“THE HOUSE OF the Rising Sun” is a folk song that once topped the charts in the United States; the most famous version was recorded by the English rock group The Animals in 1964. It’s a remorseful ballad that tells of a life gone wrong in New Orleans.
The housing market has a history of going wrong from time to time and certainly has been “the ruin of many a poor boy,” like the house of ill repute in the song; but never has the market extinguished more wealth and hopes than it did following the bursting of the housing bubble in 2007. That event was actually the culmination of numerous wrong turns by the housing industry that started at the beginning of the previous century. The industry’s road to ruin was paved with good intentions. However, once paved, it attracted too many people who were up to no good.
The timeline of housing industry transgressions from the righteous path starts during the early 1900s. That’s when the housing industry first teamed up with the federal government and financial institutions to promote and facilitate home ownership, a worthy goal indeed. After World War I, the United States faced a housing shortage and a wave of labor strikes and social unrest. A nationwide Own Your Own Home campaign was launched in 1918 by the US Labor Department and several industry groups representing real estate boards, contractors, as well as manufacturers and distributors of building materials and equipment.
Accomplishing the goals of this extensive campaign required a major expansion of the mortgage-lending business. Mortgage loans at the time generally were for no more than half the purchase price of the house and typically carried maturities of 10 years or less, with large balloon payments. In response to the need for more credit on better terms during the housing boom of the Roaring ’20s, building and loan associations flourished by pooling small savings deposits into mortgage loans that matured in up to 12 years and financed 60% to 75% of the property. Today, these institutions are called “savings and loans” (S&Ls), or “thrifts.” While certainly not an event of biblical proportions, this was the genesis of numerous financial innovations that eventually led to the financial engineering excesses that caused the Great Recession.
While business was good for the S&Ls, they were envious of commercial banks’ Fed backing. Something akin to the Federal Reserve System that Congress had created in 1914 would do nicely—they too wanted a lender of last resort. A bill introduced in Congress in 1919, promoted by the same special interest groups that had launched the Own Your Own Home campaign, established a system of federal building loan banks, modeled after the Federal Reserve System, to provide a liquidity reserve for the S&Ls. The bill languished until President Herbert Hoover in 1932 successfully pushed for the creation of the Federal Home Loan Bank (FHLB) system, which was administered by the Federal Home Loan Bank Board (FHLBB).
However, the FHLB came too late for the many S&Ls that failed during the banking crisis in the early 1930s. They had participated in the lending party of the Roaring ’20s, when total residential mortgage debt tripled. Lending standards deteriorated significantly as the building and loan associations offered second and third mortgages, balloon payments, and other innovations that made it easier to borrow money. By 1933, nearly half of home mortgages were in default. Sound familiar? The latest housing bubble confirms that history doesn’t just rhyme but sometimes repeats itself!
The very same leaders of the Own Your Own Home coalition now pressed the government for more help. In addition, President Franklin Roosevelt’s New Deal aimed to revive the busted housing market. About a third of the nation’s unemployed were in the building trade, and the government intended to get those laborers back to work by giving them homes to build.
Congress responded to these mounting pressures during the 1930s in several ways:
• 1933: HOLC. In June 1933, the Home Owners’ Loan Corporation (HOLC) was established. The HOLC introduced long-term, fixed-rate mortgage financing, specifically a self-amortizing, fixed-rate mortgage. HOLC stopped making loans in 1936 and ultimately ceased operations in 1951.
• 1933: FDIC and FSLIC. The Federal Deposit Insurance Corporation (FDIC) was created in 1933 for commercial banks to insure their deposits with funds it raised from the banks. At the same time, commercial banks were prohibited from owning investment banks. One year later, the Federal Savings and Loan Insurance Corporation (FSLIC) was set up to insure thrift deposits.
• 1934: FHA. Unlike HOLC, the Federal Housing Administration (FHA), created in the National Housing Act of 1934, never saw the sun set. The new agency provided federally backed insurance for home mortgages made by FHA-approved lenders, who were protected against losses on the mortgages they insured. The FHA was financed by insurance premiums charged to borrowers. In effect, the FHA successfully introduced a mortgage insurance system that reduced investment risk and facilitated longer-term and more highly leveraged loans at lower interest rates. It spawned private competitors such as the Mortgage Guarantee Insurance Corporation, which was founded by a real estate attorney in 1957. This was the beginning of private-sector financial institutions mimicking federal government programs to facilitate mortgage lending. So the FHA was the precursor of the credit insurance industry that culminated in the credit derivatives excesses that led to the financial meltdown during 2008.
