The collapse of the subprime
mortgage market in late 2006 set in motion a chain reaction of
economic and financial adversity that has spread to global
financial markets, created depression-like conditions in the
housing market, and pushed the U.S. economy to the brink of
recession. In response, many in Congress and the executive branch
have proposed new federal spending and credit programs that would
greatly expand the role of government in the economy but do little
to alleviate the distress caused by the financial crisis that has
spread rapidly to nearly all sectors of the economy.
Exactly when the subprime boom
became the subprime bust is open to debate, but 2006 is a good
estimate of when the system began to unravel. In 2006, many
sophisticated investment institutions in the U.S. and abroad
realized that their vast portfolios of subprime mortgages and
derivatives thereof were not as safe as they had assumed and that
they would likely incur significant financial losses. Little did
they know at the time that these financial losses would be quite
substantial and that this discovery would send financial
markets and parts of the U.S. economy into a downward spiral that
some fear will lead to a recession.
Although the subprime market
encompasses a highly diverse set of financial instruments and types
of borrowers, the Congressional Research Service (CRS) has offered
a workable definition of a subprime mortgage:
Generally, subprime mortgages are
defined in terms of the credit bureau risk score (FICO) of the
borrower. Other credit imperfections…can also cause
borrowers to be classified as subprime for a particular loan. For
example, the addition of the mortgage loan might increase the
borrower's debt-to-income level above traditionally prudent
thresholds. Generally, bank supervisors look for one or more
of the following credit-risk characteristics when deciding to label
a loan subprime:
- Recent payment delinquencies (30-day or 60-day depending on
- Judgment, foreclosure, repossession, or charge-off within prior
- bankruptcy in last five years
- Relatively high default probability (FICO below 660 or similar
- Limited ability to cover living expenses after debts
(debt-service-to-income ratio of 50 percent or more).
The CRS report also noted:
In recent years, subprime borrowers
increasingly used alternative mortgage products that
had previously been used primarily by sophisticated investors.
interest only (I-O) mortgages provide an introductory period during
which monthly payments cover only loan interest. After the
introductory period, loan payments reset to a higher amount to also
cover the loan's principal. Negative amortizing mortgages (NegAms)
allow borrowers to pay less than current interest due and result in
a higher loan balance and higher future payments.…
[A]djustable rate mortgages (ARMs) reset the interest rate with
changes in market interest rates and therefore can result in
higher or lower monthly payments depending on market
In addition, subprime mortgages
include mortgages with very low or no down payments and
second mortgages that serve as the "down payments" for first
mortgages to eliminate the need for a cash down payment and/or a
monthly premium for private mortgage insurance.
Although subprime and other risky
mortgages were relatively rare before the mid-1990s, their use
increased dramatically during the subsequent decade. In 2001, newly
originated subprime, Alt-A, and home equity lines (second mortgages
or "seconds") totaled $330 billion and amounted to 15
percent of all new residential mortgages. Just three years
later, in 2004, these mortgages accounted for almost $1.1 trillion
in new loans and 37 percent of residential mortgages. Their
volume peaked in 2006 when they reached $1.4 trillion and 48
percent of new residential mortgages. Over a similar period, the
volume of mortgage-backed securities (MBS) collateralized by
subprime mortgages increased from $18.5 billion in 1995 to $507.9
billion in 2005.
Much of this expansion reflects
increased use of these mortgages by households with
less-than-perfect credit records, moderate incomes, and/or
limited wealth to access the credit to buy a house or
refinance an existing home. Because of this greater access to
mortgage credit, falling interest rates, and rising incomes, the
homeownership rate has soared to record levels.
Because of the post-World War II
economic boom and improvements in the mortgage credit market, the
U.S. homeownership rate rose steadily from 44 percent in 1940 to 62
percent in 1960 to about 64 percent in 1970, where it remained
until 1995. When the subprime market began to grow in 1995,
homeownership jumped from the 64 percent that characterized
the previous 35 years to record levels at or near 69 percent
between 2004 and early 2007.
Boom and Bust. The economy
also benefited from the building and financing boom that took the
homeownership rate to record levels. New Housing unit starts
(single and multi-family) reached 2,068,000 units in 2005, compared
to an annual average of about 1.4 million starts during the
1990s. In 1972, generous federal subsidies propelled the
market to unsustainable levels and the all-time record of almost
2.4 million new units.
Although total starts in 2005 fell
short of the 1972 record, the impact on subprime mortgages shows up
more clearly in the single-family home market. Starts of
single-family homes reached 1.6 million units in 2004 and 1.7
million units in 2005, compared to 1.3 million in 1972 and an
annual average of about 1.1 million during the 1990s. Not
surprisingly, sales of new homes reached record levels in
2005, as did sales of existing homes.
As a consequence of this Housing
boom, construction workers, mortgage brokers, real estate
agents, landscapers, surveyors, appraisers, manufacturers and
suppliers of building materials, and many other professions and
businesses saw record levels of activity and incomes. This
activity, in turn, flowed through the rest of the economy during
the first half of this decade, contributing to the expansion
that began in 2001.
Nevertheless, 2005 was the peak
level of activity in the Housing market. Escalating home prices in
many markets with strict land-use regulations made Housing
unaffordable, even for those using increasingly risky
mortgages to finance the more expensive homes. Early defaults in
some subprime mortgages began to emerge-often after just one or two
payments-revealing a pattern of fraud in many such
transactions. As the problems worsened, Housing starts and new home
sales fell sharply in 2006, and the weakening market ended the
price escalation in many regional Housing markets.
This contributed to additional
defaults in recently originated subprime mortgages in which the
borrowers had assumed that perpetual home price increases would
allow them to refinance their way out of onerous loan terms,
including the scheduled "resets" to higher monthly mortgage
payments. A growing number of borrowers who had used subprime
mortgages and/or seconds to buy at the peak of the market with 100
percent financing found themselves carrying debt loads that
exceeded the values of their homes, making refinancing impossible.
It also made selling the homes largely impossible because the
proceeds would fall short of outstanding debt, forcing the owners
to cover the differences out of other financial resources, which
many did not have.
Because of these financial market
problems, America's Housing and mortgage market is
experiencing a catastrophic decline. After reaching more than
1.7 million units in 2005, single-family housing starts in
February 2008 fell to 707,000 units at a seasonally adjusted annual
rate-less than half the production level of February 2006 and a
40.4 percent decline from February 2007.
Sales of new homes also fell
precipitously over the same period. After reaching 1,283,000 units
in 2005, new home sales fell to a seasonally adjusted annual rate
of 590,000 in February 2008-less than half of the 2005 level and
down 29.8 percent from February 2007. For existing homes, sales
peaked at 7,076,000 units in 2005, fell to 6.4 million units in
2006, and fell to a seasonally adjusted annual rate of 5 million
units by February 2008-nearly 30 percent below the 2005 peak
Mortgage default and foreclosure
rates also began to rise, and defaults soon hit
the highest levels seen in recent years. After the beginning
of the modern subprime market in 1995, default rates on subprime
mortgages rose steadily, from around 10 percent in 1998 to almost
15 percent in early 2002, as a result of the economy's weakening
early in the decade after the dot-com stock market bubble
collapse and the 9/11 attacks. Foreclosures also jumped from
below 4 percent of outstanding subprime loans in 2000 to just over
9 percent in early 2002. In the years that followed, interest rates
fell, the economy grew more rapidly, and Housing starts and sales
The subprime market also boomed,
reflecting the fast growth of fresh, new (and untested) loans. The
default and foreclosure rates on subprime loans fell. Defaults were
around 10 percent in 2004 and 2005, which was below the
approximately 12 percent default rate on Federal Housing
Administration (FHA) mortgages for the same years. However,
subprime default rates increased to 13 percent by the end of 2006
and to more than 17 percent by the end of 2007, surpassing the FHA
default rate, which remained near 13 percent. Over the same period,
subprime loans in foreclosure also soared, from a low of 3.3
percent in mid-2005 to almost 9 percent by the end of 2007.
