The new year brings another round of the Welcome Home program. Welcome Home essentially provides $5000 grants to low- and moderate-income borrowers to put toward down payments and closing costs on home purchases. While well-intentioned and beneficial to many borrowers, the program harkens back to a recent crisis.
There were certainly several factors contributing to the housing bust in 2008. The formula is really quite simple, although both political parties have their own company lines. For example, Democrats seem to place blame on Wall Street and deregulation. Republicans chiefly tag mortgage-bundling government-sponsored enterprises (GSE).
While both explanations may contain some truth, they are insufficient and oversimplified. Again, the path to the bubble is fairly easy to understand.
Essentially, the first root of the crisis came with the founding of Freddie Mac and Fannie Mae and their paths to prominence. Both GSEs bundle mortgages and sell them as securities (private entities do this, as well, but between these two giants, they have their hands on most of the mortgage market). Bundling has a useful purpose, and here’s how it works: A lender makes a mortgage loan. Then, the lender sells the loan to, say, Freddie Mac and uses the proceeds of the sale to make another mortgage. This is referred to as “liquidity” in the market.
Later, Congress passed a law called the Community Reinvestment Act (CRA) in part to halt a practice known as “redlining,” wherein lenders would choose not to grant loans to people living in certain geographic areas. The practice was said to have reduced credit options for minority borrowers. Initially, the act had little impact on the housing market.
Then, the Federal Reserve released a study in the early 1990s purporting to show that black applicants were approved for mortgages at lower rates than white applicants. The study moved the executive branch to use the CRA to remedy the problem. Lenders were graded on how well they lent to minority groups, and if they scored poorly, then they were regulated more harshly.
Here, bundling came into play. Since the feds effectively leaned on lenders to slacken underwriting standards to reach underrepresented borrowers of all stripes, lenders were taking on more risk. To mitigate the added risk, they simply sold more loans to the GSEs. Eventually, lenders invented exotic instruments (such as credit default swaps) to spread risk out across the market. (Since these were new, they were less regulated, and this is where the left’s “deregulation” cry has some validity.) Lenders also came up with new products, such as adjustable rate mortgages which started with low rates and low payments that would adjust after a defined period. So overall, by the end of the 1990s, there was already a larger swath of risky loans in the mortgage market.
As affordable housing became a popular political clause, Congress added new programs to help more borrowers buy homes—after all, owning a home was part of the American dream—by subsidizing down payments. Then, in the late 1990s, the economy started to slow naturally, moving the Federal Reserve to lower interest rates.
All of these factors played together to first draw a significant number of buyers into the housing market. This drove up demand, which, in turn, drove housing prices and values upward—quite dramatically, actually, especially after 2000. Borrowers eventually started tapping equity in their homes to consolidate debts, buy consumer goods, etc. Many borrowers used equity to buy other homes, fix them up, and sell them (“flipping”), which increased demand even more. Builders, seeing rising values and peak demand, built like mad.
Meanwhile, credit ratings agencies rated the mortgage-backed securities as sound, so they were doing well, too. In fact, everything was going well, at least until…
Recall the risky loans. By 2005-2006, such loans made up a significant portion of all mortgages. Prior to all of the federal tinkering, homebuyers traditionally had to have good credit and a down payment (“skin in the game”). Without these two conditions, one could argue that many mortgage holders had no business having mortgages. At a minimum, lenders had to take greater credit risk.
Eventually, defaults spiked. Reality set in for marginal borrowers, who absent all of the aforementioned developments would not likely have had mortgages, and they began to fall behind. Adjustable mortgages adjusted, too, and many borrowers (from risky to quality) simply couldn’t afford the higher payments. Many of these borrowers had also tapped all of their equity, and once demand slowed, prices and values stopped rising, so homeowners were unable to refinance their loans to affordable, fixed rates.
This exacerbated the growing default problem. In 2008, since a huge chunk of loans in each mortgage-backed security was in default, those instruments lost value and were sold rapidly. Home values then started to decline because of low demand and foreclosures, which, once sold, tended to lower the value of the surrounding homes. In turn, this further exacerbated the developing problems. During the 2008 Election, the market simply melted down, leading to a financial crisis that still affects the economy nearly five years later.
These days, the housing market is looking better. Sales are up and values are starting to recover slowly. Still, many homes are stuck in foreclosure due to government interventions, which keeps many mortgage-backed securities “toxic.” Low mortgage rates are indicator that the securities are still worth very little. In fact, the Federal Reserve has engaged in a mortgage-backed security buying program to prop up the market, which, if anything, will have an inflationary effect on housing, if not the general economy.
Meanwhile, the feds are back at it again, subsidizing down payments and seeking new (and old) ways to make housing “affordable.” Rates are low. Monetary policy is inflationary. If anything, another bubble is in the works, even though the market never really recovered from the other one.