• 1938: Fannie Mae. The Federal National Mortgage Association was established by a 1938 amendment to the National Housing Act of 1934. “Fannie Mae,” as it’s affectionately nicknamed, began life as a federal government agency. It was transformed into a public–private mixed-ownership corporation in 1954, then later to a private, shareholder-owned entity in 1968. As such, Fannie is a so-called “government-sponsored enterprise” (GSE)—a private company with a public purpose. Fannie’s public mandate is to increase mortgage market liquidity by providing lenders with more cash to fund home loans. It does so by serving as a secondary mortgage market facility allowed to purchase, hold, and sell FHA-insured loans. In other words, Fannie Mae takes loans off lenders’ hands.
Back in 1938, a family could buy a house with just 10% down, financing the remaining 90% of the purchase price via a 25-year FHA-insured mortgage loan. Many soldiers returning after World War II took out FHA loans, eager to settle down, raise a family, and put the war behind them. Demand among veterans was so great that in 1944, the Veterans Administration (VA) entered the mortgage insurance game. Qualified veterans could secure VA-insured mortgage loans for no money down whatsoever. Fannie Mae started buying VA-insured loans in 1948.
The US government became almost zealous about making housing ever more affordable, bringing the American Dream of homeownership within reach of more and more Americans. FHA down payments fell to 3% and sometimes to zero. As a result, homes became highly leveraged assets, which was a win-win for everyone as long as the borrower could make the mortgage payments and home prices didn’t fall.
In fact, US home prices rose for quite a long while. From the end of World War II until 2007, they remained on an ever-rising trajectory as easily available mortgage credit bolstered demand for housing by the parents of the Baby Boomers and then by their multitudinous progeny.
Increasingly during the 1950s and the first half of the 1960s, however, the FHA was justly accused of contributing to the ruin of many American cities by subsidizing the departure of white middle-class families to the suburbs. Conversely, the agency was quite stingy in making loans to low-income workers for urban rental units, and cities fell into decline. With good intentions that spawned bad unintended consequences, the federal government was there to help. Under President Lyndon Johnson, the Housing and Urban Development Act of 1968 created the Department of Housing and Urban Development (HUD). It was established as a Cabinet department as part of Johnson’s “Great Society.” Consistent with Johnson’s civil rights initiative, the FHA was folded into HUD, which increasingly pushed lenders to make more mortgages to low-income borrowers.
The 1968 Act also ended Fannie Mae’s 30-year monopoly over the secondary mortgage market. The Government National Mortgage Association was set up as a government-owned corporation within HUD. “Ginnie Mae” guarantees timely payment of principal and interest on privately issued mortgage-backed securities (MBSs); these are basically pools of federally insured or guaranteed mortgage loans issued mainly by the FHA or VA but sometimes by other issuers. At the same time, the 1968 Act converted Fannie Mae into a private, shareholder-owned corporation, as mentioned earlier.
Two years later, the Emergency Home Finance Act of 1970 created a new housing-related GSE, the Federal Home Loan Mortgage Corporation, nicknamed “Freddie Mac.” It was established to service the thrift industry, which always seemed to want and to get whatever toy Congress gave the commercial banks. In addition, the Act expanded the powers of the two housing GSEs: Fannie and Freddie now were allowed to buy and sell mortgages and MBSs that the federal government had neither insured nor guaranteed. That incentivized lenders to churn out more “conventional” mortgage loans with less regard for loan quality; after all, the loans wouldn’t remain in their portfolios. This unintended consequence of the new business model for the GSEs helped to pave the road to housing market ruin in 2008.
So the two agencies could buy conventional conforming mortgages from banks and other lenders as well as MBSs from investment firms—freeing up more lenders’ capital to go toward more lending. They also could issue and guarantee MBSs collateralized by these mortgage loans, and they could hold mortgage loans and MBSs in their portfolios. In 1971, Freddie Mac issued the first conventional loan MBS.
