Government Responses to Housing Crisis had Mixed Results

In a recent paper entitled, Getting on the Right Track: Improving Low-Income and Minority Access to Mortgage Credit after the Housing Bust the Harvard Joint Center for Housing laid out its perspective the collapse of the housing market and the foreclosure crisis.  In this second article summarizing the paper the authors tell us what happened next.

Toxic securities were blowing up around the world, the U.S. financial system teetered on the brink of collapse, and the economy headed into a recession of unknown proportions.  In the closing months of George W. Bush's administration the government took steps to minimize losses and stabilize the situation, placing the GSEs into conservatorship and purchasing $1.4 trillion in mortgage-backed securities (MBS) through the Treasury and the Federal Reserve began.  In October 2008 the Troubled Asset Relief Program (TARP) authorized purchase of stock of distressed financial institutions.

A few months later the Obama Administration proposed and Congress passed a broad stimulus package  (the American Recovery and Reinvestment Act, ARRA) and comprehensive efforts to repair the financial system (the Financial Stability Plan, FSP) which shifted the focus away from supporting individual institutions to rejuvenating the capital and credit markets.  The largest banks were required to participate in stress tests and raise capital from private markets to repay TARP investments.

Other key elements of FSP were the Term Asset-Backed Securities Loan Facility (TALF) which sought increase credit to consumers and small businesses and the Making Home Affordable (MHA) which involved a series of initiatives to help distressed homeowners to stay in their homes or exit homeownership with fewer negative effects.   In particular, the Home Affordable Modification Program (HAMP) reduced monthly payments for households delinquent on their mortgages, while the Home Affordable Refinance Program (HARP) provided incentives to promote refinancing underwater mortgages.

A broad consensus has emerged that early actions pulled the economy back from the brink and bought time to work through problems with housing and the economy but a lot of disagreements about the effectiveness of the initiatives' individual components.  Some critics have maintained that their successes could be attributed simply to announcements of the program - one study claimed that news about MBS purchases reduced mortgages rates by 85 basis points in a month and lowered risk premiums by another 50 basis points once the program started.   Other aspects of the program were variously criticized as being illegal, ineffective, or unfair.

MHA has been especially controversial.  Intended to prevent avoidable foreclosures by incentivizing servicers, investors, and borrowers to undertake loan modifications and refinances in affordable and sustainable ways, it eventually grew to include two-dozen distinct components.  Critics complained that this complexity forced its participants to keep up with continually shifting options and requirements and created  two major implementation barriers: (1) the servicing industry's capacity constraints and (2) ongoing debate as to should pay the costs of loan restructuring- borrower, lender, investor, or the government.  Instant analyses of what was "wrong" with MHA abounded.

MHA also got off to a slow start.  The number of foreclosure starts peaked in the spring/summer of 2009 and by March, 2012 had receded by more than 70 percent. Over the same period, HAMP modifications and FHA loss mitigation and early delinquency interventions topped 3.0 million. Including the proprietary modifications by lenders in the HOPE NOW alliance, the number of families receiving assistance topped 6.0 million-more than twice the number of foreclosure completions recorded over the same period (Figure 10).

Nearly a million additional borrowers have refinanced through HARP but questions remain why more borrowers have not benefited from the program, especially since the studies indicate that 4 million more borrowers could benefit and appear to meet basic eligibility criteria for the program.  Given the potential savings to homeowners, HARP warrants another look at the factors that may be impeding participation.

There are also questions about the use of standard risk management tools in situations where the government as conservator of the GSEs already owns the risk.

• Why do GSEs add loan level pricing adjustments or upfront fees to loans judged to have higher risk characteristics, adding to the costs and thus discouraging borrowers from HARP refinancing?
• Why does the GSEs' conservator, the Federal Housing Finance Agency (FHFA) continue to resist changes despite that the GSEs have much to gain by expanding HARP refinancing? For example, the so-called "putback" risk, even with HARP's recently streamlined guidelines, may make lenders reluctant to refinance loans originated by other lenders, thereby limiting participation in the program.

During the boom servicers were challenged to keep up with the rapidly changing mortgage landscape so it was not surprising that many lacked the resources to participate fully in the recovery effort.  They were structured and staffed to process mortgage payments; loss mitigation played only a minor role and they did not have the systems, staffing, operational capacity, or incentives to implement it on such a massive scale.

Before HAMP, there was no industry consensus on the characteristics of an affordable mortgage or standards for modifications or foreclosure processing.  Stories about difficulties borrowers were having with the process - lack of information, lost applications and documentation, robo-signing, raised concerns about servicers as productive partners.  HAMP had to work with lenders and servicers to actually build a system before it could operate.  Then some servicers had to ramp up capacity and make other significant changes to implement it.

The benefits of participating in HAMP and HARP are significant. The median reduction in mortgage payments for HAMP participants is 36 percent or more than $500 per month; a total of nearly $3.7 billion annually.  Early indications suggest that the re-default rates for permanent HAMP modifications are significantly lower than for historical private-sector modifications, reflecting the program's focus on aligning incentives and achieving greater affordability.

HAMP data also indicate that the larger the payment reduction, the greater the success in limiting re-defaults.  For example, more than 40 percent of HAMP borrowers whose mortgage payments were reduced by less than 20 percent re-defaulted after 18 months. In contrast, only 16 percent of those with payment reductions of 50 percent or more did so.

Because FDIC has had apparent success with reducing the principal of loans, some have criticized HAMP for failing to do so.  HAMP modifications reduced payments for five years, while principal reduction is a permanent discharge of debt and may also encourage underwater homeowners to continue to meet their mortgage obligations by providing home they will eventually be able to rebuild equity.

