The Past, Present and Future of Fannie

Mae, Freddie Mac, and FHA

Edward Pinto Codirector

AEI International Center on Housing Risk Edward.Pinto@AEI.org

HousingRisk.org

May 6, 2014

The views expressed are those of the author alone and do not necessarily represent those of the American Enterprise Institute.

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Lessons Relearned from 2007 Housing Collapse

• Mortgage loans are only as sound as the practices used to underwrite and originate them.

• Relative loan performance is largely determined by risk characteristics at origination.

• Market stability depends on the preponderance of loans being low risk, defined as good performance under stress.

• This promotes mortgage debt being used to smooth housing consumption, not take on excessive debt to support consumption in excess of income.

– Martin Luther King Jr. recognized the problem of living beyond one’s means in his 1968 “The Drum Major Instinct” sermon.

• Political pressures will likely degrade sound lending practices over time.

• Lack of robust risk measures limits market’s ability to impose discipline.

• Bottom line:

– Transparent and objective measures of mortgage risk, home-price risk, and the capital adequacy needed to evaluate and manage housing risk.

– The government will blame the private sector, regardless of its own culpability. 2

A Century of Lessons

• The deterioration of lending standards from the early 1990s to 2007 has historical precedents.

• Earlier episodes: 1920’s, late 1950s and 1960s, early 1980s, and late 1980s.

• Mortgage default rates rose in every case, sometimes to disastrous levels.

• Prudent lending practices (or at least less risky practices) were then re-established and defaults declined.

• The pattern is clear: the abandonment of sound mortgage underwriting standards leads to trouble.

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Source: “Securitization in the 1920’s”, William Goetzmann , 2009, Securitization in the 1920's - Yale University

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Mortgage Trouble Occurs When Mortgage Debt Grows Faster than Home Value

Mortgage Trouble Occurs When Home Values Grow Faster than Fundamentals

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The Abandonment of Sound Mortgage Underwriting Standards

• Necessary pre-condition: GSE abandonment of sound underwriting

– Gail Cincotta’s 1991 Senate Banking testimony: "Lenders will respond to the most conservative standards unless [the GSEs] are aggressive and convincing in their efforts to expand historically narrow underwriting."

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An Explicit Government Guarantee Is Not the Solution

Experience has shown that any federal insurance program with an explicit guarantee will fail to protect taxpayers. • Assumes the government would be better at pricing risk than

the market. – Every government insurance program has failed or is insolvent.

• Encourages too much of the wrong kind of debt for our economy. – Debt that bids up existing housing assets and the land they sit on,

creating a temporary wealth effect and a crowding out of capital investment needed for a productive and growing economy and jobs growth.

– The result will be another artificial housing boom and consequent bust.

• Inevitably leads to politicized credit standards. – Will once again put lower-income families into housing they can’t afford,

with the same disastrous results. 7

Most Likely Outcome: Status Quo

No imperative to pass legislation.

• GSE charters are perpetual.

• Loan limits set at no lower than 2007 market peak.

• Treasury obligated to provide GSEs an additional $200+ billion.

• No time limit on conservatorship.

• Exempt from QM’s 43% total DTI limit until Jan. 2021.

• GSEs give the appearance of being profitable and these “profits” go to Treasury.

• New leadership at FHFA. 8

Given These Facts What Will AEI’s New Housing Risk Center Do to Fill the Void?

The AEI/Pinto-Oliner Risk Indices:

• National Mortgage Risk Index (NMRI) – Classifies loans into low, medium, and high risk based on default

experience of 2007 vintage loans with similar characteristics. – Currently covers nearly all gov’t-guaranteed mortgages for home

purchases (about 75% of all purchase loans) – Limited to purchase loans now; refi loans to be added in 2014.

• 27-metro Composite Collateral Risk Index (CRI) – Metro areas chosen to represent housing market in U.S. as a whole. – Expected release dates: DC-area index, mid-2014; other metro areas

throughout 2014 and 2015.

• Capital Adequacy Index (CAI) – Assesses capital reserves at institutions with large mortgage

exposure. – Under development. Expected release date: 2015.

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Measuring Stressed Default Rates

• Takeaway: Huge spread of default rates across risk buckets

• All 320 risk buckets for home purchase loans are shown at Periodic Table on HousingRisk.org

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Risk Bucket FICO CLTV Total DTI Default Rate

Very Low ≥ 770 61-70% ≤ 33% 0.8%

Low 720-769 76-80% 34-38% 4.2%

Medium 690-719 81-85% 39-43% 9.3%

High 660-689 91-95% 44-50% 22.7%

Very High 620-639 > 95% > 50% 45.8%

Note: Default rates represent cumulative defaults through year-end 2012 for Freddie Mac’s 2007

vintage of acquired loans. The loans included in the calculation are all primary owner-occupied, 30-year

fixed-rate, fully amortizing, fully documented, home purchase loans.

