Free fall: How government policies brought down the housing market

Article Highlights

  • Intrusive and misguided government housing policies were responsible for the mortgage meltdown.

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  • Average homeowner has only 7 percent equity, down from 45 percent in 1990.

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  • US government plays most significant role in housing policy of any developed country.

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Free fall: How government policies brought down the housing market

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The US housing market is in serious trouble, far worse than in almost any other developed country. Since 2006, housing prices have fallen 30 to 40 percent in most areas; millions now owe more on their mortgages than their houses are worth, and millions more have only slivers of equity. The average homeowner today has 7 percent equity in his or her home, versus 45 percent as recently as 1990. The private housing finance system has virtually disappeared, and the government system that remains is pursuing the same policies that produced the current problems. The affordable housing goals imposed on Fannie Mae and Freddie Mac in 1992 were the major contributors to both the deterioration in underwriting standards between 1992 and 2008 and the growth of an unprecedented ten-year housing bubble that suppressed delinquencies and stimulated the growth of a private securitization market for subprime loans. But other government policies are also to blame for the deterioration in the US housing market, including the thirty-year fixed-rate mortgage, the mortgage interest tax deduction, the right to refinance without penalty, and the Community Reinvestment Act. Until Fannie and Freddie’s market dominance and the government’s role in the housing finance system are substantially reduced or eliminated, the United States will continue to have an inferior and unstable housing market.

Key points in this Outlook:

  • Today, the United States has the most troubled housing market in the developed world. It’s also the only developed country with a major government role in housing policy.
  • In less than twenty-five years, “affordable housing” and other housing policies have turned a healthy market into a financial ruin. In 1989, for example, only 1 in 230 homebuyers made a down payment of 3 percent or less; by 2007, it was 1 in 3. Meanwhile, average home equity plunged from 45 percent to 7 percent. 
  • The policies that caused the financial crisis are still in force. Until they and the government’s role in housing are eliminated, the US housing market will not return to health.


Most of the discussion about the role of government housing policies in the mortgage meltdown and the subsequent financial crisis has focused on the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac and the effect of the affordable housing (AH) goals in creating demand for subprime and other risky loans. By 2008, before the US financial crisis began in earnest, 28 million such loans were outstanding in the United States—half of all US mortgages—and 74 percent of them were on the books of government agencies or government-backed or -regulated entities. Fannie and Freddie were by far the largest source of demand for these loans, but the AH goals were only one element in a series of government housing policies that were key factors in the financial crisis and the subsequent depression in the housing market. Cumulatively, these policies have had a devastating effect on the overall health of the US housing system.


The United States is the only developed country with a significant government role in housing policy. Most other countries leave housing finance largely to the private sector, have less volatility in housing starts and house prices, and do not suffer the recurring crises characteristic of the US market. Nor does the United States, for all the funds it has lavished on housing, have a particularly high homeownership rate, although US housing policies have for many generations focused on increasing homeownership. In a recent presentation that compared US government housing policies with those of fifteen developed European Union countries, Dwight Jaffee found that the United States ranked eighth in homeownership and had the third-highest mortgage rate in relation to the applicable risk-free rate. These housing markets were also more stable than the US market and had lower mortgage default rates.[1] 

Without government interference, a private US market would offer homeowners interest rate reductions for substantial down payments, limits on refinancing, and more rapid amortization—features that borrowers would find desirable. The results would be more home equity, lower leverage, lower interest rates, and greater stability in downturns. These features of private markets account for the healthier and more stable housing markets in Europe.

"The United States is the only developed country with a significant government role in housing policy."Instead, the US housing market today exhibits a large number of unhealthy conditions, almost all a direct result of government housing policies. These include disastrously low levels of home equity, government policies that continue to promote low-quality loans, mortgage-backed securities that are unattractive to long-term investors, a dysfunctional appraisal system, procyclical bank capital regulation that subsidizes excessive mortgage investment, millions of defaulted but unforeclosed mortgages, a new and overly complex regulatory structure in the Dodd-Frank Act for residential mortgage lending, and a series of advantages for a continued government role in the housing market that will make reviving a private mortgage financing market highly improbable.

