and moderate income homebuyers effectively, it should use this and other on-budget, transparent and sustainable ways to do it. Fannie and Freddie have no role here, as the only way they can participate is through reducing their credit standards with the real cost hidden in the form of expanding risk.
IV. Fannie Mae and Freddie Mac should be truly privatized, with their hidden subsidies and government-sponsored privileges eliminated over time.
Finally, Fannie and Freddie should be eliminated as GSEs and privatized—but gradually, so the private sector takes on more of the secondary market as the GSEs withdraw. The progressive withdrawal of GSE distortions from the housing finance market should lead to the sunset of the GSE charters at the end of the transition. This should include successive reductions in the GSEs’ conforming loan limits by 20 percent of the previous year’s limits each year, according to a published schedule, so the private sector can plan for the investment of the necessary capital and create the necessary operational capacity. The private mortgage market would include banks, S&Ls, insurance companies, pension funds, other portfolio lenders and investors, mortgage bankers, mortgage insurance (MI) companies, and private securitization. Congress should make sure that it facilitates opportunities for additional financing alternatives.
We know that none of this will happen in the near term, and the opposite of these principles will probably be followed by the current administration. Nonetheless, the principles define the housing finance direction that a future, market-oriented Congress and administration should take. In the meantime, all mortgage actors should try to protect themselves against the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.