- History has demonstrated that political pressures are likely to degrade sound lending practices over time.
- Stable housing markets depend on the preponderance of loans being low risk.
- AEI's International Center on Housing Risk will continue to monitor the government's push for looser lending standards.
As the United States continues to recover from the 2007 housing collapse, it is necessary to reflect back on the government’s involvement in the housing finance industry. History has demonstrated that political pressures are likely to degrade sound lending practices over time, and that no objective measure exist to track the associated risks.
- In 1934 FHA examined lending practices during the stress period from 1926 to 1933. It determined that loan-to-value (LTV) ratios had been excessive, second mortgages had allowed homebuyers to acquire homes with minimal equity, and high borrower debt-to-income (DTI) ratios left many borrowers with a diminished ability to make their payments. In response, FHA established a minimum down payment of 20%, a requirement of good to excellent credit, a maximum loan term of twenty years, and a low debt-to-income ratio, taking into account residual income. The return to sound standards resulted in two decades of low default rates.
- When the US economy entered recession in 1957, Congress reduced the FHA’s down payment requirement from 15 percent to 3 percent. By the 1960s this shift from relatively low credit risk to much higher risk resulted in a dramatic increase in FHA defaults. Further credit loosening took place in the mid- to late-1960s as a result of congressionally authorized no-money down programs targeted at low-income borrowers. By the 1970s, the least sound practices were curtailed or ended; however, FHA’s claim rates remained permanently elevated as most FHA loans were now medium to high risk.
Fannie Mae in the 1980s:
- During the high interest rate period of the early 1980s, Fannie Mae reduced its underwriting standards in order to obtain upfront fee payment on lower quality mortgages. These changes resulted in losses on loans acquired between 1981 and 1984. In 1985 Fannie Mae examined these defaults and determined defaults were driven by the same factors identified by FHA in 1934. Accordingly, Fannie re-established the traditional underwriting standards in place in earlier years.
2007/2008 Financial Crisis:
- Beginning in the mid-1990s, the Department of Housing and Urban Development (HUD) set new affordable landing standards for government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac. In response, GSEs expanded lending and guarantees to higher risk borrowers. Over the next decade, homeownership rates jumped, GSEs increased their market share by 250 percent and by 2002, Freddie Mac’s higher-risk loans comprised 45 percent of its annual business.
- The private sector followed, deepening private mortgage-backed securities markets and extending credit to still more high risk borrowers. GSEs encouraged this trend by guaranteeing millions of risk-laden private sector loans. Home-price bubbles—where home prices become unmoored from rental values, construction costs, and income growth—soon developed in response to this demand. The trend was not sustainable and financial entities holding risky loans were ill-equipped to cope with the losses. Housing prices plummeted, the mortgage market collapsed, and the resulting recession evaporated $16 trillion in American wealth. Policy responses, including the Dodd-Frank Act and Basel III, attempted to re-establish sound lending standards and boost the capital reserves held by financial institutions.
Stable housing markets depend on the preponderance of loans being low risk—i.e. loans that are unlikely to default even under stress. The International Center on Housing Risk’s National Mortgage Risk Index aims to provide objective, transparent, and real-time information about the impact of the government’s push for looser lending standards on the overall risk in the mortgage market.
Edward J. Pinto is a Codirector of AEI’s International Center on Housing Risk.