The Long Road Backwards: Prelude to Another Housing Meltdown?

Those Who’s are at it again. Pursuant to the Supreme Court’s decision in Collins v. Yellen, which ruled that the requirement that the head of the Executive agency the Federal Housing Finance Agency (FHFA) can only be removed by the President for cause represents a violation of separation of powers, the Biden Administration has moved to terminate Director Mark Calabria. FHFA was the agency created by Congress to oversee Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac in the wake of 2008’s crash of the housing market. One of the agency’s first decisions was to place the GSEs into conservatorship, to ensure that they retained the financial assets necessary to continue to serve as the de facto guarantor for the mortgage market.

Calabria, a former Director of Financial Regulation Studies at the Cato Institute, was a Trump appointee who wished to impose financial responsibility on the GSEs in order to minimize the rate of mortgage defaults. This did not sit well with Biden, who wishes for FHFA to play an active role in making housing affordable for those with the lowest incomes. It seems as if we have been here before, at this poisoned nexus between credibly good intentions and discreditably ignoring predictable outcomes. This is shades of 2002 McCulley and Krugman, calling for a housing bubble to artificially bolster an artificially dampened economy.  There are times I believe that those who fail to learn from history are doomed to become policymakers.

There are those, such as Duke’s Manuel Adelino, who point out that subprime mortgages didn’t cause the crash, and they would be correct. The percentage of subprime defaults among the morass of toxic assets wasn’t enough to bring the house of cards a-tumblin’ down. The majority of those defaulting assets were owned by mid-to-higher income buyers, many of whom purchased homes for speculative purposes. This bears acknowledgment, but we simply cannot disregard the subprime market as a proximate cause. Private mortgage securitization was largely the result of the expansion of risky mortgages, as the inherent risk in such instruments came with the promise of higher yields. In this case, securitization also allowed financial institutions to play fast and loose with capital reserve requirements, encouraging profligacy by everyone involved, including the GSEs tasked with acting as a backstop against such behavior via their own, ostensibly safer, mortgage-backed securities.

I can agree with the Constitutional reasons behind the Court’s ruling while being given pause by the reasons behind Mr. Calabria’s firing. Taking the shackles, so to speak, off FHFA will simply allow policy pressures to be exerted upon Fannie Mae and Freddie Mac that result in baggage and bailouts. Prior to the housing bubble, Fannie Mae’s annual losses averaged around 4 basis points. During the crises, those annual losses averaged 52 basis points. That is simply not acceptable for an institution designed to inject stability into the market. The duty of FHFA regulated GSEs should be, as publicly traded institutions, to their shareholders, and not the policy wishes of any given President.

Of course, in a truly free and liberal society, how we handle the least among us says much about our health moving forward. There are any number of ways to encourage the availability of homeownership to those of lowest income without allowing public policy to hijack the market in potentially disastrous fashion:

  1. Encourage states to loosen occupational licensing requirements: The major deterrent to homeownership for the poor is the lack of income needed to properly qualify for non-subprime mortgages. For many workers who don’t possess high-paying skillsets, entrepreneurship is the best path to raising their income level. Occupational licensing laws serve as an unnecessary barrier to entry, creating a ceiling to upward mobility. I am entirely in favor of, say, the barber industry creating their own internal standards and certifications to assess practitioner skill and quality. I don’t see the need for barbers to be licensed.
  2. End the Drug War: The job prospects of individuals with prison records is severely limited. This creates poverty that is often intergenerational in scope. Nonviolent drug offenses should simply not be a barrier to upward mobility. This paradigm becomes increasingly harder for policymakers to justify as in increasing number of state legislatures are not only legalizing marijuana but collecting taxes and getting into the dispensary business themselves. Drug prohibition benefits no one except those whose income is derived from creating criminals. It’s time for this paradigm to end.
  3. Let the market market: There are any number of nonprofits and private organizations, such as the Neighborhood Assistance Corporation of America (NACA) which exist solely to extend the possibility of homeownership to low-income Americans. These organizations generally also provide financial counseling, credit repair, and other similar services that assist their clients in improving their financial health beyond purchasing a home.
  4. Provide tax incentives for rent-to-own programs: I am generally in favor of lowering taxes for any reason, and this would benefit both landlord and renter. Allowing a portion, or even all, of the amount of rent received as part of a rent-to-own contract to be written off would potentially incentivize owners of rental houses to engage in more of such contracts. Additionally, allowing a tax break for improvements made by renters engaged in such a living arrangement would both lower their tax bill and increase the value of the property once they have taken ownership. As an additional caveat to mitigate predatory landlords, if they fail, without cause, to execute the contract allowing the renter to purchase the home, they might be made subject to penalties covering both the tax breaks they received, and the improvements made by the tenant.

