This risk is the direct result of pressure from the lending industry, consumer groups and political appointees, who clamored for the government to intervene when homeownership rates fell several years ago. Starting in the Obama administration, numerous government officials obliged, mistakenly expecting that the private market ultimately would take over.
In 2019, there is more government-backed housing debt than at any other point in U.S. history, according to data from the Urban Institute. Taxpayers are shouldering much of the risk, while a growing number of homeowners face debt payments that amount to nearly half of their monthly income, a threshold many experts consider too steep.
Roughly 30 percent of the loans Fannie Mae guaranteed last year exceeded this level, up from 14 percent in 2016, according to Urban Institute data. At the FHA, 57 percent of the loans it insured breached the high-risk echelon, jumping from 38 percent two years earlier.
This article is based on interviews with 24 senior administration officials, regulators, former regulators, bankers and analysts, many of whom warned that risks to taxpayers have built up in the mortgage sector with very little scrutiny.
The binge in high-risk lending has some executives and regulators on edge and could grow problematic if the economy continues to weaken or enters a recession, as more economists are predicting could happen within a year. Two Freddie Mac officials told a government inspector general earlier this year that certain loans they had been pushed to buy carried a higher risk of default, and problems could multiply when the economy slows.
“There is a point here where, in an effort to create access to homeownership, you may actually be doing it in a manner that isn’t sustainable and it’s putting more people at risk,” said David Stevens, a former commissioner of the Federal Housing Administration who led the Mortgage Bankers Association until last year. “Competition, particularly in certain market conditions, can lead to a false narrative, like ‘housing will never go down’ or ‘you will never lose on mortgages.’ ”
The risky situation is a direct outgrowth of the extraordinary steps taken more than a decade ago in response to the 2008 financial crisis, which itself had roots in excessive mortgage lending and a broad national focus on boosting homeownership.
Democrats pushed for curbs on risky lending, but Obama administration regulators later nudged Fannie Mae and Freddie Mac toward riskier mortgages. The Federal Housing Finance Agency and the Department of Housing and Urban Development continued to allow Fannie and Freddie to expand their exposure to risky loans during the Trump administration. White House officials did not directly push the change, but they did little to stop it. The Treasury Department has recently called for cutting back on mortgage-related risks, but it is not a top priority at the White House while Trump battles Democrats on impeachment.
Now the government’s response to the last crisis threatens to cause a new one. The White House and congressional leaders are searching for answers, and Trump administration officials are looking for a way to release Fannie Mae and Freddie Mac from government control. The Trump administration took a critical step, allowing the firms to hold on to more capital to cushion against future losses. The process is expected to take more than a year.
Sudden alterations to the current system could disrupt the housing market and make it more expensive for people to buy homes, a treacherous political dynamic heading into an election.
Fannie Mae and Freddie Mac purchase home loans from lenders. They retain a small portion of these loans on their books, but they package most of the loans into securities and sell them to investors. Separately, FHA insures home loans against default as an incentive for lenders to offer mortgages to higher-risk borrowers. These entities were created by Congress to try to encourage homeownership.
Company and government officials have acknowledged that the recent push to expand access to mortgages has increased risks of mortgage defaults, but they have said they have properly assessed the risks so they don’t suffer big losses in a downturn.
“Certainly, I think we do need to be concerned overall about some of the risk that’s in the mortgage market,” said Mark Calabria, director of the Federal Housing Finance Agency (FHFA), which oversees Fannie Mae and Freddie Mac. “There are some patches in the housing market that are going to hit some turbulence if there’s a downturn.”
‘Is there a right answer?’
In 2013, still scarred by the financial crisis, federal regulators faced a conundrum.
The 2010 Dodd-Frank law that overhauled banking rules required the new Consumer Financial Protection Bureau (CFPB) to crack down on mortgage practices that didn’t take into account a borrower’s “ability to repay” the loan. The provision was meant to prevent the types of abusive mortgages that proliferated during the housing bubble, ones with low, short-term teaser rates or huge monthly payments.
Lenders wanted their mortgage to receive CFPB’s blessing so they couldn’t be penalized for making predatory loans. But banks wanted to shape what CFPB’s standards looked like before it was too late, and a lobbying frenzy ensued.
“Those were all tough decisions to make at that time,” Richard Cordray, then the CFPB director, said in an interview. “The mortgage market was obviously the market that broke the economy.”
