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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 afford-
able 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 pol-
icy.Most other countries leave housing finance
Financial Services Outlook
1150 Seventeenth Street, N.W., Washington, D.C. 20036 202.862.5800 www.aei.org
Free Fall: How Government Policies Brought
Down the Housing Market
By Peter J. Wallison and Edward J. Pinto
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 deteri-
oration in the US housing market, including the thirty-year fixed-rate mortgage, the mortgage interest tax deduc-
tion, the right to refinance without penalty,and the Community Reinvestment Act. Until Fannie and Freddie’s
market dominance and the government’srole in the housing finance system are substantially reduced or elimi-
nated, the United States will continue to have an inferior and unstable housing market.
April 2012
Peter J. Wallison (pwallison@aei.org) is the Arthur F. Burns
Fellow in Financial Policy Studies at AEI, and Edward J.
Pinto (edward.pinto@aei.org) is a resident fellow at AEI.
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 home-
buyers made a down payment of 3 percent
or less; by 2007, it was 1 in 3. Meanwhile,
average home equity plunged from 45 per-
cent 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.
-2-
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 home-
ownership rate, although US housing poli-
cies have for many generations focused on
increasing homeownership. In a recent pre-
sentation that compared US government
housing policies with those of fifteen devel-
oped 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 sub-
stantial 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 down-
turns. These features of private markets account for the
healthier and more stable housing markets in Europe.
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 con-
tinue to promote low-quality loans, mortgage-backed secu-
rities 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 hous-
ing 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 poli-
cies 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 item-
ize 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 mort-
gage 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 inter-
est 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 prod-
uct 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 accu-
mulated 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 refi-
nancing mortgages without penalty—another benefit trea-
sured by consumer advocates—and cash-out refinancing.
The GSEs’ promotion of thirty-year fixed-rate loans without
The United States is
the only developed
country with a
significant government
role in housing policy.
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 mort-
gages. It is also a particular benefit for the
well-to-do, who have the financial sophisti-
cation 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 bor-
rowers did not have the financial where-
withal 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 gov-
ernment’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.
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
asmall amount of equity. According to a recent article in
the American Banker, the average loan-to-value (LTV)
ratio of all mortgages in the United States today is 93.3 per-
cent, 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 Weak-
ened Underwriting Standards
Other government policies were designed to increase
homeownership, primarily by reducing mortgage under-
writing 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”).4The 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 mort-
gage 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) bor-
rowers, 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’stightening of
the AH requirements beginning in that year and contin-
uing 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
3percent, 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.5As 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
-3-
The most significant
effect of the
government’s direct role
in housing policy was its
contribution to the
growth of the massive
housing bubble that
developed between
1997 and 2007.
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 con-
sidered 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 poli-
cies. 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 pay-
ments; 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 insti-
tutions 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 Agree-
ments 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 demon-
strating a commitment to affirmatively further fair
lending.”8HUD used the terms “equal opportunity prin-
ciples” and “fair lending” as euphemisms for reduced
underwriting standards or low-income borrowers.
In 1995, expanding the idea in the Best Practices Ini-
tiative, HUD issued a policy statement titled “The
National Homeownership Strategy: Part-
ners 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 homeown-
ership: “Lending institutions, secondary market investors,
mortgage insurers, and other members of the partnership
should work collaboratively to reduce homebuyer down-
payment 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
3percent or less, but by 2003, 1 in 7 buyers was providing
adown 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.
HUD also used the FHA, a government mortgage insur-
ance 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.
-4-
The GSEs’ government-
enabled dominance in
the housing finance
market allowed them to
become the de facto
standard setters.
-5-
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 mar-
ket 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 hous-
ing 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’sarea 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 Commis-
sion 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 portfo-
lio 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 Com-
munity 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 delin-
quency rates on these loans is impossible; banks have gen-
erally 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’shousing policies
under the CRA, but the exact number is difficult to quan-
tify. Congress should conduct a thorough investigation to
determine why banks felt the need to make CRA-like
commitments in connection with their merger applica-
tions at the Fed.
Government Policies That Distorted the
Private Mortgage Market
Without question, the most significant effect of the gov-
ernment’sdirect 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,
-6-
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 specu-
lating 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’sloosened 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 bub-
ble market, financial sources add funds as the bubble
grows but eventually sell out and withdraw as they per-
ceive 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 ulti-
mately 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 home-
ownership, 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 unprece-
dented 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.
T
wo years later,subprime PMBS were 12 percent of the
FIGURE 1
AHISTORY OF HOME VALUES
SOURCE:New York Times.
