A short story of federal housing support

Federal Promotion

The Fed
Promoting financial development is one of the duties of the government. In 1913, the Federal Reserve System (the Fed) was created. It is a central bank independent of the government, meant to counteract financial panics by helping banks with temporary liquidity problems. It is also controlling the supply of money, selling Treasury securities and supervising the bank system.

Deposit insurance
In 1933, the Fed introduced deposit insurance. The aim was to avoid rushes on banks in bad times but critics thought it would punish prudence and reward risk-taking. That profits would be privatized while the taxpayers would have to pay for the losses. Before deposit insurance, the banks usually had 20 - 30% deposits behind their loans. After the insurance they never had more than 10%.

FHA, Fannie and Freddie
The Federal Housing Administration (FHA) was created in 1934 to help people who could not otherwise afford a house. In 1938, the Federal National Mortgage Association (Fannie Mae) was founded, since 1968 it has been publicly traded. In 1970, the Federal Home Loan Mortgage Corporation (Freddie Mac) was created, likewise publicly traded. Fannie and Freddie (F&F) are Government-Sponsored Enterprises (GSEs), private/federal hybrids de facto making profit private and leaving losses to the taxpayers.
FHA insured loans given by banks. F&F bought loans from banks, giving the banks money to give new loans; after being converted to Mortgage Backed Securities (MBSs), the mortgages were sold on the open market.

Support for home owners

Political support for home owners
Federal support for home owners is not only FHA and F&F. To direct loans to real estate, in 1986 tax deductions were adjusted. In 1997, the tax on real estate gains was abolished (up to $500,000 for a couple). Together with easily available money, the result of this policy was a housing bubble. The prices were exploding and people bought real estate for speculation, not only for living. The price increase was very unevenly allocated. In some states, like California and Florida where building was heavily regulated, the prices soared; in less regulated states the price increase was more modest.

Clinton and Bush push for subprime
In 1977, the Community Reinvestment Act was passed. It was meant to reduce, in a safe and sound manner, discriminatory credit practices in low income neighborhoods. In spite of protests that banks might have to work at loss, in 1995 the law was modified to put on more pressure.
Both Clinton and Bush Jr continued the tradition, extending housing loan support to low-income earners. Homeownership rose from under 64% in 1993 to more than 69% in 2004.
The banks were pressured to relax their underwriting standards. To attract minority customers, lenders have to refrain from "unreasonable measures of creditworthiness". To counteract those who wanted more careful screening, campaigns were launched with "Ask [your congressman] why he opposes the American dream of homeownership", and with a dejected woman who complained that "we won't be able to afford the new house." In 2004, the Republicans first demanded that 42% of F&F's mortgages go to low income earners, then 50%; in 2008 56%.

Going private

Prime and subprime loans
Although there is no clearly defined borderline, loans are divided into prime and subprime. Subprime loans are given to financially weak people. Because of the bigger risk, the borrowers have to pay a higher interest rate, often much higher. It does not necessarily mean that subprime loans are bad loans; with careful screening, FHA was for a long time successfully helping people with limited resources to get a home of their own.

Privates go for subprime
On prime and carefully screened subprime loans, private banks could not compete with federally backed FHA and F&F; they decided to go subprime, to go for more risk and better rates.
So FHA lost market share to aggressive subprime lenders. These commercial lenders usually charged higher interest rates but promised less paperwork, faster approval, with no-money-down loans that seemed more affordable to many borrowers.

Lower standards hurt F&F
The new actors did not have the careful screening that FHA used to have. FHA lending featured almost everything that private subprimes lacked: sensible loan to value ratios, income verification and other assessment of the borrower, and realistic rates. It was very much the favorable FHA record that led private sector lenders to take interest in lower to middle income borrowers.
The new competition hurt F&F. Fannie workers were told to "get aggressive on risk taking or get out of the company". F&F knew that the quality of the loans was deteriorating, but even those who wanted to could do nothing because of political pressure. In 2007, Countrywide bank proudly told analysts they sold mortgages to Fannie that were "far below" even generous limits for subprime but still considered "prime" by Fannie.

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