The Role of the Federal Government
in the Home Mortgage Market
by Frank A. Hinton
Abstract
This paper will address what current programs are in place to encourage home ownership,
and what changes the federal government should pursue to continue a policy of encouraging
homeownership. Overall, the Government should encourage responsible borrowing instead of
simply making it easier to borrow. Changes in the mortgage market, including subprime lending,
credit scoring, and secondary markets for mortgages have made it much easier for people to
borrow. Government should not expand the role of the FHA or government sponsored
enterprises (GSE’s, or Fannie Mae or Freddie Mac). Instead, the federal government should end
subsidies for Fannie Mae and Freddie Mac, including the implied guarantee, and replace the
Mortgage Interest Deduction with a first-time homebuyers credit and first-time homebuyers
savings account.
There is research that shows that GSE’s have had no provable effect on homeownership.
While some have suggested that GSE’s are more efficient than traditional deposit account backed
mortgages because of securitization, securitization is now taking place outside of GSE’s, and this
is likely the result more of deregulation than of the role of GSE’s. Also, there is an implicit
government guarantee of these securities, which may not actually exist in law. Even so, the
federal government would probably bail them out, and this creates a taxpayer subsidy for risky
investments. Although they are private enterprises, GSE’s do receive federal subsidies, and there
is no guarantee that they will use these subsidies in the public interest.
The FHA has been successful in helping put low income and minorities in homes.
However, the FHA is much less central to the mortgage market than it used to be, because the
markets have become more adept at assessing risk, and thus can make loans without FHA
guarantees. Currently there are efforts to modernize FHA by increasing the amount of loans
covered, decreasing downpayment requirements, and imposing risk-based premiums. Such
changes may increase homeownership, but at the risk of putting people in homes that they are not
ready to purchase. There is also the problem of raising housing prices by increasing demand.
One of the better options suggested has been a first time homebuyers credit along with a
subsidized saving plan. The proponents of this proposal argue that this would increase
homeownership without changing demand for housing, and thus not causing housing prices to
rise. It would also encourage saving and encourage higher downpayments. Thus, buyers would
be in better positions to purchase than under expanding the FHA, which would encourage more
risky mortgages.
1
Table of Contents
INTRODUCTION ............................................................................................................................... 2
WHY SHOULD THE GOVERNMENT ENCOURAGE HOMEOWNERSHIP? .......................................... 3
GOVERNMENT PROGRAMS TO ENCOURAGE HOMEOWNERSHIP .................................................. 8
THE FHA ...................................................................................................................................... 8
GOVERNMENT SPONSORED ENTERPRISES ................................................................................... 12
Securitization.......................................................................................................................... 12
The Retained Portfolio ........................................................................................................... 13
THE MORTGAGE INTEREST DEDUCTION...................................................................................... 17
DEVELOPMENT OF THE SUBPRIME MARKET ............................................................................... 18
DEREGULATION IN THE 80’S ....................................................................................................... 19
RISK ASSESSMENT AND RISK-BASED PRICING. ............................................................................ 19
INEFFICIENCY AND CRISIS IN THE SUBPRIME MARKET .............................................................. 21
RECOMMENDATIONS .................................................................................................................... 23
INTRODUCTION
The mortgage market has undergone enormous change in the last several decades.
Deregulation of the mortgage industry, along with creation of a new secondary market for
mortgages and better ability to measure risk has led to more liquidity in the market and
innovative mortgage products. The new industry is not without its growing pains, though, and we
are now experiencing them in a new wave of foreclosures, which will have an enormous impact
on homeowners and threatens economic growth in the overall economy. Although there is
independent reason to believe Federal programs need to be reformed, it is the current crisis in the
home mortgage market that presents an incentive to take action by policy-makers. Some clearly
want to use homeownership programs as a palliative for threatened homeowners, while others
2
believe the Federal programs could be effective tools of macroeconomic policy; that is, to
prevent the mortgage crisis from affecting overall economic growth. This paper will argue that
short-term concerns should not affect changes in federal homeownership policy, but instead our
policies should be toward supplementing opportunities for homeownership in an increasingly
efficient market.
The federal government has long pursued policies to increase homeownership, starting
with the introduction of the FHA during the New Deal era, and now including the mortgage
interest deduction and the Government Sponsored Enterprises (GSEs) known as Fannie Mae and
Freddie Mac. This paper takes a broad look at the most visible of government homeownership
programs and seeks to evaluate their continuing effectiveness in light of recent developments in
the home mortgage market. This paper argues that: 1) the government should encourage
homeownership, 2) the FHA is an effective tool for doing this, but has lost importance as a result
of the development of subprime lending, 3) the GSE’s innovation lies mainly in the creation of a
secondary market, and subsidizing them is no longer an efficient use of government resources,
and 4) the mortgage interest deduction does little to encourage homeownership and should be
replaced with a refundable homeownership credit.
