Future of Housing Finance

[Fly Rod]

AUGUST 17, 2010The Future of Housing Finance
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.


Former Chief Credit Officer Edward Pinto explains how it all went wrong.
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.

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Chad CroweCompounding 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.

[fishpoopoo]

Don't get me started.

[RIJIMMY]

Originally Posted by fishpoopoo

Don't get me started.

cmon - we've missed you! I'm sure you've been hiding out since you are part of "the evil" wall street crowd

[JohnnyD]

Personally, the more the housing market plummets, the better it is for me. I'm still about 18 months away from getting a house.

Goes for the recession too... the lower she goes, the more value I'm getting per $.

On the other hand, I have a lot of friends approaching retirement and many have either had to work long or go back to work for a couple years because of the stock market's demise.

[spence]

I think he's got a lot of credibility on the issue, but seems to ignore the market forces that certainly exploited the room to move. There are root causes and symptoms, but symptoms can often be managed through regulation. Not always the right thing, but perhaps a part of the solution.

Additionally, people should look at this as a non-partisan problem. Some love to pounce on Barney as the birther of the issue, but everybody in politics has pushed for home ownership as it's a great election issue...even Bush.

-spence

[fishpoopoo]

Originally Posted by spence

I think he's got a lot of credibility on the issue, but seems to ignore the market forces that certainly exploited the room to move. There are root causes and symptoms, but symptoms can often be managed through regulation. Not always the right thing, but perhaps a part of the solution.

Additionally, people should look at this as a non-partisan problem. Some love to pounce on Barney as the birther of the issue, but everybody in politics has pushed for home ownership as it's a great election issue...even Bush.

-spence

"Market forces?"

Jesus Spence, you really need to bone up on the issue.

As far as Bawney, he should be lined up and money-shot for treason. But you're right, he's not alone in deserving blame.

There is so much open source info out there that is damning to the democrats (on the affordable housing issue), it boggles the mind.

http://financialservices.house.gov/LtrBushGSEs.pdf

[RIJIMMY]

Nice FPP - you gotta love the line - "Strong safety and soundness regulation and a vigorous affordable housing mission are not only
compatible, but will reinforce each other."

Yes, it was the evil Republican ways that got us where we are today.

[fishpoopoo]

Originally Posted by RIJIMMY

Nice FPP - you gotta love the line - "Strong safety and soundness regulation and a vigorous affordable housing mission are not only
compatible, but will reinforce each other."

Yes, it was the evil Republican ways that got us where we are today.

Well, the republicans aren't exactly off the hook - on the affordable housing issue. Remember Phil Gramm?

If you boil this humungous topic (and I mean gargantuan) down into two issues - it comes down to 1) the dumbing down of lending standards via "affordable housing policies," and, more importantly, 2) abnormally low interest rates set by the federal reserve from 2001-2004.

I blame the dems mostly for dumbing down lending standards (CRA, HUD, Fannie and Freddie), and one very stupid republican (Alan Greenspan) for the abnormally low interest rates that was the fuel for the fire that became the housing bubble.

[spence]

Originally Posted by fishpoopoo

"Market forces?"

Jesus Spence, you really need to bone up on the issue.

Please elaborate, as you seem to have interpreted my statement in a very specific manner.

As for bones, Nebe has one for ya

-spence

[fishpoopoo]

The dumbing down of lending standards, and the manipulation of interest rates are NOT "market forces."

They are government policies.

And if Nebe has starting blowing glass dildoes again I'd have to start worrying about him.

[RIROCKHOUND]

Originally Posted by fishpoopoo

And if Nebe has starting blowing glass dildoes again I'd have to start worrying about him.

You are implying he never stopped....

[fishpoopoo]

Well, he DOES get requests from the ladies for them.

[spence]

Originally Posted by fishpoopoo

The dumbing down of lending standards, and the manipulation of interest rates are NOT "market forces."

They are government policies.

I agree, but the lowering of interest rates led investors to seek better returns which came from new lending products that took advantage of the lower standards...did they not?

Hence my comment about the market exploiting the room to move.

-spence

[fishpoopoo]

absurdly low interest rates sparked mortgage originations and speculation in housing.

lots of crazy loans were made to people who weren't going to pay them back.

that's not market forces. that's manipulation.

[justplugit]

Originally Posted by fishpoopoo

absurdly low interest rates sparked mortgage originations and speculation in housing.

lots of crazy loans were made to people who weren't going to pay them back.

that's not market forces. that's manipulation.

Yup, simple solution-- 20% down, and good credit rating.

FHA still only requiring 3-4% down.

When people have to work and save a 20% down payment they have a tendency
to take care of their property and think twice before foreclosure as they have
their sweat and tears in their house/investment.

[JohnnyD]

Originally Posted by justplugit

Yup, simple solution-- 20% down, and good credit rating.

FHA still only requiring 3-4% down.

When people have to work and save a 20% down payment they have a tendency
to take care of their property and think twice before foreclosure as they have
their sweat and tears in their house/investment.

Absolutely. For most, putting 20% down also demonstrates that you can be responsible with your money. For a $250k house, it doesn't take nearly as much commitment to scratch together $8000.

[RIROCKHOUND]

Originally Posted by fishpoopoo

Well, he DOES get requests from the ladies for them.

Ladies?

[detbuch]

Originally Posted by spence

Additionally, people should look at this as a non-partisan problem. Some love to pounce on Barney as the birther of the issue, but everybody in politics has pushed for home ownership as it's a great election issue...even Bush.

-spence

And yet another Bush-did-it-too. Any more of these and you might want to get checked for Bush-did-it-too tourettes. It may only be a milder form of the it's-Bush's-fault tourettes that the Democrats have been suffering from for the past two years.