Cordray huddled with top staff, consumer groups, lenders and housing market experts to gather input. A particular focus was on how big the monthly payments could be, relative to a person’s income. If a borrower earned $5,000 a month but had a $4,000 mortgage payment, the person was likely to fall behind on bills. Regulators wanted to prevent this from happening, but they struggled to define the right threshold.
After intense debate, Cordray and his aides decided they would cap the debt-to-income (DTI) threshold at 43 percent. So if a borrower earned $5,000 a month, payments on his or her mortgage and other debt had to be less than $2,250, or the loan could be labeled as improper.
The 43 percent threshold wasn’t a scientific target, Cordray said, and people had differing views on whether it was the right level.
“It’s hard to know whether the 43 percent . . . was the right answer,” Cordray said. “Is there a right answer? Who can tell?”
Lenders were apoplectic. They warned CFPB officials that such a tight restriction, however well-intentioned, could cut off access to mortgages for many home buyers and damage the housing market further. Homeownership rates in the United States had peaked at 69.2 percent in 2004 and were falling, sinking to 65 percent in 2013.
Cordray agreed on a temporary exemption. All loans deemed adequate for Fannie Mae, Freddie Mac, FHA and other government entities, which had their own less stringent standards, would not have to abide by the new limits. The exemption for Fannie Mae and Freddie Mac would expire in 2021.
“The market had almost destroyed itself, and we were coming in, trying to sift through the wreckage and put guardrails in place so that it couldn’t happen again, but at the same time not go so far to restrict the market so much it didn’t have time to recover,” Cordray said.
Shortly before announcing the exemption, Cordray telephoned Camden Fine, who at the time was the chief executive of a community banker trade group.
“We were euphoric,” Fine said. “We breathed a big sigh of relief.”
His trade group held a party to celebrate, he said.
Risk piles up
Default rates on these loans have stayed relatively low, in part because the job market has remained strong and the economy has been healthy.
But loans with high debt-to-income thresholds are particularly dangerous during a downturn, because it can be very difficult for people to come up with payments if they lose their jobs or if their credit card bills grow. The performance of these loans in such a scenario has not been tested since the CFPB exemption was put in place five years ago.
“It’s an explosion waiting to happen,” said Robert Pozen, the former president of Fidelity Investments and a senior lecturer at the Massachusetts Institute of Technology. “People don’t seem to be worried about it, but they weren’t worried about it the last time until it all blew up.”
Fannie Mae and Freddie Mac were created more than 50 years ago by Congress, and the loans they purchase and repackage for investors help fuel the housing market. The companies charge a fee to guarantee some of the risk that borrowers might default.
Many lenders strictly adhere to Fannie Mae and Freddie Mac’s purchase standards, as certain companies will make loans only with the assurance that the mortgage giants will quickly take them off their books.
Fannie Mae and Freddie Mac are still publicly traded and have shareholders, creating an awkward dynamic that makes them answerable to both the politicians who created them and the shareholders who own them.
This business model made them cash cows before the financial crisis, when interest rates were low, housing prices were soaring and defaults were rare. But when housing prices fell and many loans soured, the companies buckled.
In 2008, to try to arrest a banking panic, the George W. Bush administration seized Fannie Mae and Freddie Mac and placed them into a “conservatorship,” so that almost all of their decisions were vetted by federal regulators. Taxpayers spent $188 billion to bail out the companies, though it was all later repaid. Many Democrats and Republicans said the companies were too big to fail, as their collapse could have imperiled the entire economy.
The companies were allowed to continue operating but with a much smaller appetite for risk, in part because taxpayers were on the hook if anything went wrong. Before the housing crisis, the companies had purchased loans with debt-to-income ratios that stretched up to 65 percent, but that was scaled back dramatically after they were seized.
In 2014, even with the new CFPB rules, Fannie Mae and Freddie Mac did not show much interest in buying loans with high debt-to-income levels. Fannie set an internal cap at 45 percent, two percentage points higher than the CFPB policy. Freddie Mac mostly followed Fannie Mae’s lead.
Homeownership rates kept falling, particularly among African Americans. In 2016, the homeownership rate fell to 63 percent, the lowest level since Fannie Mae and Freddie Mac were created. Then the government stepped in.