As the Housing and mortgage markets
began to unravel, many market analysts debated whether the damage
would be confined to the Housing market or would spill over into
the rest of the economy and contribute to a recession. While
overall economic trends during the first half of 2007 seemed to
indicate that the damage would likely be confined to the Housing
market, the deterioration in the mortgage and housing markets
during 2007 seems to have spread to other sectors. Data from late
2007 and early 2008 suggest that the weakness is spreading
beyond the housing sector and that the economy's health is at
Accelerates. The destructive decline now unfolding in the
Housing and credit markets is something that the U.S. economy has
experienced on several occasions during the previous several
decades. Serious credit crunches in the mid-1960s, mid-1970s, early
1980s, and early 1990s led to major declines in Housing production
and slowdowns or recessions in the overall economy.
However, while Housing downturns
have been common, the origins of this downturn are remarkably
different from those of the preceding downturns. Past Housing
declines and credit crunches often resulted from some combination
of Federal Reserve efforts to restrict credit to deter inflation
and/or from a weakening economy that discouraged buyers and
contributed to higher default rates and foreclosures caused by
rising unemployment. This Housing/mortgage downturn began when the
economy was growing at a healthy pace, personal incomes were
at record levels, and the unemployment rate was relatively
With the overall economy seemingly
blameless for the current Housing market problems, all
evidence suggests that something went terribly wrong in the
mortgage market and that it needs to be repaired to prevent a
repeat in the future. At the same time, the need for essential
repairs to the mortgage market should not be confused with efforts
to prevent the existing problems from spreading further and causing
In response to problems in the
mortgage market, the Administration has already taken several steps
to provide limited relief to deter foreclosures and allow those
with good credit opportunities to refinance and adjust
payments to keep their houses and stay current on their payments. As
the White House has taken these steps, Congress is considering
a number of pieces of legislation to provide additional relief to
borrowers and/or impose new regulations on mortgage market
On the broader issue of the
economy's health, the President and the congressional
leadership responded to early signs of weakness and the
devastation in the Housing and finance sectors by passing a
business bailout package in February 2008 to protect the
economy and revive the Housing market.
Since the second session of the
110th Congress began, dozens of legislative remedies have been
introduced. Many of these proposals would impose substantial
regulations on mortgage market participants to deter future
problems. While many of these regulatory efforts are well meant,
implementing them would likely limit access to mortgages to only
those with high incomes and existing financial assets. In the end,
such regulations are unlikely to make the mortgage market any safer
and could make it more vulnerable, as the painful experiences of
the 1970s and 1980s demonstrate.
During the 1970s and 1980s, the
federal government imposed strict and cloying
regulations-overseen by tens of thousands of federal
bureaucrats- on the mortgage market and the many financial
institutions that served it. Yet this imposing and costly
regulatory regime did not deter massive mortgage fraud in the FHA
insurance program in the late 1960s and early 1970s, nor did the
regulators prevent the complete collapse of the heavily
regulated savings and loan industry in the late 1980s. When the
smoke finally cleared, both federal deposit insurance
agencies-the Federal Savings and Loan Insurance Corporation
(FSLIC) and the Federal Deposit Insurance Corporation (FDIC)- were
insolvent, and covering their losses cost taxpayers an
estimated $130 billion.
However chaotic and costly the
current mortgage market collapse has been to the largely
unregulated residential mortgage market, all of the losses to
date have been and will be borne by private participants, not
by the taxpayer. Indeed, federal regulation of such mortgage
market participants as Citigroup, Washington Mutual, Wells Fargo,
Countrywide Financial, and Fannie Mae did not prevent them from
racking up tremendous losses in their residential mortgage
operations. Assuming that they and other federally regulated
depository institutions remain solvent, all of their losses will be
borne by their shareholders, partners, employees, and
In an effort to inject a note of
reality into the growing nostalgia for the heavily regulated
mortgage markets that existed in the pre-securitization era of
mortgage finance, the next section of this paper reviews the
heavily regulated mortgage market from the early 1950s up to
the spectacular and costly collapse of the savings and loan
industry in the late 1980s.
The financial upheavals of the
Great Depression fell most heavily on the Housing and mortgage
finance markets, and a disproportionate share of bank insolvencies
was associated with financial institutions with loans concentrated
in residential and agricultural real estate. As borrowers defaulted
and real estate values fell, worried depositors attempted to
withdraw their funds, causing many depository institutions to
Key federal initiatives emerged
from the collapse, including the Federal National Mortgage
Association (FNMA, now Fannie Mae); the Federal Home Loan Bank
Board to serve as a kind of Federal Reserve for the savings and
loans and the mutual savings Banks; the FHA; the FDIC; and the
FSLIC to insure deposits at savings and loans. Importantly, the FHA
and FNMA pioneered the use of the long-term, fixed-rate,
level-payment, fully amortized mortgage, replacing the then-common
five-year balloon mortgage, thereby providing mortgage lenders and
investors with a more stable cash flow.
Because of postwar prosperity and
millions of returning GIs eager to form families and buy homes,
Housing construction accelerated, and homeownership rates
reached record levels. By 1950, the homeownership rate went
above 50 percent for the first time since the 1890 census, when the
U.S. Census Bureau began collecting such data.
During the first several decades
after World War II, savings and loan (SL) associations and
mortgage bankers became the dominant players in the market,
and many of the FHA mortgages originated by mortgage bankers were
sold to Fannie Mae, while their conventional loans were sold in the
secondary market to life insurance companies, pension funds,
and depository institutions. During this period, life insurance
companies, pension funds, and individuals began to reduce their
investments in residential mortgages in response to federal efforts
to keep mortgage interest rates low, leaving the SLs and
government-sponsored enterprises (GSEs) as the dominant lenders in
SLs grew rapidly because they
benefited from a number of regulatory advantages over commercial
Banks, their chief competitors. The Glass-Steagall Act of 1933
limited the banks' ability to compete by prohibiting them from
paying interest on checking accounts and allowed the Federal
Reserve to set a ceiling on the interest rate that they could pay
on passbook savings deposits (regulation Q). For part of that
period, savings and loans had no such limits and were able to offer
a higher rate on savings deposits and thereby attract money and
customers from banks.
However, this advantage came with a
cost. In return for the deposit rate advantages and important
concessions on federal income tax liabilities, SLs agreed to
strict regulations on their deposits and loans. They could not
offer demand deposits and were prohibited from investing in
anything other than long-term, fixed-rate residential
mortgages. As a result, SLs were in the potentially
unstable position of financing 30-year loans with short-term
deposits that could be withdrawn essentially on demand. While
this precarious position "worked" if the yield curve remained
upward-sloping (long-term rates higher than short-term ones)
and interest rates remained stable from year to year, volatility in
either could jeopardize the solvency of the dominant SL
The first blow to this unstable,
heavily regulated system came in the early 1960s, when the pressure
to finance the Housing and population boom in California
induced the federally insured California SLs to seek deposits
from the rest of the country by offering higher savings account
rates and easy bank-by-mail transactions. As depositors from the
Midwest, South, and East responded enthusiastically to higher
interest rate earnings, eastern SLs were unable to compete
because all of their funds were tied up in long-term,
lower-yielding mortgages. To prevent deposit funds from
flowing from the East to the West, Congress imposed deposit rate
ceilings on SLs in 1966 but gave them a 0.5 percentage
point advantage over commercial banks.