WHY SHOULD THE GOVERNMENT ENCOURAGE HOMEOWNERSHIP?
Homeownership should not be an end in itself, but should be a means of building wealth,
and narrowing the wealth gap. Research points out that homeownership has many positive
externalities, including building wealth and increasing educational opportunities for children.1
1
Michael Collins, Eric Belsky, and Karl E. Case, Exploring the Welfare Effects of Risk-based Pricing in the
Subprime Mortgage Market 6 (Joint Center for Housing Studies of Harvard University, Paper BABC 04-8, 200k4),
available at http://www.jchs.harvard.edu/publications/finance/babc/babc_04-8.pdf.
3
For example, studies have found that children of homeowners are more likely to graduate and
obtain overall higher levels of education than children of renters, and this is especially true
among low-income families.2 Others have found that that while the principal forms of household
wealth, including homes and retirement assets do not generate income, they add to overall
financial security, as well as increasing economic and political power.3
Wealth inequality in the U.S. is too high, and it is growing. In 2001, the top 1 percent of
the population controlled 33.4 percent of household wealth, and the top 20 percent owned 84.4
percent of the nations wealth.4 Comparing the Gini indices for income distribution to wealth
distribution is useful to show the gap between rich and poor. In 2005, the Gini index for income
was 0.47, while the Gini index for wealth was 0.81 in 2006. The income inequality gap is also
fairly substantial, but not nearly as unequal as the wealth gap.5 Table 1 Shows the bottom
quartile of American households in 2004 had no net wealth at all, while the top quartile controls
87 percent of total wealth.6
2
Christopher E. Herbert and Eric S. Belsky, The Homeownership Experience of Low-Income and Minority
Families: A Review and Synthesis of the Literature 103-105 (U.S. Dep’t. of Housing and Urban Development,
Office of Policy Development and Research 2006).
3
Edward N. Wolff and Ajit Zacharias, Wealth and Economic Inequality: Who’s at the Top of the Economic
Ladder? 5 (Levy Institute December 2006) available at http://www.levy.org/pubs/limew1206.pdf.
4
JONATHAN BARRY FORMAN, MAKING AMERICA WORK 36 (Urban Institute 2006).
5
Wolff & Zacharias, supra note 3, at 5.
6
Zhu Xiao Di, Growing Wealth, Inequality, and Housing in the United States 4 (Joint Center for Housing Studies of
Harvard University, Paper W07-1, 2007), available at http://www.jchs.harvard.edu/publications/markets/w07-1.pdf.
4
Table 1. Wealth Distribution is Much More Unbalanced than That of Income.
Source: Zhu Xiao Di, Growing Wealth, Inequality, and Housing in the United States 4 (Joint Center for Housing
Studies of Harvard University, Paper W07-1, 2007), available at
http://www.jchs.harvard.edu/publications/markets/w07-1.pdf.
Between 1995 and 2004, the wealth gap increased despite increased wealth amongst the
top three quartiles (the bottom quartile still had no net wealth). In 1995, top quartile households
had 23.5 times as much wealth as the lower middle quartile, which increased to 33 times as much
in 2004. Over the same period, the bottom quartile actually saw a loss in average net wealth.
Table 2. Comparisons of Wealth and Income Distribution
5
Source: Zhu Xiao Di, Growing Wealth, Inequality, and Housing in the United States 22 (Joint Center for Housing
Studies of Harvard University, Paper W07-1, 2007), available at
http://www.jchs.harvard.edu/publications/markets/w07-1.pdf.
Wealth inequality has grown, and homeownership has actually exacerbated wealth
inequality. While housing wealth increased among all quartiles, the top quartile saw a much
larger increase in housing wealth than the bottom quartile. Thus, the wealth gap was actually
increased by housing wealth.7
As shown by Table 3, housing wealth is still much more evenly distributed than other
forms of wealth, and this was still a positive trend as of 2004. Despite the widening gap,
homeownership is increasing wealth in absolute terms at all levels. 8 Home equity is an
important part of this, and as of 2004, home equity was growing in the lower quartiles as well,
even despite the popularity of home equity loans.9
Home equity is still the single largest source of wealth in the United States, accounting
for 32.3 percent of all household wealth.10 Home equity is even more important among lower
7
Id.
8
Id. at 18.
9
Id.
10
Herbert & Belsky, supra note 2, at 4.
6
income and minority households, where home equity accounts for 56.2 percent of household
wealth among the lowest quartile of households, and 61.8 percent of household wealth for
African-Americans.11
Table 3. Housing Wealth More Evenly Distributed than Other Forms of Wealth.
