How Serious Is the Mortgage Problem That Will Confront President Obama?
About This Event

Since the mortgage meltdown began in the summer of 2007, many observers have commented that government policy has seemed to lag events. Predictions about the scope of the problems in the housing and mortgage markets, and particularly how they might affect the health of the financial system, have consistently been Listen to Audio

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too optimistic. One of the reasons for this is the difficulty of obtaining accurate information, even for policymakers. Fannie and Freddie, for example, have been making subprime or other nontraditional loans for at least a decade but reporting them as prime loans. These loans total approximately $1.6 trillion. As a result, 44 percent of all loans, or a total of 25 million loans, are outstanding subprime and other nontraditional loans--more than double what anyone understood at the beginning of the mortgage market collapse. Edward Pinto, a former chief credit officer for Fannie Mae, has done an extensive study of the scope of the mortgage problem and will report at this conference on what President Barack Obama will confront when he takes office on January 20.

1:45 p.m.
Edward Pinto, financial services industry consultant
Alan Boyce, Absalon
Jay Brinkmann, Mortgage Bankers Association
Paul Miller, Friedman, Billings, Ramsey Group
Peter J. Wallison, AEI
Event Summary

WASHINGTON, JANUARY 30, 2009--Before policymakers can begin to craft legislation to address the declining mortgage and housing markets, it is essential that they understand the scope of the problem that they are trying to fix. At an AEI conference on January 16, Peter J. Wallison noted that everyone--from policymakers and private-sector leaders to the stock market itself--seems to have underestimated, and continues to underestimate, how large the dollar amount and number of subprime and Alt-A mortgages really are.

One factor that significantly contributed to public misinformation about the scope of the nonprime mortgage market, Wallison explained, was the fact that Fannie Mae and Freddie Mac consistently reported all of their risky loans as prime loans from the early 1990s through 2007. Because they were seen as backed by the U.S. government and were exempt from reporting to the Securities and Exchange Commission for most of this period, few people had an interest in investigating the contents of their portfolios.

Recently, Edward Pinto, a former chief credit officer for Fannie Mae, undertook a study of the size of the GSEs' subprime and Alt-A portfolios. He presented his findings at this conference. Pinto stated that out of the 57 million mortgages in the United States, approximately 25 million--44 percent--are nonprime, more than double the estimates prior to 2008. Aggregating the loans made by Fannie, Freddie, and the Federal Housing Administration, "the government has its hands in more than half" of the extant nonprime loans, he said. Moreover, many of these loans were initiated in 2005, 2006, and 2007, making this portfolio "generally unseasoned . . . compared to the rest of the marketplace." This quality may pose significant problems for policymakers in the coming years if these loans default or foreclose at a higher rate than other, less risky, portfolios.

Certain economic, political, and social conditions created an environment that encouraged the growth of the subprime and Alt-A sector over the past decade and a half. Pinto attributed the nonprime explosion to a growing tolerance for loosened lending standards, increased leverage in the mortgage finance industry, extremely high loan-to-value and combined-loan-to-value ratios, and very low interest rates imposed by the Fed. Alan Boyce of Absalon elaborated: "It doesn't help that everyone's behavior was encouraged by politicians, the press, regulators, etcetera. Investors couldn't get enough risk."

This housing euphoria led home prices to spike in 2007; they later declined about ten percent through October 2008 and are now falling at about one percent per month. Pinto estimated that this declining trend will continue for at least the next year and that house prices will ultimately have to drop 24-30 percent from their peak before they return to normal. "The challenge for President Obama," Pinto explained, "is that we're facing an environment that is in many ways more challenging than the situation that was faced in the 1930s. The vast majority of delinquent loans are upside-down in terms of loan-to-value." Paul Miller of the FBR Group added, "I'm not going to say that we're heading for a depression, but it sure feels that way. . . . You can pretty much bet that the banking system in general is insolvent."

How can we get out of this deepening crisis? "The only way to undertake a loan modification program is to create sustainable loans that preserve and build up homeowner equity," Pinto said. "Existing programs do not do this." Indeed, recent reports from the comptroller of the currency observe that over 60 percent of loan modifications are defaulting within eight months of being adjusted. Future programs must focus on shoring up the "three C's"--collateral, credit, and capacity to pay--so that the market can finally find a floor under housing values.

Jay Brinkmann of the Mortgage Bankers Association suggested that assistance programs need to be targeted to specific geographic regions, especially the "sand states" of California, Florida, Nevada, and Arizona, which have been setting the national average for foreclosure rates for every type of loan. He worried that prime loans in these states would underperform subprime and Alt-A loans in other states. Brinkmann also recommended that, in the future, Fannie and Freddie should be responsible for looking at the macroeconomic effects of their lending decisions. Because they own or interact with such a large share of the mortgage market, they are in a unique position to take a global view of industry trends.

Miller and Boyce agreed that regardless of what steps the Obama administration takes, it must implement policies immediately. "Until the government makes that step," Miller said, "we're just going to go from crisis to crisis until the point that the government slowly takes over the entire financial institutions of this country. . . . Obama has to deal with the housing market, but first he has to deal with the insolvency of the financial system, and he has to do it [sooner] rather than later."


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