The worst blow to SLs came in
the mid-1960s, when a decade of interest rate stability was ended
by nearly two decades of volatile and steadily escalating
interest rates. This culminated in the early 1980s when short-term
interest rates (as measured by the three-month Treasury bill) rose
steadily from 3.5 percent in 1964 to 14 percent in 1981, with
sub-peaks in 1970, 1974, and 1990. In every instance, SLs had
difficulty holding deposits and competing with other attractive
short-term investment opportunities while their interest
earnings growth was severely limited by their portfolios of
fixed-rate, long-term mortgages that changed only slowly.
By 1980, the SL industry was
technically insolvent because the market value of its mortgage
loan portfolio was less than the value of the deposits financing
it. Congress belatedly responded by reducing the regulatory burden
on the industry.
Yet it was too late. By the end of
the 1980s, the SL industry began to collapse. In the late
1980s, more than 1,000 SLs became insolvent and filed for
bankruptcy. By 1995, only 1,645 SLs were in operation compared
to 3,234 in 1986, and the industry's share of the mortgage market
had fallen from 44 percent in 1970 to 21 percent by 1990.
Because the value of the insolvent
SLs' assets was less than that of their deposits, the FSLIC
was required to cover the difference between the value of the
assets and what was owed to the federally insured depositors. The
losses quickly exceeded the reserves of the FSLIC, which was
subsequently merged into the FDIC. The debacle ultimately cost
federal taxpayers approximately $130 billion.
A New System Arises from the
Rubble. As the old system was collapsing, a new system was
emerging to take its place. Unhindered by the
counterproductive regulations that Congress had imposed on the
previous system, the new one was largely free of federal
regulation. Some of the belated reforms adopted during the 1980s
shaped the new system that emerged in the 1990s, pushing
homeownership rates to record levels but also contributing to
the current financial debacle, although it has imposed few burdens
on taxpayers so far.
Among the institutional changes
made during this period was the breakup and privatization of Fannie
Mae in 1968, which was then limited to buying only mortgages
insured by the FHA or guaranteed by the Veterans
Administration (VA). One of its new parts, renamed the Government
National Mortgage Association (GNMA or Ginnie Mae), was
transferred to the U.S. Department of Housing and Urban
Development and tasked with operating the new "pass-through" (a
type of MBS) mortgage securities program. Consisting of bundled
FHA-insured and VA-guaranteed mortgages, these new pass-through
securities were guaranteed by the full faith and credit of the
federal government. They also marked the first serious effort to
systematize the securitization of mortgages, a process that would
later come to dominate the mortgage market in response to the
diminishing role of depository institutions.
In 1970, two years after
privatizing Fannie Mae, Congress created a companion GSE named the
Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).
Initially "owned" by the savings and loans, the FHLMC was created
to serve and facilitate a secondary market for conventional
mortgages on behalf of the savings and loan industry at a time when
Fannie Mae largely served the mortgage banking industry
because it was legally limited to buying only FHA-insured or
VA-guaranteed mortgages. The FHLMC soon also developed pass-through
securities for conventional mortgage loans. Over time, the limits
on types of mortgages allowed to each GSE were dropped, and both
now focus largely on conventional mortgages.
The 1970s also saw the revival of
the private mortgage insurance industry, which had been largely
destroyed by the collapse of the Housing finance industry during
the Great Depression. Absent mortgage insurance, conventional loans
generally required a down payment of 20 percent to satisfy
lender/investor risk concerns, in contrast to 3 percent for the FHA
and zero percent for the VA, thereby limiting their use to those
with sufficient savings. However, with private mortgage insurers
(PMIs), the down payment on a conventional loan could be as low as
5 percent, giving more households access to this type of
financing, particularly for homes that cost more that the loan cap
for FHA mortgages. Both the FHA and PMIs charged the borrower an
insurance premium equal to 0.5 percent of the outstanding loan
Finally, beginning in the late
1970s, SLs and other lenders began to offer borrowers
adjustable-rate, conventional mortgages in which the interest rate
changed periodically in accordance with some agreed-upon index.
Today, the London Interbank Offered Rate (LIBOR) is used. The
purpose of this change was to help the beleaguered SLs enhance
their solvency and better survive unsettled market conditions
by allowing them to match the return on their assets more closely
with the cost of their liabilities.
Before this, SLs offered only
one type of mortgage: the fixed-rate, level-payment, fully
amortized mortgage. Although SLs were not prohibited from
offering adjustable-rate mortgages, relatively low state usury
ceilings in 48 states often made them impractical. Later in the
1970s, the FHA and VA were also permitted to insure and guarantee
Mortgage Market, 1990-2005
The collapse of the SL
industry and the growing popularity of conventional mortgages
(now that private mortgage insurance allowed for low down payments)
led to a number of significant changes in the residential mortgage
finance market. In 1955, conventional mortgages accounted for 56
percent of outstanding mortgage debt (the FHA accounted for 16
percent, and the VA the remainder), and their share of the market
grew steadily over the next several decades, reaching 94.7 percent
of outstanding one-four family residential mortgage debt by 2006,
with VA and FHA sharing the remaining 5.3 percent of the market.
As FHA/VA market share declined,
FNMA was allowed to join FHLMC in the conventional market, and
their pass-through securities quickly dominated the
securitized secondary market at the expense of the GNMA, which was
still limited to the FHA/VA mortgages. Among the major changes in
the mortgage market was a significant change in the role played by
the different types of lenders/investors, as Table 1
From 1960 to the early 1980s, the
savings institutions (SLs and mutual savings Banks, in
states where they could be chartered) were by far the primary
source of residential mortgage credit. However, the legacy of
heavy-handed federal and state regulation impaired both their
financial solvency and their ability to compete beginning in the
1970s. Their market share began to fall, while FNMA and FHLMC
filled the vacuum and expanded at a rapid pace.
Between 1980 and 1990, savings
institutions' share was cut in half as a result of the SL
collapse, while the regulated but protected GSEs doubled their
share. By 2000, GSEs accounted for approximately the same
market share as savings institutions controlled during their
earlier peak between 1960 and 1980. Over these same periods,
commercial Banks gradually expanded their share, while life
insurance companies abandoned the market, which no longer provided
a competitive yield compared to other debt instruments.
However, this state of affairs was
only temporary because a series of major management
failings at the leading GSEs forced government regulators to
curb FHLMC and FNMA lending activities as their accounting scandals
were unraveled and a new set of federal regulations was
developed for them. At the same time, a new market emerged,
driven in part by a host of new subprime mortgage instruments and a
financial industry that developed a variety of new
mortgage-backed securities to sell on global secondary markets
to investors that heretofore had little participation in America's
residential mortgage finance system. As the last column of Table 1
shows, between 2000 and 2005, the GSE share shrank by 7 percent,
and the market share for non-GSE, privately issued, mortgage-backed
securities jumped by nearly 10 percentage points.
In effect, as the troubles and
scandals confronting the GSEs limited their investment
activities, the private sector more than stepped into the void and
contributed to a record-breaking boom in mortgage lending and
homeownership and a near record in new Housing construction.
Mortgages Emerge and Expand
With the U.S. homeownership rate
plateauing at 64 percent from 1970 through the early 1990s, future
growth prospects for the mortgage finance industry were limited to
whatever growth in household formation and price appreciation
could add to a predictable stream of refinancings and resales,
unless a new product was introduced to expand homeownership and
refinancings. That new product was the subprime mortgage,
which from about 1995 through 2006 helped to boost the
performance of the Housing and Housing finance markets to and
sometimes beyond all previous records.
As noted earlier, a wide variety of
new and innovative debt instruments were available to
consumers in the subprime and prime markets. This section
lists and briefly describes some of the more common types
offered by lenders.