Source: Zhu Xiao Di, Growing Wealth, Inequality, and Housing in the United States 5 (Joint Center for Housing
Studies of Harvard University, Paper W07-1, 2007), available at
http://www.jchs.harvard.edu/publications/markets/w07-1.pdf.
To sum up, the wealth inequality gap has increased, and housing wealth has exacerbated
that gap. However, housing wealth is increasing net wealth across the board. These numbers are
from 2004 at their latest, and it is unclear whether what direction wealth equality has taken since
then. As the subprime crisis had not hit when these figures came out, it is not out of the realm of
reason to predict that the wealth inequality gap will continue to grow, and it is unclear whether
the trend of increasing housing wealth will continue. It is not enough to hope that the subprime
11
Id.
7
bust will not threaten this positive trend. One can imagine that, given recent developments, this
trend in increasing home equity across the board may take a downward turn.
GOVERNMENT PROGRAMS TO ENCOURAGE HOMEOWNERSHIP
THE FHA
The FHA is a federal government agency that was created in 1934 to insure the full value
of home loans made by private lenders. This was a response to bank failures that locked up the
housing market during the Great Depression. The FHA has been credited with increasing the
homeownership rate from 40 percent during the Great Depression to around 67 percent today.12
Perhaps one of the most important contributions of the FHA has been in creating a new
standard for long-term fully amortized home loans. Prior to the introduction of the FHA, loans
were typically short-term loans of 3 to 5 years, at the end of which the full balance of the loan
would become due. When the balloon payment came due, homeowners would simply refinance
for another short-term loan. By insuring the entire value of a 20-year mortgage with 80 percent
loan-to-value ratio (later 30 years, with 95+ percent loan to value ratio), the FHA took on the risk
that borrowers would default, making banks more willing to loan with lower downpayments and
longer repayment terms. Thus, the FHA helped create what we think of as the standard mortgage
product today.13
A few questions are raised with regard to the FHA. First, does the FHA actually increase
homeownership? Second, even if it does, is it worth the risk (which the taxpayer ultimately
bears). Third, what changes could make the FHA more effective.
12
Albert Monroe, How the Federal Housing Administration Affects Homeownership 3 (Joint Center for Housing
Studies of Harvard University, Paper W02-4, 2002), available at
http://www.jchs.harvard.edu/publications/governmentprograms/monroe_w02-4.pdf.
8
Harvard economist Albert Monroe finds that the FHA does increase homeownership. By
comparing FHA affordability with conventional loan affordability, Monroe concludes that the
FHA increases homeownership by 0.6 percent overall. What is more interesting is that the FHA
has its greatest impact among the least-advantaged, raising homeownership rates between 1970
and 1990 by 1.57 percent among those in the 90th percentile of FHA’s effects on house purchase
affordability, and by as much as 3.66 percent among blacks in the 90th percentile, and 5.17
percent among married couples with children in the 90th percentile.14
Monroe’s study measures the effects of the FHA for a time before the recent boom of
subprime lending. It is of course, very unclear whether the FHA’s effect holds true in light of the
development of subprime lending. FHA- and VA-guaranteed loans dropped from 7.4 percent of
market share in 2001 to just 2.7 percent in 2005. During that same time, subprime and Alt-A
loans increased from 11.3 percent to 32.5 percent.15
The benefits that the FHA once provided in the market have slowly been worn away.
While at one time the FHA offered the best option for those with little money for downpayments,
now mortgages are available in the subprime market that require less than the 3 percent FHA
requirement.
Proposals to update and modernize the FHA are widely circulated. Of course, President
Bush’s initiative is the one that has gotten the most attention. The basics of the legislation are
higher caps on loan amounts, risk-based pricing of premiums, eliminating requirements for
13
Id. at 5-6.
Id. at 5.
15
Robert Van Order, Government Sponsored Enterprises and Resource Allocation: With Some Implications for
Urban Economies 11 (Ross School of Business Paper No. 1085, 2007), available at
http://ssrn.com/abstract=1002467.
14
9
downpayments, and increasing the loan term from 30 to 40 years.16 House Resolution 1852, the
bill that contains the President’s plan to modernize the FHA has passed the U.S. House of
Representatives, and has been referred to committee in the Senate.17 In the regulatory field, the
President has already implemented a plan to allow delinquent mortgagors to refinance with FHA
backed loans.18
H.R. 1852 seems to have fairly substantial bipartisan support, with 348 voting for it, and
72 voting against it in the House. All Democrats who voted cast their votes in favor of the bill,
as did a majority of Republicans.19 Supporters of FHA reform see H.R. 1852 as both a way to
mitigate the current mortgage crisis and as a way to positively affect homeownership more
generally.