We have outlined many of these ills in prior Outlooks.[2] In this piece, we will look at the ways US government policies, by degrading many elements of what had once been a healthy and well-functioning system, have left the US housing market in serious trouble.

Government Policies That Reduce Home Equity and Promote High Leverage

One of the most familiar, and popular, government policies is the mortgage interest deduction, which allows homeowners to deduct from their taxable income the interest they pay on mortgages and home-equity loans. The benefit extends only to the minority of taxpayers who itemize their deductions and thus is not available to those who take the standard deductions or the 45 percent of the population who pay no income taxes at all. In 2009, one in four taxpayers itemized mortgage interest, accounting for about two-thirds of the mortgage interest paid by all borrowers.

Under this policy, in the midst of the housing bubble that developed between 1997 and 2007, homeowners could borrow against the inflated equity in their homes, deduct the interest on these loans (unlike with any other personal loans), and spend the money on vacations and other baubles. When the bubble deflated, many of these homeowners found themselves without any significant equity in their homes and deeply in debt. Since 1986, residential mortgage debt has increased from 39 percent of gross domestic product to 50 percent in 1999 and then to 75 percent in 2007.

The deductibility of mortgage interest goes hand-in-hand with the thirty-year fixed-rate mortgage. This loan, which—unaccountably—is still lauded by consumer advocates, maximizes interest deductibility in the early years of loan amortization. This might make sense if most homeowners stayed in their homes for thirty years. Because most of early mortgage payments go to interest, deducting the interest would help young families during their peak spending years, with deductions gradually decreasing as they grew older, earned more, and had fewer expenses. But, on average, families stay in their homes for only seven years, so when they move to a new home they have accumulated relatively little equity in their previous residence and thus have little to contribute to the new one.

One of the lessons we thought we learned from the mortgage meltdown and resulting financial crisis was that homeowners—like financial institutions themselves—had become too highly leveraged. Yet consumer advocates and members of Congress still seem to believe that the whole purpose of the government housing finance system is to retain the thirty-year fixed-rate mortgage. A fixed-rate fifteen- or twenty-year mortgage would be a much better loan to encourage. It would amortize more quickly, build equity for homeowners, and be less risky for lenders.

Other policies that encourage equity stripping are refinancing mortgages without penalty—another benefit treasured by consumer advocates—and cash-out refinancing. The GSEs’ promotion of thirty-year fixed-rate loans without prepayment penalties led to mass refinances when interest rates declined in the early 2000s. Although refinancing without penalty enables homeowners to reduce the interest rate on their mortgages, it also increases lenders’ risks and thus raises interest rates for all mortgages. It is also a particular benefit for the well-to-do, who have the financial sophistication and lending sources to take advantage of refinancing opportunities.

Sophisticated financial players have always preferred to acquire prime loans to low-income borrowers because these borrowers did not have the financial wherewithal to refinance as frequently. Refi- nancing without penalty is one reason why US mortgage rates are higher than those in the European Union, despite the US government’s willingness to take mortgage credit risks through the GSEs, the Federal Housing Administration (FHA), and others. In addition, refinancing without penalty enables borrowers to restart another thirty-year fixed-rate mortgage term, with low amortization of principal in the early years—another contributor to high leverage and low equity in US homes.

"The most significant effect of the government's direct role in housing policy was its contribution to the massive housing bubble that developed between 1997 and 2007."Cash-out refinancing permits homeowners to take equity out of homes when they refinance, often leaving them without equity when housing prices decline. During 2003, equity extraction totaled $400 billion, with over $700 billion extracted in each of 2004 and 2005. Although housing prices rose sharply during the ten-year housing bubble between 1997 and 2007, the increased value of homes was largely illusory; when the bubble collapsed and housing prices returned to normal trend levels, millions of homeowners who had engaged in cash-out refinancing found themselves “underwater,” their homes worth less than their mortgage debt, while millions of others had only a small amount of equity. According to a recent article in American Banker, the average loan-to-value (LTV) ratio of all mortgages in the United States today is 93.3 percent, which means that the average US homeowner has less than 7 percent equity in his or her home. As recently as 1990, US home equity was 45 percent.[3]

Government Housing Policies That Weakened Underwriting Standards

Other government policies were designed to increase homeownership, primarily by reducing mortgage underwriting standards. The most important of these policies were the AH goals enacted in Title XIII of the Housing and Community Development Act of 1992 (the “GSE Act”).[4] The GSE Act, and its subsequent enforcement by the US Department of Housing and Urban Development (HUD), set in motion a series of adverse changes in the structure of the US mortgage market and more particularly the gradual degrading of traditional mortgage underwriting standards.