Ultimately, the purpose of securitization is to spread and mitigate risk, and if government owned mortgage guarantors are to exist, they must operate solely within the parameters of this purpose. As fairly recent history has demonstrated, when Freddie and Fannie act irresponsibly, it provides a signal to market actors that the government approves of irresponsible securitizations, insurance schemes and risk, and will bail out bad actors. We simply cannot afford to travel this long road backwards.


Tarnell Brown is an Atlanta based economist and public policy analyst.


READER COMMENTS

Phil H
Jul 27 2021 at 9:19pm

There is a hotly contested economic question in the middle of this piece. The problem is that Brown doesn’t contest it:

“Manuel Adelino…point[s] out that subprime mortgages didn’t cause the crash, and [is] correct…but we simply cannot disregard the subprime market as a proximate cause.”

What? Subprime didn’t cause the crash, but we can’t rule it out as a cause? Either this is just a random contradiction, or a lot of work is being done by the words “market” or “proximate”. I certainly can’t tell which one is supposed to make the difference, or why Brown thinks so. If he doesn’t want to make the argument here because it’s long and/or technical, that’s OK, but he should say so explicitly rather than assert what “we” “can” or “cannot” “regard” or “disregard”. This is not an argument.

MarkW
Jul 28 2021 at 6:53am

You seem to be trying not to understand.  The argument is that the loose standards (‘liars loans’, NINJA loans, mortgages with low or no down payment) that were designed to make subprime lending possible also enabled the other risky, speculative practices that ultimately did most of the damage.

Phil H
Jul 28 2021 at 11:35am

Always start by telling me what I think. It makes you sound much smarter.

KevinDC
Jul 28 2021 at 9:16am

I don’t see the issue. A “proximate cause” of something is, by definition, not the true (or distal) cause. Saying “X did not cause Y, but X was a proximate cause of Y” is not a contradiction – it’s a simple, textbook application of what it means to call something a “proximate cause.”

Phil H
Jul 28 2021 at 11:34am

That is the definition. But it’s not the argument Brown makes. At least, I can’t find anywhere in this piece the thing that he argues caused the subprime mortgages, and was the ultimate cause.

KevinDC
Jul 28 2021 at 1:20pm

I can’t find anywhere in this piece the thing that he argues caused the subprime mortgages, and was the ultimate cause.

This seems like a very different objection than what you voiced in your first comment. In your first comment, you took issue with him saying that subprime mortgages didn’t cause the crisis but were a proximate cause. You suggest that this is either a “random contradiction” or that “a lot of work is being done by the words ‘market’ or ‘proximate’. I certainly can’t tell which one is supposed to make the difference, or why Brown thinks so.” In response, I pointed out that it’s pretty clear that the standard, ordinary meaning of the the term “proximate cause” does all of the work required to clear out the contradiction you seemed to be concerned about.

Now, you seem to be raising an altogether different objection – he’s saying X was only a proximate cause of Y rather than the true cause, but not telling us what he thinks the true cause was. This is very different from a claim of contradiction! However, if you wanted to find where “in this piece the thing that he argues caused the subprime mortgages, and was the ultimate cause,” these lines in the second paragraph should help:

This did not sit well with Biden, who wishes for FHFA to play an active role in making housing affordable for those with the lowest incomes. It seems as if we have been here before, at this poisoned nexus between credibly good intentions and discreditably ignoring predictable outcomes. This is shades of 2002 McCulley and Krugman, calling for a housing bubble to artificially bolster an artificially dampened economy.  There are times I believe that those who fail to learn from history are doomed to become policymakers.

That is, activist government policy aimed at “making housing affordable for those with the lowest incomes” is somewhere “we have been before” and calls us back to the creation of “a housing bubble to artificially bolster an artificially dampened economy.” Maybe he could have made it more clear if he threw in an extra sentence saying “and by the way, when I say ‘we’ve been here before’ I’m talking about previous activist government policies aimed at achieving the same goal, which led to a huge expansion in subprime mortgages,” but it seemed pretty clear to me on the first reading.

However, I also see that the author left a comment, presumably intended to be a reply to you, at 12:33am, but it came in as a standalone comment rather than a direct reply. Still, he spells out the basic case in some more detail, so that’s definitely worth checking out.