Douglas Elmendorf of the Brookings Institution suggests that the FHA should be the
vehicle through which the government tries to mitigate the mortgage crisis. Specifically,
Elmendorf says that using the FHA would be a more direct and controlled way to prevent
foreclosures than to allow the GSEs to enter the subprime market. Elmendorf suggests the
efforts should be limited to those at risk of losing their homes who can reasonably afford to stay
in their homes with an FHA refinance, and should also specifically not cover those who bought
homes as investments, or those who simply cannot afford to stay in their homes. In other words,
16
Federal Housing Administration, Overview of Current Reforms and Reform Legislation,
http://www.fha.gov/reform.cfm.
17
H.R. 1852, 110th Cong. (2007).
18
Legislative and Regulatory Options for Minimizing and Mitigating Mortgage Foreclosures: Hearing Before the
House Committee on Financial Services, 110th Cong. (2007) (statement of Alphonso Jackson, Secretary of Housing
and Urban Development), http://financialservices.house.gov/hearings_all.shtml.
19
Office of the Clerk, U.S. House of Representatives, http://clerk.house.gov/evs/2007/roll876.xml.
10
personal responsibility should be balanced with limited efforts to help those who are most in
need and least at fault.20
Proposals to modernize the FHA walk a fine line between continuing the policy of
encouraging homeownership and bailing out borrowers. Certain aspects of FHA modernization
have the smell of a bailout about them, specifically the regulatory change known as FHASecure
that allows the FHA to refinance delinquent subprime mortgages, and the zero-downpayment
requirement. Kiff and Mills also recommend modernization of the FHA as a palliative, and agree
with Elmendorf that “subprime borrowers should not be artificially kept in houses they cannot
afford”21 and suggest that zero-downpayment mortgages and refinances of subprime mortgages
do exactly that.22
As it seems likely that some form of H.R. 1852 will be passed in the near future, this is
probably the fine line that must be drawn. Political reality is that the FHA will be expanded.
The question is whether its expansion will be a modernization that will offer those who can
afford it a safer alternative to the subprime market, or whether it will be a bailout of an industry,
as well as individuals, that took risks and lost. This paper argues elsewhere that the market is in
the process of correcting itself. Major reform should be to make the FHA more responsive to
developments in the mortgage industry, but not make the FHA a tool for a bailout.
20
Douglas W. Elmendorf, Notes on Policy Responses to the Subprime Mortgage Unraveling, 6 (Brookings,
September 2007), available at http://www3.brookings.edu/views/papers/elmendorf200709.pdf.
21
John Kiff and Paul S. Mills, Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime
Mortgage Markets 15 (IMF Working Paper No. 07/188, 2007), available at http://ssrn.com/abstract=1006316.
22
Id.
11
GOVERNMENT SPONSORED ENTERPRISES
Among the most controversial of all government programs are the Government
Sponsored Enterprises, Fannie Mae and Freddie Mac. GSEs do two things. First, they help
mortgage originators package mortgages as residential mortgage-backed securities to sell on
financial markets (a process called securitization), and then they provide credit guarantees for
those mortgage backed securities. Second, GSEs borrow money by issuing debt securities on
financial markets in order to buy mortgages, which they then hold in their own portfolios.23 Both
of these activities are designed to free up cash so that banks can make more mortgage loans.24
These institutions are subject to a number of criticisms, including that they do not increase
homeownership, they increase demand, and thus price, for housing, and that they are
monopolistic.
Securitization
Securitization has probably done more than anything to transform the mortgage industry.
Securitization allows the mortgage originator to sell a group of mortgage obligations to a third
party, sometimes a GSE, which packages the mortgages and resells them on capital markets as
mortgage-backed securities.
The traditional method of financing home loans with money from depository accounts
was inefficient, in the sense that banks originated the loans, and held them as portfolio
investments. Thus, a bank (or other depository institution) carried the entire risk of default and
23
David J. Reiss, The Federal Government's Implied Guarantee of Fannie Mae and Freddie Mac's Obligations:
Uncle Sam Will Pick Up the Tab 2 (Brooklyn Law School, Legal Studies Paper No. 83, 2007). available at
http://ssrn.com/abstract=1010141.
