I appreciate the chance to respond to the Federal Housing Finance Agency’s (FHFA) request for comments on how its regulations may be made more effective and less burdensome. This comment relates to continuing efforts to maintain safe and sound access to credit for creditworthy borrowers, as referenced in the annual report to Congress.
This comment is submitted with the assistance of the Mercatus Center at George Mason University, which is dedicated to advancing knowledge about the effects of regulation on society. As part of its mission, the Mercatus Center conducts careful and independent analyses that employ contemporary economic scholarship to assess rulemaking proposals and their effects on the economic opportunities and the social well-being available to all members of American society.
This comment addresses the efficiency and efficacy of FHFA oversight of Fannie Mae and Freddie Mac (hereafter “Enterprises”) from an economic point of view. The Enterprises have a long history of facilitating home ownership, and continued progress on this goal through a systemically safe framework is something that all Americans should be able to support. The rise and fall of housing markets before the financial crisis has been widely blamed on declining underwriting standards, so those standards have been tightened since the crisis. But lending standards in terms of borrower qualifications appear to have been commendably stable at the Enterprises before the crisis. Tightening standards since the crisis have shifted the Enterprises away from longstanding norms. Tight lending standards have been destabilizing because they have prevented home buyers from accessing the benefits of ownership, and they have undercut demand for homeownership in regions where, for decades, buyers had reliably depended upon the services of the Enterprises. A return to longstanding norms will support continued recovery of lost home equity value for existing owners. Transitioning from renter to owner has rarely been more affordable. Both current owners and new buyers will benefit.
The Role Of The Enterprises In Housing Affordability
Housing policy should pursue two separate and important objectives: (1) the affordability of housing and (2) access to the benefits of ownership. The first objective has mostly to do with the rental expense of households as tenants, and the second objective has more to do with prices and credit. Rental expenses are largely a reflection of supply and demand in a given location at a given time. Prices and credit reflect a more complicated set of factors in capital markets.
First and foremost, the affordability of housing rents is the more primary goal, because failure on this objective means that households can lack the means for shelter. Access to ownership is also important and provides ample benefits to individual households and to society at large, but the downside of being an owner versus being a tenant is much less problematic than the downside of being a tenant versus being homeless.
The Enterprises can have a positive effect on both rental affordability and homeownership, but it is also important to understand these motivations separately in order to craft policies that produce the highest public benefit.
The Enterprises have provided many creditworthy families with access to ownership by ensuring the soundness and liquidity of mortgage markets. This has granted the benefits of ownership to millions of American families, which is a valuable service in and of itself. But more importantly, access to ownership has been an important source of funding for new housing supply. This indirectly affects the first objective noted earlier—the affordability of housing. New supply helps to keep the rental value of homes in check.
Millions of households that would have been creditworthy owners in past decades are not owners today. The lack of access to credit for those potential buyers has reduced homeownership rates for working-age households to the lowest levels in more than 35 years. The post-crisis bias toward prudence has suppressed new housing supply enough that it is now causing rents to rise. This is leading to a vicious cycle of unaffordability as a lack of supply leads to rising rent, which then makes it more difficult for potential new buyers to fund new supply, which leads to more rising rents, and so on.
A return to long-standing precrisis lending norms would be an important source of improved housing affordability.
Rising Home Prices During The Housing Bubble Were also Primarily Caused By A Lack of Supply and Rising Rents
During the housing boom that preceded the financial crisis, home prices in some cities rose to exceedingly high levels. Viewing housing affordability through the lens of home prices, this appeared to be a time when housing was becoming unaffordable for many Americans. Furthermore, prices rose quickly in a short time frame. Those rising prices seemed to be related to loose credit markets or aggressive lending from the Enterprises and private lenders. The tightening of credit standards seemed like a reasonable response to the affordability problem, and the foreclosure crisis that followed appeared to confirm that loose lending had caused housing to become unsustainably unaffordable.
But a proper estimation of the role of the Enterprises during the housing bubble and after requires carefully viewing rental affordability separately from the affordability of homeownership.
The rising cost of housing during the housing boom was primarily a product of rising rents in places where local limits to housing expansion prevent local supply from expanding to meet rising demand. This is most acute in a handful of metropolitan areas that are centerpieces of the new economy and thus attract many newcomers in search of economic opportunity. Most notably, these areas include New York City, Los Angeles, Boston, and the San Francisco area.