The AH goals required Fannie and Freddie to meet certain quotas when acquiring mortgages. The GSE Act had initially specified a quota of 30 percent; that is, 30 percent of the GSEs’ mortgage purchases had to be loans that were made to low- and moderate-income (LMI) borrowers, defined as borrowers at or below the median income in their communities. During the Clinton administration, HUD increased this quota to 42 percent in 1995 and 50 percent in 2000. HUD’s tightening continued in the George W. Bush administration so that by 2008 the main LMI goal was 56 percent, and a special affordable (SA) subgoal had been added requiring that 27 percent of the loans GSEs acquired be made to borrowers who were at or below 80 percent (and, in some cases, 60 percent) of the median income in their communities.

The initial 30 percent quota was not burdensome for the GSEs. In 1993, for example, Freddie Mac was able to meet the 30 percent quota by acquiring the prime loans that it traditionally purchased from originators. In the same year, 7 percent of its purchases met the SA subgoal. But the GSE Act required HUD to promulgate a new set of goals beginning in 1996, and HUD’s tightening of the AH requirements beginning in that year and continuing through 2008 forced the GSEs to seek loans of less than prime quality. For example, when HUD’s new AH goals for 1996 were released in late 1994, Fannie and Freddie reduced their down payment requirements to 3 percent, and by 2000—after HUD announced plans in 1999 to raise the AH goals to 50 percent—they were acquiring loans with no down payments at all.

HUD made no secret of its intentions, then or since, to reduce underwriting standards and elide the differences between prime and nonprime mortgages.[5] As HUD observed when raising the AH goals to 50 percent in 2000:

Because the GSEs have a funding advantage over other market participants, they have the ability to under price their competitors and increase their market share. This advantage, as has been the case in the prime market, could allow the GSEs to eventually play a significant role in the subprime market. As the GSEs become more comfortable with subprime lending, the line between what today is considered a subprime loan versus a prime loan will likely deteriorate, making expansion by the GSEs look more like an increase in the prime market.[6]

In terms of their later effects, the AH goals were clearly the most consequential of the government’s housing policies. HUD succeeded in moving the GSEs away from their policy of acquiring only prime loans. As the agency well knew, it was difficult to find prime loans when at least half of all loans the GSEs acquired had to be made to borrowers at or below the median income in their communities. Borrowers in this category seldom had significant down payments; they also had low credit scores, high debt, and uncertain employment prospects. Large numbers of nonprime loans would increase homeownership but risk major losses in the future.

Nevertheless, by 2008, before the financial crisis, Fannie and Freddie—in complying with the AH goals—either held or had guaranteed 13.4 million subprime or other nonprime mortgages; the government as a whole—including the FHA and other institutions controlled or regulated by the government—held or had insured over 20 million similar nonprime mortgages. This amounted to 74 percent of the 28 million nonprime mortgages present in the US financial system before the financial crisis.[7] When these loans began to default in unprecedented numbers in 2007 and 2008—an effect later called the “mortgage meltdown”—they weakened the financial institutions that held them as investments and brought on the financial crisis.

But HUD did not stop with the GSEs. It also harnessed the FHA and various private firms in an effort to reduce underwriting standards. In 1994, for example, HUD began a program to enlist other members of the mortgage financing community in an effort to increase low-income mortgage lending. In that year, the Mortgage Bankers Association—a group of mortgage financing firms not otherwise regulated by the federal government and not subject to HUD’s legal authority—agreed to join a HUD program called the Best Practices Initiative.