Congress in 1992 granted HUD the power to regulate Fannie Mae and Freddie Mac. HUD’s Office of Federal Housing Enterprise Oversight regulated these two publicly traded GSEs until 2003, when Congress shifted oversight to the Treasury Department. The 1992 law required HUD’s secretary to make sure that housing goals were being met and, every four years, to set new goals for Fannie Mae and Freddie Mac.
HUD pushed mortgage lenders to lower their standards and extend even more credit to low-income borrowers. Both Henry Cisneros, HUD Secretary from 1993 to 1996, and his successor, Andrew Cuomo, HUD head from 1997 to 2001, took their homeownership-promoting cues from their boss, President Bill Clinton. At the 1996 Democratic National Convention, Clinton announced: “Tonight, I propose a new tax cut for homeownership that says to every middle-income working family in this country, ‘If you sell your home, you will not have to pay a capital gains tax on it ever—not ever.’”
The next year, Clinton’s proposal became law: the Taxpayer Relief Act of 1997 exempted most home sales from capital gains taxes. Specifically, the law exempted the first $500,000 in home sale gains for a married couple—and the first $250,000 for singles—provided that they had lived in the home for at least two of the previous five years. Prior to 1997, a one-time capital gains exclusion of up to $125,000 was permitted for homeowners over the age of 55. That meant people no longer would have to buy a house valued at least as high as their previous one to avoid the tax if they had already used their one-time exemption. Americans now had even more incentive to buy and sell homes. According to an article in the December 18, 2008 New York Times, a study by a Federal Reserve economist suggested that 17% more homes were sold during the decade after the law’s passage than would have been the case without the law.
The loosening of mortgage restrictions under Cisneros allowed first-time buyers to qualify for loans they never previously could have received, thus setting the stage for the subprime mortgage meltdown that began 10 years after he left HUD. President Clinton endorsed HUD’s National Homeownership Strategy, which was viewed as a win-win policy and quickly implemented as follows: (1) First-time homebuyers applying for HUD-insured mortgages no longer were required to prove five years of stable income; three years was enough. (2) Lenders were permitted to hire their own appraisers rather than independents approved by the government; these saved borrowers some money but inflated appraisals. (3) Lenders no longer had to interview most government-insured borrowers in person or maintain physical branch offices.
HUD under Cisneros’ reign instituted, in December 1995, a requirement that 42% of GSE mortgages serve low- and moderate-income families. Later, under Cuomo, that was raised to 50%. Cuomo also upped the GSEs’ quota of mortgages bought that reflected underserved neighborhoods and very low-income borrowers. “Part of the pitch was racial,” asserted an article in the August 5, 2008 Village Voice, “with Cuomo contending that the GSEs weren’t granting mortgages to minorities at the same rate as the private market.”
At first, the new rules didn’t sit well with Franklin Raines, who presided over Fannie Mae from 1998 to 2004. “We have not been a major presence in the subprime market,” he said according to an August 5, 2008 article in the Village Voice, “but you can bet that under these goals, we will be.” If Raines thought that diving into the risky subprime end of the market was imprudent or even reckless, Cuomo shared no such qualms. “GSE presence in the subprime market could be of significant benefit to lower-income families, minorities, and families living in underserved areas,” Cuomo wrote about his new goals, according to the Voice. Effectively, the government forced the GSEs into a much riskier business model. Prescient industry observers expressed concern that the new mandates would result in rising loss levels for the GSEs, leading to a possible government rescue.
So the GSEs dove into risky business notwithstanding the initial reservations of Raines and others—and with seeming abandon. They embraced alternative loan products, subprime loans and securities, and flexible product lines that provided 100% financing with as little as $500 down from borrowers. All three—Fannie Mae, Freddie Mac, and Ginnie Mae—pioneered the securitization of mortgage loans. Their securities were highly prized because they were deemed to be government guaranteed; strictly speaking, however, that was true only of Ginnie Mae securities.
To an important extent, the financial calamity of 2008 was greatly compounded by so-called “private-label” securitization of mortgages by Wall Street’s credit derivative wizards. These securities were created using highly complex and opaque derivatives that magically made them seem—and be deemed—as creditworthy as the ones created by the GSEs, which of course they weren’t.
All these factors combined to create one colossal mess, culminating in the financial crisis of 2008. However, before that major debacle, there was a warm-up act during the late 1980s and early 1990s involving the S&L industry. It provided a cautionary tale that was largely ignored.