Get Ready For the Subprime Mortgage Crack-Up 2.0
In 1991 community advocate Gail Cincotta, in testimony before the Senate Banking committee stated: "Lenders will respond to the most conservative standards unless [the GSEs] are aggressive and convincing in their efforts to expand historically narrow underwriting." The next year Congress imposed affordable housing mandates on Fannie Mae and Freddie Mac. Over the next 15 years the Department of Housing and Urban Development (HUD) forced the abandonment of traditional underwriting standards, which led to an accumulation of an unprecedented number of weak and risky non-traditional mortgages. The collapse of housing and mortgage markets, and the ensuing Great Recession, may be directly traced to those events in the early-1990s.
Earlier this month the following headline appeared in the Wall Street Journal: "U.S. Backs Off Tight Mortgage Rules: In Reversal, Administration [HUD/FHA] and Fannie, Freddie Regulator Push to Make More Credit Available to Boost Housing Recovery." Clearly memories as to the causes of the recent housing market collapse are short. Indeed, political pressures are once again increasing on the private sector to degrade sound lending practices.
The headline refers to two policy statements made May 13, one by Mel Watt, director of the Federal Housing Finance Agency (FHFA), and the other by Shaun Donovan, secretary of HUD. The FHFA is the regulator of Fannie Mae and Freddie Mac, which along with the Federal Housing Administration (FHA) are responsible for guaranteeing about 75 percent of all mortgage credit in the United States.
Watt announced a course reversal from his predecessor Edward DeMarco. One of his most significant moves was the alignment of FHFA's policies -- with respect to discouraging private sector discretion in adhering to strong underwriting standards -- with those of the FHA. Watt warned lenders and private mortgage insurers that "credit overlays result in the rejection of many loans that would otherwise meet [Fannie Mae and Freddie Mac] credit standards." This echoes FHA Commissioner Carol Galante's 2013 statement: "[L]ender overlays are damaging the recovery by limiting access to creditworthy borrowers."
The parallels to Cincotta's statement are unmistakable: regulators must convince lenders and private mortgage insurers to stop utilizing more conservative standards than allowed by government agencies.
Why do policymakers want to force the private sector to originate easy credit loans? First is the desire to use easy credit to juice an anemic economic recovery. Yet we have already had 6 years of the lowest interest rates in generations, combined with already loose lending standards. The result has been increasing home prices in concert with stagnant incomes, leading to reduced affordability, particularly in places like California.
Second is to expand access to "creditworthy borrowers." This statement is duplicitous. The real goal is to get the private sector to originate more loans to sub-prime borrowers with credit scores below 660 or pre-tax debt-to-income ratios above 43 percent, and to non-prime loans to borrowers with tiny down payments. This is a continuation of a fifty-plus years housing policy based on using ever greater leverage in a futile attempt to expand homeownership by helping unqualified borrowers buy homes.
This leverage has taken the form of reduced down payments, higher debt ratios, extending loan terms to 30 years, and credit to those with impaired credit histories. This policy failure is evidenced by a stagnant homeownership rate which today stands at 62 percent (excludes owners with seriously delinquent loans), the same rate as in 1960. Yes, the rate did hit 69 percent in 2004, but that was thanks to the loose lending standards resulting from Congress' following Gail Cincotta's prescription. Contrast 1940 to 1960, a period during which the home ownership rate rose dramatically for both blacks and whites. Why? Precisely because home lending until 1960 was not highly leveraged, making it low risk to homebuyers and lenders alike.
The cautionary remarks of Watt's predecessor, Ed DeMarco, also made on May 13, are pertinent: "[d]o not confuse weakening underwriting standards and underpricing risk with helping people or promoting market efficiency. A government effort to assist families with limited resources and poor credit history to take on increased leverage seems a curious public policy."