Andrew Harnik/AP Photo
FHFA Director Mark Calabria, right, accompanied by Treasury Secretary Steve Mnuchin and HUD Secretary Ben Carson, defends the plan for ending government control of Fannie Mae and Freddie Mac, at a Senate Banking Committee hearing on Capitol Hill, September 10, 2019.
With unemployment at double-digit rates and millions of workers furloughed, the economy is in its worst straits since the Great Depression. Yet while defaults may still rise, so far the mortgage market has not collapsed. Much of this is due to the tremendous financial support provided to individuals in the CARES Act, support that is rapidly running out. But the endurance of the mortgage market in the face of such severe adverse economic conditions is also a testament to the effectiveness of significant reforms in response to the 2008 financial crisis. The mortgage market is holding up because mortgage underwriting in the U.S. has never been at higher standards.
This is not guaranteed to last. Major changes, now in process, may put the mortgage market in the crosshairs again, and raise the risk that millions will lose their homes. First, the Consumer Financial Protection Bureau (CFPB) is proposing a radical easing of lending standards that will allow lenders to lend without regard to the borrower’s total debt obligations.
At the same time, the Federal Housing Finance Agency (FHFA) and Treasury Department are racing to end the conservatorships of government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. These actions can both be finalized without congressional approval, so the next administration may well be facing a fait accompli and the makings of an entirely avoidable crisis.
The CFPB proposal would undermine the Dodd-Frank Act’s centerpiece reform of the mortgage market: the prohibition on making mortgages without verification of the borrower’s ability to repay the loan. Currently, mortgage lenders can evade this prohibition if the loan meets certain requirements, chief among them that the ratio of the borrower’s monthly debt payments to the borrower’s income must be under 43 percent. The CFPB is proposing eliminating this requirement, and instead using the interest rate on the loan as a proxy for ability to repay, which would allow lenders to again freely make low-down-payment, high-debt-to-income loans, just as they did during the bubble.
Today’s unprecedented COVID-19 threat is contained in mortgage markets because of the stability of the system, based upon the tight regulation of mortgage lending.
Meanwhile, administration officials are negotiating changes to Fannie Mae and Freddie Mac, the GSEs that are charged with purchasing mortgages on the secondary market to create more capital for home loans. The Trump administration wants to return Fannie and Freddie back to their pre-2008 position as privately owned firms. Various proposals to reform the GSEs have all stalled in Congress, but the FHFA, their conservator, has proposed massively higher capital requirements, far more than would have been necessary to cover Fannie and Freddie’s total losses in the 2008 financial crisis, levels that will reduce their ability to compete or maintain their market share.
The combination of releasing the GSEs from conservatorship, hamstringing them with excessive capital requirements, and the loosening of underwriting standards is a recipe for disaster. It would unleash the “private label” Wall Street securitization machine that financed the junk mortgages of the housing bubble. Rolling back underwriting requirements enables Wall Street to return to dodgy mortgage products, and releasing the GSEs from conservatorship will create an uneven regulatory playing field that favors Wall Street. Only Fannie and Freddie—not Wall Street—would be subject to capital requirements, affordable-housing duties, and a requirement of private-mortgage insurance for low-down-payment loans. In such a competitive environment, the GSEs will either have to take on more risk or lose market share, precisely the situation that led to the 2008 financial crisis.
As we detail in our book, The Great American Housing Bubble, the story of the bubble is a tale of a rate war in which everyone inevitably lost. Until 2003, Fannie and Freddie dominated the mortgage market, issuing over 70 percent of all U.S. mortgage-backed securities. Historically, Fannie and Freddie did not meaningfully compete with one another on the standards they set for mortgages. Instead, they competed on operational efficiency and on service to the lenders who sold them mortgages. This meant that Fannie and Freddie were able to uphold mortgage underwriting standards.
Starting in 2003, however, the rise of private Wall Street securitization competed away Fannie and Freddie’s market share. While private securitization was not new, innovations in financial-transaction structuring enabled it to expand rapidly. By 2006, Fannie and Freddie’s combined share of U.S. mortgage-backed security issuance had fallen to under 40 percent. Private Wall Street securitization, not Fannie and Freddie, was the financing channel for the junk mortgages of the bubble: While realized losses between 2006 and 2014 on private-label mortgage-backed securities were over 24 percent of the loan balances, losses on Fannie and Freddie loans were a mere 3 percent.
When private capital fled the housing market in 2007, Fannie and Freddie honored their public mission to support lending, even as the market cratered. Fannie and Freddie were not the cause of the crisis, but collateral damage.
Fannie and Freddie continue to support the housing market today. Unlike wholly private firms, they don’t run when there’s trouble in the markets.
Fannie and Freddie continue to support the housing market today. Unlike wholly private firms, they don’t run when there’s trouble in the markets. But if the GSEs’ footprint is pushed back to make them niche players, which appears to be the Trump administration’s plan, they will not have the capacity to step up in the next crisis, which will inevitably come as the deregulated lending market inflates a bubble with a lending frenzy.
Today’s unprecedented COVID-19 threat is contained in mortgage markets because of the stability of the system, based upon the tight regulation of mortgage lending. The planned deregulatory move undermines this pillar of market stability.
The key lesson of the bubble is that unregulated competition for mortgage credit risk will inevitably result in a deterioration of lending standards and an unsustainable bubble. Competition in the housing finance market is desirable—but only along the right dimensions. We should encourage competition in terms of operational efficiency and consumer-friendly innovation, not a race to the bottom for credit risk.
Ensuring a stable and affordable housing finance system requires maintenance of underwriting standards, capital requirements, and affordable-housing duties for all participants. If we don’t learn these lessons, we’re doomed to a volatile housing finance market of bubbles and busts.
