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.

By EDWARD PINTO

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.]

Why did we divert so much capital into housing?

Read Megan on asset bubbles.

Haven't we learned anything from the housing crisis?

House Democrats seek to expand the Community Reinvestment Act...

There is no question that as the government pursued affordable-housing goals—with the Community Reinvestment Act providing approximately half of Fannie’s and Freddie’s affordable-housing purchases—trillions of dollars in high-risk lending flooded the real-estate market, with disastrous consequences. Over the last 20 years, the percentage of conventional home-purchase mortgages made with the borrower putting 5% or less down more than tripled, from 8% in 1990 to 29% in 2007 (see chart above). Adding to the default risk: of these loans with 5% or less down, the average down payment declined from 5% to 3% of the loan’s value.

As for Fannie and Freddie, most of the loans with 5% or less down that they had acquired by 2005 had down payments of 3% or even no down payment at all. From 1992 to 2007, the two entities acquired over $3.1 trillion in low-down-payment or credit-impaired loans and private securities backed by credit-impaired loans—and these are performing horribly: the delinquency rate on Fannie’s and Freddie’s remaining $1.1 trillion in such high-risk loans is 15.5% as of this past June 30, about 6.5 times the rate on the entities’ traditionally underwritten loans. All this risky lending, of course, drove the nation’s homeownership rate up and inflated a housing-price bubble.

Incredibly, the House Financial Services Committee is considering legislation that would broaden the scope of the CRA

Because as we all learned in Poli Sci 101, spreading federal largesse to favored constituencies (in this case, poor minorities) is more important than sound economics.

And people wonder why government doesn't work...

Democrats expand the CRA

Peter Schweizer at Forbes:

As we try to shake off the financial crisis, here's a bright idea. Take a law that has led to the writing of an enormous amount of bad mortgages and expand it. Then take enforcement away from bank examiners and give it to housing activists. Sound like a poisonous cocktail? Well, it is what the Obama administration and Democrats are currently stirring up on Capitol Hill.

The White House and Congress want to expand a 30-year-old law--the Community Reinvestment Act (CRA)--that helped to fuel the mortgage meltdown. What the CRA does, in effect, is compel banks to seek the permission of community activists to get regulatory approval for bank expansions and mergers. Often this means striking a deal with activist groups such as ACORN or unions like the Service Employees International Union and agreeing to allocate credit to poor and minority areas that are underserved.

In short, the CRA encourages banks to make trillions in loans they would not ordinarily make. What's more, these agreements often require that banks offer no-money-down mortgages and remove caps on how much debt a borrower can take on. All of this is done in the name of "financial democracy."

The CRA is not about community development; it is, essentially, affirmative action in lending. Trillions in loans are now to be made not on the basis of whether they can be paid back but to meet CRA goals. This is precisely what we need to get away from. Drinking this potent cocktail would be dangerous to our financial health.

Housing update

Megan thinks low-to-no downpayment loans were the biggest mortgage fraud problem, with loans insured by the Federal Housing Administration leading the way.

Ordinary Dave foresees a bloody mess in commercial real estate.

"An interview with Barney Frank"

Mostly on financial regulation, with some talk of healthcare and online gambling near the end:

Snail bubble

"Administration's Reform Plan Misses the Mark"

I join Cato's pessimism:

The Obama Administration is presenting a misguided, ill-informed remake of our financial regulatory system that will likely increase the frequency and severity of future financial crises. While our financial system, particularly our mortgage finance system, is broken, the Obama plan ignores the real flaws in our current structure, instead focusing on convenient targets.

Shockingly, the Obama plan makes no mention of those institutions at the very heart of the mortgage market meltdown – Fannie Mae and Freddie Mac. These two entities were the single largest source of liquidity for the subprime market during its height. In all likelihood, their ultimate cost to the taxpayer will exceed that of TARP, once TARP repayments have begun. Any reform plan that leaves out Fannie and Freddie does not merit being taken seriously.

Instead of addressing our destructive federal policies aimed at extending homeownership to households that cannot sustain it, the Obama plan calls for increased “consumer protections” in the mortgage industry. Sadly, the Administration misses the basic fact that the most important mortgage characteristic that is determinate of mortgage default is the borrower’s equity. However, such recognition would also require admitting that the government’s own programs, such as the Federal Housing Administration, have been at the forefront of pushing unsustainable mortgage lending.

While the Administration plan recognizes the failure of the credit rating agencies, it appears to misunderstand the source of that failure: the rating agencies’ government-created monopoly. Additional disclosure will not solve that problem. What is needed is an end to the exclusive government privileges that have been granted to the rating agencies. In addition, financial regulators should end the outsourcing of their own due diligence to the rating agencies.

The Administration’s inability to admit the failures of government regulation will only guarantee that the next failures will be even bigger than the current ones.

Prophetic quote of the day

Oy vey:

"The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble."

—Lefty economist and future Nobel Laureate Paul Krugman, August 2002.

(ht Megan)

"Reagan Did It"

In yesterday's Times, Paul Krugman argued that Reagan was responsible for the recent housing crisis.