24
Id. at 1-2
12
all the risk of fluctuating interest rates. Securitization was simply a way of tapping a new source
of funds and spreading risk to capital markets.25
In the late 1960s and early 1970, Congress created the modern entities of the Government
National Mortgage Association, or Ginnie Mae, a government agency, and the Federal National
Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corporation, or
Freddie Mac, which are government-sponsored private enterprises. Freddie Mac and Fannie Mae
(the GSEs) essentially created the secondary mortgage market.26 In recent years, Fannie Mae and
Freddie Mac have purchased 70 percent of conventional, conforming loans. These are loans
made to prime borrowers under a certain value. This has propelled the two companies to become
the second and third largest companies in the U.S.27 Between 1975 and 2002, the GSEs went
from securitizing almost no loans to securitizing over 40 percent of the stock of home
mortgages.28
The Retained Portfolio
The most controversial aspect of the GSEs is their role in purchasing and holding
mortgages by issuing debt securities. Fannie Mae and Freddie Mac currently have $4.45 trillion
in mortgage obligations (including both the retained portfolio and the credit guarantees on
mortgage-backed securities). The number in itself seems huge, but compare that number to the
25
Van Order, supra note 6, at 14; Kiff & Mills, supra note 21, at 4.
26
Van Order, supra note 15, at 5.
Jie Gan and Timothy J. Riddiough, Monopoly and Informational Advantage in the Residential Mortgage Market,
REVIEW OF FINANCIAL STUDIES 7 (forthcoming), available at http://ssrn.com/abstract=962321.
28
Kristopher Gerardi, Harvey S. Rosen, and Paul Willen, Do Households Benefit from Financial Deregulation and
Innovation? the Case of the Mortgage Market 6 (FRB of Boston, Public Policy Discussion Paper No. 06-6, 2006)
available at http://ssrn.com/abstract=934422.
28
Kiff and Mills, supra note 21.
27
13
$5.05 Trillion that the U.S. government has in publicly held debt, and the $5.4 trillion of debt in
the entire U.S. Corporate bond market.29
There is a wealth of information available on Fannie Mae and Freddie Mac, especially
because they are so controversial. The main subsidy that GSEs receive is not in the form of
actual cash, but in the form of an implied guarantee that the GSEs have from the federal
government. This is an interesting phenomenon because the implied guarantee probably does not
actually exist in law. Indeed, the debt securities issued by GSEs have an explicit disclaimer
stating that they are not guaranteed by, and do not constitute an obligation by the U.S.
Government. Even so, there is widespread, well-founded belief that the U.S. Government would
bail them out if they became insolvent.30
There is a real fear that the GSE’s could become insolvent, too. The very subsidies that
allow are intended to help the GSEs often end up creating more risk. For example, the GSE’s
have much lower capital requirement than other financial institutions. Fannie and Freddie are
only required to keep 2.5 percent of their outstanding obligations on hand.31 This low
capitalization requirement puts the GSE at high risk of interest rate fluctuation. If interest rates
go up, the rate of return on their investments may not meet the amounts they owe in debt, and a
bailout might be required.32 Also, they are exempt from many state and federal laws, including
exemption from registration with the SEC.33
29
Reiss, supra note 23, at 3.
Id. at 2.
31
Id. at 39.
32
Id. at 4.
33
Id. at 31.
30
14
GSE’s role as securitizers probably leads to more efficient resource allocation. This is
almost exclusively a result of where they spend their subsidy (i.e. the bond market) rather than
the fact that they have a subsidy.34 Because both banks and GSE’s receive subsidies, the subsidy
itself is not what makes GSEs more efficient than banks at allocating resources toward home
mortgages. Both depository institutions and GSEs compete with each other for loans; thus the
problems created by the dueling subsidies make the benefits of GSEs only marginally better at
resource allocation than banks. Although it is very unclear exactly what effect the subsidies
have, it appears that subsidies of GSEs, especially the implied guarantee, lead to a price decrease
of about a quarter of a percentage point.35
While GSEs do seem to have an effect on resource allocation and liquidity, it is not at all
clear what their effect is on homeownership overall, or whether their programs targeting lowincome and minority households are effective. And even the benefits that GSEs offer in terms of
liquidity and resource allocation could be very dangerous overall. They provide liquidity because
they transfer their risks to the taxpayer via the implied guarantee, and they allocate more
resources, but this does not necessarily mean more efficiently. GSE’s resource allocation
function may actually drive up demand for housing, thus driving up price.36
The other side of this argument is that banks also receive subsidies. Given FDIC insured
deposit accounts, banks can lend from these deposit accounts with subsidized risk. Thus,
changing the subsidies for GSEs might unfairly change the market share.37 Although not a
34
Van Order, supra note 15, at 37.
Id. at 20.
36
Id. at 36.
37
Id. at 6.