A subprime mortgage is generally
defined as a mortgage in which the borrower's credit quality is
impaired relative to the volume of debt incurred. Within the
subprime category are a number of different types of mortgage
instruments that offer alternative repayment and loan-to-value
plans. In many instances, elements of these different types of
mortgages are combined in a single instrument.
The term "adjustable-rate mortgage" describes any mortgage
with an interest rate and payments that adjust according to some
formula agreed upon by the borrower and lender. ARMs have been
generally available to borrowers for about three decades on
prime mortgages, but variants have been common to subprime
mortgages over the past 10 years. The traditional ARM linked
the mortgage's interest rate to the LIBOR plus several percentage
points (the "margin").
Often, the interest rate is fixed
for the first few years and then resets annually or semiannually as
market rates change and according to the contractual "cap" on
the allowable increase in the rate on the reset date. Thus, even if
the LIBOR rate does not rise over the term of the loan, the loan's
interest rate and required monthly payment would still rise.
For example, New Century (once a
major subprime lender) offered a 2/28 ARM loan with an 8.64 percent
rate for the first two years and subsequent rates that would
be linked to the LIBOR at a 6.22 percent margin. After the first
two years, the interest rate would be updated every six months at
an initial cap of 1.49 percent, a period cap of 1.5 percent, and a
lifetime cap of 15.62 percent. Under this arrangement, the monthly
payment would rise 32 percent by the 31st month, assuming no change
in the LIBOR.
When applied to subprime mortgages
in recent years, some lenders for the first year or two would
charge a low initial interest rate (a "teaser rate") that would
then reset to a much higher rate in subsequent years. In some
cases, these new rates were above market rates and could
significantly increase the monthly payment. A 2/28 ARM was a
30-year mortgage with a teaser rate that would reset after two
years, and the new rate would be linked to market rates for
the next 28 years. A 3/27 ARM follows a similar pattern.
Alt-A Mortgages. Sometimes
referred to as a "low-doc" mortgage, an Alt-A mortgage is
structured like the other mortgages described in this
section but is made available only to prime borrowers or those
with FICO scores above 660. However, these prime borrowers were
required to offer only limited documentation on their
qualifications, so many may not have been as "prime" as they
represented themselves to be, as subsequent default rates
Extremely Low- or
No-Down-Payment Mortgages. As home prices appreciated and
as mortgage originators and lenders looked to expand their pool of
potential customers beyond those with sufficient savings and net
worth to make the required down payment (generally 5 percent to 20
percent), lenders and investors began to offer and buy
mortgages with little or no down payment. Sometimes they provided
more than 100 percent financing by allowing buyers to borrow a
portion of their settlement costs.
For the most part, these borrowers
were believed to have incomes and credit histories sufficient to
meet future payment obligations, and continued home price
appreciation was expected to create an equity cushion sufficient to
protect the lender. The most common FHA mortgage requires only a
down payment of 3 percent, or even less if the borrower finances
half of the closing costs, as is permitted. Not surprisingly,
between the end of 2003 and 2006, the default rate on FHA mortgages
exceeded the default rate on subprimes.
In some cases, a no- or
low-down-payment financing package was arranged by using a first
mortgage equal to 80 percent of the property's value (thereby
avoiding the 0.5 percent PMI premium) and a separate second
mortgage (often called a "naked" or "silent" second) to cover the
remaining 20 percent. In the event of a foreclosure, the first
mortgage holder would have first claim on subsequent sale proceeds,
while the second mortgage holder would receive whatever
remained, if anything.
Mortgages with no down payment are
considered risky because the absence of equity provides the
lender with little cushion in case of losses at foreclosure and
limits the borrowers/owners' incentive to keep up their
payments because they have little to lose through default and
foreclosure. As one analyst noted, "A home without equity is just a
rental with debt."
Most mortgages today are fully amortized, meaning that each monthly
payment covers both the interest and a portion of the principal.
Over the life of the mortgage (typically 30 years), the
principal amount will gradually be paid down to zero.
An interest-only mortgage permits
lower initial monthly payments by allowing the borrower to defer
any repayment of principal until a year or more into the loan. For
example, if principal payments are deferred for three years,
payments after the third year would rise to a higher level than
they would have been if the mortgage had been amortized
beginning with the first payment because the principal must now be
paid down over 27 years rather than 30. The mortgages carry risks
similar to no- and low-down-payment mortgages and ARMs.
Mortgage. A negative-amortization mortgage is much riskier than
an interest-only mortgage because the initial payments do not cover
all of the interest, so the interest deficiencies are added to
the loan's principal, which increases over time along with the
borrower's indebtedness. Once the flexible payment period ends, the
monthly payments are even larger because the loan amount has
increased and the amortization period is shorter. Risks to the
lender are more severe than the risks that are encountered with
Increasing Risk in the Past Few
Years. A recent study by the Federal Reserve Bank of New York
tracked a number of the changes in the quality of Alt-A and
subprime loans that originated from 1999 through 2006 and were
packaged in MBSs. In the Alt-A market, the loan-to-value ratio
increased from 76 percent in 2002 to 80 percent in 2006, and the
share of loans with silent seconds increased from 2.4 percent to
38.9 percent. Over the same period, loans with full documentation
declined from 36 percent to only 16.4 percent.
For subprime mortgages, the
loan-to-value ratio increased from 80.7 percent in 2002 to 85.5
percent in 2006, and the share of loans with silent
seconds increased from 2.9 percent to 27.5 percent. Over the
same period, subprime loans with full documentation declined from
65.9 percent to 57.7 percent.
As noted earlier, newly originated
subprime, Alt-A, and home equity lines (seconds) totaled $330
billion in 2001 and accounted for 15 percent of all residential
mortgages. Just three years later, in 2004, they accounted for
almost $1.1 trillion in new loans and 37 percent of residential
mortgages. Their volume peaked in 2006 at $1.4 trillion in
loans and 48 percent of residential mortgages.
Impact on the
Giving less creditworthy borrowers
access to mortgage credit increased the U.S. homeownership rate by
more than 4 percentage points during this rapid expansion of
subprime mortgages. In 1995, just when the subprime market was
starting to expand, the homeownership rate was 64.7 percent of
households-comparable to the average rate for the preceding three
decades. However, as the subprime mortgage market grew, so did
homeownership, which reached an all-time peak of 69
percent in 2004.
Based on the most recent Census
estimates (2006), the homeownership rate increased from the
pre-subprime rate of 64.7 percent in 1995 to 68.8 percent in 2006.
In other words, looser credit standards allowed an additional
4.6 million American households and families to become homeowners
than might otherwise have been the case without these mortgage
market innovations. As the subprime market has unraveled and
homes have gone into foreclosure, the homeownership rate has
declined from its peak of 69 percent in 2004 to 68.1 percent in
2007, diminishing the number of net new owners who may have been
created by the growth of the subprime market.
The more liberal qualification
terms and creative payment streams also encouraged existing
homeowners to refinance their homes, often converting their
increased home equity into cash to spend on home improvements, debt
consolidation, and other consumer goods. The Federal Reserve Bank
of New York study reports that more than half of the subprimes that
originated between 1999 and 2006 and were repackaged in MBSs were
used for purposes other than to purchase a house. In six of
the eight years, less than 40 percent of loans were used to
purchase an owner-occupied home.
Such refinancings and respendings
were encouraged by the federal and state income tax codes,
which allow the deduction of mortgage interest payments from
taxable income, but not interest paid on other forms of consumer
debt. Thus, using a mortgage refinancing or a new second loan
to purchase a car, remodel a kitchen, or pay off credit card debt
or student loans would yield tax savings that the other types of
debt would not.