A response at Commentary Magazine:

First, he attributes the results of the Garn-St. Germain Depository Institutions Act of 1982, and thus the S&L crisis of the late 1980’s, entirely to Ronald Reagan, as though Reagan was ruling by decree. It was Democrat Fernand St. Germain, Congressman from Rhode Island, who dropped into the bill in the middle of the night the provision that raised the government guarantee on bank deposits from $40,000 to $100,000 and assorted other goodies for the powerful S&L lobby. It passed both houses with veto-proof majorities.

Second he lies with statistics, especially the “savings rate,” which measures only family income versus outgo. Mortgage payments, for instance, which add to net worth, are not counted, nor are capital gains, unless realized. In the great boom of the 1982-2007 period, families saved more by increased housing and investment gains than by old-fashioned savings.

Third, he writes, “traditionally, the U.S. government ran significant budget deficits only in times of war or economic emergency. Federal debt as a percentage of G.D.P. fell steadily from the end of World War II until 1980. Translation: Reagan began running up the debt to unsustainable heights.

What he doesn’t say is that while the debt remained fairly steady in dollar terms in the late 40s, and in 50s and 60s (it increased by roughly a third in the 1960s though), it declined as a percentage of GDP thanks to strong economic growth. But in the 1970’s, with Congress firmly in the hands of Democrats and with weak Republican presidents Nixon (after Watergate broke) and Ford, the debt tripled in dollar terms. It declined slightly as a percentage of GDP only because of the roaring inflation of that decade.

Link blag

TMV: NROite Andy McCarthy does not understand the law. The motive of torture does not matter; the intent matters.

Keith Hennessey explains Obama's international tax proposals. Verdict: they are a form of protectionist isolationist and will actually backfire and give U.S. companies further incentives to move HQs overseas.

Megan: Why was Canada so unaffected by the banking crisis? It wasn't regulation. Its bankers are simply very conservative, and didn't trust easy money.

Ruffini sees springtime for GOP moderates. Politico reports that the party is recruiting RINOs. One can hope, but I don't see them becoming electable without the party reforming its attitudes. For the near future, having that R next to their name is a big sink.

Boston Herald: From the Dept. of Terrible Liberal Ideas, poor welfare recipients in Massachusetts are being given free cars.  Sigh.  The belief that poor won't be poor if government gives them enough free stuff marches ever on in leftopias.

Truth in economics blog headlines: "This Is Not a Post About Jessica Alba".

Hey look this stuff is getting cheaper

So why won't the media report the good news?! [Was that an ironic question? -ed.]

A brief history of home values

Amazing:

A tale of reckless greed

(meme) By Saying Yes, WaMu Built Empire on Shaky Loans

hilzoy summarizes

On the broader subject, last week Drezner round up five useful guides to the current crisis.

ACORN: a chart

Look here. It's difficult to know how to begin making sense of this. It is obviously anti-Obama and embellishing or exaggerating, but I'm supposing there is at least a kernel of truth, likely more than a kernel.

But it's genuinely difficult to draw the line between fact and fiction; between what really matters and what might be dismissed with a sensible explanation.

I wish all the sources I can find about ACORN weren't so obviously biased.

As a baseline, I've seen no evidence that Obama's involvement with ACORN was in any kind of bad faith. He seems to have some fundamental disagreements with me about how government should interfere with the credit markets and force lenders to give NINJA mortgages. But I'm not sure it's worse than things like the prosperity gospel, for instance. Ideas like George W. Bush's "ownership society" contributed to the problem, as well.

I'm going to try to understand this ACORN thing and post more if I can....

Republican National Committee: VOTE FRAUD ALERT: Obama & ACORN Fact Sheet

That links back to the Obama camp's fight the smears website, which makes counter-assertions they dispute.

Here are a couple HuffPost stories: 3 October, 5 October

I'm trying hard to find stuff that's less partisan, but the pickings are slim.

I did a search on RCP, for instance: The hits are Fox News, Michelle Malkin, National Review, and some talk show hosts. Hardly an unbiased filter, but then they'll all say the rest of the media is biased towards Obama. Even the New York Times is a "pro-Obama advocacy group" these days, according to the McCain campaign.

I think I'd like a respected conservative blogger like Ross Douthat to look into the ACORN story. Today he has two posts on Bill Ayers. Those are great reads compared to the usual partisan hackery.

Keating economics

TPM:

For weeks, many of you have been asking me, why haven't the Democrats been bringing up McCain's history as a member of the Keating Five? Especially since it ties so clearly into today's financial crisis, his wife's company's ties to Keating and his history of supporting lax banking and finance industry regulation? When is the Obama campaign going to bring this up, I keep hearing.

Well, I think you've got your answer.

Must we look backward like this?

I suppose there is important substance here -- unlike Obama's connection to someone who blew up things when Obama was a young kid (Ayers) or the ethically dubious astroturfing of his strategist's independent partnership (Axelrod's ASK) -- but I do wish we could focus more on how to fix things rather than assigning blame.

*sigh* . . but as long as we're looking backwards, Obama wrote a letter in early 2007 which looks interesting.