Toward the end of the Obama administration, FHA Commissioner Ed Golding and his staff had an idea about how to push Fannie Mae to buy more high-DTI loans in a way that would boost homeownership, particularly among African Americans.
The Pew Charitable Trusts found in 2015 that 7 million households spent more than half of their income on rent. Obama administration officials wanted to help as many of these people as possible instead buy homes, so they could build up equity. But they were hamstrung by Fannie Mae and Freddie Mac’s tight restrictions.
Not only had Fannie Mae made it more difficult for borrowers with a DTI above 45 percent to secure loans, but it marked loans that exceeded 43 percent DTI as particularly problematic and scrutinized them more closely.
Golding said he told Fannie Mae officials that the company’s practices could be seen as a violation of the Fair Housing Act because it effectively discriminated against lower-income borrowers, particularly African American families, who had higher debt-to-income levels. Golding conveyed this concern to FHFA, Fannie Mae’s supervisor. FHFA, at the time under Director Mel Watt, began working on plans to direct Fannie Mae to purchase loans with higher debt-to-income thresholds, Watt said.
The order came in April 2017, three months after Trump’s inauguration. Watt, a former Democratic congressman from North Carolina, said in an interview that his agency informed the Trump administration of its plan but did not seek permission or receive any pushback. Fannie Mae began purchasing more mortgages that had higher debt-to-income levels, according to data from FHFA’s inspector general.
Watt said his research found that even though the loans seemed riskier, they would perform better because of the careful scrutiny of Fannie Mae and Freddie Mac that also takes into account credit scores and other factors. And he said failing to act would have made the companies and the FHFA targets of an anti-discrimination lawsuit, though it is unclear whether the Justice Department was prepared to file such a suit.
“It is intuitive — you think the higher somebody’s debt-to-income ratio, the more problems they are going to have,” he said from his home in North Carolina, where he is now retired. “But that’s just not the best criteria to apply, to be quite honest.”
The companies, still in a conservatorship and effectively being run by FHFA, quickly complied, and some lenders immediately notified borrowers about the new policies.
“Our efforts to increase access to single-family mortgage credit, including our expanded affordable housing program and our plan for fulfilling our duty to serve underserved markets, expose us to increased mortgage credit risk,” Fannie Mae said in a regulatory filing.
Two Freddie Mac executives told FHFA’s inspector general that the company “remains concerned by the risks from mortgages” that have been allowed under the 2017 directive, according to the inspector general’s report.
Spokesmen for Fannie Mae and Freddie Mac said the entities had worked to limit potential losses during a downturn, and last year Freddie Mac began scaling back some of its exposure to loans with high debt-to-income ratios. The firms said they use sophisticated financial models to anticipate problems and that they sell some risk to investors, but they have acknowledged that the expanded exposure could lead to higher losses.
A warning call
FHA is a division of the Department of Housing and Urban Development, and it insures millions of mortgages against losses. Many of these loans go to lower-risk borrowers who don’t have much money for down payments. The program is vital to many families but played a minor role in the housing market before the financial crisis, backing 3.14 percent of mortgage debt in 2007.
But its prominence rose sharply during the Obama administration and continued surging when Trump took office, as officials made it easier for more loans to qualify for government insurance. In 2017, 10.9 percent of all single-family mortgage debt was backed by FHA, more than triple the rate 10 years before. And more than half of those loans went to borrowers who had extremely high levels of debt.
Unlike Fannie Mae and Freddie Mac, FHA’s exemptions from the CFPB rule are permanent. FHA doesn’t buy loans from lenders, but it offers insurance in case the borrower cannot repay. The agency is designed to help borrowers who otherwise wouldn’t have access to loans, including those with poor credit who cannot make large down payments.
FHA officials during the Trump administration watched as the loans they insured appeared riskier and riskier. It wasn’t until March, more than two years after Trump was sworn in, that HUD finally took major steps to intervene. It sent a notice to lenders saying that more scrutiny of the loans was needed, but it stopped short of blocking risky borrowers from receiving loans. And it still insures the loans made before the recent warning.
FHA had found that roughly 25 percent of all new mortgages it backed, equivalent to more than $50 billion in loans, had debt-to-income levels above 50 percent, the highest level since 2000.
Even though the risks to Fannie Mae, Freddie Mac and FHA have expanded, the government’s effort hasn’t been entirely successful in addressing concerns about homeownership. African American homeownership rates fell this year to a multi-decade low.