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Government Housing Policies in the Lead-Up to the Financial Crisis: a Forensic Study

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Government Housing Policies in the Lead-Up to the Financial Crisis: a Forensic Study Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study Edward J. Pinto DISCUSSION DRAFT DATED 2/5/2011 Abstract: The major cause of the financial crisis in the U.S. was the collapse of housing and mortgage markets resulting from an accumulation of an unprecedented number of weak and risky Non-Traditional Mortgages (NTMs). These NTMs began to default en mass beginning in 2006, triggering the collapse of the worldwide market for mortgage backed securities (MBS) and in turn triggering the instability and insolvency of financial institutions that we call the financial crisis. Government policies forced a systematic industry-wide loosening of underwriting standards in an effort to promote affordable housing. This paper documents how policies over a period of decades were responsible for causing a material increase in homeowner leverage through the use of low or no down payments, increased debt ratios, no loan amortization, low credit scores and other weakened underwriting standards associated with NTMs. These policies were legislated by Congress, promoted by HUD and other regulators responsible for their enforcement, and broadly adopted by Fannie Mae and Freddie Mac (the GSEs) and the much of the rest mortgage finance industry by the early 2000s. Federal policies also promoted the growth of over- leveraged loan funding institutions, led by the GSEs, along with highly leveraged private mortgage backed securities and structured finance transactions. HUD‘s policy of continually and disproportionately increasing the GSEs‘ goals for low- and very-low income borrowers led to further loosening of lending standards causing most industry participants to reach further down the demand curve and originate even more NTMs. As prices rose at a faster pace, an affordability gap developed, leading to further increases in leverage and home prices. Once the price boom slowed, loan defaults on NTMs quickly increased leading to a freeze-up of the private MBS market. A broad collapse of home prices followed. ©2010 Edward J. Pinto I wish to thank all those who reviewed various drafts and provided so many excellent comments. Opinions and any errors contained herein are mine. Preface: Events of the late 1980s and early 1990s1 joined three disparate groups in a common cause: low- and moderate-income housing: 1. Fannie Mae decided in 1986 to give up its government charter and become a private company.2 This decision was quickly reversed in 1987 when it was decided that its funding advantages and implicit government guarantee under its charter were too valuable to surrender. Instead it would turn its focus to protecting its charter franchise privileges. Over the next 5 years Fannie would develop and begin implementing a strategy to use its low- and moderate-income housing mission as the means to ―protect the franchise‖. Fannie would use copious amounts of low- and moderate-income housing lending to capture its regulator, Congress,3 in an effort to assure that Congress would not change its charter privileges to its detriment. Lehman Brothers‘ consultant Jim Johnson was hired in 1988 to more fully develop this strategy. By 1991 Johnson was Fannie‘s chairman and CEO. In 1991 Johnson announced Fannie‘s opening bid, a commitment4 to acquire $10 billion in affordable housing loans under a program called ―Opening Doors‖.5 Johnson‘s strategy was successful in that Fannie was able to prevent any charter changes from being enacted after 1992 (the year ―The Federal Housing Enterprises Financial Safety and Soundness Act of 1992‖ (the ―GSE Act of 1992‖ or ―GSE Act) passed with Fannie‘s support) until 2008; three months before Fannie and Freddie were placed in conservatorship.6 7 2. National People‘s Action (NPA) and ACORN, along with other community and consumer advocacy groups concluded that Fannie and Freddie‘s underwriting requirements were to blame for the failure of the Community Reinvestment Act of 1977 (CRA) to gain traction. In about 1986, NPA began to meet separately with Fannie and 1 From 1985-1987 the author was Fannie‘s Senior Vice President for Marketing and Product Management, with responsibility for single- and multi-family lending and affordable housing and from 1987-1989 was Executive Vice President and Chief Credit Officer. 2 This decision was not made public 3 Congress had issued Fannie‘s charter and was the only entity that could change it. 4 A commitment is a pledge to acquire (in Fannie‘s case or originate in the case of a lender) a quantity of loans usually over an announced time period. Virtually all the commitments mentioned in this paper were fulfilled, 5 ―Fannie Mae's Johnson Says Corporation Ready to Meet Housing Goals in Legislation‖, PR Newswire, March 31, 1993, http://www.thefreelibrary.com/FANNIE+MAE%27S+JOHNSON+SAYS+CORPORATION+READY+TO+MEET +HOUSING+GOALS+IN...