NCPA - National Center for Policy Analysis

Only a Private Housing Finance Market Can Produce Stability

December 19, 2013

As long as the government controls the housing finance market, it will continue to be unstable, says Peter Wallison, a fellow at the American Enterprise Institute.

The government began its involvement in the housing finance market in 1934, when the Federal Housing Administration (FHA) was established. The FHA began insuring mortgages, and underwriters had strict standards, requiring a 20 percent minimum down payment, a strong credit record and a low debt-to-income ratio. With these standards, the FHA operated smoothly, with defaults on mortgages below 1 percent.

But in 1957 -- after the economy went into a recession -- Congress reduced that down payment requirement to 3 percent. The move was made in order to stimulate housing demand and had nothing to do with assuring the quality of mortgages. What happened?

  • By the late 1960s, foreclosures were 16 times higher for FHA mortgages than they had been in 1953.
  • Conventional mortgage foreclosures, however, remained relatively stable, as their loan-to-value ratios were much lower than for FHA mortgages.

Fannie Mae was established in 1938 and Freddie Mac came in 1970. The two government-sponsored enterprises entered the conventional loan market in 1970, but they were required to acquire only prime loans. Between 1953 and 1991, foreclosures in the conventional market remained consistently below 1 percent.

But in 1992, activists began complaining that Fannie Mae and Freddie Mac's standards were excluding too many people from homeownership.

  • Congress passed new legislation that required Fannie and Freddie to buy mortgages that were made to low and moderate income borrowers, instituting a 30 percent quota originally.
  • The Department of Housing and Urban Development gradually changed these goals, increasing the numbers to 56 percent in 2008.

To meet these requirements, Fannie and Freddie had to reduce their underwriting standards.  As new buyers entered the market, housing prices rose, leading to the housing bubble. Prices began falling in 2007, and because more than half of all mortgages had been made to borrowers with poor credit, the United States saw record defaults in 2008. Investors fled the market and the financial crisis began.

As long as the government controls housing finance policy, this boom and bust pattern will continue.

Source: Peter J. Wallison, "Only a Private Housing Finance Market Can Produce Stability," American Enterprise Institute, December 12, 2013.


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