This program involved “Fair Lending Best Practices” agreements that HUD described as follows: “The Agreements not only offer an opportunity to increase low-income and minority lending but they incorporate fair housing and equal opportunity principles into mortgage lending standards. These banks and mortgage lenders . . . serve as industry leaders in their communities by demonstrating a commitment to affirmatively further fair lending.”[8] HUD used the terms “equal opportunity principles” and “fair lending” as euphemisms for reduced underwriting standards or low-income borrowers.

In 1995, expanding the idea in the Best Practices Initiative, HUD issued a policy statement titled “The National Homeownership Strategy: Partners in the American Dream.” The first paragraph of chapter 1 leaves no doubt about what HUD had set out to do: “The purpose of the National Homeownership Strategy is to achieve an all-time high level of homeownership in America within the next 6 years through an unprecedented collaboration of public and private housing industry organizations.” The paper then made clear that reducing down payments would increase homeownership: “Lending institutions, secondary market investors, mortgage insurers, and other members of the partnership should work collaboratively to reduce homebuyer downpayment requirements. Mortgage financing with high loan-to-value ratios should generally be associated with enhanced homebuyer counseling and, where available, supplemental sources of downpayment assistance.”[9]

HUD’s policy was successful. In 1989, only 1 in 230 homebuyers bought a home with a down payment of 3 percent or less, but by 2003, 1 in 7 buyers was providing a down payment at that level and by 2007, the number was less than 1 in 3.[10] The program’s contribution to the reduction in home equity and the subsequent increase in leverage is obvious.

"The GSEs' government-enabled dominance in the housing finance market allowed them to become the de facto standard setters."HUD also used the FHA, a government mortgage insurance agency it controlled, to lead the way in reducing underwriting standards. Established in 1934 to assist the housing market during the Great Depression, the FHA was originally a prime-quality lender but found its niche in later years as the government’s principal agency for assisting low-income housing. As such, HUD was a natural competitor for the GSEs as they began to implement HUD’s enhanced AH goals, and it appears that HUD used the FHA to lead the GSEs toward reduced down payments.

In 1993, for example, shortly after the goals were adopted, the FHA began to increase the percentage of its loans that involved down payments of less than 3 percent; these went from 13 percent in 1992 to 28 percent in 1996. From there, they rose sharply to more than 50 percent in 2000, coinciding with another increase in the AH goals. After that, the FHA’s percentage of these risky loans began to decrease as the GSEs—which were off-budget enterprises—took on more of the risky loans necessary to meet the increasing AH goals.

For a time, as the GSEs expanded their loan purchases, the FHA became less important for assisting growth in homeownership. Recently, however, as their conservator has tightened the GSEs’ lending standards and reduced the effect of the AH goals, the FHA has increased its market share of home purchase loans, from 8 percent in 2007 to 43 percent in 2010.[11] In other words, the current administration is no different from the last two, which were willing to reduce the underlying equity in housing to spur home sales—an adverse trade-off between short-term objectives and long-term market health.

Another government policy that weakened the housing market before the financial crisis was the Community Reinvestment Act (CRA), which required banks to make mortgage credit available in “underserved communities” in the bank’s area of operations. Originally enacted in 1977, the act initially required banks only to reach out to these communities. The results did not satisfy the act’s supporters, and in 1995 new regulations went into effect that required banks to make loans in underserved communities even if the loans did not meet their normal lending standards. These were not quotas in a formal sense, but examiners were supposed to assess whether individual banks were making the required effort, as shown by actual loans on their books.