The more generous terms and
qualifications for subprime loans also encouraged and allowed
otherwise qualified prime borrowers to buy beyond their means,
giving them access to more expensive houses than would have been
unaffordable with a traditional mortgage, which would require a
larger down payment. In a similar vein, these easy financing
terms encouraged many households to buy a second home for
recreation or investment, and some owners/investors bought
Mortgage Market Unravels
While many believed that carefully
underwritten subprime mortgages provided manageable risks, the
evidence suggests that underwriting standards in the prime and
subprime mortgage markets collapsed at some point during the
past 10 years for reasons that are not yet fully apparent. Part of
the decline in standards may have stemmed from the rapid price
escalation in the value of the underlying collateral-the land and
structures that secured the mortgage. This led many strapped
borrowers and their lenders/investors to believe that the borrowers
could refinance their way out of any payment problems. Lenders
and investors also came to believe that ever-escalating home prices
would eliminate any loss in the event that a risky borrower
defaulted and the loan was foreclosed.
While such optimism seems foolish
in hindsight, it seemed appropriate at the time and provided
important economic benefits for all involved. An obvious benefit is
that as many as 4.5 million additional homebuyers and
borrowers generated new business and revenues for real estate
agents, mortgage agents, real estate and mortgage brokers, and
commercial banks. The many participants in the subsequent
securitization process earned fees for each packaging and
repackaging as the risks were sliced and diced to tailor securities
to each investor's needs. On top of this was the boom in
refinancing for those who already owned their homes but were
attracted to better terms and the opportunity to convert home
equity to cash.
A less appreciated benefit of the
diminished underwriting standards was the reduction in costs for
many involved in the process. The advent of no-documentation
("no-doc") loans in which borrowers are on the honor system to
provide information on their incomes, assets, debts, and credit and
employment histories saved the lender/investor the considerable
expense of establishing the borrower's suitability, which involves
sorting through and verifying the copious documentation by
calling or writing employers, Banks, brokerage firms,
utilities, and other parties. Reducing these and other loan
origination costs in the due diligence process increases the
profit from a given stream of revenues.
Similar economies in costs occurred
during the subsequent securitization process, thereby allowing for
a more attractive return to the end buyer while still yielding
handsome fees to the many loan bundlers, securitization
packagers, and securitization repackagers that formed a gantlet of
fee-earning opportunity between the initial borrower and the
ultimate investor. In the past, the secondary market financial
institutions that repackaged mortgages into mortgage-backed
securities would reexamine the portfolio of mortgages to confirm
their quality. This entailed examining a random sample of as many
as 10 percent of the backing mortgages to confirm their promised
quality. This costly and time-consuming process was replaced by a
faster and much less costly process called "representations and
warranties," in which the originator/consolidator of the loans
being securitized and sold would confirm that the loans were of a
certain quality and would agree to buy back any loans that failed
to perform as promised. The representations and
warranties in turn were often based on the borrowers' credit
As events soon revealed, many of
these representations and warranties were exaggerated. When
the loans defaulted and the ultimate investors returned them for
the required repurchase, originators and down-market consolidators
faced financial obligations well in excess of their capital
and soon filed for protection under the federal bankruptcy
This left many investors holding
devalued mortgages and with no remedy beyond pushing for
foreclosure. The CRS reported in September 2007 that 90
mortgage lenders/brokers had gone out of business since the
first of the year. And mortgage originators were not
the only financial institutions forced to compensate down-market
investors. Merrill Lynch, Citigroup, and the merged Bear
Stearns were among several major firms forced to buy back mortgage
securities that they had sold to investors.
The National and
Global Subprime Risk
The collapse of the savings and
loan industry (see Table 1) ended the "originate and hold" era of
mortgage lending and, out of necessity, greatly expanded the
Housing industry's reliance on the "originate and sell" process.
Today, more than 65 percent of all outstanding mortgages have been
sold to investors in the secondary market, including the federally
sponsored GSEs. Many of these mortgages have been sold through the
securitization process in which a bundle of mortgage loans serves
as collateral for some form of mortgage-backed security, which
is sold to institutional and individual investors in the
secondary market. The monthly payments from the millions of
individual mortgagors (borrowers) are passed through a gantlet of
servicers, arrangers, and asset managers (net of fees) to the
ultimate holder of the MBS.
Typically, the originator, which
could be a bank or a mortgage broker, makes the loan to the
borrower/ homebuyer, collects a fee in the process, and sells the
loan to an arranger who borrows from a warehouse lender (or uses
internal funds) to acquire the pool of mortgages. The arranger then
repackages the mortgages into an MBS, insures the payment of
interest and principal through a bond insurance fund, and then has
a rating agency (i.e., Fitch, Moody's, or Standard and Poor's) rate
the MBS. The pool is transferred to a trustee, an asset
manager is selected, and the MBS is sold to investors. In the early
stages of the pool's formation, the originator services the loans
(collects the monthly payments, passes them on to the arranger, and
places tax and insurance payments in escrow). Once the pool is
completed, the asset manager selects a permanent servicer to
replace the originator.
At each stage of the process, the
various entities involved collect service fees. Yet the further a
subsequent participant is from the mortgagors, the more
difficult it is for the participant to assess the risk of the
pooled mortgages accurately. As the Federal Reserve Bank of New
York study contends, as many as seven separate key "frictions" are
involved in the process of mortgage securitization.
In the past, these subsequent
participants in the process would have confirmed the stated quality
of the pool by inspecting a portion of the mortgages in detail, but
the diminishing amount of documentation over the early years
of this decade may not have provided much useful information. Thus,
participants increasingly relied on the originator's
representations and warranties. In effect, the process relied
largely on trust among individuals whose compensation depended on
closing the deal.
Adding to the risk, some MBSs were
repackaged into highly leveraged securitized investment
vehicles (SIVs) and collateralized debt obligations (CDOs),
further compounding the risk to the ultimate investor. Default
on a small portion of the underlying mortgage portfolio could
dramatically reduce the security's value, causing huge losses for
the investor or for those who guaranteed the payment of
principal and interest on the security.
The multibillion-dollar write-offs
taken by Citigroup, Merrill Lynch, Bear Stearns, and other
investment banking firms are attributable to their decision to
repurchase such highly leveraged, mortgage-backed securities
that they had previously sold to investors. As the problems
worsened, it became apparent that financial institutions throughout
the world were experiencing significant losses.
While the political debate and
media discussion of the issue sometimes tend to reduce the problem
to a single cause and process, the problem is really a series of
independent problems. Some of these problems are geographically
concentrated in only a few states and/or metropolitan areas.
Economic Adversity. In some
cases, economic adversity has been an important contributing factor
in mortgage defaults and foreclosures, notably in the
manufacturing-dependent states of Michigan, Indiana, and Ohio. In
these states, unemployment is rising, and the shares of mortgage
loans listed as seriously delinquent (over 5.5 percent) or in
foreclosure (3.3 percent to 3.8 percent) are the highest in
the nation. (Nationally, 3.62 percent are seriously delinquent, and
2.04 percent are in foreclosure.) According to a recent survey of
delinquency and foreclosure rates, borrowers in these three states
were not overly reliant on subprime mortgages, which accounted for
13.8 percent to 14.3 percent of these states' mortgages compared to
12.7 percent nationally. This suggests that the economic
problems concentrated in these states, not necessarily the
quality of the underwriting, were an important cause of the loan
Florida, Louisiana, and Nevada rank
among the six states with the highest rates of seriously
delinquent mortgages (90 days or more), and Florida and Nevada
are among the states with the highest foreclosure rates (over 2.8
percent). A combination of higher subprime use
(16.0 percent) and high-cost Housing in comparison to buyer incomes
may have contributed to Florida's problems.