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
200
190
180
170
160
150
140
130
120
110
100
90
80
70
60
200
190
180
170
160
150
140
130
120
110
100
90
80
70
60
WORLD
WAR I
WORLD
WAR II
GREAT
DEPRESSION
1970s
BOOM
1980s
BOOM
CURRENT
BOOM
The Yale economist Robert J. Shiller created an index of American housing prices going back to 1890. It is based
on sale prices of standard existing houses, not new construction, to track the value of housing as an investment
over time. It presents housing values in consistent terms over 116 years, factoring out the effects of inflation.
The 1890 benchmark is 100 on the chart. If a standard house sold in 1890 for $100,000 (inflation-adjusted to
today’s dollars), an equivalent standard house would have sold for $66,000 in 1920 (66 on the index scale) and
$199,000 in 2006 (199 on the index scale, or 99 percent higher than 1890).
DECLINE AND RUN-UP Prices dropped
as mass production techniques appeared
early in the 20th century. Prices spiked
with post-war housing demand.
BOOM TIMES Two gains in recent decades
were followed by returns to levels consistent
since the late 1950s. Since 1997, the index
has risen about 83 percent.
-7-
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, homeown-
ers 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 rat-
ing 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 mort-
gage 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 mort-
gage 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 rela-
tively 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 compa-
nies 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 tax-
payers—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 for-
eign central banks; insured US banks induced to buy
-8-
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 FHA and the GSEs
The GSEs’ government-enabled dominance in the hous-
ing 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 hous-
ing bubble.
In the 1970s, the GSEs developed standard form resi-
dential appraisal reports, known as the Uniform Residen-
tial Appraisal Report, which became the industry standard.
Until the mid-1980s, an acceptable appraisal for a residen-
tial mortgage involved at least three approaches—replace-
ment (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 auto-
mated underwriting systems or to use any other auto-
mated underwriting system. Gradually, then, the GSEs’
systems became the dominant automated underwriting
systems in the market, used by originators as well as mort-
gage 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 Fan-
nie’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. Auto-
mated 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 mecha-
nisms that tested for the performance of loans with cer-
tain 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.
Conclusion
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
awell-functioning housing finance system.
-9-
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
ashambles, requiring many repairs and years of recovery.
But no recovery can begin until Congress and the Amer-
ican 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.
Notes
1. Dwight M. Jaffee, “A Privatized U.S. Mortgage Market” (pre-
sentation, Conference on the GSEs, Housing, and the Economy,
Washington, DC, January 24, 2011), www.rhsmith.umd
.edu/cfp/events/2011/GSE2011/presentations/Jaffee.pdf (accessed
April 18, 2012).
2. See, for example, Peter J. Wallison, “Dodd-Frank and Hous-
ing Finance Reform: A Cure That’s Worse Than the Disease,” AEI
Financial Services Outlook (April/May 2011), www.aei.org/outlook
/economics/financial-services/housing-finance/dodd-frank-and-
housing-finance-reform/; and Peter J. Wallison, “Empty Promise:
The Holes in the Administration’s Housing Reform Plan,” AEI
Financial Services Outlook (February 2012), www.aei.org/outlook
/economics/financial-services/housing-finance/empty-promise-the-
holes-in-the-administrations-housing-finance-reform-plan/.
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 Octo-
ber 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,
www.aei.org/paper/economics/financial-services/housing-finance
/government-housing-policies-in-the-lead-up-to-the-financial-
crisis-a-forensic-study.
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,
www.gpo.gov/fdsys/pkg/FR-2000-10-31/pdf/00-27367.pdf
(accessed April 23, 2012). Emphasis added.
7. Peter J. Wallison and Edward J. Pinto, “Why the Left Is Los-
ing the Argument over the Financial Crisis,” The American,
December 27, 2011, www.american.com/archive/2011/december
/why-the-left-is-losing-the-argument-over-the-financial-crisis.
8. US Department of Housing and Urban Development,
Hawaii Newsletter (Fall 2001), www.hud.gov/local/hi/working
/nlwfal2001.cfm (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, http://web.archive.org
/web/20010106203500/www.huduser.org/publications/affhsg
/homeown/chap1.html (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, http://media.corporate-ir.net/media_files/irol
/71/71595/reports/2009_AR.pdf (accessed April 20, 2012).
13. National Community Reinvestment Coalition, CRA
Commitments (September 2007), www.community-wealth.org
/_pdfs/articles-publications/cdfis/report-silver-brown.pdf (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.
