My long-time friends, Alex Pollock and Ed Pinto, have devoted their careers to promoting and supporting sound and affordable housing for our nation. Unfortunately, their wisdom and advice have too often fallen on the deaf ears of politicians seeking expedient ways to lure campaign contributions, power and votes. I urge you to take some time to read their latest article below. These issues are enormously important to our nation. By Bill Isaac
As the philosopher George Santayana said, those who cannot remember the past are condemned to repeat it. The U.S. has a history of catastrophic housing finance blunders to remember, but will we? There have been three dramatic failures of government policy in four decades – hardly an enviable track record! The issue is now whether we wish to risk another one by again reducing credit quality through Fannie Mae and Freddie Mac. Unfortunately, it looks like this will probably happen.
Fannie and Freddie remain the dominant companies in American housing finance, in spite of having little capital and being hyper-leveraged. Their assets to equity ratio is 116:1. They are regulated by the U.S. Federal Housing Finance Agency (FHFA), which is also their Conservator and has great power over them.
In June 2021, the U.S. Supreme Court ruled that the FHFA was unconstitutionally structured because its director could only be removed from office for cause. The Court held that the director must be able to be removed from office at any time by the President.
Upon the Court’s decision, President Biden immediately fired the FHFA director, Mark Calabria. This was a pretty clear example of how political U.S. housing finance is.
Calabria had been following a policy of increasing the capital of the GSEs in preparation for privatizing them, and of reducing their risk to the taxpayers; his acting replacement forthwith reversed this course. We are already seeing a sharp change in the regulatory marching orders for Fannie and Freddie – from a future as privatized companies to a future of being used to accumulate the risk of the government’s housing policies, from reducing to increasing the risk to the taxpayers who are on the hook for Fannie and Freddie’s losses.
Following the Supreme Court decision, any U.S. President now has direct political control over most of the mortgage finance system, including the nearly $7 trillion in mortgage risk held in the Fannie and Freddie balance sheets.
Although we agree that the Supreme Court’s decision about the FHFA is correct on its constitutional merits, it does aggravate the fundamental problem: that the U.S. has a heavily nationalized and socialized housing finance system.
We turn to the history of the travails and enormously costly mistakes this system has made.
The first time began in 1968. The Department of Housing and Urban Development (HUD) presented a “10-year housing program to eliminate all substandard housing,” but since there were then, like now, very large budget deficits, this program was implemented off-budget.
This was done through the 1968 Housing and Urban Development Act, which had the government insuring subsidized single- and multifamily loans through the Federal Housing Administration and then Fannie Mae funding them. Fannie had been up to then a government agency with its debt on-budget, but to hide it, the 1968 Act converted it to an off-budget entity.
The off-budget Fannie funded the largest expansion of subsidized housing in the nation’s history with up to 40-year fixed rate loans. Just like the savings and loans of the time, it lent very long and borrowed short on a leveraged balance sheet, but its lending at fixed rates for 40 years as it headed into years of sharply rising funding costs eclipsed even the savings and loans’ 30-year fixed rate loans.
By the 1970s, HUD’s program turned into a disaster for cities and their residents, as described in the book Cities Destroyed for Cash: The FHA Scandal at HUD (1973). Detroit, Chicago, Cleveland and many other cities long suffered from the effects of HUD’s scheme. And by the early 1980s Fannie’s loans had accumulated such huge interest rate risk losses that it was effectively insolvent. It was only able to continue in business given its backing by the Treasury.
The second time is the spectacular failure of the savings and loan industry, with a $150 billion taxpayer bailout in 1989. This collapse reflected massive losses from both interest rate risk and credit risk, but the savings and loan industry was in its heyday a darling of American politicians. Its trade association, the U.S. League for Savings, now long gone, was a power in Washington DC. The savings and loans benefitted from many special advantages and from a political regulator, the Federal Home Loan Bank Board (FHLBB), which acted as a cheerleader for the industry and maintained close ties to the housing industry. The FHLBB was abolished in 1989, but the current FHFA is its third-generation successor.
The third time began in 1992. Over the following years, the government forced Fannie and Freddie to reduce their credit standards so as to acquire hundreds of billions of dollars in risky loans under the rubric of affordable housing. The first of many “trillion-dollar commitments” was announced by James Johnson, Fannie’s very politically connected CEO, in March 1994. He vowed to “transform the housing finance system.” He did, but not in the way he intended.
In 1994, HUD trumpeted its National Homeownership Strategy,’ about which President Clinton claimed: “Our home ownership strategy will not cost the taxpayers one extra cent.” A poor prediction indeed! The bailout of Fannie and Freddie alone took $190 billion.
This government policy was pursued until 2008 through HUD’s authority to impose what were called “Affordable Housing Goals” on the GSEs. To meet ever more aggressive HUD goals, Fannie and Freddie had to continually reduce their mortgage credit standards, especially with respect to loan-to value and debt-to-income ratios. Instead of HUD’s strategy advancing homeownership,
The full extent of the catastrophic credit risk expansion that took place has now been documented in a detailed analysis researchers at FHFA and AEI released in May 2021. This is the first “comprehensive account of the changes in mortgage risk that produced the worst foreclosure wave since the Great Depression.” By analyzing over 200 million mortgage originations from 1990 onward, they showed “that mortgage risk had already risen in the 1990s, planting seeds of the financial crisis.” In 2008 Fannie and Freddie were bailed out by the taxpayers and put into conservatorship.
The Congress elected in the wake of the crisis adopted the Dodd-Frank Act of 2010, which reflected the view that insufficient regulation caused the crisis. But the key culprits, Fannie and Freddie, were untouched by the legislation, left with no capital, but still functioning. It had become entirely clear that the US government is effectively the 100 percent guarantor of Fannie and Freddie, with the taxpayers fully on the hook, so the financial markets provide unlimited funds for their operations. Fannie and Freddie continue to operate profitably in their government conservatorship by using the U.S. Treasury’s global credit card. In addition, the Federal Reserve owns more than $2 trillion of their mortgage-backed securities and is still buying them for the central bank balance sheet.
Now the “American Jobs Plan” proposes spending $318 billion to construct and modernize more than two million houses. It is almost certain that the government will use its heightened control over Fannie and Freddie to once again make them the central elements of its housing plans by another weakening of credit standards. Thus, we face the prospect of combining some of the features of HUD’s 1968 subsidized housing debacle, with the housing subsidies of the savings and loan system, with Fannie and Freddie’s disastrous foray into high credit risk lending. It looks like we are once again heading for trouble.
However, the government does not have to follow the flawed policies of previous administrations. If instead, the following four principles were followed, the United States would have robust, successful housing finance system it needs without nationalized mortgage risk:
1. The housing finance market can and should function principally as a private market, not a government-dominated one.
2. We can create a robust housing finance market without depending on a government guarantee by ensuring mortgage credit quality and fostering the accumulation of adequate capital behind housing risk.
3. The federal government should use on-budget, transparent and sustainable programs if it wants to subsidize low-and moderate-income home buyers effectively. Fannie and Freddie have no role here, as the only way they can participate is through reducing their credit standards with the real cost hidden in the form of expanding risk.
4. Fannie and Freddie should be truly privatized, with their hidden subsidies and government-sponsored privileges eliminated over time.
It is certain that none of this will happen in the near term, and indeed the opposite of these principles will probably be followed by the current administration. Nonetheless, the principles define the housing finance strategy that a future, market-oriented Congress and administration should take. In the meantime, all mortgage actors will need to protect themselves against the increased credit risk that Fannie and Freddie, under orders from the FHFA, will be generating.