Sunday, August 22

The future of housing finance

[Stolen from behind the WSJ pay wall...]

We'll never get a rational mortgage system until the government's affordable housing mandates are ended.


Today the Obama administration will begin a discussion on how to overhaul our nationalized housing finance system. Moderated by Treasury Secretary Timothy Geithner and Shaun Donovan, secretary of the Department of Housing and Urban Development (HUD), the "Conference on the Future of Housing Finance" seeks answers to what went wrong in the U.S. housing market. This promises to be the next big domestic policy debate—one that could mold housing finance for a generation or more. But the early signs of where policy makers might be headed are not promising.

A consensus is building around a three-part grand bargain:

• An explicit federal guarantee of a large portion of the mortgage-backed securities created to finance American's home mortgages;

• A tax on these securities to fund low-income housing initiatives; and

• A requirement that issuers of securities meet affordable housing mandates.

This is a dead end for two reasons. First, while supporters of an explicit federal guarantee tell us it will never be called upon, Americans have read this book before and know how it ends.

The second is much less well known but equally deadly: the central role in the recent real estate collapse that was played by the federal affordable housing policy created by Congress and implemented since the 1990s by HUD and banking regulators.

In 1991, the Senate Committee on Banking, Housing, and Urban Affairs was advised by community groups such as Acorn that "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."

Congress made this advice the law of the land when it passed the inaptly named Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (GSE Act of 1992). This law imposed affordable housing mandates on Fannie Mae and Freddie Mac.

Thus, beginning in 1993, regulators started to abandon the common sense underwriting principles of adequate down payments, good credit, and an ability to handle the mortgage debt. Substituted were liberalized lending standards that led to an unprecedented number of no down payment, minimal down payment and other weak loans, and a housing finance system ill-prepared to absorb the shock of declining prices.

In 1995, HUD announced a National Homeownership Strategy built upon the liberalization of underwriting standards nationally. It entered into a partnership with most of the private mortgage industry, announcing that "Lending institutions, secondary market investors, mortgage insurers, and other members of the partnership [including Countrywide] should work collaboratively to reduce homebuyer downpayment requirements."

The upshot? In 1990, one in 200 home purchase loans (all government insured) had a down payment of less than or equal to 3%. By 2006 an estimated 30% of all home buyers put no money down.

"[T]he financial crisis was triggered by a reckless departure from tried and true, common-sense loan underwriting practices," Sheila Bair, chair of the Federal Deposit Insurance Corporation, noted this June. One needs to look no further than HUD's affordable housing policies for the source of this "reckless departure." If the mortgage finance industry hadn't been forced to abandon traditional underwriting standards on behalf of an affordable housing policy, the mortgage meltdown and taxpayer bailouts would not have occurred.

Compounding HUD's forced abandonment of underwriting standards was a not-unrelated move to increased leverage by financial institutions and securities issuers. They were endeavoring to compete with Fannie and Freddie's minimal capital requirements. The GSEs only needed $900 in capital behind a $200,000 mortgage—many of which had no borrower down payment. Lack of skin in the game promoted systemic risk on both Main Street and Wall Street.

How should we go about repairing this dysfunctional housing finance system?

The goals should be larger down payments, stricter underwriting standards, reliance on the private sector and private capital, and the removal of affordable housing mandates. If there is to be an affordable housing policy, it should not be implemented by hidden subsidies and loose lending standards, but instead made transparent and funded on budget by the government.

Getting there will take time—probably a 15-year rebuild that fosters an orderly phase-out of government guarantees and a transition to a deleveraged, market-based system. This will require both long- and short-term policies.

Long-term we should consider ideas such as: the proposal by Columbia University's Charles Calomiris to increase minimum down payments by 1% per year over 15 years, bringing them back to 20%, where they had been for decades. Peter Wallison of the American Enterprise Institute has suggested that the private sector be encouraged to grow by reducing the GSEs' maximum mortgage amount by a percentage every year until it matches the Federal Housing Administration's (FHA) reduced limit, at which point the GSEs disappear. I have suggested that the FHA be returned to its former role of serving the low-income market over a five-year period, but with a higher minimum down payment so borrowers have more skin in the game.

