Fannie Mae and Freddie Mac

Turning the American Dream into a Nightmare

Oonagh McDonald

• Publisher: Bloomsbury Academic
• Year: 2012
• ISBN:
  9781780930046
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

This book is available as open access through the Bloomsbury Open Access programme and is available on www.bloomsburycollections.com. This book examines the role of Fannie Mae, Freddie Mac and other key players in the American mortgage market, in precipitating the current global financial crisis. From President Clinton's announcement of the 'National Home Ownership Strategy' in 1995 to its collapse in 2008, this book deftly explains the aims and consequences of extending mortgage lending to people who could not afford home ownership. Bankers, investment banks, rating agencies and derivatives have all been awarded their share of the blame, while politicians, regulators and government agencies have successfully avoided theirs. Fannie Mae and Freddie Mac have been implicated, but the true story of their marriage made in hell has never been told.

1

The Seeds are Sown

Introduction

It is impossible to understand and appreciate the extent of subprime lending and its contribution to the global financial crisis without an analysis of the origins of such lending and the operations of the US mortgage market, especially from the mid-1990s to the time when the bubble finally burst in 2008. The period was dominated by the “American Dream of Homeownership” to which all actors in the mortgage market subscribed, even if it was only a matter of paying lip-service to the dream. What marked the difference between this era and the preceding ones was that successive Presidents espoused the dream, but did little to make it a reality.

What happened subsequently was that politicians recruited all the federal housing agencies to serve the end of “home ownership for all.” This book will explore the ways in which every aspect of the market was subsumed to that purpose; how a combination of the contribution of all those agencies, working together with the banks and other players who grabbed money-making opportunities, created a huge pool of subprime mortgages. It was a heady mix of good intentions, the reasonable aspiration of owning one’s own home, negligence, greed, fraud on the part of some lenders, some government agencies, and even borrowers as well, driven by politicians of every hue. These all combined to encourage all the players to take on risks, which they either did not understand, or which they thought they could handle in the good times. The good times did not last.

The Clinton era

The crisis arose out of laudable political aims and aspirations: to extend the American dream of home ownership. “You want to reinforce family values in America, encourage two-parent households, get people to stay home? Make it easy for people to own their own homes and enjoy the rewards of family life and see their work rewarded. This is the big deal. This is about more than money and sticks and boards and windows. This is about the way we live as people and what kind of society we’re going to have.” These were the widely held ideals expressed by President Clinton when he announced the National Homeownership Strategy in June 1995, which was the beginning of the affordable homes era. These ideas had not been plucked out of the air: much research lay behind them.¹

The National Homeownership Strategy brought together fifty-six leading organizations concerned with mortgages, affordable home ownership, community activists, state housing provision, government departments and many others as “Partners in the American Dream,” including the American Bankers Association; America’s Community Bankers; the Federal National Mortgage Corporation, and the Federal Home Loan Mortgage Corporation (commonly known as Fannie Mae and Freddie Mac respectively); the National Association of Realtors; the National Council of State Housing Agencies; the Neighborhood Reinvestment Corporation; and the US Department of Housing and Urban Affairs.

Amongst the Action Points included in the program under the strategy of reducing down-payment and mortgage costs, especially for low- and moderate-income home buyers, were more flexibility in down-payment requirements to include “public subsidies or unsecured loans;” counseling to accompany mortgage financing with high loan-to-value ratios; and flexible mortgage underwriting criteria. The actions of Fannie Mae and Freddie Mac in introducing affordable loans for home purchase, loans requiring only 3% from the purchaser when an additional 2% is available from other funding sources such as gifts, unsecured loans and government aid, were commended in the National Strategy announced in May 1995.

The aim was quite explicit. “Since 1993,” the President said, “nearly 2.8 million households have joined the ranks of America’s homeowners, nearly twice as many as in the previous two years. But we have to do a lot better. The goal of this strategy, to boost homeownership to 67.5% by the year 2000, would take us to an all-time high, helping as many as 8 million American families to cross that threshold … and we’re going to do it without spending more tax money.”² The reference to not spending any more tax dollars is significant. President Clinton did make further cuts in the housing budget, especially for public housing: here, changes involved the replacement of high-rise concrete blocks with low-level scattered housing. However, the total stock for public housing fell during that period, as did new units for subsidised rental accommodation,³ and this must also be considered part of the background against which the political push for affordable housing should be assessed.

