Set the Wayback Machine for Housing Finance Reform, But To When?

Brad Miller Headshot

The debate over housing finance is odd even by the current standards of political debate in Washington, which sets a high bar.

Proposals to limit government involvement in housing finance have nothing to do with the failings of the system, and certainly nothing to do with what went wrong in the financial crisis. The proposals are born of self-interest, dogma, self-interest masked as dogma, or perhaps political reality, but certainly not experience.

Fannie and Freddie were shareholder-owned corporations run for a profit when they came to grief and entered federal conservatorship. The two companies began, however, as government agencies that bought mortgages from banks so banks could lend more money and more families could buy homes. Fannie, the older of the two companies, can be traced to the New Deal.

Fannie was an experiment, not the product of dogma. “The country needs…and demands bold, persistent experimentation,” Columbia law alum Franklin Roosevelt said in his 1932 campaign for President. “It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something.” The method did not fail.

Before the New Deal, banks offered short-term balloon mortgages with daunting down payments and high interest rates. There was no secondary market of any consequence, so banks held mortgages in their portfolios. The mortgages were worse than illiquid: when balloons came due during one of the frequent financial crises, banks could not refinance even performing mortgages. Homeowners needlessly lost their homes and their down payments to foreclosure, performing assets became nonperforming assets for already-struggling banks, and the housing market collapsed until the mortgage market revived. Not surprisingly, relatively few families owned their own homes.

Fannie and Freddie changed all that. For almost 70 years the mortgage market was stable, liquid and affordable. Homeownership increased dramatically and became an important part of the financial security of millions of families. The two agencies set and enforced underwriting standards—debt to income, loan to value and the like. And mortgage terms were pretty standard, not “exotic,” so homeowners with Fannie or Freddie mortgages did not have to worry that predation lurked in the legalese.

Mark Zandi, a prominent economist, in 2002 described the two companies as “the most successful policy initiative ever undertaken by government.”

The two companies were “privatized” in the sixties. Both did well. In 2001, Fannie was 13 and Freddie was 18 on Fortune Magazine’s list of most profitable corporations.

By the nineties, however, Fannie and Freddie did not have the business of buying mortgages to themselves. Others in the financial industry, notably Wall Street banks, also bought mortgages and sold their own “private-label” securities backed by the mortgages, also quite profitably. From 2002 to 2006, the height of the housing bubble, Wall Street banks overtook Fannie and Freddie in the market that Fannie and Freddie invented and issued the majority of mortgage-backed securities.

“Subprime” mortgages, which were originally defined as mortgages that Fannie or Freddie would not buy, grew to 28 percent of all mortgages and were almost entirely predatory. More than 70 percent of subprime mortgages were refinances, not loans to purchase homes. Many families who otherwise had little in savings owned their own homes. If anything went wrong—illness, job loss, divorce, major home repairs—they had little choice but to borrow against their homes. The mortgages had an adjustable rate with a quick, automatic reset after just two or three years. The typical adjustment resulted in an increase in monthly mortgage payment of 30 to 50 percent, and 70 percent had prepayment penalties.

The mortgages trapped homeowners in a cycle of refinancing. Homeowners paid upfront costs and fees for the next mortgage and a prepayment penalty to get out of the last mortgage. Subprime mortgages stripped homeowners of the equity in their homes as the housing bubble inflated. Wall Street banks paid little attention to underwriting standards and bought mortgages on the assumption that the value of homes as collateral would continue to increase, and that any risk was borne by investors anyway.

For the industry and their political allies, subprime mortgages were the triumph of innovation that comes from unfettered capitalism.

William M. Dana testified at a congressional hearing on March 30, 2004, on behalf of the American Bankers Association. Dana said “the ABA believes that the development of the subprime market has been a positive development for American consumers.” Financial innovation “has made credit available to many consumers who had previously been left out of the marketplace,” he said. “The development of the subprime market has assisted those borrowers tremendously.”

“I need not remind my colleagues on the committee that Americans currently enjoy the highest rate of homeownership in the history of America,” Republican Congressman Hensarling said at a congressional hearing on May 24, 2005. “The benefits of free enterprise and competition have been plentiful. With the advent of subprime lending, countless families have now had their first opportunity to buy a home or perhaps be given a second chance. The American dream should never be limited to the well-off or those consumers fortunate enough to have access to prime loan rates.”

In fact, most subprime borrowers qualified for prime mortgages. Subprime lenders very aggressively marketed the mortgages to homeowners with substantial equity, especially in communities of color, and few borrowers understood the legalese of their “exotic” mortgages.