35
15
subsidy, banks have an informational advantage that GSEs do not. Banks, as originators of
loans, are better able to measure risk of the particular loans they make. They do not rely on the
good faith of other originators to sell them good loans, as GSEs do. Banks’ risk assessment
aligns more closely with their long-term interests that GSEs do.38
Whether the 25 basis points is worth it or not is perhaps made clear when one considers
that every time the Federal Reserve Board cuts interest rates by 1/4 percent, they have the same
effect as GSEs do. And as to keeping liquidity in the market, GSEs are market players. If the
cost of their funds goes up, they will buy fewer mortgages. This relationship between GSE cost
of debt and return on mortgages is actually more volatile than the relationship between mortgage
yields and money market rates generally.39
Another possible inefficiency caused by GSEs is the lack of risk-based pricing in the
prime market. While information technology has led to risk-based pricing in the subprime
market, the same information technology allowed the GSEs to maintain a monopoly on
securitization in the secondary market for prime mortgages. The terms offered to prime
borrowers are largely uniform, despite the fact that GSEs have accumulated a huge amount of
consumer information that could help them diversify the products they offer to prime buyers.40
Most retail mortgage lenders apply the proprietary credit evaluation models of the GSEs
to determine whether they will offer a prime loan. The cost of collecting the kind of data that
GSEs have access to would be prohibitive. Thus, if they want to sell their loans on the secondary
market, lenders will apply GSE standards. And since GSEs do not open up their technology,
38
Id. at 16.
Peter J. Wallison, Thomas H. Stanton & Bert Ely, PRIVATIZING FANNIE MAE, FREDDIE MAC, AND THE FEDERAL
HOME LOAN BANKS 18 (American Enterprise Institute, 2004).
39
16
GSEs have essentially a monopoly on buying and selling prime loans. Competition is deterred
because the cost of developing this technology is too high, and the profits too low to enter the
market.41
In a perfectly efficient market, prices would vary to reflect the risk taken on by lenders.
However, the prime market is still largely marked by one rate for a broad range of prime
borrowers. Risk within the prime market is not based on risk, but is subject to crosssubsidization, where those prime borrowers with less risk pay the same rates, thus subsidizing,
the risk posed by more risky, but still prime borrowers. If risk-based pricing were to take hold in
the prime market, solidly prime borrowers would benefit by paying less for their loans, while
marginally prime borrowers would suffer from the loss of subsidy paid by the less risky prime
borrowers.42 Thus, monopoly and informational advantage of the GSEs have led to less efficient
prime markets.
THE MORTGAGE INTEREST DEDUCTION
The mortgage interest deduction attempts to encourage homeownership by allowing
taxpayers, if they choose to itemize, to deduct interest paid on residential mortgages.43
The sad truth about the mortgage interest deduction (MID) is that it has very little effect
on low-income homeowners. One of the reasons for this is that low-income homeowners do not
generally itemize deductions. Thus, they are not able to take advantage of this tax break.44
40
Gan & Riddiough, supra note 27, at 9.
Id. at 7-9.
42
Collins, Belsky, and Case, supra note 1, at 11.
43
William G. Gale, Jonathan Gruber, and Seth Stephens-Davidowitz, Encouraging Homeownership Through the
Tax Code 1178 (The Urban-Brookings Tax Policy Center, 2007), available at
http://www3.brookings.edu/views/articles/gale/20070618.pdf.
44
Id. at 1178.
41
17
As with other government subsidies, an interesting notion is that the MID actually may
increase the price of housing in a non-elastic market. Where there is little available space for
development, the MID can drive demand for housing up, thus driving up the price. This is not
the case in areas with a more elastic supply of housing,45 because those who will take the MID
can take it on rental properties that they own. Higher income households will benefit more from
the MID than lower income households. Thus, there is incentive for those with higher incomes
to purchase rental property, and then pass the benefit on to renters through cheaper rent.46
Given that the MID does little to encourage homeownership, the cost of the MID is too
high. For 2006, the cost was about $70 billion. This is a $70 billion tax break that goes to the
highest income households and does not encourage homeownership.47 One proposal suggests
that we eliminate the MID and replace it with a refundable tax credit to first time homebuyers.
The credit would be available to households where no one had owned a home in the previous
three years. The amount would be set at $3,000 for an individual and $6,000 for a married
couple. A high estimate is that this would cost $16.8 billion in revenue. Similar programs in
other countries, as well as smaller programs in the U.S., have had generally positive results in
encouraging homeownership.48
DEVELOPMENT OF THE SUBPRIME MARKET
The mortgage market has undergone significant changes in the last 35 years. The
standard 30-year fixed rate mortgage, while still an important part of the market, is no longer the
45
Id. at 1179.
Id.
47
Id. at 1178.
48
Id. at 1184-85.
46
18
only choice for homebuyers. This is a result of a number of different changes, especially
deregulation, risk-based pricing, and the creation of a secondary market.