The survey also calculates a "next
worse" group, with six states in the seriously delinquent category
and nine states in the next-worse foreclosure category.
California is in both groups and is the worst-performing of the
Pacific states. California fares worse than the national average,
although not as badly as the Midwestern manufacturing states.
In another national survey of
foreclosures that attempts to capture the rate of deterioration
over the past year (February 2007 to February 2008),
California and several other states performed very poorly.
Compared with a nationwide increase of 57 percent, foreclosures
increased by 131 percent in California, 210 percent in Arizona, and
145 percent in Wisconsin.
Affordability and Land-Use
Regulations. While Wisconsin's deterioration stems from its
concentration on manufacturing, the problems in California,
Florida, Nevada, Arizona, and selected parts of the D.C., New York,
and Chicago metropolitan areas stem largely from their restrictive
land-use regulations and the effect of these regulations on
Housing prices and affordability.
Beginning in California in the
1960s and Oregon in the 1970s, states and localities began to
implement a variety of land-use regulations to control, limit,
manage, and/or guide the growth of residential development in
their states and communities. For the most part, these
regulations involved the adoption of growth boundaries, mandatory
green space, farmland preservation, downzoning, exclusionary
zoning, large lot zoning, high impact fees, and infrastructure
concurrency. The implementation of such land regulations
accelerated over the past decade as more and more states and
localities adopted them.
As a consequence, the volume of
land available for development shrinks and its cost rises. The
escalation in land prices leads directly to higher house
prices, and as house prices rise faster than incomes, homes become
Because of its long history of
counterproductive land regulation, house prices in California are
the highest in the nation. San Francisco is one of the least
affordable areas in the United States. The median sales price for
homes in the San Francisco area was an estimated $777,300 in the
fourth quarter of 2007, down from $846,800 in the second
quarter. According to one survey, the
median-priced home in San Francisco was more than 10 times the
median household income in the region, making it one of the
country's least affordable regions.
Because of statewide land
restrictions, similar unaffordability trends characterize most
California cities, making California one of only two states where
the 2007 homeownership rate was below 60 percent. By contrast,
because of their less regulated land markets, median home prices in
Dallas ($145,000), Houston ($150,300), and Atlanta ($164,300) are
very affordable and equal to less than three times their regions'
As noted, California also suffers
from high default and foreclosure rates, and this trend is
worsening. Similar influences and outcomes characterize Phoenix,
Las Vegas, and many cities in Florida. This partially reflects the
fact that the high cost of Housing has compelled many middle-income
homebuyers to incur excessive levels of debt to fulfill the
American dream of becoming homeowners.
Table 2 illustrates this
correlation, using data from a CRS table that show the connection
between the preponderance of ARM usage in a community and
an independent measure of mortgage risk. This report adds a third
column to provide a measure of a region's affordability and a
fourth column to describe its land-use practices. As is
apparent, the high-risk, ARM-dependent regions also have high
measures of unaffordability and land-use regulation.
Predatory Lenders, Predatory Borrowers. For much of the past decade, some in Congress and the advocacy community have complained about the prevalence of "predatory lending," a practice in which individuals of modest means and limited sophistication are seduced into taking on debt, often secured by their home. Some define predatory lending as occurring when the lender convinces the borrower to borrow "too much." Sometimes, outright fraud is involved, and the nature of the obligations is misrepresented. In other cases, individuals may willingly agree to a loan that carries high interest rates, large fees, and harsh terms that are beyond their capability to service with their modest incomes and financial skills, hoping that something will work out in the future. Some fall behind in their payments and ultimately lose their homes through foreclosure.
For some debtor advocates, subprime loans are synonymous with predatory lending because they typically carry higher interest rates and fees to compensate lenders for the additional risk of default that they assume by lending to such borrowers. As noted earlier, the many definitions and characteristics of a subprime loan relate entirely to the lackluster credit history of the borrower. While there have certainly been instances of fraud, there is little evidence to suggest that they constitute a significant component of the subprime problem nationally, although there are instances of localized abuses. The high foreclosure and default rates in low-cost Atlanta and Detroit may be examples of such abuses.
In contrast, as more evidence emerges from the millions of faltering mortgagors (subprime, Alt-A, and/or prime), it is becoming apparent that some portion of the problem -- perhaps a significant portion -- may stem from "predatory borrowing," defined as a transaction in which the borrower convinces the lender to lend too much. As underwriting standards declined and as this decline became obvious to many in the real estate business, some people took advantage of the lax standards to buy homes that they could not otherwise afford, to refinance homes to acquire other consumer durables or pay down credit card debt, or to buy homes for investment (renting or selling) without revealing that the homes were not their primary residences.
In many cases, the growing use of low- or no-documentation mortgages (sometimes called "liar loans") allowed people to exaggerate their incomes and receive loans that they were not qualified to receive. On top of this was the growing proclivity to use a second mortgage to pay a down payment to an unwitting first mortgage lender -- prime or subprime -- with the lender believing that the borrower had no other significant debt obligations.
A variant of predatory borrowing is the seemingly naïve and unwitting borrower who is victimized by an organized combination of real estate investors, appraisers, agents, and loan officers who combine to sell overpriced homes to unqualified borrowers to earn substantial commissions, fees, and capital gains by misrepresenting the borrower's qualifications. In a number of these cases, the victims have been modest-income immigrants with limited financial sophistication and English language skills, while the perpetrators are their ethnic cohorts who take advantage of their language and real estate skills to encourage the borrowers to agree to financial transactions that are beyond their means. While the hapless borrower soon defaults, the perpetrators receive their fees up front at closing, and all losses are borne by the downstream holder of the resulting mortgage or by the participants who warranted the quality of the mortgage.
Beginning in the 1990s and accelerating through this decade, American households on average reduced their savings rates and embarked on a debt-fueled binge of consumer spending, including acquiring homes that many could not "afford" without incurring excessive debt. From 1970 to 1989, Americans saved more than 9 percent of their personal income. In the 1990s, the savings rate fell by almost half to a little over 5 percent, dropping close to 2 percent by 1999. It remained at about 2 percent from 2000 until 2005, when it fell below 1 percent, where it has remained since. Because these savings rates include contributions to 401(k) plans and other retirement savings programs -- funds that are unavailable for current spending purposes -- the "discretionary" household savings rate, including money that could be used for a down payment on a house or for an unexpected expenditure, has been substantially negative in recent years.
With the nation awash in easy credit and with many mortgage lenders willing to provide subprime mortgage loans and/or risky second mortgages that obviated the need for any down payment, households had little incentive to save and began to spend more than they earned. At the same time, car loans, credit card debt, and equity lines of credit became available on similarly generous terms, further undermining incentives to save while enhancing a household's ability to spend.
As debt burdens increased, new monthly "mandatory" spending commitments such as cable television, Internet service, and cell phones added to the traditional monthly spending obligations that include electricity, heat, water and sewage, and taxes. As inflation has worsened for some essential consumer products and services -- Merrill Lynch reports that spending on food, energy, and medical care is at its highest share of personal income since 1960 -- the pressures on personal incomes have intensified. As a result, a growing number of households are experiencing difficulty staying current on their mortgages, credit cards, and auto loans.
Declining House Values. As the subprime problems have led to weakness in the Housing market, home prices in many communities have declined. According to the SP/Case Schiller Index of 20 metropolitan areas, home prices in January 2008 fell by 10.7 percent from a year ago. The National Association of Realtors reported that median sales prices of existing homes in February 2008 had fallen 8.2 percent nationwide from a year ago.
With many borrowers buying their houses with little or no down payment and having little or no equity in their homes, the decline in prices has left many holding assets that are worth less than what they owe on them. Merrill Lynch estimates that as many as 9 million households may have "upside down" mortgages in which the debt exceeds the value of the house and the equity is negative.
