All of them needed NTMs (non-traditional mortgages) in order to meet various government requirements. Fannie and Freddie were subject to increasingly stringent affordable housing requirements; FHA was tasked with insuring loans to low-income borrowers that would not be made unless insured; banks and S&Ls were required by CRA to show that they were also making loans to the same group of borrowers; mortgage bankers who signed up for the HUD Best Practices Initiative and the Clinton administration’s National Homeownership Strategy were required to make the same kind of loans. Profit had nothing to do with the motivations of these firms; they were responding to government direction.
I’ll jump ahead a few pages to get to how this resulted in the mispricing of risk:
By 2000, Fannie was effectively in competition with banks that were required to make mortgage loans under CRA to roughly the same population of low-income borrowers targeted in HUD’s AH goals. Rather than selling their CRA loans to Fannie and Freddie, banks and S&Ls had begun to retain the loans in portfolio. In a presentation in November 2000, Barry Zigas, a Senior Vice President of Fannie, noted that “Our own anecdotal evidence suggests that this increase [in banks’ and S&Ls’ holding loans in portfolio] is due in part to below-market CRA products.”
In other words, banks and S&Ls subject to CRA were making mortgage loans at below market interest rates, and thus could not sell them without taking losses. This was troubling for Fannie because it meant that in order to capture these loans they would have to increase what they were willing to pay for these loans. Doing so would underprice the risks they would be assuming.
It is important to recognize what was happening. Fannie, and the banks and S&Ls under CRA, were now competing for the same kinds of NTMs, and were doing so by lowering their mortgage underwriting standards and adding liabilities and subsidies. Simply as a result of supply and demand, all of the participants in this competition were required to pay higher prices for these increasingly risky mortgages. The banks and S&Ls that acquired these loans could not sell them, without taking a loss, when market interest rates were higher than the rates on the mortgages. This is the first indication in the documents that the FCIC received from Fannie that competition for subprime loans among the GSEs, banks, S&Ls, and FHA was causing the underpricing of risk—one of the principal causes of the mortgage meltdown and thus the financial crisis.
One reason this process has gone so under-reported is that many of our debates about the role of the government in the housing crisis have centered on one piece of regulation or another. Was it the CRA? Was it Fannie and Freddie? Was it HUD?
What Wallison establishes is that we have perfect storm of regulation here. A bunch of different regulations that applied to different market and governmental actors all urged the same thing: lower credit standards and more risk.
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