DEREGULATION IN THE 80’S
Despite attempts by Congress to create a secondary mortgage market through the GSEs, it
simply was not going to happen without deregulation to allow investors to take advantage of the
benefits of mortgage-backed securities. Even though the GSE’s were formed in the late 1960’s
and early 1970’s, it was not until the 1980s that securitization really took off. State usury laws,
as well as federal caps on the interest banks could pay depositors, meant that banks could not
offer a rate of return on mortgages that would create demand to buy securities in the secondary
market. Also, changes in regulations of accounting procedures allowed banks to more easily sell
mortgages on a secondary market.49 In 1982, regulations were finally eased to allow lenders to
offer adjustable rates on mortgages, a regulation that further decreased inflation risk.50
The effect benefited banks by allowing them to sell mortgages and make money by
servicing the loans, while demand was created when investors saw the opportunity to get a better
rate of return.51
RISK ASSESSMENT AND RISK-BASED PRICING.
The traditional loan approach to risk assessment was for a loan officer to sit down and
independently evaluate risk based on a number of factors. In this market, there were two kinds of
applicants: those who could get prime loans, and those who could get no loans. Loan officers
49
Kristopher Gerardi, Harvey S. Rosen, and Paul Willen, Do Households Benefit from Financial Deregulation and
Innovation? the Case of the Mortgage Market (FRB of Boston, Public Policy Discussion Paper No. 06-6, 2006)
available at http://ssrn.com/abstract=934422, at 5.
50
Kiff & Mills, supra note 21, at 3.
51
Gerardi, Rosen & Willen, supra note 49, at 5.
19
evaluating individual applications lacked information to be able to determine the exact nature of
the risks involved. Thus, if an applicant for a home mortgage did not have prime credit, the
applicant was simply out of luck.52
In the mid 1990’s, underwriters began automating the risk-assessment, often using
numerical credit scores. This both decreased the cost of analyzing a borrowers credit worthiness,
and allowed lenders to price their loans based on a more standardized procedure.53 Because
lenders can measure risk more accurately, they can charge high risk borrowers a higher rate and
low risk borrowers a lower rate. This increased pricing flexibility has lead to more efficient
markets. A market is created that formerly did not exist, even though borrowers were willing and
able to pay, and lenders were willing and able to loan to them.54
Subprime lending thus developed due to a number of factors. Securitization could not
have happened, and indeed did not happen, until deregulation took place. While the creation of
the GSEs occurred in 1968 with the express intent of creating a secondary mortgage market, it
was not until the deregulation of the industry that securitization started to take place on a
widespread scale.55 There was very little incentive for investors to buy mortgage-backed
securities until they could expect a decent return, and this required getting rid of state usury laws.
Risk based pricing requires the ability to accurately assess risk and the ability to actually pay a
higher return for riskier products. Thus, the ability to assess risk, pay a return based on that risk,
52
Collins, Belsky, & Case, supra note 1, at 3.
Gerardi, Rosen & Willen, supra note 49, at 8.
54
Collins, Belsky, and Case, supra note 1, at 5.
55
Gerardi, Rosen & Willen, supra note 49, at 5.
53
20
and spread the risk more easily through the capital markets gave us the subprime mortgage
market.
INEFFICIENCY AND CRISIS IN THE SUBPRIME MARKET
The innovations that resulted in the subprime market also led to some inefficiencies, and
it is probably safe to say, some market failure. The models used to measure risk in the subprime
market appear to have significantly underestimated risk. The subprime market developed during
the strongest period of economic expansion in American history, and an unusually strong housing
market. It appears that we underestimated a risk, which has now become a reality.56
The unbundling of mortgage services has created more risk, in that originators have an
incentive sell more products, not to manage risk. This results in decisions to take on more risk
than what the investors would if they were the decision-makers. At best, this can lead to lax
underwriting standards. At worst, it can incentivize brokers and originators to lie about an
applicant’s credit-worthiness.57
Because of the higher rate return for subprime mortgages, lenders may also be
incentivized to steer borrowers toward more costly mortgage products, even if the buyer qualifies
for better terms. The complexity of these financial products is such that a borrower would
probably need to be fairly sophisticated to understand the terms. The problem is that those who
are seeking subprime lending are probably not the most savvy in the first place.58 Originators
may actively seek to sell these loans to people who do not understand that they cannot afford
them.
56
Collins, Belsky, and Case, supra note 1, at 8.
Id. at 9.
58
Id.
