Understanding the role of GSEs, HUD and affordable housing in the subprime crisis

Housing Matter newsletterA page 1 story in the Washingtom Post Tuesday laid a major part of the blame for the subprime lending meltdown at the feet of HUD for failing to rein in Fannie Mae and Freddie Mac from buying large numbers of subpime mortgage backed securities comprised of loans made in minority and low income neighborhoods.

The Post reports…

Eager to put more low-income and minority families into their own homes, the agency [HUD] required that two government-chartered mortgage finance firms [Fannie and Freddie] purchase far more “affordable” loans made to these borrowers. HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing.

Housing experts and some congressional leaders now view those decisions as mistakes that contributed to an escalation of subprime lending that is roiling the U.S. economy.

The agency neglected to examine whether borrowers could make the payments on the loans that Freddie and Fannie classified as affordable. From 2004 to 2006, the two purchased $434 billion in securities backed by subprime loans, creating a market for more such lending. Subprime loans are targeted toward borrowers with poor credit, and they generally carry higher interest rates than conventional loans.

While there are a few factual errors and things to quibble about in the story the Post is correct to point out the failures of HUD to exercise proper oversight authority, so far as affordable housing goals, over the government-sponsored enterprises led the GSEs to supporting bad subprime lending.

Back in 2002 the Texas Low Income Housing Information Service began an in-depth investigation of Fannie Mae’s lending practices in the Dallas-Fort Worth Metroplex. We issued a lengthy report (which few read) and a summary newseltter that attributed the rapid rise of subprime lending and the deficit of prime home mortgage loans in minority and low-income neighborhoods to Fannie Mae’s failure to adopt underwriting criteria for prime loans based on real-life credit risk among low income and minority borrowers.

The fact is that the government-sponsored enterprises (Fannie Mae and Freddie Mac) by virtue of their dominance of the secondary market define the characteristics of a prime and a subprime loan. We contend that Fannie and Freddie essentially abandoned the affordable housing and inner-city minority homebuyer markets because the mortgage loans involved were smaller in amount and thus less profitable than loans of higher income populations and loans made in suburban areas. By abandoning these markets Fannie and Freddie left some to subprime lenders. If Fannie and Freddie had spent the time and effort to understand the affordable mortgage market a significant share of the borrowers who ended up with subprime loans should and could have qualified for a prime mortgage which they could have afforded and would not have defaulted on.

The GSEs did not bother with this market. Yet Congress and HUD wanted to increase minority and lower income homeownership and rightly looked to the government-sponsored enterprises to play a role. So Fannie and Freddie took the easy way out. In response to HUD requirements that they increase the percentage loans made to minority and lower income borrowers the GSEs started buying up portfolios of loans made by subprime lenders in the markets that the GSEs themselves had abandoned.

The Washintong Post investigation mirrors our findings…

“The market knew we needed those loans,” said Sharon McHale, a spokeswoman for Freddie Mac. The higher goals “forced us to go into that market to serve the targeted populations that HUD wanted us to serve,” she said.

But because Fannie and Freddie were buying mortgage-backed securities rather than the actual subprime loans, their involvement came too late to require stiffer standards from lenders.

Fannie and Freddie “made no progress in civilizing the market,” said Sandra Fostek, a senior regulator at HUD.

A lot of these loans were junk. They were poorly underwritten. The borrowers did not know what they were getting into. An industry trade publication reported that the GSEs even purchased mobile home loans originated to borrowers with “C” grade credit in order to meet affordable housing lending goals. This particular portfolio cratered. Foreclosures were widespread. Incredibly high gave the GSEs credit toward meeting their affordable housing lending obligations for purchasing these junk loans.

The chummy relationships between HUD regulators of the GSEs during the Clinton administration led to a practice, continued by the Bush administration (although less chummy), of looking the other way as Fannie and Freddie absurdly purported to meet affordable housing goals by purchasing ill-conceived subprime mortgages.

A small number of us have been hollering about this for the past five or six years, to no avail. Finally, the country is waking up to the consequences of the failure to insist that Fannie and Freddie act responsibly. But it is too late to save the damage to the overall economy, the devastation of lower income families in during foreclosure and the ravaging of communities filled with abandon homes.

You would think with public attention finally focused on this problem we would learn our lesson. But here is my concern. Congress is not going to take the time to understand that the problem is not with the affordable housing goals placed on Fannie and Freddie. Political leaders are not going to insist that the GSEs properly and actively act to assess credit risk and to lead the private mortagae market into responsible lending in affordable housing. Instead, in a rush to fix the larger problem that subprime lending is causing the economy, I will bet that Congress will direct Fannie and Freddie to further restrict mortgage credit to minimize risk.

If this happens, and Fannie and Freddie withdraw further from the affordable housing market two things will happen. First, credit worthy but “nontraditional” (in GSE terms) potential low income home buyers will be completely shut out of the prime mortgage market. Second, new forms of subprime and predatory lending, completely unregulated, will slowly reemerge from the ashes of the subprime mortgage meltdown and will plague lower income borrowers once again.

It is absolutely essential that Congress act to fundamentally reform the GSEs to extend prime mortgage credit to all classes of creditworthy borrowers.

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