How the Government Is Creating Another Housing Bubble

Editor’s Note: Peter J. Wallison is a senior fellow at the American Enterprise Institute. This post is based on an article by Mr. Wallison and Edward J. Pinto, a resident fellow at the AEI.

It is hard to believe, but it looks like the government will soon use the taxpayers’ checkbook again to create a vast market for mortgages with low or no down payments and for overstretched borrowers with blemished credit. As in the period leading to the 2008 financial crisis, these loans will again contribute to a housing bubble, which will feed on government funding and grow to enormous size. When it collapses, housing prices will drop and a financial crisis will ensue. And, once again, the taxpayers will have to bear the costs.

In doing this, Congress is repeating the same policy mistake it made in 1992. Back then, it mandated that Fannie Mae and Freddie Mac compete with the Federal Housing Administration (FHA) for high-risk loans. Unhappily for both their shareholders and the taxpayers, Fannie and Freddie won that battle.

Now the Dodd-Frank Act, which imposed far-reaching new regulation on the financial system after the meltdown, allows the administration to substitute the FHA for Fannie and Freddie as the principal and essentially unlimited buyer of low-quality home mortgages. There is little doubt what will happen then.

Since the federal takeover of Fannie and Freddie in 2008, the government-sponsored enterprises’ (GSEs’) regulator has limited their purchases to higher-quality mortgages. Affordable housing requirements Congress adopted in 1992 and the Department of Housing and Urban Development (HUD) administered until 2008 have been relaxed. These had required Fannie and Freddie to buy the low-quality mortgages that ultimately drove them into insolvency and will cause enormous losses for the taxpayers.

The latest regulatory change does not reduce the total losses that taxpayers will suffer from HUD’s policies; those losses, estimated at about $400 billion, are baked in the cake. But the higher lending standards now required of Fannie and Freddie should reduce future losses.

Not so for the FHA. While everyone has been watching Fannie and Freddie, the administration has quietly shifted most federal high-risk mortgage initiatives to FHA, the government’s original subprime lender. Along with two other federal agencies, FHA now accounts for about 60 percent of all U.S. home purchase mortgage originations. This amounts to more than $1 trillion and is rising rapidly. The administration justifies this policy by saying it is necessary to support the mortgage market, yet borrowers are once again receiving high-risk loans.

The goal of Congress and regulators should be to foster the residential mortgage market’s return to the standards that used to prevail in 1990, before the affordable housing requirements were imposed on Fannie and Freddie. At that time, mortgages required 10 to 20 percent down payments, and were only made to borrowers with good credit and relatively low debt-to-income ratios. When loans of this kind were the standard in the residential mortgage market, we did not have financial crises brought on by the collapse of a housing bubble.

The Dodd-Frank Act, however, exempts FHA and other government agencies from appropriate standards on mortgage quality. This will give low-quality mortgages a direct route into the market once again; it will be like putting Fannie and Freddie back in the same business, but with an explicit government guarantee.

For example, thanks to expanded government lending, 60 percent of home purchase loans now have down payments of less than 5 percent, compared to 40 percent at the height of the bubble, and the FHA projects that it will increase its insured loans total to $1.34 trillion by 2013. Indeed, the FHA just announced its intention to push almost half of its home purchase volume into subprime territory by 2014-2017, essentially a guarantee to put taxpayers at risk again.

What is the answer? The Dodd-Frank Act needs significant amendment, so that it applies quality standards to FHA and other government agencies. This should not seriously impair credit availability for low-income borrowers with good credit. For many years, until it had to compete with Fannie and Freddie for affordable loans, FHA had reasonably good standards for the mortgages it would insure. As late as 1990, only 4 percent of the loans it insured had down payments of 3 percent or less, though by 2008 this number was 44 percent.

Establishing reasonable lending standards for the FHA, while still allowing it to make loans to low-income borrowers, would assure that the agency does not become the unworthy successor to Fannie and Freddie.

Dodd-Frank was badly designed in numerous ways. Many observers have noted that it did not address the government housing policies that caused the financial crisis. A first order of business for the new Congress should be to correct this error by requiring that the FHA and other government mortgage lenders abide by reasonable mortgage lending standards.

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  1. Joseph R. Neal
    Posted Monday, December 27, 2010 at 11:52 am | Permalink

    An unintended consequence is the stagnation of housing construction, sale and resale in small town rural America. Mortgage investors are required to meet stringent guidelines to purchase mortgages. One of the criteria is that there be a “recent” comparable sale. In small town rural America market turnover is not comparable to larger urban markets and consequently mortgage deals in excess of $200k are scarce to non-existent within the time-frame mandated. Consequently, “no-brainer” mortgage deals go unfunded. In small town rural America in migration is the primary economic driver (ex-urbia is not a phenomena). Current mortgage investment guidelines will stagnate these healthy investments and compound liquidity issues in small town America.

    This policy manifests the root cause of the fictitious bubble. The investment bankers commoditized that which was not a commodity. The “full throated” reforms continue and extend this fiction which spawned an industry founded upon fraud. Law not only punishes bad behavior but also promotes good behavior.

    Reform must cure the infection which legitimized, promoted and laid down the pathway for the fraudulent looting of the seed stock (private ownership of land and homes) of our Republic.