With further price erosion likely, this situation will only worsen. As a consequence, many borrowers/owners are deciding that the wiser course is to relinquish their homes and debt obligations and move to a less costly rental. As home prices decline, this could spur even more defaults, particularly among borrowers whose mortgage loans are about to reset to a higher payment.
Of course, with many of these mortgages repackaged into securities and resold to investors around the globe, the hundreds of thousands of defaults and subsequent foreclosures caused by some combination of these factors have undermined the value of these securities and have shaken global confidence in U.S. financial markets and institutions.
Potential for Continued Deterioration
While many hope that the worst is over and that the economy and the Housing and finance markets will bottom out in mid-2008, there are many reasons to be cautious about the near-term and longer-term prognoses for the Housing and Housing finance markets. Unlike past real estate recessions, much of the deterioration experienced so far has occurred when the economy was healthy, jobs were abundant, and credit was readily available at reasonable rates.
By early 2008, credit had become scarce for all but the best risks, and slowing economic activity has raised the risk of increased unemployment and depressed incomes. With inflation starting to cut into discretionary spending and many consumers maxed out on debt, a consumer spending retrenchment may be more likely than a consumer spending boom.
For Housing and mortgage finance markets, the problems will likely take longer to resolve. This year and the next may be as bad or as worse as 2007. In the short run, the number of contractual mortgage payment resets in 2008 will be significantly greater than the number of resets in 2007. The number of resets in 2009 will be lower but still high by past measures.
Because the subprime and Alt-A mortgages approaching reset are of a lower quality and higher risk than those that have reset over the past few years, defaults and foreclosures could be higher. With foreclosures up 60 percent but foreclosed properties selling at a rate of only 4.4 percent, the growing inventory of unsold homes will dampen any revival of the new home construction market and the dependent industries.
Over the longer haul, the Housing market and the vast volume of debt that it collateralizes will likely continue to be depressed as a return to higher quality lending standards permanently excludes from homeownership many millions of potential buyers/borrowers with moderate incomes and/or no net worth. Meanwhile, continued turmoil in the subprime market and the economy will push many of their income-class cohorts from ownership to renting.
As noted, the more exacting pre-1995 credit standards kept the U.S. homeownership rate fluctuating at about 64 percent of households, with the remaining 36 percent either uninterested in homeownership or unable to afford it or to qualify for the necessary loans. However, the lowering of credit standards to qualify for a subprime mortgage steadily raised the homeownership rate from 64 percent in 1994 to the all-time record of 69 percent in 2004. Given the estimated 110 million U.S. households, this increase means that an additional 4 million to 5 million new households became homeowners, many of whom would not have qualified for homeownership in the past. This increase helped to fuel the boom in construction and finance and contributed to the economic growth during this period.
With credit standards tightened to something closer to past standards, many of these households will again be excluded from the Housing market, and marginal borrowers who lose their houses through default and foreclosure are unlikely to return to homeownership anytime soon. Tightened credit standards will likely cause the homeownership rate to drift back toward the 64 percent of the recent past. In the process, approximately 4 million to 5 million owner-occupied houses could gradually come back onto the market, keeping downward pressure on home prices and new home construction and contributing to more defaults and foreclosures as a growing number of "upside down" borrowers choose not to remain homeowners.
While some may view this prospective outcome as unlikely or extreme, the U.S. homeownership rate had already fallen by 0.9 percentage points from its 2004 peak by the end of 2007 -- almost 20 percent of the distance back to the 1995 rate of 64.7 percent. This 0.9 percent decline in the homeownership rate represents about 1 million households eliminated from homeownership.
Possible Courses of Action: Good and Bad
With the near future likely to bring more housing market stress, it is essential that any federal and state remedies not exacerbate matters as some of the proposed (and implemented) policies would certainly do. Nor should they undermine the ability of moderate-income households to access mortgage credit and homeownership. Importantly, federal, state, and local policies should focus on facilitating the orderly transition to a Housing market that is characterized by lower prices and fewer owners. They should not attempt to prop up the current levels of both, which will be unsustainable without large taxpayer subsidies and continued instability.
Policies That Undermine a Lender's Security. Many proposals at the federal and state levels would compel borrowers and lenders to renegotiate the terms of the mortgage loan or would force such changes on a lender on behalf of a borrower. While some view these efforts as essential to avoid a costly foreclosure and loss of a home, such proposals could undermine the certainty of the contract between borrower and lender and thus reduce the credit available to less creditworthy borrowers because lenders would be unsure of their right of recovery in the event of a default.
Proposals that would create such uncertainty include those that would allow borrowers facing foreclosure to file for bankruptcy in the hope that a judge would compel the lender to change the loan's terms. For example, Ohio officials are urging lawyers in the state to offer defaulting borrowers pro bono services to fend off foreclosure, and a federal judge in Milwaukee is urging borrowers to join a class-action suit to cancel their loans for what may be minor errors in loan-related paperwork.
Federal Reserve Board Chairman Ben Bernanke's recent urging of lenders to reduce the principal owed by struggling borrowers to lessen the likelihood of foreclosure was viewed by many as unhelpful. Such recommendations could lead many investors, including those abroad, to believe that investment in a U.S. financial instrument is an even riskier proposition if leading government officials recommend the voluntary breaking of contracts. It could also create the moral hazard of encouraging struggling borrowers who are current in their payments to fall behind in order to become eligible for a reduction in principal and/or interest rate.
More regulation? A common response by many Members of Congress and the Administration is to impose greater (or different) federal regulation on all participants in the mortgage lending process in the misguided belief that a deficiency of federal regulations contributed to the current subprime problems. Yet, as the pre-1990 mortgage market demonstrated, the tight and cloying federal and state regulatory system in place at that time did not prevent a massive collapse of the Housing finance market in the late 1980s. Indeed, abundant evidence suggests that these regulations contributed to the collapse by preventing the savings and loans from establishing stable balance sheets. This collapse cost taxpayers about $130 billion.
More recently, anyone who has gone through a real estate settlement is familiar with the abundance of paperwork (and costs) associated with purchasing a home and acquiring a loan. This paperwork is the consequence of a host of federal regulations that have accumulated over several decades.
In the same vein, many of today's financial institutions that have suffered significant losses from the subprime problem (some of which stand accused of irregular lending practices) were federally chartered and subject to regulation and oversight by multiple federal agencies. Closer to home, the presumed intense federal oversight of Fannie Mae and Freddie Mac, the two major GSEs, did not prevent employees of either agency from engaging in massive accounting fraud in the early part of this decade. Nor did this intense oversight prevent them from incurring major losses (almost $9 billion in the second half of 2007) from bad mortgage investments in their most recent fiscal year.
While a careful review of the extant federal regulatory regime is certainly in order, any changes should be consistent with maintaining a free and open system that continues to serve those households that are capable of achieving homeownership and those investors and lenders who are willing to help them achieve their dreams. The history of federal mortgage finance regulation is largely one of costly failure. There is no rational reason to expect better results from more regulation in the future.
GSE Expansion. In March 2008, the Office of Federal Housing Enterprise Oversight (OFHEO) announced that it would permit Fannie Mae and Freddie Mac to invest a portion of OFHEO's directed capital surplus in MBSs and mortgages. In February, the OFHEO increased the dollar cap on the mortgages that they are permitted to purchase. The capital surplus change will allow these two GSEs to increase their mortgage purchases by up to $200 billion. The Federal Home Loan Banks, another GSE, will be permitted to invest up to $100 million in this expansion.