The CRA is enforced through regulators’ refusals to grant bank applications of various kinds. A bank that receives an unfavorable CRA rating, for example, could be denied regulatory approvals for merger and other expansions. This could be very troubling for larger banks bent on expanding through acquisitions, as well as smaller ones hoping to be acquired at some point. Despite many bankers’ complaints about the losses they were suffering in making these loans, very few of them disclosed these losses—perhaps for fear of retaliation from community activists. Thus, although there were strong incentives for making CRA-type loans, the actual numbers and their delinquency rates are hard to find. However, in its 10-K annual report to the Securities and Exchange Commission for 2009, Bank of America made one of the few bank references to CRA loan quality: “At December 31, 2009, our CRA portfolio comprised six percent of the total residential mortgage balances, but comprised 17 percent of nonperforming residential mortgage loans. This portfolio also comprised 20 percent of residential net charge-offs during 2009.”[12]

Nevertheless, there are plentiful data on commitments by large banks to make CRA-type loans in connection with applications to the Fed for permission to merge with small and medium-sized institutions between 1997 and 2007. In a 2007 report, for example, the National Community Reinvestment Coalition (NCRC) reported that in this ten-year period its member organizations had induced banks that were seeking merger approvals from the Fed and other agencies to commit almost $4.5 trillion in CRA-type lending. Press releases at the time these mergers were approved (available online) backed up this claim. After this report received publicity, it was pulled from NCRC’s website, though it is now available elsewhere on the web.[13] These report loans totaling $1.3 trillion made to fulfill prior commitments,[14] but determining the delinquency rates on these loans is impossible; banks have generally refused to make these data available, and the Financial Crisis Inquiry Commission (FCIC)—established by Congress to investigate the causes of the 2008 financial crisis—did not seriously attempt to investigate this issue.

We can estimate the number of low-quality mortgages made at the behest of the government’s housing policies under the CRA, but the exact number is difficult to quantify. Congress should conduct a thorough investigation to determine why banks felt the need to make CRA-like commitments in connection with their merger applications at the Fed.

Government Policies That Distorted the Private Mortgage Market

Without question, the most significant effect of the government’s direct role in housing policy—especially its attempt to increase homeownership through the AH goals—was its contribution to the growth of the massive housing bubble that developed between 1997 and 2007. This was by far the largest and longest-lasting house price bubble in US history and increased real housing prices (adjusted for inflation) almost 90 percent, about nine times larger than any previous bubble.

Figure 1, developed by the New York Times from data on real home prices by Robert Shiller of Yale University, shows the differences in stark terms. There has been very little serious study of why this bubble was so much larger than any of its predecessors. One factor may have been an income tax law change in 1997, which made speculating in homes a vocation for many homeowners. A married couple could live in a home for two years and pay zero tax on the first $500,000 of capital gain.[15] But the most important element of this bubble—different from any previous one—was the government’s role.

HUD’s loosened underwriting standards succeeded in increasing homeownership: between 1995 and 2004, the US homeownership rate rose from 64 percent—where it had been for thirty years—to more than 69 percent. That added substantial demand to the market, which gave the bubble a bigger boost than simple speculation might have accomplished on its own. In a normal speculative or bubble market, financial sources add funds as the bubble grows but eventually sell out and withdraw as they perceive the risks to have increased.

This is probably the mechanism that naturally limits the size of housing and other asset bubbles in markets not substantially affected by government objectives. But the 1997 to 2007 bubble was different because it was ultimately fed by a government social policy, not the normal profit-making goals of investors and speculators. Unlike private speculators, the government does not fear losses when it is pursuing an objective like increasing homeownership, and it persisted in feeding money into the market long after the risks would have driven private sources out.

By 2002, the bubble had been growing for an unprecedented five years, and speculators, investors, and other funding sources that would otherwise have left the market began to believe that it would be different this time and the normal rules no longer applied. In that year, subprime PMBS passed the $100 billion mark for the first time, yet this still amounted to only about 4 percent of the market. Two years later, subprime PMBS were 12 percent of the market and kept growing from there. In 2006, 20 percent of all originations were subprime mortgages, and about three-quarters of these were securitized.[16]

In a market where prices are rising quickly, homeowners who cannot meet their mortgage obligations can often refinance or sell their homes without a loss. In the midst of a housing bubble, therefore, subprime loans can look like excellent risk-adjusted investments. For this reason, by 2004, private investors had become interested in PMBS backed by subprime loans; these securities were offering high yields but not showing losses commensurate with their risk. This phenomenon was helped along by the fact that the low interest rates in the early 2000s had produced a vast number of refinanced and unseasoned mortgages, which in their early years characteristically have low rates of delinquency and default. Finally, the rating agencies seemed to see things the same way and were putting triple-A ratings on pools of subprime loans. Thus, in early 2007, for example, Austan Goolsbee—later head of President Obama’s Council of Economic Advisers—noted: “the vast majority of even subprime borrowers have been making their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have even been delinquent on a payment, much less defaulted.”[17]