NMRI for Home Purchase Loans

* Index changes measured from first month shown. Source: AEI International Center on Housing Risk, www.HousingRisk.org. Separate index not available for VA guaranteed loans. RHS is Rural Housing Service.

Fannie/Freddie and FHA/RHS indices edged up further in March, while composite index was little changed because of a decline in the FHA loan share.

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4%

8%

12%

16%

20%

24%

28%

4%

8%

12%

16%

20%

24%

28%

Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14

Fannie/Freddie: +1.1 ppt, from 4.9% to 6.0%*

Composite: +0.9 ppt, from 10.6% to 11.5%*

Stressed default rate

FHA/RHS: +1.8 ppt, from 22.3% to 24.1%*

FHA/RHS share of purchase loans: Jan-14: 33.0%; Feb-14: 31.5%; Mar-14: 30.3%

Calibrating Mortgage Safety

• Composite index substantially above 1990 level, but not approaching 2007 level when underwriting was exceptionally lax.

• Fannie/Freddie index somewhat above 1990 level and rising.

• FHA index extremely high and rising. Sharp contrast with safe underwriting during 1935-55.

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NMRI - purchase loans Latest date

Latest

Value

1935-1955

vintages (est.)

1990 vintage

(est.)

2007 vintage

(est.)

Composite index Dec. 10.8% NA 6% 19%

Fannie and Freddie Dec. 5.8% NA 4% 13%

FHA Dec. 24.1% 3% 15% 30%

A low-risk loan has an average default rate under stress of 3% and a maximum default rate of less

than 6%. An index value of less than 6% is indicative of conditions conducive to a stable market.

GSE Low-Risk Origination Shares, Purchase Loans

Source: AEI International Center on Housing Risk, www.HousingRisk.org.

Continued downward trend in low-risk share for both Fannie and Freddie.

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58%

60%

62%

64%

66%

68%

70%

72%

74%

58%

60%

62%

64%

66%

68%

70%

72%

74%

Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14

Freddie Mac

Fannie Mae

Combined

Note: FHA/RHS low-risk share (not shown) is about 1%.

Purchase Loans with Total DTI Greater Than 43%

Source: AEI International Center on Housing Risk, www.HousingRisk.org.

No discernible impact from QM regulation. Federally guaranteed loans are exempt

from Total DTI limit in QM, so share with Total DTI > 43% likely to remain high.

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10%

15%

20%

25%

30%

35%

40%

45%

50%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14

FHA/RHS

Composite

Fannie/Freddie

Mortgage Risk Index (MRI) and House Prices in

Major California Metro Areas

• Mortgage risk indices for most metro areas are below the national average, but are trending up

along with home price overvaluation.

• Metro area/county indices for FHA not yet available.

• However, FHA’s California volume is disproportionately in Riverside-San Bernardino and the Central Valley (defined in next slide), a signal of heightened default risk in those areas.

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Fannie/Freddie MRI Fitch Home Price

Overvaluation

Metro Area/County Oct-Dec 2012 Jan-Mar 2014 2012 2013:Q3

San Francisco 3.6% 3.9% 15-20% 25-30%

Oakland 4.2% 5.2% 10-15% 25-30%

Los Angeles County 4.6% 5.7% 10-15% 20-25%

Orange County 4.0% 4.8% 25-30% > 30%

Riverside-San Bernardino 5.0% 6.4% Sustainable 10-15%

San Diego 4.6% 5.3% 20-25% > 30%

National Average 5.0% 5.9% --- ---

Note: Fannie Mae MRIs are estimated using the Fannie Mae California state MRI and the Freddie Mac ratio of the metro area/county MRI to the

California state MRI. San Francisco includes Marin, San Francisco, and San Mateo counties; Oakland includes Alameda and Contra Costa counties.

Fitch estimates from Fitch Ratings, “U.S. RMBS Sustainable Home Price and Economic Risk Factor Report – January 2014”.

Driver of Housing Policy: Homeownership Rates

– Homeownership rate differences among minorities and whites are worthy of national discussion, as are potential solutions.

– According to the Census Bureau, the homeownership rates for Non-Hispanic Blacks (Blacks), Hispanics, and Non-Hispanic Whites (Whites) are 43.2 percent, 45.5 percent, and 73.4 percent respectively.

