Mel Watt, Director of the Federal Housing Finance Agency, recently announced that he will reduce the minimum mortgage down payment requirement for Fannie Mae and Freddie Mac – the housing financing behemoths that he controls as their conservator since the financial crisis – to three percent. This marks a return to pre-crisis down payment standards, and a departure from the traditional 20 percent requirements that had been standard prior to the 1990s, and which had once again become the norm since the financial crash. The stated goal is to expand opportunities for low-income borrowers, and thus help to mitigate economic inequality. But intentions and consequences can be very different. Similar attempts to subsidize risky mortgages in the 1990s and 2000s ended up increasing inequality. Congress should be wary of allowing Director Watt to take such a step.
Affordable housing policy has used a variety of tools to encourage credit to flow to high-risk mortgages for low-income Americans. Beginning in the 1990s, Fannie Mae and Freddie Mac purchased much of the loans to low- and very low-income borrowers that banks were being encouraged to originate through contractual obligations they entered into as part of the process of gaining permission from regulators to merge. In exchange, both banks and Fannie and Freddie were allowed to back their portfolios with paper-thin levels of capital. Fannie and Freddie also were supervised by a department of the Office of Housing and Urban Development, which had no experience as a bank regulator and no resolution authority.
Over time, under the administrations of both President Bill Clinton and President George W Bush, in order to achieve rising mandated loan purchases, Fannie and Freddie were pushed into pretending that near-zero down payments and a lack of documentation of employment and income for applicants were acceptable underwriting practices. The result was a flood of risky mortgages – not just for the urban poor, but for everyone.
Why did a program targeted for the poor end up affecting so many middle-income borrowers? The prospect of profiting from housing price appreciation encouraged many (not just the urban poor) to do whatever it took to get access to highly subsidized mortgage credit, including exaggerating their incomes. The mortgage underwriting standards adopted by Fannie and Freddie in order to meet their affordable lending mandates had to apply to everyone, not just low-income, urban borrowers. A two-tiered underwriting system was not possible, as it would have been an explicit recognition that the loans the GSEs were purchasing were of low quality. Thus, mortgage standards became debased for everyone, and a large swathe of the US middle class, along with low-income Americans, were given powerful incentives to gamble – and to engage in outright fraud – because they could buy a suburban dream house with no money down and no documentation of their income and employment.
Bankers and the GSEs played along because they received benefits for doing so, including approval of proposed bank mergers, lax regulation (low capital ratio requirements for both banks and GSEs) and too-big-to-fail protection, which became apparent when the banks and GSEs were bailed out by taxpayers.
There is substantial evidence from academic studies that increasing competition among banks promotes credit growth in a way that tends to reduce inequality. In contrast to the evidence about the inequality reductions that attend competitive banking policy, the government credit programs of 1992-2007 that targeted inequality through Fannie and Freddie mandates not only failed to promote a broadening of home ownership, they had disastrous unintended consequences for the poor that have exacerbated inequality. In the wake of the housing collapse, many low-income Americans with large mortgage obligations faced foreclosure and the loss of both their homes and their accumulated savings, which has only made inequality more pronounced.
The access to subsidized mortgage credit was the financial equivalent of telling a struggling family that the government would only help them if they agreed to devote all of their income to buying a massive, subsidized lottery ticket that had a chance of paying off big, but a much higher chance of wiping them out completely. The lottery ticket was the mortgage. The subsidy was the lax underwriting standards and generous lending terms granted by a banker. The prize was home ownership. The portion of the ticket funded by the family was the income stream they had to devote to the mortgage. By design, many of the families drawn into programs like this could not win: housing markets are volatile, and the income streams of the poor are, by definition, low and uncertain.
Reserve Bank of India governor Raghuram Rajan referred to this indirect approach to addressing inequality as a "let-them-eat-credit" policy. As Rajan and many others since have recognized, this highly indirect and risky approach to addressing inequality reflected the conscious choice to use mortgage credit subsidies, rather than other government programs, to address inequality. Prominent politicians of both parties were enthusiastic supporters of the lottery ticket approach. In retrospect, these policies seem to have been very unwise, arguably even cruel. Why were politicians willing to take this approach, and why does Mr. Watt want to bring it back?
First, politicians tend to be short-sighted. Massive public investments in education might reduce inequality much better in the long run, but politicians are in the business of winning elections in the short run. In fact, if they fail to win the next election their political careers almost always come to an abrupt end. We cannot emphasize the importance of this simple idea strongly enough: politicians are not in the business of maximizing social welfare; they are, and must be, in the business of getting elected.
Second, one of the central discoveries of cognitive psychology is that people tend to heavily discount the future. They will choose to accept a small amount of money today, over a larger amount a year from now. The implication is that any politician brave or foolish enough to fashion a campaign on the basis of what he or she is going to do for the electorates' grandchildren will lose to a candidate who campaigns on the basis of what he or she will do for the electorate right now.
If you put these basic insights together you can see why American politicians have strong incentives to frame policies that will result in the redistribution of income in the very near term. They have to offer an immediate solution to a problem that is salient to a broad swathe of the electorate, even if that solution might be counter-productive in the long run. If they fail to do so, they will be defeated by a candidate with far weaker scruples.
There was another important factor that favored mortgage lottery tickets over other inequality-reducing policies, such as educational investments –namely, lower political cost. The funding for the mortgage lottery tickets was not included in the federal budget. Politicians did not have to vote for on-budget expenditures that might raise the ire of taxpayers. Instead, they could provide a combination of mandates and protections that entailed substantial, but unrecognized, public expenditures.
The electorate is all too susceptible to claims that government credit subsidies are free lunches. The temptation to make such claims is all the greater when government debts reach unsustainable levels. In the United States, the overextended nature of federal government entitlement programs and the unsustainable implied levels of future federal debts have redoubled opposition against major new expenditure programs of any kind. This will make it all the more attractive to pursue off-budget solutions to inequality.
Unfortunately, mortgage credit subsidies often end badly for the poor, and therefore, can be a wasteful and short-sighted palliative for addressing inequality. They are no substitute for the creation of sustained improvements in the skills and job prospects of workers, and the promotion of competitive markets – including credit markets – that provide broad access to economic opportunities. Mr. Watt should reconsider his proposed 3 percent down payment, and, if he insists, Congress should step in.
This column is an excerpt from "Bank Rules & Their Impact on Inequality." Read the full paper here.
Charles W. Calomiris is a member of the Shadow Open Market Committee and the Henry Kaufman Professor of Financial Institutions at Columbia University. Stephen Haber is the AA and Jeanne Welch Milligan professor in the School of Humanities and Sciences and Peter and Helen Bing senior fellow of the Hoover Institution at Stanford University.
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