Crime Scene Investigation: The Premeditated Assault On the Prime Mortgage

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With the Romney/Ryan ticket now in place, the debate moves to fundamental questions about the economy. The big issue which Governor Romney continues to focus on is the contrast between the government-centered society embraced by President Obama, and the Romney/Ryan vision for a society centered on freedom of choice, and free markets.

When it comes to a government centered society and its deleterious consequences, our Government Mortgage Complex is the undisputed poster child. There has been no greater economic failure than the collapse of the housing market due to decades of government intervention and crony capitalism.

Voters need to be reminded about how this disaster came about. It began with the premeditated assault on high-quality, credit-worthy prime mortgages. The perpetrators were Fannie Mae, community groups, and Congress, each of which had the means, motive and opportunity for undertaking this assault.

As early as 1991, community activist Gale Cincotta, was laying the path for undertaking such an assault in her testimony before the Senate Banking Committee. "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," she stressed.

Using Fannie and Freddie as the means to expand underwriting standards caused an immediate problem for existing subprime lenders and insurers. In 1992, about 14% of new mortgages had impaired or subprime credit with a FICO credit score below 660. Virtually all these borrowers were already served by private subprime lenders or those using FHA insurance. As Fannie and Freddie expanded into subprime, something had to give-subprime lenders would have to abandon the field or move further out the risk curve. They chose the latter, with the result that both prime and subprime lending got into much more risky loans.

The motives of Fannie, community groups, and Congress were clear. Fannie wished to protect its valuable federal charter by using trillions of dollars in flexible loans to woo and capture its regulator: Congress. Community groups like ACORN relied on flexible lending to create multiple revenue streams from banks, lenders, Fannie and Freddie, HUD, and others, since they made money from counseling homebuyers, assisting in loan originations, and counseling defaulting borrowers. Members of Congress viewed the many trillions of dollars in flexible lending announced by Fannie and Freddie as a superior form of pork to help them get reelected. It was off-budget, costless, and seemingly inexhaustible. This virtue was extolled by President Clinton in 1995: "Our home ownership strategy will not cost the taxpayers one extra cent."

The opportunity was provided for by federal legislation and initiatives. While there were many, three from the 1990s bear special mention. The first was the ironically named "Federal Housing Enterprises Financial Safety and Soundness Act of 1992." At the behest of ACORN and other community advocacy groups and with the support of Fannie Mae, Congress imposed affordable housing (AH) mandates on Fannie and Freddie. HUD was established as their AH mission regulator. Within 18 months after passage of the 1992 Act, Jim Johnson. Fannie's chairman committed the company to "transforming the housing finance system" and vowed to "provide $1 trillion in targeted lending."

This was followed in 1995 by President Clinton's National Homeownership Strategy in which HUD formalized and greatly expanded a long-standing policy goal: the reduction of down payments. It asked "[l]ending institutions, secondary market investors, mortgage insurers, and other members of the partnership [to] work collaboratively to reduce homebuyer down payment requirements."

Also in 1995, the Community Reinvestment Act (CRA) regulations were revised to be more quantitative and outcome based. Banks were now measured on their use of "innovative and flexible" lending standards, and their performance was compared to market competitors. As pointed out by Fed Chairman Bernanke in 2007: "Further attention to CRA was generated by the surge in bank merger and acquisition activities that followed the enactment of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994." CRA's stick of denying a merger application was now combined with CRA's carrot of announcing a big CRA commitment to flexible lending standards to help assure merger approval. The result was trillions of dollars in CRA commitments, largely "negotiated" by community advocacy groups.

By 2004, HUD would extol its, and Fannie and Freddie's, role in its self-described "revolution in affordable lending:"

"Over the past ten years, there has been a ‘revolution in affordable lending' that has extended homeownership opportunities to historically underserved households. Fannie Mae and Freddie Mac have been a substantial part of this ‘revolution in affordable lending.' During the mid-to-late 1990s, they added flexibility to their underwriting guidelines, introduced new low-down payment products, and worked to expand the use of automated underwriting in evaluating the creditworthiness of loan applicants.... Between 1993 and 2003, conventional loans to low income and minority families increased at much faster rates than loans to upper-income and non-minority families."

There is ample evidence that these lending flexibilities accomplished Ms. Cincotta's desire for "aggressive and convincing" loosening by Fannie and Freddie. For the revolution to succeed, the Five Cs of Credit - capital, credit, capacity, collateral, and confidence - had to be abandoned.

First, with respect to capital, Fannie went from having no home purchase loans with a down payment of three percent or less in 1992, to nearly 40% in 2007. Second, Fannie loans with subprime credit - as evidenced by a FICO credit score of less than 660 - tripled from about 6% in 1990 to 18% in 2007. Third, by 2007, over 1/3rd of Fannie and Freddie's fully documented loans exceeded a 45% total debt-to-income (TDI) ratio. This level was well in excess of their prior maximum level of about 42% in 1991, which had been associated with "B" grade or worse subprime loans. Fourth, Fannie and Freddie, as the de facto standard setters for collateral valuation, effectively eliminated the use of investment and replacement cost approaches to value, and weakened the comparable sales approach. Finally, Fannie and Freddie's confidence in borrower income statements evaporated as the percentage of acquisitions denominated as Alt-A, low document, or no document went from near zero in 1991 to nearly 40% in 2007.

This led to Ms. Cincotta's second goal coming to fruition: lenders, following Fannie and Freddie's aggressive and convincing loosening of their "narrow" underwriting standards, responded by loosening their formerly conservative standards. This premeditated assault on the prime mortgage led to the largest housing bubble in our history followed by the largest bust. The perpetrators were Fannie, Freddie, community groups, Congress, and HUD.

Edward Pinto is the chief risk officer and co-director of the Internal Center on Housing Risk at the American Enterprise Institute.    

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