Between 2002 and 2006, the private market for PMBS backed by subprime loans grew substantially. One myth about the this period—accepted and repeated by the FCIC and many others—is that private mortgage securitizations took a larger share of the market between 2004 and 2006 than Fannie and Freddie. However, this is true only if one ignores the purchases of private-label securities by Fannie and Freddie to meet their AH goals. Between 2004 and 2006, Fannie and Freddie bought about 20 percent, or $613 billion, of the private mortgage securitizations tracked by the FCIC. These securities should be attributed to Fannie and Freddie rather than the private sector because they were created to meet the GSEs’ demand. In that case, the GSEs’ own issuances, plus the PMBS they acquired, totaled $3.2 trillion, compared to $2.6 trillion in private issuances over the same period. Thus, the private-sector market share of securitizations never exceeded GSEs issuances between 2004 and 2006.[18]

Eventually it became impossible to ease credit standards sufficiently to maintain a continued flow of mortgages to feed this market. The bubble flattened, delinquencies and defaults began to rise, and by 2007 the PMBS market—at that point, collateralized by about 7.8 million subprime and other risky loans—had collapsed, with devastating consequences for the financial institutions holding these securities. It does not excuse the behavior of the private institutions that put themselves in jeopardy to point out that their activities accounted for only a small proportion of the subprime and other risky loans that caused the mortgage meltdown and the financial crisis.

Underlying the giant housing bubble that drew them in was a government investment that in 2008 consisted of 20.4 million subprime and other risky loans—about three times the size of the PMBS market. If the government had not created a ten-year bubble by making massive investments in subprime and other low-quality mortgages, the private sector would never have been drawn into the subprime market in such a significant way. The weakening of financial institutions in the mortgage meltdown—and the resulting financial crisis—would never have occurred.

Government Policies That Reduced Private Demand

Government policies have also distorted the private mortgage market by narrowing the range of institutions that are likely to support the market. Mortgages are relatively long-term investments, naturally attractive to firms like insurance companies and pension funds that could match mortgage investments with their relatively long-term liabilities. However, the Fed’s flow of funds data make clear that this is not occurring. Insurance companies and pension funds are shunning investment in GSE or FHA/Ginnie Mae securities.[19] The reasons for this are not hard to find. With the government—really, the taxpayers—taking the credit risk on these mortgages, their yields are too low to attract long-term private investors, who earn higher yields by taking the credit risk on debt securities. If the government has already absorbed that risk, the yields on government-backed instruments are too low to meet the investment needs of these major institutional buyers.

In 2006, at the height of the housing bubble, only 6.3 percent of the assets of these institutional investors consisted of mortgage-backed securities issued by the GSEs; in 2011, even that small proportion had declined to 5.4 percent. Considering that insurance companies and pension funds have over $12 trillion to invest in long-term assets, this is a source of housing finance funds that the government’s role has forfeited. The buyers of government-backed mortgages have been foreign central banks; insured US banks induced to buy these instruments by favorable capital regulation; and federal, state, and local governments and their pension funds, which are required by law to invest in only the safest instruments.

The Effects of the GSEs

The GSEs’ government-enabled dominance in the housing finance market allowed them to become the de facto standard setters. The result was a significant deterioration in two areas—appraisals and automated underwriting—that contributed both to procyclicality in the housing market and the growth of the immense 1997–2007 housing bubble.

In the 1970s, the GSEs developed standard form residential appraisal reports, known as the Uniform Residential Appraisal Report, which became the industry standard. Until the mid-1980s, an acceptable appraisal for a residential mortgage involved at least three approaches—replacement (or construction) cost, rental value (or income), and comparable value. Replacement cost and rental value changed slowly as housing prices rose and fell, acting as countercyclical brakes on large increases or decreases in housing prices. In the mid-1980s, the GSEs concluded that the rental value approach was no longer required on the owner-occupied mortgages they bought. In the mid-1990s, they made a similar decision regarding the replacement cost approach.