– Credit is a key input into the ultimate sustainability of any loan and the stability of both neighborhood and national housing markets.

• The credit profile for these groups is vastly different.

– A 2007 Federal Reserve report to Congress on credit scoring found that the median scores for Blacks, Hispanics, and Whites were 618, 670, and 737 respectively (medians interpolated from the Fed data).

– The same report found credit scores to be “predictive of credit risk for the population as a whole and for all major demographic groups” and further “credit characteristics included in credit history scoring models do not serve as substitutes, or proxies, for race, ethnicity, or sex.”

– Blacks and Hispanics are expected to account for well over half of the growth in households from 2010 to 2025.

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While Leverage Has Increased, the Homeownership Rate Has Been Stagnant since 1960

* Interpolated between 1950 and 1960

**Estimated loan term for 1970

***Adjusted for the 8.70% and 5.64% of loans that were seriously delinquent in 2010 and 2013 respectively (assumes 70% of homeowners have mortgages). 17

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25

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40%

50%

60%

70%

80%

90%

100%

FHA: average LTV (1940-1967), median LTV (1980-2013 (left axis)

US homeownership rate(left axis)*,***

FHA: average term inyears (right axis)**

Risk Level and Default Rate Correlate for all Vintages

*30 year, fixed rate, fully amortizing, fully documented, owner occupied loans 18

Combined LTV and FICO Highly Correlated to Default Rate for Home Purchase Loans (2007 Vintage)

• t

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Combined LTV and FICO Highly Correlated to Default Rate for Cash Out Refinance Loans (2007 Vintage)

• t

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Contentious Issues: Duty to Serve and Disparate Impact

• One view: “narrow” underwriting prevents low-income and minority borrowers from getting loans to the same extent as higher income/non-minority ones.

• Another view: the QM credit box is broad, deep, and pro-cyclical during a boom—all FHA (and Fannie and Freddie) are eligible – High risk lending has a disparate impact on low-income and

minority families and neighborhoods

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A Thought Experiment

• To raise Black and Hispanic homeownership rates to the White rate of 73.4 percent would require the origination of 10 million 30 year loans totaling $1.7 trillion with an average credit score of 630, a down payment of 3.5 percent and a median debt-to-income ratio of 42%.

• These loans clearly present high risks to homebuyers, neighborhoods, lenders, mortgage insurers, and taxpayers. – 35-30% default rate under stress

– Defaults not evenly distributed—greater concentration in low-income and minority neighborhoods

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A Second Thought Experiment

• A home loan with a 630 FICO, 4% down payment and 42% DTI. • FHA’s advantages and cross subsidies allow substantial underpricing of

high risk loans compared to the private sector. – 12% rate on a private 30 year fixed rate loan (rate based on Barclay’s

data) with a loan payment constant of 12.34—clearly a high risk loan. • Amortized LTV after year 5 – 94%.

– 4.25% rate on an FHA 30 year loan with 1.75% upfront MIP and 1.35% annual MIP with a loan payment constant of 7.25—clearly still a high risk loan. • This is due to fact that the reduced loan constant was allowed to be fully

capitalized into a 67% higher home price. • Amortized LTV after year 5 – 89%.

• An alternative: – Allow the FHA home buyer to purchase a 32% higher priced home by reducing

the term to 15 years, the rate to 3.25%, and the MIP to 0.65% (loan payment constant = 9.15). • This dramatically reduces risk to the borrower and neighborhood. • Amortized LTV after year 5 – 70%.

• Year 5: three times the wealth building effect: $10,500 ($150,000 home price) vs. $31,000 ($119,000 home price)

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Insanity: doing the same thing over and over again and expecting different results – Albert Einstein

• 60 years of policy failure—increasing leverage will increase homeownership. – FHA’s failed effort to serve lower-income borrowers in the 1960s and early-1970s

was chronicled in Cities Destroyed for Cash.

– The affordable housing mandates contained in the 1992 GSE reform act did not end well.

– Duty to Serve and Disparate Impact in the context of the pro-cyclical QM credit box would have the same result:

• Increased leverage bids up the price of existing housing, making it less affordable, and leads to volatile home prices for those least able to cope.

• “Mortgage has become just another word for trouble…instead of a straight, broad highway to debt-free ownership” for families with the ability, desire and discipline to become homeowners. (FHA 1935)

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For more information

• Go to: www.HousingRisk.org

• My email: Edward.Pinto@AEI.org

• Listen to our monthly National Mortgage Risk Index Briefing calls: email Edward.Pinto@AEI.org

– Next call: 10AM EDT on May 27

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