In national data, rising prices didn’t appear to be related to rising rents. But viewing metropolitan areas individually makes it clear that rising rents in this handful of metro areas were the primary source of rising prices. Those rising rents were even the source of the brief period of rising prices in places like Arizona, because much of the new housing in Arizona was being built to house the thousands of households that had to move away from California because of California’s shortage of housing. The housing bubble was mainly caused by a localized housing shortage that caused rents in those locations to rise. Those rising rents led to a migration event that overwhelmed the housing markets in a few cities. Cities that had housing bubbles generally fall into two categories: (1) cities with housing shortages that led to endemic net out-migration that surged during the bubble, and (2) cities with generous local housing policies who experienced a disruptive surge of in-migration during the bubble. Local housing supply policies and migration flows explain the development of the housing bubble. Credit markets were facilitating activity that was caused by those other factors.
This is corroborated by the lack of evidence that standards related to borrower quality changed significantly during the boom. The Urban Institute tracks mortgage risks with their “Housing Credit Availability Index.” According to their index, borrower risks were fairly stable during the boom. Risks in mortgage markets were generally the result of increasing risk in the terms of mortgages. Defaults early in the crisis were more a result of falling prices than a cause of them. The complex mortgages that led to many of the early defaults were taken out by sophisticated borrowers who had the means to make payments and tended to default more strategically in the face of falling prices. According to the American Community Survey, in 2006 and 2007 mortgaged homeownership declined first among households with incomes in the top quintile. Homeownership among households with lower incomes did not decline until 2008 and after, when they were confronted with the toxic combination of rising unemployment, collapsed home prices, and extremely tight lending standards.
The rise of risky mortgages and the housing price surge of 2004–2006 were not associated with any rise in the rate of homeownership, generally. There was no rise in borrowing or ownership among households with lower incomes relative to households with higher incomes. And when homeownership had been increasing—from 1994 to 2004—the increase was almost entirely among young households with rising incomes and college educations. The Survey of Consumer Finances from the Federal Reserve also confirms that new homeownership throughout the housing boom was focused on households with incomes in the top quintiles, with college educations, and with managerial or professional jobs. And the number of homes bought by first-time homebuyers was declining as early as 2005 and continued falling during the period after that (when so many mortgages led to foreclosures). The years when the bulk of bad mortgages were made were not years when the number of new homebuyers was swelling—quite the opposite is true.
Public Sources of Mortgage Support Were Commendably Countercyclical During the Boom But Have Been Procyclical Since The Crisis
During that time, especially during the late price surge of 2004–2005, standards at the Enterprises were especially stable. One of the more striking trends during that period is their loss of market share during the boom years from 2003 to 2005. The combined market share of the Enterprises and the Federal Home Loan Banks, including mortgages held in portfolio or in pools sold to third parties, was about 37 percent at the end of 2003. It was down to 30 percent by the end of 2005.13 Federal Housing Administration lending programs pooled through Ginnie Mae were losing market share even more sharply and persistently. The combined market share of the Enterprises, the Federal Home Loan Banks, and Ginnie Mae mortgages declined from 40 percent in 1994 to 33 percent in 2005. The housing boom was not driven by aggressive public lending programs. This stability is reflected in the book of business held by the Enterprises. Of all the mortgages with known FICO scores in Fannie Mae’s book of business, in 2000, 63 percent had FICO scores below 740. As Fannie Mae’s book grew in absolute terms during the boom, the portion of its book going to lower FICO scores gradually declined. It was 57 percent from 2005 to 2007. Then, in reaction to the crisis, credit standards were tightened drastically. In 2008, Fannie Mae’s book of business included about $1.2 trillion in mortgages associated with FICO scores above 740 and $1.5 trillion in mortgages associated with FICO scores below 740. By 2015, only 39 percent of Fannie Mae’s book of business had FICO scores at origination below 740; the book of business had increased to $1.7 trillion for FICO scores above 740 and had decreased to $1.1 trillion for FICO scores below 740. Freddie Mac appears to have followed a similar pattern.
More Generous Lending Will Improve Housing Affordability
The period after 2008 is associated with sharp declines in housing starts and homeownership rates and worsening rent affordability. Reflecting on the difference between rent affordability and price affordability, it is clear that the Enterprises can play a role in both.
