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Re-inflating the Housing Bubble

This year, the Mortgage Bankers Association chose an unintentionally revealing location for their annual conference — a Las Vegas casino. At the conference, US Representative Mel Watt, the new head of the Federal Housing Finance Agency (FHFA), announced plans to lower underwriting standards for mortgage lending. Specifically, Fannie Mae and Freddie Mac, the two semi-private firms regulated by the FHFA, will be subsidizing mortgages with down payments as low as 3 percent, a number not seen since before the financial collapse of 2008. Simply put, banks will be able, and encouraged, to sell more subprime mortgages. These looser regulations are designed to increase economic growth and free up credit for people who otherwise might not be able to own a home, but are dangerously similar to the Bush-era policies that were a component of the economic environment that prompted the global recession in 2008.

The collapse of the housing bubble in 2008 was the result of years of selling subprime mortgages (often with misleading information about the true amount payments would eventually cost for low-income families), which were then bundled into mortgage-backed securities and sold. Mortgage-backed securities were attractive to investment bankers because of their high returns, but they ultimately defaulted due to the borrowers’ inability to make payments over the long term.

The Obama administration’s policy regarding housing in recent years has been to promote equal access to home ownership, especially for young people buying their first home and people with credit damaged by the recession. The Justice Department is encouraged to reassure banks that the banks won’t face legal consequences for ‘risky’ subprime loans. Obama officials are also encouraging banks to offer refinancing deals, even to homeowners who owe more than their house is worth. In his State of the Union Address this year, President Obama outlined a noble plan for increased housing equality and economic growth. Making it easier for people to take out loans, especially those with credit damaged by the recession or young people looking to own their first home, would, he argued, have beneficial effects for the livelihoods of many families and for the economy as a whole. As he said in his speech: “Why would we be against that?”

The president is right in being somewhat baffled — the surging housing market in the last couple years has been beneficial mostly to established homeowners, or those with good credit. Before the crisis in 2008, 40 percent of home purchases were by first-time buyers. Now, that number is 30 percent. The rewards of the current housing boom are being distributed to fewer people than before. Much of this could be explained by the fact that millennials aren’t buying houses at the rates their parents and grandparents did. A study by Pew Research found that nearly one in four millennials, generally defined as anyone born between 1980 and 2000, live in a multigenerational home, a proportion higher than any previous generation. Other debts, such as student loans, and the fact that many young people live in cities, could explain the lack of home ownership in this generation. From 2007 to 2012, in the midst of the recession, new home purchases fell 30 percent for people with FICO credit scores above 780, according to numbers from the Federal Reserve. However, during the same period, new home purchases fell 90 percent for people with credit scores between 620 and 680. The tightening of credit after the recession was necessary, but those actions may have led to an overcorrection.

In any event, the so-called “tight credit” the Obama administration worries about appears to be working itself out in the coming years anyway. In 2014, the average FICO credit score for a loan dropped from 738 to 726. After hitting a low in 2012, the Mortgage Credit Availability Index jumped 16 percent in September. The solution to the problem of overly tight credit might be to wait as credit is freed up naturally.

The Federal Housing Finance Agency recently announced it will lower the down payment requirements from 5 percent to 3 percent. In an effort to make this action attractive to mortgage lenders, FHFA promised that if these loans default, taxpayers will absorb the risk. Today, Fannie Mae, Freddie Mac are back to insuring 90 to 95 percent of all home loans. This will lead to more home purchases, and create economic growth for realtors and investors. However, loans given with a low down payment are most often the ones that default. A study by the University of Texas in Dallas found that the biggest commonality throughout foreclosures wasn’t the credit score of the borrower, but the size of the down payment. Buyers with low down payments were far less likely to be able to keep paying and many of their mortgages ended in foreclosure. A low down payment means that borrowers whose homes lose value are more likely to default, because the lack of a substantial down payment means they don’t have any cushion to potentially volatile changes in the housing market.  In the heyday of the early-2000s housing bubble, one could buy a house with a down payment as low as 2.5 percent, a rate that isn’t too far from the FHFA’s current requirement of 3 percent. In 2008, these loose regulations culminated in widespread foreclosures that dramatically reduced the wealth of countless middle-class families.

After the financial collapse, the government put an end to so-called “predatory loans” that were given out to unfit borrowers, despite the fact that the government was encouraging those very banks to issue predatory loans the entire time. Now government policy is headed back in that direction.

It is estimated that subsidies from Fannie Mae and Freddie Mac will cost an average of roughly $2.5 billion a year in the next decade. Rather than subsidizing middle- and low-income families, whom this policy purports to help, the government is choosing to subsidize investment banks.

The political realities behind this decision are apparent. President Obama wants to boost the economy, and lowering mortgage regulations is a simple way of achieving that. Best of all, these new policies can be implemented entirely through executive action, whereas other means of creating economic growth — a stimulus, for example — would require the approval of Congress. This is a strategy the President has been using for the past year, as evidenced by his recent string of executive actions on things like immigration and the pay of federal contractors. In his State of the Union speech this year, he put it succinctly: “wherever and whenever I can take steps without legislation to expand opportunity for more American families, that’s what I’m going to do.”

These policies ignore the underlying problems with this country’s housing policy. More affordable housing could be achieved through higher wages or simply increasing the housing supply. Growing income inequality is amplified in the housing market. Since 2000, the top income decile has seen a 73 percent increase in housing value, while the bottom 40 percent saw an increase of only 59 percent. The bottom 40 percent of people own only 8 percent of the nation’s housing wealth, while the wealthiest 10 percent own 52 percent. This policy ultimately keeps houses unaffordable for most people, but sells them in such a way that they appear affordable at the outset. The main attraction to lowering down payments is that it is a policy that makes housing more affordable, without the houses decreasing in value. The reality is that it’s unsustainable in the long run.

Furthermore, looser credit policies aren’t achieving their intended goal. After the government subsidized mortgages before the crash, the percentage of homeowners in the US stubbornly remains at 65 percent, the lowest since 1995. Moreover, there is debate over whether promoting home ownership is a worthy economic goal — European countries often have populations where 50 percent of people rent, and yet are still affluent.

There are better ways to achieve this goal. Rather than subsidizing mortgage debt, the government could subsidize equity, helping low-income buyers or first time homeowners build a larger cushion in case home values fluctuate. This would help homeowners directly, rather than the indirect policy of subsidizing the creditors rather than the debtors. With the $2.5 billion spent every year subsidizing debt for mortgage lenders, they could subsidize 10 percent of the equity on roughly 200,000 homes worth $125,000.

Inequality and unfairness in the housing industry is a serious problem, one that needs to be addressed by curbing income inequality, not by lowering underwriting standards and subsidizing risky investments. While these measures help low-income families buy homes and spur economic growth in the short term, they disregard potential long-term dangers to the housing market.

About the Author

Mitchell Johnson '18 is a staff writer for the Brown Political Review.