Aaron
Jul 27 2021 at 10:43pm

I agree with the general premise here that the GSEs are distorting the market in ways that worsen problems with affordability. The first two solutions listed seem like a total non sequitur though. I don’t disagree with the notion that occupational licensing and the war on drugs are bad policies. Their relationship to housing affordability is indirect at best. In addition, that the proposed solutions fail to even acknowledge the role local regulations such as exclusionary zoning, height restrictions, and minimum parking requirements play in making housing less affordable, and thus in need of government subsidy (even the alternative forms proposed here), seems like a serious oversight. Let’s not let reciting libertarian shibboleths about occupational licensing and the war on drugs get in the way of clear analysis of cause and effect in making housing unaffordable.

 

Tarnell Brown
Jul 28 2021 at 12:48am

The relationship of occupational licensing and the drug war to home affordability is, in fact, indirect, but their relationship to individual income is not,  For instance,  those convicted of a felony and imprisoned, see their annual earnings upon release decrease by an average of 52%, while those convicted but not imprisoned (i.e. probation) see their annual earnings decrease by an average of 22%. As such, far from being a “libertarian shibboleth,” drug convictions have an impact on a potential buyer’s income and creditworthiness, creating a correlation, however indirect.

Your point regarding local restrictions is well taken, but the overall tenor of this article was the role of Federal policy, and what they can pressure statehouses to do.  The impact of local ordinances is a varied enough warren of contradictions and obsolescences as to require its own separate treatment.

Justin
Jul 31 2021 at 9:43am

I don’t see a problem with local government real estate restrictions.  Yes, they may make housing more expensive in a particular community, but they can also make that community a nicer place to live.  A lot of people like lower density living and they shouldn’t be forced to suffer large ugly apartment buildings just because some rich developer is able to buy up a few acres of land near them.

robc
Aug 2 2021 at 12:05pm

Why not?

If they didn’t want an apartment near by, they should have outbid the developer.

I really don’t understand people who think they get to control property they don’t own.  It literally baffles me.

 

 

 

 

Tarnell Brown
Jul 28 2021 at 12:33am

For simplicity’s sake, while the number of subprime mortgages rose in the period preceding the collapse, other types of debt instruments for low income borrowers, such as FHA loans, declined in proportion to the increase in subprime lending to the degree that loans to the less creditworthy made up roughly the same share of the market. What happened overall was that with credit being easier to get in general, demand for housing rose to the point that we can say it overheated.

To facilitate this boom, financial institutions began securitizing mortgages at historic rates. Mortgage securitization is nothing new, but prior to the housing boom, it was mostly the province of GSEs such as Fannie and Freddie. Of course,
the GSEs’ purpose is to increase liquidity in the mortgage market so lenders  can reinvest their funds and lend more, but they were supposed to do so up to a certain level of risk tolerance. In order to compete with the proliferation of private-label securitization, the GSEs began to subsume more risk into their securities, a foolish gambit considering that they guarantee the majority of mortgages in the US.

This, of course, signaled that mortgage backed securities had the blessing of the government, especially given the pressures placed on lenders to increase loans to the less creditworthy. Remember, though, the proportion of such loans remained relatively flat within the market. The largest share of low interest loans went to middle class borrowers with good credit profiles, who no longer had to place large down payments on the homes they were acquiring. With home values skyrocketing, a fair number of these purchases were for speculative reasons.

When the walls of Jericho came tumbling down, immediate blame was placed on subprime borrowers, who had high default levels. However, poor borrowers always have high default levels. The purpose of securitization is to spread risk, and subprime mortgages were not a large enough percentage of the assets held to collapse anything at all. It was historically high levels of defaults for ostensibly creditworthy middle class borrowers that made up the bulk of toxic assets.

So, to summarize, the increase in subprime lending led to an overall increase in easy lending. This spurred innovative private securitization that added fuel to an already heating market. Irresponsible behavior by lenders, borrowers, GSEs, regulators, and, really, everyone at all led to high default levels not just within the subprime
market, but within the prime market as well. It was this latter that precipitated the crash. None of this would have happened without increased lending in the subprime market, so it is a proximate cause, but not the culprit it has sometimes been made out to be.

Mark Brophy
Jul 28 2021 at 6:36am

The government shouldn’t encourage the availability of homeownership to those of lowest income, they should rent their homes and those should be small and not be in expensive places like San Francisco and New York. People should only buy things like housing that they can afford. Individuals, businesses, and governments have incurred too much debt. Interest rates should be allowed to increase to free market levels.

David Seltzer
Jul 28 2021 at 9:59am

Your essay is freighted with sound reasoning. I suspect the antecedents to the sub-prime debacle and resultant TBTF are grounded in moral hazard and regulatory capture. It seems the lenders and GSE’s are incentivized to take unreasonable risk because, by observing previous government bailouts, they believe, losses will be absorbed by taxpayers and wins will accrue to the lenders  and GSE’s.

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