57
21
Edward Gramlich of the Urban Institute points out that the subprime mortgage market
follows a pattern for revolutionary market innovations. We have innovation, broad investment in
that innovation based on unrealistic expectations, and then a crash.59 The lesson we are to take
from this is that the market will, and already is, working out these inefficiencies. Already the
credit market has tightened significantly, as lenders know they will not be able to sell mortgages
with the same level of risk onto the secondary market. That’s not to say that regulation is not at
times necessary, but regulation should seek to correct the market failures within the subprime
market, not annihilate it altogether.60 Thus, while the short-term picture is grim, in the long run,
this is simply a step on the way to achieving greater efficiency in the market. Gramlich does
concede that the overall foreclosure rate for subprime mortgages is 12 percent, and as high as 20
percent for certain types of mortgages, and even more will have excruciating debt burdens, but
manage to keep their homes.61
The pessimistic side of the argument is that even this level of foreclosure may be
unacceptable. Whether or not this is an acceptable rate of foreclosures may be influenced by the
level of negative externalities that accompany such inefficiencies. Foreclosures on subprime
mortgages affect a disproportionate number of low-income and minority census tracts. Even if
one considers 12 percent a small amount, the effect would be much greater if this is limited to a
fairly narrow geographical area. High concentrations of mortgage foreclosures have the potential
to drive down housing prices and lead to abandonment, crime, and blight in neighborhoods.62
59
Edward M. Gramlich, Booms and Busts: The Case of Subprime Mortgages (Urban Institute, August 2007),
available at http://www.urban.org/UploadedPDF/411542_Gramlich_final.pdf.
60
Id. at 7.
61
Id. at 5.
62
Collins, Belsky, and Case, supra note 1, at 10.
22
Chances are fairly high that the subprime market will see substantial consumer protection
regulation, including changes to the Truth in Lending Act and the Real Estate Settlement
Procedures Act.63 Regulation is beyond the scope of this paper, but such regulation should
balance the gains possible from subprime lending with the potential for abuse, market failure,
and negative externalities.
RECOMMENDATIONS
One of the interesting things about the home mortgage market is that many of the most
controversial issues are more about distribution of risk than distribution of wealth. In this sense,
we can be optimistic that as risk is better quantified and better gauged, efficient markets will do
much to increase the housing wealth of individuals. The subprime mortgage market has some
promising innovations as well as some serious inefficiencies. Clearly, some of the current
practices are predatory, inefficient, and will hurt homebuyers in the short run. Regulations are
already being imposed though, and markets are beginning to reassess risk, which will hopefully
lead to some better practices in subprime lending. Regulation is beyond the scope of this paper.
The innovations underlying the subprime mortgage market represent innovation that has
taken place without the level of government subsidies that GSEs or banks that operate within the
prime market have. They have quickly eaten away at FHA’s share of the subprime borrowers.
They have also opened up new options for people who could not afford a home with a
conventional mortgage. After a market correction, we could see strong performance by riskbased pricing and securitization that will lead to much more ability for low-income and minority
house to finance houses that they can afford.
63
Gramlich, supra note 59, at 8.
23
The FHA has increased homeownership significantly in the past. Subprime lending has
largely diminished their importance in the market, but given the current market correction facing
the subprime industry, the FHA may be well-placed to provide an alternative to buyers who do
not qualify for prime rates and who are leery of subprime lenders. The FHA should be allowed
to charge premiums based on the risk of the individual borrower. The passage of H.R. 1852
would allow for this. At the same time, we should be a bit skeptical of FHASecure allowing
homeowners already in default to refinance their mortgages. Right now would be a better time to
work on preventing defaults than to save those who have already defaulted.
Fannie Mae and Freddie Mac deserve a lot of credit for their role in opening up new
capital markets for financing home mortgages. However, the implied guarantee creates too much
risk to ask taxpayers to continue to subsidize GSEs, especially given how little effect GSEs have
on increasing homeownership rates. Fannie Mae and Freddie Mac should be privatized.
Privatization would allow the GSE’s to continue their operation, but would shift the risk to the
private sector. The subprime market has shown that government subsidies are not required to
create and sustain a secondary market.
The Mortgage Interest Deduction should be replaced with a first time homebuyers credit.
A fully refundable credit of $3,000 for an individual or $6,000 for a married couple who had not
purchased a home in 3 years would cost $16.8 billion. Once the MID was replaced, this would
mean a net savings of $53.2 billion. Such a credit would be more progressive and would be less
likely to raise the cost of housing.64
64
Gale, Gruber, & Davidowitz, supra note 43, at 1184.
24
When looking at the overall home mortgage market, it appears that the Federal
Government could increase homeownership by actually spending less. The proposals in this
paper actually save the federal government money, are more progressive, and would hopefully
result in overall more distribution of wealth in the form of homeownership.
Homeownership has important social implications, especially in terms of educational
opportunities for children. Even more importantly, homeownership can help to narrow the gap
between rich and poor. While addressing income inequality is important, we must not forget the
importance of creating wealth in our society, and one of the best ways to create wealth amongst
those with the least income and wealth is to open up the dream of homeownership to them. We
should encourage the market where it has succeeded, and update our homeownership policies to
reflect those successes, not try to hold them back.
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