Fannie and Freddie hemorrhaged market share. If there is anything more mind-numbing than a PowerPoint presentation at your own office retreat, it has to be a PowerPoint presentation from someone else’s retreat. But there is a PowerPoint presentation from Fannie’s senior management retreat in 2006 that is as grimly fascinating as the cockpit recording of a doomed flight. They were worried that “if we do not seriously invest” in the subprime market, “we risk becoming a niche player, becoming less of a market leader, and becoming less relevant to the secondary market.”

Fannie and Freddie did not buy and securitize predatory mortgages, and their underwriting never sunk to the asset-only standards of the private-label securitization market. But to their eternal regret, Fannie and Freddie lowered underwriting standards, and bought private-label mortgage-backed securities issued by their Wall Street competitors for their investment portfolios. In the words of the PowerPoint, they decided on a “strategy…to say ‘yes’ to our customers by increasing purchases of sub-prime and Alt-A loans.”

The rest of the story is fairly well known. The private-label securitization market collapsed in 2007, when bubble burst. Vacant foreclosed homes stigmatized neighborhoods and priced-to-sell foreclosed homes flooded real estate markets. The decline in home values became a rout.

Fannie’s and Freddie’s regulator took the two companies into conservatorship on September 6, 2008.

The private-label securitization market has never revived. In 2013, Fannie and Freddie, both still in conservatorship, issued 99 percent of new mortgage-backed securities. With high underwriting standards and no competition, the two companies are once again very profitable. Fannie and Freddie have now paid the government $34 billion more than they received in the crisis, and are not finished.

The lesson of experience, therefore, is that for the vast majority of Americans, the housing finance system was a spectacular success when dominated by government agencies acting for the public good and a catastrophic failure when dominated by Wall Street in pursuit of profit. Republicans and Democrats alike, however, now favor “reform” to reduce the role of government and “bring back private capital” to the private-label securitization market. Many proposals would hand Fannie’s and Freddie’s profitable business to Wall Street along with cheap government reinsurance against catastrophic losses, and do little to support affordable housing.

In short, many proposals for housing finance set the Wayback Machine to 2005. For Wall Street banks, it would be a return to the glory days of housing finance, only with less competition and even more taxpayer subsidies.

Those days were not so glorious for homeowners and investors, however.

Investors got mugged in the private-label securitization market once. The patent conflicts of interest that were celebrated a decade ago as “synergy” gave banks little incentive to act in investors’ best interests. In private-label securitization, the bank that issued mortgage-backed securities hired a trustee, usually another bank, which hired a servicer, which was usually a subsidiary of the bank that hired the trustee. The investors’ contract is with the trustee, and required precious little of the trustee. Investors’ remedies were frustratingly inadequate.

Without reform, investors will likely return to the private-label securitization market only at interest rates disadvantageous to homeowners.

Perhaps we should set the Wayback Machine further back. Perhaps we should aim for policies that create a stable, liquid and affordable mortgage market, so middle-class families can own homes and build wealth.

The private-label securitization market could still compete or fill market niches, but with consumer protections and without obvious conflicts of interest. Trustees and servicers would have a fiduciary duty to put the interests of investors ahead of their own. Trustees would have an enforceable duty to supervise the work of servicers diligently, and hold servicers accountable. Trustees would have an enforceable duty to require lenders to buy back mortgages that were not what lenders promised. Investor protections would protect homeowners, and homeowner protections would protect investors.

For most Americans, that would be the return to the glory days of housing finance.

This post comes to us from Brad Miller (Columbia JD 1979). Miller is now a Senior Fellow at the Roosevelt Institute, and Of Counsel at Grais & Ellsworth LLP, which represents plaintiff-investors in mortgage-backed securities litigation. He represented North Carolina in Congress from 2003 to 2013. Congressman Miller served on the House Financial Services Committee and was principal House sponsor of legislation to regulate subprime mortgages and to create the Consumer Financial Protection Bureau, both of which were enacted as part of the Dodd-Frank Act.

3 Comments

  1. thombiz

    The Treasury is following it’s steadfast plan to wind down Fannie and Freddie and put them into receivership which will eliminate them. The Treasury is not to be trifled with, so Congress…”KEEP YOUR DAMN HANDS OFF of the Treasury”!

  2. Bill Maloni

    Excellent commentary, Congressman (they never lose the title!), but it is heavy slogging in the Congress these days.

    Very few people (even many Democrats) want to accept the positive story and operations of F&F, not remembering past the 2008 Debacle.

    The legitimacy of those government actions, in that tempestuous period, still are up in the air and imbedded in more than 20 lawsuits against the US Treasury and Fannie’s and Freddie’s regulator.

    Both political parties and the Obama White House seem content to kick this can down the road and hope the Courts or some future Admin and Congress will make it right.

    I see no “Profiles in Courage” on the Hill these days or even practical good sense, just mindless buzz words and epithets

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