Because of the GSEs’ dominance in the market, these changes became market practices. If an originator was likely to sell mortgages to Fannie or Freddie, it no longer made sense to require a more costly appraisal that included replacement cost and rental value. That kind of appraisal also tended to hold down the value of the home, impeding sales by reducing the size of loans financing sources would approve. Reliance solely on comparable prices, moreover, was highly procyclical. As home prices rose, higher comparables begat higher-priced sales. When the bust came in 2007, this procyclical process began to work in reverse; now, it is difficult to sell a home because comparable-properties appraisals are so low that buyers frequently cannot get the financing to meet a price they would be willing to pay.

Another area where the GSEs’ dominance had similar effects was automated underwriting; in a kind of Gresham’s law in operation, the system with the lowest standards drove out others. Because of the nature of automated underwriting, which accounts for experience in the market, this not only reduced underwriting standards but also had procyclical effects that drove the development of the housing bubble.

As with appraisal practices, if a mortgage originator wanted the option to sell mortgages to Fannie or Freddie, it was a waste of money to establish different or more stringent standards than those in the GSEs’ own automated underwriting systems or to use any other automated underwriting system. Gradually, then, the GSEs’ systems became the dominant automated underwriting systems in the market, used by originators as well as mortgage insurers to determine acceptable mortgage quality.[20] By the mid-2000s, Freddie was purchasing more loans approved by Fannie’s system than its own, because Fannie’s system approved more mortgages overall.

The dominance of the GSEs and their automated underwriting systems also had two other adverse effects. First, because of the GSEs’ need for subprime and other risky mortgages to meet AH goals, they adjusted their systems to accept mortgages that were goals-rich. Automated underwriting allowed originators to test in real time whether a subprime or other low-quality mortgage would be acquired by the GSEs before it was approved. Without real-time testing, many subprime mortgages would never have been made; it would have been too risky to fund the loan and later find that neither of the GSEs would buy it.

Second, the systems also contained feedback mechanisms that tested for the performance of loans with certain qualities. If a particular subprime loan had a low delinquency rate in the recent past, the automated system would accept it, even though a human underwriter—with longer experience in the market—might have considered it too risky. As weaker and weaker subprime mortgages were accepted and showed few delinquencies, more and more of these mortgages were approved, again in an upward spiral with the prices of homes.


Government housing policies did more than increase the numbers of subprime and other weak mortgages in the US financial system; they also encouraged Americans to reduce the equity in their homes, built a massive ten-year bubble that obscured growing risks in the mortgage market, forfeited the support of insurance companies and private pension funds—both natural sources of mortgage funding—and tended to degrade the quality of the peripheral elements, such as appraisals, necessary for a well-functioning housing finance system.

Despite all the government’s “help,” the United States has higher mortgage rates in relation to the risk-free rate than other developed countries and a homeownership rate that falls in the middle among these same countries. These policies have left the American housing market in a shambles, requiring many repairs and years of recovery. But no recovery can begin until Congress and the American people recognize that the problems of the housing market are the result of government intervention to a degree experienced nowhere else in the developed world.

Peter J. Wallison ([email protected]) is the Arthur F. Burns Fellow in Financial Policy Studies at AEI, and Edward J. Pinto ([email protected]) is a resident fellow at AEI.