Racial discrimination and home ownership

The issue of racial discrimination in housing, and hence the need to increase home ownership in low-income and underserved areas, had already come to the fore when the Federal Reserve Bank of Boston published a study entitled “Mortgage Lending in Boston: Interpreting HMDA data.”⁴ Based on the Home Disclosure Act data for 1990, together with their own survey, the authors concluded that the data showed substantially higher denial rates for black and Hispanic applicants. Even high-income ethnic minorities, the authors claimed, were more likely to be turned down than low-income whites. They reached this conclusion after finding that the higher denial rate for minorities is accounted for, in large part, by such applicants having higher loan-to-value ratios and weaker credit histories than whites; they are also more likely to seek to purchase a two- or four-unit property than a single family home. A black or Hispanic applicant in the Boston area is roughly 60% more likely to be denied a mortgage than a similarly situated white applicant. “In short,” the paper concludes, “the results indicate that a serious problem exists in the market for mortgage loans, and lenders, community groups and regulators must work together to ensure that the minorities are treated fairly.”⁵ The authors rightly state that “this pattern has triggered a resurgence of the debate on whether discrimination exists in mortgage lending.”

The study did more than trigger a debate; it led to increased community activity and encouraged politicians to use legislation and bank lending to achieve social aims. Groups such as the Association of Community Organizations for Reform Now (ACORN) and many other local groups engaged in direct action, such as arranging sit-ins in bank branches until banks agreed to lend more, entering into partnerships with local groups to lend to low-income areas, or demanding that banks publish more of the information they were already required to provide for the authorities under the Home Mortgage Disclosure Act, 1975.

The article also sparked an intense political debate, conducted in the media, and had a major influence on public policy, largely because it came from an important government agency and, as such, was bound to capture public attention. Its central claim did not go undisputed. It led to an avalanche of academic papers, some arguing that the conclusions were based on incomplete data or; that there were serious errors in the data, which, when removed, also removed the evidence supporting the discrimination hypothesis;⁶ that several alternative model specifications perform better than the logit regression models used for the Boston study in terms of various econometric performance measures, and do not support the conclusions;⁷ or that the model uncertainty can be eliminated using Bayesian model averaging (the result of the latter indicates that race has little effect on mortgage lending.⁸) Another paper rejected the Boston study’s market level model, arguingthat the “standard” Boston model can only be used, at best, on the basis of a bank-specific analysis, based on its own particular lending guidelines.⁹

Many studies followed the Boston one in focusing on denial rates. Others argued that this was entirely the wrong approach: they have “not determined the profitability of loans to different groups … A valid study of discrimination in lending would calculate default rates, late payments, interest rates and other determinants of the profitability of loans” and that “failure to do so is a serious methodological flaw.”¹⁰ Still other analyses indicated that black households have higher default rates, suggesting that differences in defaults or transaction costs may explain the results.¹¹ The wide range of criticisms of the Boston analysis suggests that it may not have been the most reliable foundation on which to build public policy, but neither politicians nor regulators wished to be perceived as being unconcerned about such widely reported racial discrimination in lending.

Lawrence Lindsay, then a member of the Board of Governors of the Federal Reserve, having been informed of numerous problems in the Boston study said, “The study may be imperfect, but it remains a landmark study that sheds an important light on the issue of potential discrimination in lending.”¹² This, despite the fact that the vital element missing in the HMDA data is a lack of information about the credit history of the borrower and the difficulties as time went on in tracking default rates. These are both issues regarding data which will be explored at a later stage.

Changing the underwriting standards

Given that the debate about racial discrimination began at the Federal Reserve Bank of Boston, it is small wonder that it was followed by “Closing the Gap: A Guide to Equal Opportunities Lending” with a foreword by Richard Syron, President and Chief Executive, in which he quoted approvingly Lawrence B. Lindley, a member of the Board of the Federal Reserve System: “The regulatory issues in the 1990s will not be limited to safety and soundness, but will increasingly emphasise fairness: whether or not the banks are fulfiling the needs of their communities.” Syron states that the Federal Reserve Bank of Boston have developed a comprehensive program for all lenders who wish to ensure that all their borrowers are treated fairly, and to “expand their markets to reach a more diverse customer base.” Lenders should review every aspect of their lending practices, staffing and training to ensure that no part of the process is “unintentionally racially biased,” since underwriting guidelines are historically based on “data that primarily reflect nonminority mortgage loan participants.”¹³ In particular, the lack of a credit history “should not be seen as a negative factor,” since certain cultures encourage a “pay-as-you go” approach. Instead a willingness to pay debt promptly should be assessed through a review of utility, telephone and medical bills, and rent payments; and past credit problems should be reviewed for extenuating circumstances.

Similar considerations should apply to employment history, where lenders should focus on the applicant’s ability to maintain or increase his or her income level. Interestingly enough, the Guide noted that Fannie Mae and Freddie Mac (of which more later) would accept as valid income sources: overtime and part-time work; second jobs (including seasonal work); retirement and Social Security income; alimony and child support; Veterans administration benefits; welfare payments and unemployment benefits. Together with CRA-lending (see below), these recommendations would inevitably weaken underwriting standards, as thrifts and commercial banks sought to increase lending based on this guidance.

