Politicians, regulators and lenders still have much to learn from a period dominated by the "affordable housing" ideology.
A full understanding requires a careful analysis of its impact and the role played by Fannie and Freddie in the Clinton and Bush era. They still pose a risk in view of the huge number of subprime loans they insure. They are only in conservatorship, and could be resurrected, out of control in a new life, subject to the whims of a government's housing policy, as before. Politicians have ducked decisions about their future, although the time for decisions is approaching. The Treasury has only agreed to invest whatever is necessary to maintain GSE solvency until Dec. 31.
It took just thirteen years to wreck the U.S. housing market with destabilising effects for the rest of the world.
It began in 1995, when President Clinton announced his National Home Ownership Strategy, aiming to extend home ownership to another 8 million families by 2000, to reinforce family values, without costing "any extra tax money." The "affordable housing" ideology came into being. Lenders would be "encouraged" to provide mortgages for everyone, by adopting "flexible underwriting" standards.
The Federal Reserve Bank of Boston's "Guide to Equal Opportunities Lending" set out what this meant. Down payments could be funded through gifts or loans from nonprofit agencies. A record of paying utility bills or rent on time could be substituted for a credit score; income could be welfare, unemployment benefits or child support. This was Richard Syron's solution, when he was the Boston Fed's President, long before he became the chief executive of Freddie Mac. Loans made to such borrowers were subprime but the regulators did not recognise them as such or the inherent risks until 2007, by which time it was too late.
President Clinton's autobiography refers to the changes made to the Community Reinvestment Act in glowing terms, because between 1993 and 2000, banks lent over $800 billion in mortgages to low-to-moderate income families, over 90% of all the loans in the 23 years of the Act. Banks were "encouraged" to comply, because the Riegle-Neal Act came into force at the same time. Banks that wanted to merge with or acquire banks in another state had to have an "outstanding" (publicly disclosed) rating, in terms of the proportion of loans to low-to-moderate income groups. A spate of mergers and acquisitions followed, since the banks often agreed to commit millions of dollars to affordable-home loans in low-income areas or to minority communities.
The Department of Housing and Urban Development, as the "mission regulator" of Fannie Mae and Freddie Mac, set the targets for the purchase of mortgages for low -to -moderate income groups, special affordable-housing groups and those in underserved areas. These targets were set for three years at a time, beginning in 1996. They were increased every three years, reaching 57% in 2008 for low-to-moderate incomes, and for special affordable goals, 27%. The GSEs were shareholder-owned, profit-seeking corporations, but were obliged to fulfil HUD's public policy purposes. They did not make loans, but bought loans made by mortgage originators.
James Johnson, CEO of Fannie during the 1990s, made a $1 trillion commitment for targeted housing finance for 10 million poor families. His successor, Franklin Raines, introduced the Flexible 97 product (a 3% down payment) and the Flex100 Home Purchase Loan. Freddie Mac introduced the Homes Possible 100, followed by frequent announcements of new "mortgage products," spelling out to lenders the kind of loans the GSEs would purchase. Fannie also entered into partnerships with a wide range of lenders, including Countrywide Financial. More and more subprime mortgages were included in their MBSs, and then sold to U.S. commercial banks, insurance companies, mutual funds, thrifts and foreign private investors with triple-A ratings, owing to the belief in an "implicit" government guarantee.
This belief enabled the GSEs to borrow cheaply from a wide range of investors, including foreign central banks, and then make a profit on their guarantee fees. The triple-A rating could not reflect the quality of the loans, constituting their MBSs. By 2008, about 26 million out of the 55 million mortgages outstanding were subprime. That estimate is supported by various analyses, such as Ed Pinto's forensic study of government housing policy in the run-up to the financial crisis. It also follows from the reckless departure from safe underwriting standards, which the goals set for loan purchases by Fannie and Freddie by HUD inevitably required.
From mid-2006 onwards, falling house prices, higher interest rates and a rising tide of defaults undermined price discovery. Banks throughout the world could not assess the quality of the assets held by other banks, and so were unwilling to lend to each other. Fannie and Freddie had to be bailed out and then taken into conservatorship, where they still guarantee $5. 2 trillion of U.S. mortgages. Together with other credit programs, the government loan guarantees $7.9 trillions, 52% of GDP in 2011, but they are not included in the current administration's budgetary considerations.
Nothing has been done about Fannie and Freddie' future. They should be phased out over a set period of years. They are surplus to requirements. Other advanced markets function well without such institutions and do not require a single securitization platform. Regulators, having focussed their attention on how to prevent banks which are "too big to fail" from failing in the future, should turn their attention to the ultimate cause, bad lending. Sound underwriting practices should be reintroduced and enforced, replacing the disastrous affordable housing ideology.
Oonagh McDonald is a former member of the U.K. Parliament, and a former board member of the Financial Services Authority. This article is adapted from her book "Fannie Mae and Freddie Mac: Turning the American Dream into a Nightmare."