Finally, the property appraisal process should be re-engineered along the lines suggested by the Collateral Risk Network, an organization representing the nation's leading appraisal experts. The boom was promoted by appraisal practices that relied on one input—the latest prices that were the result of an overheated market. A return to traditional appraisal theory based on price trends, replacement cost and value as a rental is necessary.

To get the housing finance system out of intensive care, short-term policies need to be implemented that promote deleveraging. Perhaps some of the excess supply of foreclosed properties should be sold to buyers who agree to put 40% down and use the properties as rentals. Josh Rosner, managing director of the research firm Graham Fisher, has suggested that homeowners who voluntarily pay down a portion of the principal on their underwater mortgage receive a tax credit also applied to their mortgage principal. In return, they would forgo future tax deductions of their mortgage interest payments.

While the road to housing hell may have been paved by the government, the road back will be built by the private sector.

Mr. Pinto, a consultant to the mortgage finance industry, was executive vice president and chief credit officer at Fannie Mae in the late 1980s.

[The long, 183-page PDF version of Mr. Pinto's paper is here.]


  1. I might read this later but I'm just going to comment on what I think about the housing crisis based on things that have happened in my area.

    Three years ago a couple with two kids bought the house next to me for $170,000. The father was an engineer who got laid off and they had to move out of state and sell the house. It sold for $135,000. Last month the old retired couple who bought it with savings because of the golf course across the street put it back up for sale for reasons unknown to me. It's going for $105,000. Whoever buys it will probably pay no more than $80,000. It's a buyers market with houses right now, but why cant people afford to live? Is the middle class becoming low class? Where is the middle class?

    My family bought this house for $34,000 in 1984 and as appraisal value kept going up, they kept pulling out loans and mortgages and at times this place appraised for $160,000. We're living good, for now. Even thought two of don't work and the other is a mailman. For a decade we afforded things that nobody on this salary could and today this house appraises for $41,000. If they closed that gold course across the street this house would be ready for demolition. Not worth the ground it's on.

  2. What bothers me the most is that nearly half the people on this road *WANT* the golf course to close, and these are the people who've been living here for decades. I cant help but to think that they are insane. The most expensive property bought in the last ten years here is next to me on the other side, bought in 2001 for $390.000. 14 acres with the house way back from the street. A good 2 minute walk. Every time I've talked to them, which is only a few times cause they're snobby, they want to move. But they cant. That house and property wouldn't go for more than $200,000 right now. Probably less because nobody wants to move here. A once upper middle class place is quickly turning into a ghetto.

  3. "Thus, beginning in 1993, regulators started to abandon the common sense underwriting principles of adequate down payments, good credit, and an ability to handle the mortgage debt"

    I just started reading it and I failed to mention in my rant that people around here make good money except for the old timers like us (People who bought decades ago) but my family profited big time off buying a house - by buying I mean paying for, buying - for $34,000 and leeching off it as appraisal value went up. But nobody can leave here without losing lots of money and nobody can stay here without having to live in a developing ghetto.

  4. This is my last comment because I didn't bother to read all of your post before I started commenting and I don't want to inundate.

    This comment is in a question: what should be who can not afford a home do? Should less homes be built? Should more people be homeless? Should their be more renters and profiteers in the industry of renting out owned property? I used to work construction... for a few months at least. I made 7.50 and hour with the hope of making 13 one day - this was back in 2003. The supervisor and the foreman combined made $70 an hour while dicking around and smoking cigarettes. We already knew what to do but they took the cut anymore for sealing the deal for the job. Is it possible that, perhaps, homes are way over priced due to greed?

  5. Nevermind any "typing" errors, I'm using windows 7 speech recognition. It's not so bad if you train it well. Doing so is a hobby of mine, not quite there.