    Five measures come to mind. One, repeal “The Commodity Futures Modernization Act;” two, divorce Investment Banking from Commercial Banking, now and forever; three, authorize private “Attorneys General;” four, prohibit the creation of markets which sweep billions of pennies daily based upon fictionalized volatility; and five, extend the statute of limitations in order to counter the attitude that “we will be gone by the time they figure this out.”

    “Quants” are only people. There is nothing special about them at all except their overwhelming insatiable greed and world view that one should be paid by billions for creating something from nothing which has zero utilitarian or productive value.

    The entire banking industry must atone for the looting of the Republic and the destruction of the greatest experiment in self-government in the history of man.

    Insurance fraud is a crime. Mortgage fraud is a crime. Suppose lawyers rather than Bankers and loan originators were the offenders. Does anyone think there would be a “full throated” debate cloaked in self-righteousnes supported by 100’s of millions of dollars from Bar Associations?

  2. Ron Rossi
    Posted Monday, December 27, 2010 at 12:05 pm | Permalink

    Here is Republican chesnut again; the whole reason the economy melted down and we, the taxpayers went $14 Trillion in hock was a bunch of liberals in government forcing lenders to make home loans to minorities on houses they could not afford. (Code for blacks and hispanics.) Krugman calls this a conservative Zombie idea; one that has no factual basis but it gets repeated enough so maybe the discredited idea might fool stupid people.
    It seems you think the melt down had nothing to do with moral hazard and Wall Street profiting on both ends of the bubbles. Forget about moral hazard, CDOs, CDSs, TARP, etc.
    The entire subprime mortgage pool was $1.4 Trillion if they all failed. We could have used just a fractoin of the $14 Trillion total bail out money we spent in the last three years (it IS that big) on bank mergers, AIG, TARP, to just pay off the sub prime mortgages and EVERY OTHER home mortgage in America. With what was left over we could have bought houses for anyone else in America that did not have a home. (See Griftopia)
    Instead of doing something good with all that money (like a healthcare system, new power grid, new transportation grid) we made a bunch of banana republic capitalists rich on Wall Street and left the citizens with the debt TWICE. Once on the mortgages themselves and the rest in national debt.
    And how did the Community Reinvestment Act of 1977, which prohibited redlining in poor neighborhoods, cause Contrywide, WAMU, etc. to make bad loans?
    Latvia and Ireland had the same problem with the securitization fraud Wall Street pulled on America. How did our Congress cause that exactly?
    You are looking at the wrong end of the causality here. Sub Prime borrowers were not the problem they were victims with the rest of us. It is a lot bigger than that. It is a systematic creation of bubbles and profiting by the casino that is Wall Street on the up and down that is the problem. These folks create nothing but suck America (and the free world that follows our example) dry.
    I just watched Inside Job and saw the anti intelectual (really criminal) bent of paid off academics exposed. What did you get?

  3. Douglas B. Levene
    Posted Wednesday, December 29, 2010 at 10:00 am | Permalink

    1) Mortgages with little or no down payments are far more likely to default than mortgages with 10-25% down payments. The size of the down payment seems to be a far better predictor of default than any other factor, including the credit quality of the borrower and the level of documentation.

    2) Had underwriting standards not been loosened in the 1990s and 2000s, there would have been no real estate bubble and no collapse of the real estate market, and hence, no Panic and no Great Recession.

    3) The above points are fairly uncontroversial and incontrovertible. The real question is what caused the loosening of underwriting standards. One theory lays the blame at the feet of the regulators – for encouraging home lending to poor people or people who otherwise were not really capable of repaying a mortgage without the ability to refinance in an ever-rising market, and for not imposing regulatory restrictions (higher capital requirements, higher down payment requirements), on banks and other mortgage issuers. Another theory says that Wall Street’s creation of MBSs gave the banks and other mortgage issuers a source of money with no strings attached that in turn enabled them to issue mortgages with weakened underwriting standards. I suppose someone some day will sort out the relative causation.

    4) Regardless of the causes of the problems in the past, it’s fairly clear what the solutions should be going forward. At the very minimum, no government funding should be provided, either directly (FHA) or indirectly (FDIC), for any mortgage with less than a substantial downpayment. Whether that should be 10% or 20% or even more, I don’t know, but it should be obvious to all that a continued Government policy of guaranteeing mortgages with 3% down payments is folly squared. In a more sane world, there would be no Government support for mortgage financing at all, but at the very least the Government should avoid creating the next financial catastrophe.

  4. Joseph R. Neal
    Posted Wednesday, December 29, 2010 at 11:43 am | Permalink

    Your opening reply is offensive and small minded. You apply lables and presume “code words.” The words are used in the generic.

    The principle point is that nationwide legislation applicable to all markets has stagnated small town rural America because the dynamic of market activity demographically is not “uniform.” Rarely will an appraiser find a “recent” sale (within 90 days according to the new guidelines) of a deal in excess of $500,000 in small town rural america. A Banker is trained to bank the customer AND the ollateral. The sins of the investment bankers have dribbled to the local markets.

    ALL bureaucrats push for the Utopoia of “uniformity.” Demand where it exists should be promoted not extinquished because it does not fit within some comfortable guideline.

    Commercial banking is a local not national proposition. State Bank Examiners would have dones a better job policing fictionalized investments. Where was the collaterla? Go to and look up “The Warning” which tells teh story of Brooksley Born’s clarion cry to “watch out.” Her predictions were correct. The CFMA was passed to legitimize that which she pointed out were illegal.

    What are your recommendations?

    Or are you going to call names and conjure labels under the guise of intellectual postulation.