One of the more consequential moments for the future of the U.S. economy happened off the campaign trail Monday, at a ballroom in the Mandalay Bay Hotel in Las Vegas. At the annual conference of the Mortgage Bankers Association, Mel Watt, chairman of the Federal Housing Finance Agency (FHFA)—the conservator for Fannie Mae and Freddie Mac—delivered a speech that will matter to anyone who wants to buy a home or even hold down a steady job in the next few years.
As expected, Watt signaled to mortgage bankers that they can loosen their underwriting standards, and that Fannie and Freddie will purchase the loans anyway, without much recourse if they turn sour. The lending industry welcomed the announcement as a way to ease uncertainty and boost home purchases, a key indicator for the economy. But it’s actually a surrender to the incorrect idea that expanding risky lending can create economic growth.
Watt’s remarks come amid a concerted effort by the mortgage industry to roll back regulations meant to prevent the type of housing market that nearly obliterated the economy in 2008. Bankers have complained to the media that the oppressive hand of government prevents them from lending to anyone with less-than-perfect credit. Average borrower credit scores are historically high, and lenders make even eligible borrowers jump through enough hoops to garner publicity. Why, even Ben Bernanke can’t get a refinance done! (Actually, he could, and fairly easily, but the anecdote serves the industry’s argument.)
It’s important to separate the truth about housing regulations from the industry’s propaganda. Doing so reveals the mortgage industry's effort to strangle the housing market in the short term and cull regulations in the long term.
After the financial crisis, Congress did enact a series of changes designed to prevent another epidemic of predatory lending. The most important rules force lenders to actually consider a borrower’s ability to repay the loan—something that ought to be self-evident, but wasn’t during the bubble.
But another thing happened after the crisis. The collapse of the private mortgage-backed securities market has led to Fannie and Freddie, the so-called government-sponsored enterprises (GSEs), either buying or guaranteeing nine out of every ten new loans. Lenders who want to sell their mortgages rather than hold onto them—and that’s basically everyone—must therefore conform to GSE purchasing standards.
Under the “representations and warranties” language that accompanies any sale, the GSEs can identify loans that don’t meet their standards and force the lender to buy them back. Since 2011, FHFA has settled 17 lawsuits with banks over reps and warranties for over $18.2 billion in cash, and collected billions in additional repurchases.
This one-two punch of enhanced regulation and the threat of consequences for bad lending has created a much safer housing market. Mortgages originated in 2012-2014 have performed exceedingly well, with low rates of default. But mortgage lenders are unhappy with any oversight that eats into their profits.
So the industry has engaged in an insidious tactic: tightening lending well beyond required standards, and then claiming the GSEs make it impossible for them to do business. For example, Fannie and Freddie require a minimum 680 credit score to purchase most loans, but lenders are setting their targets at 740. They are rejecting eligible borrowers (which, after all, make lenders money) so they can profit much more from a regulation-free zone down the line.
Let’s call this what it is: a shakedown. You can see this clearly from the opening session of the Mortgage Bankers Association conference, where the trade group’s leadership sounded more like mob dons. “If they're going to regulate us, they must work to better understand the unintended consequences on consumers,” said MBA Chairman Bill Cosgrove. “Enforcement should be the exception to the rule, not the rule itself,” added President David Stevens. Concluded Cosgrove, “Today's lenders are paying many times over for mistakes that may have been out of their control... It's time for the penalty phase to end.” Nice mortgage market you’ve got there; shame if something happened to it.
Sadly, Watt, the FHFA chairman, has paid attention to these howls of protest, and has scrambled to “open the credit box,” to use the industry term. In Monday’s speech, he announced additional changes to the representations and warranties language. Generally speaking, the GSEs limit buybacks to the first three years. But they can demand buybacks later in certain prescribed cases of fraud, data inaccuracies or misrepresentation. However, Watt announced that his agency would establish “a minimum number of loans that must be identified with misrepresentations or data inaccuracies” to trigger the buybacks. In other words, lenders can now pass the GSEs a certain number of fraudulent loans, as long as they stay below the threshold.
Watt also added a “significance” test, requiring repurchase of mortgages with misrepresentations only if the loan would have otherwise been ineligible for GSE purchase. In other words, the misrepresentations themselves—inaccurate borrower income statements, for example—are acceptable, unless they meet this subjective “significance” standard, which lenders can dispute through a new, independent process.
It’s important to note that the GSEs do not independently review the loans they purchase. They ask the lenders to self-represent that the loans meet their criteria. So the threat of repurchases really represents the only opportunity for the GSEs to enforce their rules. Limiting them creates powerful incentives for lenders to pass off bad loans, putting all the risk on the GSEs—at this point the taxpayer—while collecting all the profits. (Rules to force lenders to retain some risk on the mortgages they sell have been weakened as well, removing another reason for them to care about the quality of the loans.)
In addition, Watt announced new guidelines to accept as low as 3 percent down payments for “targeted” borrowers, rather than the current limit of 5 percent. While Watt stressed that the 3 percent down payment policy was narrow, Fannie Mae CEO Tim Mayopoulos seemed ebullient about it in a separate speech. “We want this business,” Mayopoulos gushed. Incidentally, it’s just axiomatic that mortgages with lower down payments have higher default rates.
MBA President David Stevens praised Watt’s speech, and with good reason. By taking the GSEs off the playing field in seriously enforcing lending standards, policing the mortgage market falls to the Consumer Financial Protection Bureau, which has authority under the ability-to-repay rule. CFPB simply has a much smaller staff and resources to oversee a multi-trillion-dollar market. Moreover, it was the threat to lenders’ bottom lines that kept them from falling back to old predatory habits. Only the GSEs had the ability to make that threat credible, and now they’re bugging out.
The entire sorry display reflects a false premise. Tight lending isn’t holding back the housing market, at least not any more than a lack of money in the bank accounts of the vast majority of would-be borrowers. Having low- and middle-income Americans over-extend themselves with risky mortgages creates only an illusion of prosperity, one that’s sure to crash if and when they subsequently fall into foreclosure. “If we don’t get solid wage growth among the lower-income population, there’s no way we can solve that problem with more aggressive lending,” said Amir Sufi, professor of finance at the Booth School of Business at the University of Chicago.
Fixing the housing market requires putting people in the financial position to carry a mortgage, not slashing lending standards. It’s as if government’s best and brightest threw up their hands, deciding they had to return to bubble economics as the only way to produce growth. This has the lending industry, which profits handsomely from bubbles on the way up, licking their chops, especially if they can sell off the loans to the taxpayer and let them deal with the consequences.
Given what we know about how lenders shuttled borrowers with weak credit into loans they couldn’t afford, the prospect of a rerun should be frightening enough for any policymaker to reject. But the industry played Mel Watt and other officials like a fiddle, and we’ll all be singing the blues in the aftermath.