-a013133485 6 ―The Federal Housing Enterprises Financial Safety and Soundness Act of 1992‖, 102nd Congress (1991-1992) H.R.6094.EH, http://thomas.loc.gov/cgi-bin/query/D?c102:3:./temp/~c102J9LOCG:: or http://www.fanniemae.com/global/pdf/aboutfm/understanding/charter.pdf 7 Fannie‘s (and Freddie‘s) charter was established by congressional act. As such, only Congress could amend it. The GSE Act of 1992 was a wholesale revision of Fannie‘s (and Freddie‘s) charter; however Fannie supported the changes, including the addition of the affordable housing goals. Freddie had only emerged from being a subsidiary of the Federal Home Loan Bank Board in 1989 and more or less acquiesced with Fannie‘s position. 2 Freddie in an effort to get them to adopt more flexible underwriting standards in an effort to expand CRA lending. While agreeing to a number of pilot programs, Fannie and Freddie were initially dubious about many of the requested flexibilities. By the early 1990s NPA, ACORN and other groups were dissatisfied with the perceived pace of change and were concerned that Fannie, Freddie, and lenders ―still viewed them as ‗special programs‘ and have not incorporated them into standard underwriting practices.‖8 Having gotten CRA passed in 1977, NPA, ACORN, and other community groups appealed to Congress in 1991 to force change at the GSEs. 3. Congress had long used HUD and its loan guarantee arm, FHA (created in 1934), as its main tools to provide low- and moderate-income housing. However, in 1990 two budgetary changes made it more difficult for Congress to expand low- and moderate- income housing through HUD and FHA. First, HUD and FHA were agencies of the federal government and included in the discretionary portion of the budget. In 1990 Congress had reached a limit in what it could do on budget: ―In 1990, as part of a new, multiyear budget agreement, the Congress and the President adopted new procedures for deficit control. Those procedures, embodied in the Budget Enforcement Act of 1990, established statutory limits on discretionary spending and a deficit-neutral pay-as-you-go (PAYGO) requirement for new mandatory spending and tax legislation.‖9 A second change came about with the passage of the Federal Credit Reform Act of 1990. To the extent FHA‘s expected premiums were insufficient to cover expected losses, these amounts would need to be incorporated as a budget item. Third, at the same time, the Omnibus Budget Reconciliation Act of 1990 required FHA to establish a reserve fund and set its premiums so as to ensure actuarial soundness.10 As a result of these provisions, Congress had to find another means if it wanted to significantly expand financing for low- and moderate-income housing. Fannie and Freddie filled the bill perfectly. Both were off budget, could raise virtually unlimited sums in the capital markets, and could use their substantial volumes of traditional low risk lending to subsidize low- and moderate-income housing. As an added bonus, Congress was also able to meet the demands of an important constituency group - community advocacy organizations. 8 ‖Not in My Back Yard: Removing Barriers to Affordable Housing‖, Chapter 3, page 13 http://www.huduser.org/Publications/pdf/NotInMyBackyard.pdf 9 Congressional Budget Office testimony on Budgeting for Emergency Spending, June 23, 1998 http://www.cbo.gov/doc.cfm?index=591&type=0 10 GAO, ―Credit Reform‖, September 1994, http://www.legistorm.com/ls_score/gao/pdf/1994/9/ful24685.pdf 3 In 1992 the interests of Fannie, community groups, and Congress converged resulting in the passage of GSE Act. Fannie got its wish as the GSE Act formalized its strategy of using affordable housing to protect its key charter privileges – protection that would last until 2008, two months before it and Freddie would be forced into conservatorship. The community groups got their wish now that Fannie and Freddie were required to loosen underwriting standards in support of CRA. Congress got its wish by moving the affordable housing mission largely off- budget and at the same time, placing itself in a position to take credit for the affordable housing activities of Fannie and Freddie. Fannie‘s 1991 opening bid of $10 billion was called and raised by Congress‘ in the GSE Act of 1992. In 1994 Fannie raised its bid with a $1 trillion commitment. Over the next dozen years, additional commitments totaling $6 trillion by Fannie and Freddie, $1 trillion by Countrywide, and $4-plus trillion by big banks would follow.11 I have called this a forensic study because my goal was to investigate and document the motives, opportunities, and means by which the main participants (Congress, joined by the executive branch, Fannie and Freddie, and community groups) accomplished the desired loosening of loan underwriting standards. These actions would ultimately derail the world‘s largest economy and cost the American people untold trillions of dollars.
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