1. Dwight M. Jaffee, “A Privatized U.S. Mortgage Market” (presentation, Conference on the GSEs, Housing, and the Economy, Washington, DC, January 24, 2011), (accessed April 18, 2012).
2. See, for example, Peter J. Wallison, “Dodd-Frank and Housing Finance Reform: A Cure That’s Worse Than the Disease,” AEI Financial Services Outlook (April/May 2011),; and Peter J. Wallison, “Empty Promise: The Holes in the Administration’s Housing Reform Plan,” AEI Financial Services Outlook (February 2012),
3. Barbara A. Rehm, “Programs from Hamp to Harp More Crutch Than Cure,” American Banker 177, no. 33 (March 1, 2012): 1.
4. Public Law 102-550, 106 St. 3672, H.R. 5334, enacted October 28, 1992.
5. See Peter J. Wallison, Dissent from the Majority Report of the Financial Crisis Inquiry Commission (Washington, DC: AEI Press, 2011), 45–85; and Edward J. Pinto, Government Housing Policies in the Lead-Up to the Financial Crisis: A Forensic Study (Washington, DC: American Enterprise Institute, February 5, 2011), 104–08,
6. Department of Housing and Urban Development, “HUD’s Regulation of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac),” Federal Register 65, no. 211 (October 31, 2000): 65106, (accessed April 23, 2012). Emphasis added.
7. Peter J. Wallison and Edward J. Pinto, “Why the Left Is Losing the Argument over the Financial Crisis,” The American, December 27, 2011, /why-the-left-is-losing-the-argument-over-the-financial-crisis.
8. US Department of Housing and Urban Development, Hawaii Newsletter (Fall 2001), (accessed April 18, 2012).
9. US Department of Housing and Urban Development, “The National Homeownership Strategy: Partners in the American Dream” (chapter 4, action 35), 1995, (accessed April 18, 2012). Emphasis added.
10. Wallison, Dissent from the Majority Report, 55 (figure 4).
11. Mortgage Bankers Association, “2004-2010 HMDA Home Purchase Owner-Occupied by Borrower Race,” January 13, 2012 (draft).
12. Bank of America, 2009 Annual Report (Charlotte, NC: Author, 2010), 69, /71/71595/reports/2009_AR.pdf (accessed April 20, 2012).
13. National Community Reinvestment Coalition, CRA Commitments (September 2007), (accessed April 18, 2012).
14. Wallison, Dissent from the Majority Report, 85–92.
15. Vikas Bajaj and David Leonhardt, “The Reckoning: Tax Break May Have Helped Cause Housing Bubble,” New York Times, December 18, 2008.
16. Inside Mortgage Finance, Mortgage Market Statistical Annual, vol. 1 (2012): 17. 
17. Austan Goolsbee, “‘Irresponsible’ Mortgages Have Opened Doors to Many of the Excluded,” New York Times, March 29, 2007.
18. Pinto, Government Housing Policies, 144.
19. This point is discussed in greater detail in Wallison, “Empty Promise.”
20. The one notable exception was Countrywide, which after being helped to market dominance by the GSEs, negotiated the right to use its own underwriting system called the Countrywide Loan-Underwriting Expert System (CLUES). CLUES was kept updated with the latest variances agreed to by one or both GSEs.

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Monday, July 21, 2014 | 9:15 a.m. – 11:30 a.m.
Closing the gaps in health outcomes: Alternative paths forward

Please join us for a broader exploration of targeted interventions that provide real promise for reducing health disparities, limiting or delaying the onset of chronic health conditions, and improving the performance of the US health care system.

Monday, July 21, 2014 | 4:00 p.m. – 5:30 p.m.
Comprehending comprehensive universities

Join us for a panel discussion that seeks to comprehend the comprehensives and to determine the role these schools play in the nation’s college completion agenda.

Tuesday, July 22, 2014 | 8:50 a.m. – 12:00 p.m.
Who governs the Internet? A conversation on securing the multistakeholder process

Please join AEI’s Center for Internet, Communications, and Technology Policy for a conference to address key steps we can take, as members of the global community, to maintain a free Internet.

Thursday, July 24, 2014 | 9:00 a.m. – 10:00 a.m.
Expanding opportunity in America: A conversation with House Budget Committee Chairman Paul Ryan

Please join us as House Budget Committee Chairman Paul Ryan (R-WI) unveils a new set of policy reforms aimed at reducing poverty and increasing upward mobility throughout America.

Thursday, July 24, 2014 | 6:00 p.m. – 7:15 p.m.
Is it time to end the Export-Import Bank?

We welcome you to join us at AEI as POLITICO’s Ben White moderates a lively debate between Tim Carney, one of the bank’s fiercest critics, and Tony Fratto, one of the agency’s staunchest defenders.

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