As structured, this expansion will do little to address the problem at hand and may hinder the recovery of struggling but still viable mortgage lending institutions. No restrictions limit how the two GSEs can invest their newly expanded portfolio limits, and any debt that they issue will be viewed by the market as government guaranteed. These two advantages will position them to cherry pick among the new, conforming first mortgages for the estimated 5.5 million homes that will be bought, sold, and financed this year by qualified buyers.
As the evidence indicates, qualified buyers seeking conforming loans have no problem obtaining credit these days, so this change may be largely negative because the GSEs will be competing unfairly with private lenders/investors for whatever little business is available. This will further undermine private lenders' and investors' revenues and profits when both are under pressure.
In addition, while this initiative is unlikely to ameliorate any of the manifest problems confronting the mortgage market this year, it will reverse several years of reform efforts to pare back the substantial influence that these two troubled GSEs exert on the financial markets. This proposal amounts to yet another significant and unnecessary federal intrusion into the nation's financial and Housing markets.
FHA Expansion. The Federal Housing Administration has been intimately involved in the subprime process, first as a part of the recent trend toward providing mortgage credit to borrowers of limited means by offering them risky no- or very low-down-payment mortgages to help them buy homes -- much as many subprime lenders were doing at the same time. A 2007 Government Accountability Office report on these new riskier loans stated:
In...examining FHA's actions to manage the new risks associated with the growing proportion of loans with down-payment assistance, we found that the agency did not implement sufficient standards and controls to manage the risks posed by these loans.... According to FHA, high claim and loss rates for loans of this type of down-payment assistance were major reasons for changing the estimated credit subsidy rate from negative to positive for fiscal year 2008.... [I]ncorporating the impact of such loans into the actuarial study of the Fund for fiscal year 2005 resulted in almost a $2 billion (7 percent) decrease in the Fund's estimated economic value.
The growing riskiness of the FHA's mortgages can also be seen in its sharply increasing default rates, which exceeded the default rate on subprime loans between 2003 and 2006 before subprime defaults surged ahead in 2007 to 18.82 percent, compared to 14.11 percent for FHA mortgages. With the Administration's Hope Now plan extending FHA mortgage refinancing opportunities to existing subprime borrowers under certain conditions, FHA default rates will likely rise over the next several years.
More recently, Representative Barney Frank (D-MA) and Senator Christopher Dodd (D-CT) have proposed using the FHA to refinance certain existing subprime loans at lower principal amounts and interest rates and to compensate existing mortgagees with cash payments to relinquish any claims on the borrowers. The plan is expected to cost America's taxpayers $20 billion to refinance up to $300 billion of subprime mortgages. To the extent that these new riskier, refinanced borrowers incurred high default rates that threatened the FHA's reserve fund, the taxpayers could be on the hook for even higher outlays.
Tax Subsidies. In addition to the many finance-related legislative proposals, a few Members of Congress have proposed offering generous tax credits ($5,000 to $15,000) to buyers who purchase certain types of homes -- including homes facing foreclosure and unsold, newly built homes completed before an earlier date -- to aid some builders who are holding unwanted inventory. The problem with these targeted approaches is that they largely concentrate the benefits on the more irresponsible participants in the market at the expense of those who acted responsibly.
Few responsible homebuilders build homes on speculation. Instead, they build only in response to confirmed sales supported by substantial deposits. With the new home market having peaked in 2005, any business building on speculation in 2007 deserves no sympathy or support from the taxpayer. With new home sales now deeply depressed, this plan would undermine responsible builders' efforts to survive by giving their less responsible competitors a taxpayer-funded advantage.
This proposal could also become extremely costly, especially if it is expanded to all sales in an effort to address the counterproductive inequities inherent in some of the existing plans. With home sales running at an annual rate of about 5.5 million units, the lost tax revenue from such an expansion would amount to about $27 billion per year.
Private credit Relief Facilities. Both Members of Congress and independent analysts have proposed the creation of a new federally funded and operated credit facility that would acquire troubled mortgages from a lender/investor, presumably at a discount, and then rewrite the terms of the mortgage to allow mortgagors to meet the payments and keep their houses. Such a facility would be modeled on the Home Owners Loan Corporation that was created during the Great Depression to perform a similar role.
While eligible but troubled mortgagors would presumably be limited to those who engaged in no fraud, misrepresentation, refinancings, or silent seconds, federal bureaucracies have a decidedly checkered record in exercising good judgment when evaluating credit risks. FHA borrowers have very high default rates that exceed the default rate on subprime mortgages in some recent years. Furthermore, federally sponsored GSEs have recently engaged in major accounting fraud and have lost billions of dollars in mortgage investments, despite regulations that limit them to the safer sectors of the market.
A better bet would be for the Treasury Department and the Federal Reserve to encourage the creation of private entities that would perform the same function, albeit with no taxpayer money. One source of funding might be all of the mortgage lending and investing institutions that would benefit from selling some portion of their holdings to such a facility. In this regard, it is worth noting that in their early days, Fannie Mae, Freddie Mac, and the FHLBB were capitalized and "owned" by their clients.
While some may contend that the potential risks are such that no private investors would be interested in such a proposal, former executives of a major mortgage lender have recently announced plans to raise $2 billion to buy distressed mortgages at a discount, restructure them, and resell them as performing mortgages at a profit. Other financial firms are looking to enter the same market. For example, the Private National Mortgage Acceptance Company (PennyMac) was created for just this purpose. Congress, the U.S. Treasury, and the Federal Reserve should look for ways to encourage the private sector to create many more such entities, including a review of relevant tax laws and regulations that may hinder their creation.
Limiting Aid to Restoring Property Rights and Affordable Housing. In some regions, home prices increasing much faster than personal incomes have been a chief cause of the overuse of risky forms of mortgage finance and the recent mortgage debt explosion, including the even faster growth in subprime mortgage debt. As a consequence, both prime and subprime borrowers have been forced to take on more debt than is sometimes prudent in order to become homeowners, while lenders have had to accept lower down payments to make the numbers work for the typical borrower.
Both the Administration and Congress have accommodated abusive land-use regulations that have caused this house price inflation. In many cases, the chief purpose of these regulatory abuses is to raise home prices as part of exclusionary zoning practices and to allow a community to "upgrade" its demographic profile by excluding lower-income residents.
Regrettably, by raising the loan caps on GSE lending and FHA mortgages, Congress and the Administration are accommodating and encouraging these land-use abuses, which will continue to make homeownership unaffordable for many moderate-income families. An important first step would be to rescind the loan cap increases and make their restoration contingent on reform of a region's land regulations.
Among the many risks confronting the United States is that many of the proposed relief measures would substantially and permanently expand the scope of the federal government while doing little to address the current financial crisis. Few will remember that, while the New Deal of the 1930s substantially and permanently increased the scope of the federal government, the process of federal expansion was well underway before Franklin Roosevelt took office in 1932.
Following the stock market collapse in October 1929, the Hoover Administration attempted to spend its way out of the Great Depression, increasing federal spending by 47 percent between 1929 and 1932. As a result, federal spending as a percentage of GDP increased from 3.4 percent in 1930 to 6.9 percent in 1932. By 1940, federal spending had reached 9.8 percent. During that period, many of the federal programs now being buffed up for expanded action -- Fannie Mae, the Home Owners' Loan Corporation, the FHA, the FHLBB -- were created for much the same purpose.
While this point of nostalgia has excited many advocates of an expanded federal government, ordinary citizens and taxpayers should note that, despite all of the new government spending and bureaucracy building, fewer Americans had jobs in 1940 than in 1929. Furthermore, the homeownership rate of 43.6 percent in 1940 was the lowest recorded by the Census Bureau, even below the 47.6 percent rate of 1890.
Ronald D. Utt, Ph.D., is Herbert and Joyce Morgan Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.