During the housing boom, new homes were mostly being constructed in less expensive areas. The noticeably high prices in the cities with housing shortages concealed one of the primary characteristics of the housing boom. The mass migration out of the expensive cities and the rise in housing starts at the time were part of a nationwide attempt at reducing housing costs. Even in places such as Arizona, where prices suddenly jumped in 2004 and 2005, the tens of thousands of additional residents who were moving into the state to claim those new homes were largely moving from California.16 They were moving into Phoenix to reduce their housing expenses. The same was true for the hundreds of thousands of other households who moved out of the highpriced cities and into the many other cities that avoided a bubble in home prices.
There are two distinct types of cities in the United States: (1) a handful of cities where local housing supply cannot match reasonable increases in demand, and (2) most other cities where supply can expand. In the first type of city, new avenues for mortgage access and home ownership mostly pushed up prices and created a migration event. In the second type of city, new avenues for home ownership fund new supply. The dominance of the cities with a shortage of housing during the housing boom has diverted the national consensus from that fact.
Where the Enterprises have had an active role in facilitating mortgage access, they have played an important part in both objectives for housing affordability. They facilitated the transition of millions of households from tenants to owners. And indirectly but more importantly, they facilitated the development of new housing supply. In an age where a few important cities have housing shortages that have come to dominate the financial stresses of their residents, this factor is hugely important, even if the supply must be developed in Atlanta, Dallas, and Phoenix because such development is opposed in New York and California.
The Enterprises had little to do with rising prices in New York and California (private securitizations developed largely because market-clearing prices in those places frequently defy conventional lending standards). To the contrary, lending by the Enterprises was facilitating new supply in the parts of the country that permitted new supply. This provided an outlet of affordable housing for the millions of Americans forced to migrate from the cities where limited supply was causing rents and prices to be extremely high.
Because of the housing shortage, inflation rates on shelter had been higher than general core inflation for a decade from 1995 to 2005. It was only at the peak of homebuilding activity that shelter inflation briefly reconverged with general core inflation. Then, as soon as housing starts began to decline in 2006, shelter inflation shot up again. It continues to run high. In the 12 months leading up to March 2018, prices on shelter have risen 3.3 percent while prices on all items other than energy, food, and shelter have only risen 1.2 percent. This has been the pattern for much of the recovery.
The Enterprises were a source of stability during the housing bubble, both because their book of mortgages performed well compared to other conduits for mortgages and because the federal backstop stabilized mortgage-backed securities markets. It has been their retreat from generous lending that has contributed to instability since then. Enterprise lending has shifted toward more valuable homes purchased by borrowers with higher FICO scores. But the housing bubble was the result of a supply shortage and a migration event, not a decline in borrower quality. This shift in standards has therefore been misdirected, and funding for housing in low-tier markets has been hampered as a result. This has hampered housing supply in most cities, which is the primary reason for rising rents.
A return to the lending standards that the Enterprises used successfully for many years during and before the housing bubble would be a tremendous move toward both objectives for housing affordability. Mortgage affordability has never compared more favorably to rent affordability.18 Millions of American households who are qualified and capable of being owners have been kept out of the housing market. There is much room for expanded lending. The second goal—the facilitation of home ownership—can safely be accomplished today.
But more importantly, a new commitment to broad homeownership will trigger the development of new supply and will address the first goal—affordable rents. Because of the lack of capital flowing into low-tier housing markets, homebuilders are having trouble funding new lots. The focus on tight lending standards and on enforcing affordability of home prices has led to a lack of new supply and worsening affordability of rents. The focus on prudence in the second goal has led to a failure of the first goal. And now rents are rising enough to cause a failure to meet both goals.
It is true, however, that in the cities that have severe housing shortages, new borrowers will mostly only push up prices. In those cities, it could well be the case that more generous lending will be destabilizing and disruptive because it will allow some home buyers to consume more of the limited stock of housing. So while the country is in great need of more generous mortgage lending generally, it may be prudent to retain tight lending standards in cities where rising demand will only raise prices. In those cities, there is a conflict between the two affordability objectives, so the proper balance is less clear. But in most of the country, the shift to more generous lending standards will lead to better access and better affordability for both owners and renters. This should be a priority.
Please see this paper, which is an introduction to new research on the importance of low supply and migration during the housing bubble.