The current financial crisis began with the collapse of Fannie Mae and Freddie Mac in July. The dominant institutions in the American mortgage market, and among the most powerful institutions politically, became wards of the government in a matter of weeks. What was their fatal flaw?
One popular explanation, often advanced by the GSEs themselves, is their “affordable-housing goals.” In 1992, as part of the Federal Housing Enterprises Financial Safety and Soundness Act, Congress required the GSEs to devote some of their mortgage purchases to housing for families in the lower half of the income distribution, and also to families living in areas considered to be “underserved.” Housing for both homeowners and renters is included. Specific percentage targets were set on a transition basis; the U.S. Department of Housing and Urban Development was required to revise the targets periodically, by regulation, which it has done three times (1996, 2001, and 2005).
The law requires HUD to set goals on the basis of the kinds of mortgages the GSEs actually buy — their market — and the importance of lower-income borrowers and underserved areas in that market. Research in the late 1990s showed that the GSEs were already buying the better-quality subprime mortgages (known as “A-minus” loans, as opposed to “B and C”) and also low-documentation loans (“Alt-A”), so the goals in 2001 and 2005 included these loans as part of their market.
The goals are then set as percentages of the loans the GSEs actually buy; during 2001-2004, for example, out of every 100 loans they purchased, 50 were supposed to be for homeowners and renters in the lower half of the income distribution. This may sound high, but in those years other lenders, making loans to the same kinds of borrowers as the GSEs, made more than 57 percent of their loans to lower-income families. Effective in 2005, the goal was raised to 52 percent, with a further increase to 53 percent for 2006.
The affordable-housing goals are a wonderful excuse. They let the GSEs off the hook and shift the blame to the Bush administration, at the same time diverting attention from the refusal of congressional Democrats to allow stronger regulation of Fannie and Freddie after their accounting scandals surfaced in 2003. The goals are even blamed by some conservatives, who see them as credit allocation, and overlook the special privileges conferred on the GSEs by their federal charters which create something close to a federally sponsored duopoly in the mortgage market.
But this convenient explanation doesn’t fit the facts.
The GSEs began buying subprime mortgage-backed securities (MBS) heavily in 2002. Their purchases of sub-prime MBS doubled between 2002 and 2003, and doubled again in 2004 — from $38 billion to $81 billion to $176 billion. All this happened before the housing goals were changed in 2005.
After the new goals went into effect, their subprime MBS purchases actually declined. Their share of the subprime MBS market followed the same pattern: It went up before the goals were changed, and dropped afterward. The GSEs were buying half of all subprime MBS in 2003, and only 20 percent by 2006. Essentially, what happened is that the market for subprime MBS took off in the early years of the decade, and the GSEs went with the market for a few years, then began pulling back.
The GSEs also relaxed their underwriting standards generally in the early years of this decade, as reported in a new analysis by HUD staff economists. They began making significantly riskier loans to homebuyers beginning in 2002, offering larger loans to families with a given income level. They took still more risk in 2003. Again, this is before the goals were changed, not after.
For homeowners who refinanced their mortgages, the GSEs relaxed their standards to a much greater extent, beginning in 2002 and continuing through 2006. This is particularly relevant because refinances are less likely to count toward the affordable-housing goals; in general, homebuyers have lower incomes than homeowners who are refinancing, and homebuyers are more likely to live in “underserved” areas. The GSEs often pointed out that the refinance boom of the early 2000s was making it harder to meet the goals. If they felt the new goals were creating a problem, they would have relaxed their standards more for home purchase loans and less for refinances.
(Here also the GSEs were not alone. Other lenders started to take more risk in 2002, and relaxed their underwriting standards more for refinances.)
If the affordable-housing goals don’t account for the GSEs’ behavior, what does? The best explanation is the simplest: The GSEs badly misjudged the risk of subprime mortgages. So did other lenders. But the GSEs — because they were bigger, were required to hold less capital, and carried the implicit backing of the U.S. government — took the biggest risk and had the biggest fall.