Using the Community Reinvestment Act (CRA)

All of these issues lay behind the development of the National Homeownership Strategy as described in an Urban Policy Brief prepared by the Housing and Urban Development Department in 1995. The Strategy was described as an unprecedented public-private partnership, designed to increase home ownership to a record level over the following six years. Home ownership was described in romantic terms: “The desire for home ownership is deeply rooted in the American psyche. Owning a home embodies the promise of individual autonomy and of material and spiritual well-being … In addition to its functional importance and economic value, home ownership has traditionally conveyed social status and political standing. It is even thought to promote thrift, stability, neighborliness and other individual and civic virtues.” The brief then refers to the bi-partisan support for Federal policies designed to encourage home ownership from Presidents Herbert Hoover to Ronald Reagan.

The problem that President Clinton sought to address was the decline in home ownership rates beginning in the 1980s, falling to 64.1% in 1991. The decline was sharpest amongst those for whom the possibility of buying their own homes has always proved more difficult such as low-income families with children (from 39% to 27%). Rates stagnated at about 43% for blacks, but dropped from 43% to 39% for Hispanics between 1980 and 1991. During the late 1960s and the 1970s, it was argued that banks would not lend to specific neighborhoods regardless of the residents’ creditworthiness, and that these areas were red-lined largely because of the residents’ race, ethnicity and income. Various Acts had been passed to reduce discrimination in the credit and housing markets, including the Fair Housing Act, 1974, the Equal Credit Opportunity Act, 1974 and the Home Mortgage Disclosure Act, 1975. The Community Reinvestment Act, 1977 (CRA) was also designed to encourage depository institutions to meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods “in a manner consistent with safe and sound operations.” The CRA applies to all federally insured banks.

To deal with all of these issues, President Clinton’s approach to the extension of home ownership, especially in low-income and underserved areas, which would greatly assist with the problem of racial discrimination, was two-pronged: the introduction of the Strategy; and the amendments to the regulations under the Community Reinvestment Act as a further step after the Federal Housing Enterprises Safety and Soundness Act, 1992, which, inter alia, requires the existence of the Federal National Mortgage Corporation and the Federal Home Loan Mortgage Corporation (commonly known as Fannie Mae and Freddie Mac respectively.) Fannie Mae and Freddie Mac had to meet annual percent-of-business goals established by the Housing and Urban Development Department (HUD) for three categories: low and moderate income; underserved; and special affordable.¹⁴ Clinton regarded the CRA changes as one of the highlights of his presidency:

One of the most effective things we did was to reform the regulations governing financial institutions under the 1977 Community Reinvestment Act. The law required federally insured banks to make an extra effort to give loans to low- and modest-income borrowers, but before 1993, it never had much impact. After the changes we made, between 1993 and 2000, banks would offer more than $800 billion in home mortgage, small-business and community development loans to borrowers covered by the law, a staggering figure that amounted to well over 90% of all loans made in the twenty-three years of the Community Reinvestment Act.¹⁵

When Congress passed the Act in 1977, it was built on the straightforward proposition that deposit-taking banking organisations have a special obligation to serve the credit needs of the neighborhoods in which they maintain branches. At the time of the passing of the Act, banks and thrifts originated the vast majority of home purchase loans. Concerns had been expressed not only about racial discrimination, but also about the deterioration in the condition of many of America’s cities, especially in low-income neighborhoods, and many believed that this had been caused by limited credit availability, blaming the mainstream depository institutions for their alleged unwillingness to lend to low-income neighborhoods, despite the presence of creditworthy consumers.

The initial focus on t...

Table of contents

• Fannie Mae and Freddie Mac
• Copyright
• Contents
• Acknowledgements
• List of Abbreviations
• Introduction
• Timeline
• 1: The Seeds are Sown
• 2: Two More Tools in the Tool-Kit
• 3: The Role of the Housing and Urban Development Department (HUD)
• 4: Mortgage Data
• 5: The “Mission Regulator” for Fannie Mae and Freddie Mac
• 6: The GSEs and the Developing Crisis
• 7: The Dominance of the GSEs
• 8: The Beginning of the End for Freddie Mac
• 9: The Beginning of the End for Fannie Mae
• 10: The Years 2005 to 2007
• 11: The Subprime Market Grew and Grew and No One Knew
• 12: Why Did Fannie Mae and Freddie Mac Get Away with It for So Long?
• 13: The End Cometh
• 14: What Next?
• Appendix
• Notes
• Bibliography
• Index