[spence]

Originally Posted by fishpoopoo

absurdly low interest rates sparked mortgage originations and speculation in housing.

lots of crazy loans were made to people who weren't going to pay them back.

that's not market forces. that's manipulation.

Certainly, but I was speaking more to US borrowing rates (like 1%) and big outside investors seeking better returns. It's not like people were looking for a way to package mortgage backed securities just so banks could issue more loans...there was a demand that drove the process from both sides.

-spence

[spence]

Originally Posted by detbuch

And yet another Bush-did-it-too. Any more of these and you might want to get checked for Bush-did-it-too tourettes. It may only be a milder form of the it's-Bush's-fault tourettes that the Democrats have been suffering from for the past two years.

No, just a comment for the "it's all Frank's fault" crowd. You're mighty pissy tonight. I seem to remember Bush praising government lending for it's efforts towards his "ownership society".

Don't worry, I'll get back to the other thread in due time...

-spence

[detbuch]

Originally Posted by spence

. . . I seem to remember Bush praising government lending for it's efforts towards his "ownership society".

-spence

Yikes . . . you did it again.

[spence]

Originally Posted by detbuch

Yikes . . . you did it again.

It is hard not discussing leadership when their policy is being discussed. Perhaps this gives "ownership society" an unintended double meaning



-spence

[RIJIMMY]

Im not blaming Frank and Co for all the mess, but Obama - you know the extremely educated leader of this country, has taken a one sided view and blamed all of it on Repubilican policies and Wall Street, which is one of two things - a lie, or he is too dumb to understand the complexity.

[JohnnyD]

Originally Posted by RIJIMMY

Im not blaming Frank and Co for all the mess, but Obama - you know the extremely educated leader of this country, has taken a one sided view and blamed all of it on Repubilican policies and Wall Street, which is one of two things - a lie, or he is too dumb to understand the complexity.

Or exactly the same as what every other politician in America does.

[RIJIMMY]

Originally Posted by JohnnyD

Or exactly the same as what every other politician in America does.

change you can believe in? New Washington?

I cant say I ever heard Bush blame Clinton for the dot-com bubble burst or not getting bin-laden.

[Bronko]

Is the Summer of Recovery over?

[RIJIMMY]

Originally Posted by Bronko

Is the Summer of Recovery over?

its now the Fall of fall

[buckman]

Originally Posted by Bronko

Is the Summer of Recovery over?

Now that we put the threat of terrorism and war behind us we can turn the page and solve the economy. No worries

[fishpoopoo]

Originally Posted by spence

Certainly, but I was speaking more to US borrowing rates (like 1%) and big outside investors seeking better returns. It's not like people were looking for a way to package mortgage backed securities just so banks could issue more loans...there was a demand that drove the process from both sides.

-spence

With 1% rates, folks were more inclined to borrow money and plow them into low-returning securities. It's called leverage. To retail investors it's called margin.

Take a $1,000 face value bond with an annual coupon of 3%. That bond throws off $30 of interest per year.

Your return on invested capital, if you plow $1,000 of your own money into that bond, is 3% per annum.

Take the same scenario. But instead of plunking down $1,000 of your own money, you borrow $900 and only put $100 of your own money down.

You are still earning $30 in interest.

You are paying 1% on the $900 you borrowed, or $9.

On a net basis, you are earning $30-9 = $21.

$21 divided by $100 of your own money = 21% return on invested capital. That compares with 3% ROIC if you put $1,000 of your own money up.

This is all hunky dory, as long as rates stay at 1% and that your banker doesn't call in your loan and your investors in your hedge fund (the guys who furnished the $100 of capital you plowed into that $1,000 bond) don't ask for their money back.

From 2001 through 2007, this is exactly what happened, with institutional investors taking advantage of artificially low interest rates.

This caused two undesirable things:

1) a massive increase in borrowing and leverage to amplify returns
2) rampant speculation in all asset classes

When subprime CDO's started to blow up (the underlying loans weren't being repaid), guess what happened?

1) The bond we used as the example above dropped in price
2) Banks started calling their loans in
3) Nervous hedge fund investors started asking for redemptions.

So the "market forces" you refer to, which were all motivated by ridiculously low interest rates, coupled with the spark of bad sub-prime loans, initiated a massive unwinding of leverage.

That $900 you borrowed - you had to pay it back quick, so you sold your $1,000 bond. Unfortunately, due to market conditions, you took a loss on that bond. It dropped to $750 face value.

Two things happened: As a result of the drop in price, the $100 equity financing the $1,000 investment got wiped out. Also, you couldn't pay back the full amount of the $900 you borrowed from a bank. You could only pay back $750.

Repeat this over a skillion times - and you can see why the financial markets tanked. This not only happened with bonds, but with stocks, foreign currencies, and commodity futures and all sorts of instruments (hell, even a few plugs were involved I'm sure). And we haven't even talked about the $1.4 quadrillion (notional amount) of credit default swaps outstanding at the time.

Getting back to my original point: the "market foces" that you refer to that eventually bit us in the ass came about due to lower interest rates (government policy).

NONE of this would have happened if the federal reserve did not bring rates to almost zero % from 2001-2004.

[spence]

The low rates were a response to economic conditions largely influenced by the market. Certainly you could argue this was a wrong move, but it's not like the government was setting policy in a vacuum.

It's also not like investors are altruistic, they're trying to make money. Whatever is legal is fair game. Hence my comment about the market exploiting the room to move.

I'm not blaming the markets or investors, the entire thing was a gigantic fuster cluck.

-spence