Rightwingers will be quick to point out Obama's association with ACORN, which is viewed as being partly responsible for this mess. But I think Obama's letter from a year and a half ago shows that he was aware of the problem.

In considering how to judge a candidate's position on issues, I like to look at the totality of their proposals. It seems to me that under a President Gore or a President Kerry or a President Obama, we would not be so bogged down in Iraq or would have avoided it entirely. You do realize we're spending on the order of a trillion dollars there, right?

Think of how much better those resources (labor and material as represented by U.S. dollars) would have been spent on things like housing and healthcare rather than foreign nation-building by force of arms and private Haliburton and Blackwater-style contracts.

Point is, Obama seems to have the "radical" idea that the government's resources are better invested at home rather than trying to create friends in the Middle East.

As a libertarian, I'd prefer to radically slash the government's size and taxes across the board. But if that's not the choice I'm given -- if the choice is between Democratic social subsidies or the neocons' Vietnams and Iraqs and between these tax plans and these levels of fiscal responsibility -- I think we know what the saner choice is.

Banks matter

One of Sullivan's readers explains why you shouldn't be dismissive of the current financial crisis.

For more detail, Princeton economists give an hour's worth.

This is your legacy

...well, one of them.



You know who you are.

On the plus side, I rather doubt Wall Street will be skiddish about seeing the Democrats come to power, and we can all look forward to Obama's rediscovery of Clintonomics.

Cheer up, there are much brighter days ahead!

Why not nationalize?

Three days ago when I read Yglesias' "Nationalize Everything", I emailed Megan essentially asking:

New Deal 2.0 ? I'm sure there are problems with the idea... could you explain?

I'm sure many people had the same type of question, and here is her answer.

Bailout flailing...

(this post updated as the day progressed...)

Watch: stock indexes

Ambers:

More than 131 House Republucans and 95 House Democrats vote against it.

A rush to cash-in on T-bills...

Dow down nearly 600...

Will Pelosi hold the vote open to get 12 more votes?.

Yeesh, everyone wants political cover....

Where Were You When The World Economy Collapsed?

Where's Tom Delay when you need 'em?

Who gets blamed for the House Republicans? McCain? Obama? No one?

What's the contingency plan?

What can the government do by itself?

CNN:

Legislation to bail out the U.S. financial system appears near defeat on the floor of the House. More than enough members of the House had cast votes to defeat the bill, and the vote was being held open, apparently as efforts were under way to persuade people to change their vote. The Dow reacted sharply, plummeting more than 700 points.developing story

McArdle:

I've been watching the debate on CSPAN, and as of now, HR 3997 looks like it's just failed, unless this is some weird procedural vote I don't understand. Nays won 228 to 205, with 1 vote still uncounted. The markets just plunged, with the NASDAQ and the S&P both down more than 6%.

Democrats voted for it pretty narrowly -- 140 to 95. The Republicans shot it down 65 to 133. I find it hard to believe that they're voting their conscience; they're voting their electoral interest in November. I hope their constituencies enjoy the bank panic.

Actually, what I hope is that I'm wrong, we don't need a bailout, and after a period of liquidation, everything will settle down. If so, I will happily confess my error. But I'm very much afraid that I am not wrong, and things are about to get pretty grim.

FiveThirtyEight:

Among 38 incumbent congressmen in races rated as "toss-up" or "lean" by Swing State Project, just 8 voted for the bailout as opposed to 30 against: a batting average of .211.

By comparison, the vote among congressmen who don't have as much to worry about was essentially even: 197 for, 198 against.

Sullivan: "In the end, they were worried about re-election."

NYT has a great vote chart. If my Rep. had voted no I'd be on the phone right now.

NRO's corner is an interesting read today if you want to understand WTH the neocons are thinking. Politically, two points stand out so far:

1. The failure of Republicans to deliver the votes they promised is bad for McCain, who bragged about his supposed success in getting them to vote for it


2. Democrats are now likely to say: "Well, we tried to come together" and proceed to pass a leftist version of the bailout on a party line vote

Ross Douthat ponders:

The best case: This is an example of America's democratic institutions reasserting themselves in the face of the attempt by a panicked technocratic elite to prop up reckless institutions that richly deserve to fail.

The worst case: You know what.

The most likely scenario, as of 3 PM this afternoon: The stock market continues to drop. Some version of the bailout passes in the next week. The American economy staggers into a recession, but passes through the storm without 1930s-style suffering; the Republican Party is not so fortunate. Even though most Americans claim to oppose the bailout [update: not anymore], the House GOP's obstructionism is widely viewed as having worsened the economic situation; the fact that these are contradictory positions does not faze an electorate that wraps all of the country's current troubles up, ties them with a bow, and lays them at the feet of the Bush-led GOP. John McCain loses by a landslide in November. The Democratic Party regains years or even decades worth of ground among the white working class, consolidates the Hispanic vote, and locks up a large chunk of highly-educated voters who might otherwise lean conservative. The much-discussed liberal realignment happens. And a politician running on a Ron Paul-style economic platform does very, very well in the GOP primaries of 2012.

That last line is the first sign of good news for the future that I've come across. Could it be so?