Housing policy blamed for collapse

February 17, 2011 06:58


Beginning in 1992, with the imposition of affordable housing requirements on the GSEs, mortgage underwriting standards began to erode. HUD caused this erosion by raising the affordable housing goals through the Clinton and Bush administrations, until more than half of all loans the GSEs had to buy were required to be made to borrowers at or below the median income where they lived.

By Peter J. WallisonStatement before the Housing Financial Services Committee

Chairman Bachus, ranking member Frank and members of the Committee:

By June of 2008, there were 27 million subprime and Alt-A mortgages in the U.S. financial system–half of all mortgages. These weak and risky loans had begun to default in unprecedented numbers when the 1997-2007 bubble began to deflate, and by 2008 many financial institutions that held these mortgages–or mortgage-backed securities based on them–were in trouble.

No one doubts that it was the failure of these mortgages–what was known at the time as the mortgage meltdown–that caused the financial crisis. Nothing like this had ever happened before. In previous bubbles, the number of subprime loans was very small, and losses when they deflated were generally confined to local areas. In this bubble, the mortgage losses were large and the losses international.

In light of these facts, the question the Commission should have answered–and did not–was why there were so many bad mortgages outstanding in 2008? Obviously, there had been a serious decline in underwriting standards–something else that had never happened before. Neither the Commission nor the other dissenters ever advanced a plausible explanation for the decline in underwriting standards. Both seemed to assume that easy credit automatically produces subprime loans. But this is far from obvious.

Before the 2008 crisis, the United States had frequently experienced periods of low interest rates, large flows of funds from abroad, and housing bubbles. We also had the same regulatory structure and relied on financial institution managements to anticipate risks. None of these conditions or factors–separately or together–had ever before resulted in a mortgage-based international financial crisis. Under these circumstances, it is logical to focus on the one unprecedented element in the U.S financial system before the crisis–the large number of subprime and other risky loans.

My dissent focuses on the only plausible explanation for the build-up of these loans–U.S. government housing policy. Beginning in 1992, with the imposition of affordable housing requirements on the GSEs, mortgage underwriting standards began to erode. HUD caused this erosion by raising the affordable housing goals through the Clinton and Bush administrations, until more than half of all loans the GSEs had to buy were required to be made to borrowers at or below the median income where they lived.

In addition, the GSEs were put into competition with FHA, insured banks under the Community Reinvestment Act, and subprime lenders–all of whom were looking for borrowers who were also at or below the median income. Prime loans were difficult to find among these borrowers. So, to acquire the loans the government was demanding, underwriting standards had to be reduced. By 2000, for example, Fannie was offering to buy mortgages with no downpayment. My dissent details how these weak government-mandated loans caused the growth of the bubble; how the bubble created the private label market for securities backed by subprime loans; and how the failure of all these weak loans destroyed the value of the mortgage backed securities and thus weakened financial institutions around the world.

Finally, the Commission majority’s report propagates the false idea that the GSEs bought these risky loans not because of the affordable housing requirements but to regain market share or for profit. My dissent documents that this is not true. For example, this quote from Fannie’s 2006 10-K report:

“[W]e have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD’s increased housing goals and new subgoals. These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses.”

Could it be any clearer? The deterioration in underwriting standards was caused by U.S. government policy, and this caused the financial crisis– not a lack of regulation or a failure of risk management. In my view, then, the Dodd-Frank Act was not soundly based and will not prevent a future financial crisis.

Peter J. Wallison is the Arthur F. Burns Fellow in financial policy studies at AEI.



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