The extent to which loan servicers can modify loans or reduce principal depends on the loans pooling and servicing (P&S) agreements which were often loosely drafted and offered limited guidance what was allowable.  Government representatives quickly encountered strong opposition from many lenders and investors who were reluctant to share significantly in the cost of the meltdown.  Sometimes this reflected the investor's interest in retaining the right to future gains when home prices rebound and sometimes a concern that writing down principal on a large scale would encourage "strategic default" among borrowers and undermine the legal and moral foundation upon which mortgage lending rests.

In July 2010 Congress passed the Dodd- Frank Wall Street Reform and Consumer Protection Act which established a Consumer Financial Protection Bureau (CFPB) to consolidate rulemaking, supervision, and enforcement of consumer protection regulations and a Financial Stability Oversight Council (FSOC) with the authority to require the Federal Reserve to supervise any financial institution which could pose a threat to the country's economic stability.  It also created comprehensive federal oversight of the derivatives market and imposed safeguards and transparency on the process of securitizing pools of loans for investors and enacted other provisions to limit the ability of banks to become "too big to fail." 

Dodd-Frank also triggered a wide debate over the proper role of the government in the mortgage marketplace.  Some have argued that the mortgage boom and bust was itself attributable to regulatory over-reach in private markets and specifically pointed to Community Reinvestment Act (CRA) lending requirements, GSE affordable housing goals and FHA's focus on expanding credit access for underserved people and communities.

The authors flatly state that, "Although many factors contributed to the crisis, CRA, the GSE goals, or FHA lending to low-income and low-wealth borrowers do not appear to be among them."  First, there is little evidence that lending requirements had been in force for more than three decades contributed to the crisis.  Second, that crisis emerged after the share of mortgage lending activity covered under CRA had experienced a sustained decline as mortgage banking subsidiaries, affiliates of bank holding companies and independent mortgage companies took a growing share of the market.

The evidence also suggests that only a small share, somewhere in the 5 to 10 percent range, of high-priced subprime loans can be linked to efforts to meet CRA's lending requirements.  Finally, there is some indication that loans made to low- and moderate-income homebuyers as part of banks' efforts to meet their CRA obligations actually performed better than subprime loans originated by lenders not subject to CRA requirements.

The status of Fannie Mae and Freddie Mac as government sponsored enterprises led to a lack of clarity about the extent the government backed their debt and to the notion there was an implicit government guarantee and that the two were too big and too important to be allowed to fail.  This assumption was incorrect and stockholders lost all their equity in the companies but the ambiguity did allow the GSEs to take on excessive leverage and was a key factor in their failure.

Some have claimed that the GSEs failed because, in 1992, Congress imposed goals, which HUD ratcheted up in 2000 and 2004, to ensure that Fannie Mae and Freddie Mac "led the market" in providing affordable mortgage loans to low- and moderate-income borrowers and communities.  In response, the GSEs set up community lending programs that eased downpayment and underwriting requirements on a very limited basis.  

The authors say there is little evidence that these elevated housing goals drove the GSEs to purchase the riskier subprime and Alt-A loans that led to substantial losses during the mortgage bust.  They cite two studies concluding that market pressures probably played a larger role than the goals in the purchases of riskier loans.  Also there is evidence that the GSEs only played a small role in supporting the purchase of high cost loans. 

Using 2005 HMDA data, the Joint Center found that loan sales to the GSEs accounted for a tiny 3 percent of all higher-priced home purchase loans, while private securitizations and other conduits accounted for as much as 48 percent.   Another study found that the GSEs relied on clearly defined geographic areas to determine which loans received goal credit and which did not, concluding that the GSE goals did not have a significantly negative effect on outcomes.

This is not to say that eliminating or privatizing the GSEs would have no impact on housing markets. As a result of the implicit government subsidy, the GSEs enjoyed a 25-50 basis point funding advantage over other highly rated securities. Nevertheless, it is clear that only about a half or a third of whatever financial advantage existed was passed through to borrowers. Studies from the late 1990s and early 2000s suggest that the GSE impact on lowering mortgage rates was in the 20-25 basis point range, and possibly small as 16 basis points. The rest of the initial funding advantage provided by the government subsidy was paid out to GSE shareholders or captured by their private sector partners in the secondary market.

The authors conclude that by relaxing their underwriting standards in search of greater MBS market share, the GSEs contributed greatly to the boom in mortgage lending, but their housing goals had little to do with the rampant growth in subprime lending that lies at the root of the crisis.

Advocates for a smaller government role in mortgage markets have also targeted FHA, arguing that FHA and its secondary mortgage market partner Ginnie Mae crowd out the private sector while its supporters maintain that FHA has played an important countercyclical role as lender of last resort during periods of market weakness and has backed away during housing booms.

FHA and Ginnie Mae have also expanded access to affordable mortgage capital, especially in lower-income and/or minority borrowers and communities.  According to the 2010 HMDA data, FHA insured 37 percent of all owner-occupied home purchase loans in that year but 60 percent of loans to both African-American and Hispanic/Latino borrowers.

FHA, the GSEs, and lenders that originated CRA eligible loans all suffered losses; these programs are not perfect and would benefit from reform. "At the same time, though, it is important to avoid drawing the wrong conclusion about the role of government in the mortgage market and sacrifice an important goal of the current system: broadening access to mortgage credit to a wide range of creditworthy low-income and low-wealth borrowers."  They did not cause the housing crisis, but their reform is essential to expanding access to affordable mortgage credit in a sustainable way.

Moving from short term crisis management to long-term reform, the third article summarizing the Joint Center's paper will look at their concrete proposals for the future.