A Government-Mandated Housing Bubble

There is very little doubt that the underlying cause of the current credit crisis was a housing bubble. But the collapse of the bubble would not have led to a worldwide recession and credit crisis if almost 40 percent of all U.S. mortgages--25 million loans--were not of the low quality known as subprime or Alt-A.

These loans were made to borrowers with blemished credit, or involved low or no down payments, negative amortization and limited documentation of income. The loans' unprecedentedly high rates of default are what is driving down housing prices and weakening the financial system.

Barney Frank recently admitted that it had been a mistake to force homeownership on people who could not afford it. Renting would have been preferable. Now he tells us.

The low interest rates of the early 2000s may explain the growth of the housing bubble, but they don't explain the poor quality of these mortgages. For that we have to look to the government's distortion of the mortgage finance system through the Community Reinvestment Act and the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.

In a recent meeting with the Council on Foreign Relations, Barney Frank--the chair of the House Financial Services Committee and a longtime supporter of Fannie and Freddie--admitted that it had been a mistake to force homeownership on people who could not afford it. Renting, he said, would have been preferable. Now he tells us.

Long-term pressure from Frank and his colleagues to expand home ownership connects government housing policies to both the housing bubble and the poor quality of the mortgages on which it is based. In 1992, Congress gave a new affordable housing "mission" to Fannie and Freddie, and authorized the Department of Housing and Urban Development to define its scope through regulations.

Shortly thereafter, Fannie Mae, under Chairman Jim Johnson, made its first "trillion-dollar commitment" to increase financing for affordable housing. What this meant for the quality of the mortgages that Fannie--and later Freddie--would buy has not become clear until now.

On a parallel track was the Community Reinvestment Act. New CRA regulations in 1995 required banks to demonstrate that they were making mortgage loans to underserved communities, which inevitably included borrowers whose credit standing did not qualify them for a conventional mortgage loan.

To meet this new requirement, insured banks--like the GSEs--had to reduce the quality of the mortgages they would make or acquire. As the enforcers of CRA, the regulators themselves were co-opted into this process, approving lending practices that they would otherwise have scorned. The erosion of traditional mortgage standards had begun.

Shortly after these new mandates went into effect, the nation's homeownership rate--which had remained at about 64 percent since 1982--began to rise, increasing 3.3 percent from 64.2 percent in 1994 to 67.5 percent in 2000 under President Clinton, and an additional 1.7 percent during the Bush administration, before declining in 2007 to 67.8 percent. There is no reasonable explanation for this sudden spurt, other than a major change in the standards for granting a mortgage or a large increase in the amount of low-cost funding available for mortgages. The data suggest that it was both.

As might be expected, the market for subprime and Alt-A loans grew along with the rise in homeownership. Some have argued that unregulated groups such as mortgage brokers and bankers, working with subprime lenders such as Countrywide Financial, supplied both the easier credit and the lower loan standards, but the facts belie this.

From 1995 until 2004, subprime loans by the traditional subprime lenders like Countrywide averaged slightly more than 5 percent of all mortgages, far too few to account for the growth in either homeownership or the housing bubble. CRA loans, totaling 3 percent of originations, were also too few. Where, then, did all the low-quality loans come from?

From 1994 to 2003, Fannie and Freddie's purchases of mortgages, as a percentage of all mortgage originations, increased from 37 percent to an all-time high of 57 percent, effectively cornering the conventional conforming market. With leverage ratios that averaged 75-to-1, and funds raised with implicit government backing, the GSEs were pouring money into the housing market. This in itself would have driven the housing bubble.

But it also appears that, perhaps as early as 1993, Fannie Mae began to offer easy financing terms and lowered its loan standards in order to meet congressionally mandated affordable housing goals and fulfill the company's trillion-dollar commitment. For example, in each of the years 2000 and 2001, the first years for which data are available, 18 percent of Fannie's originations--totaling $157 billion--were loans with FICO scores of less than 660 (the federal regulators' cut-off point for defining subprime loans). There is no equivalent data available for Freddie, but it is likely that its purchases were proportionately the same, amounting to an estimated $120 billion.

These sums would have swamped originations by the traditional subprime lenders, which probably totaled $119 billion in these two years. Data for Alt-A loans before 2005 are unavailable, but the fact that that Fannie and Freddie now hold 60 percent of all outstanding Alt-A loans provides a strong indication of the purchases they were making for many earlier years.

The GSE's purchases of all mortgages slowed in 2004, as they worked to overcome their accounting scandals, but in late 2004 they returned to the market with a vengeance. Late that year, their chairmen were telling meetings of mortgage originators that the GSEs were eager to purchase subprime and other nonprime loans.

This set off a frenzy of subprime and Alt-A mortgage origination, in which--as incredible as it seems--Fannie and Freddie were competing with Wall Street and one another for low-quality loans. Even when they were not the purchasers, the GSEs were Wall Street's biggest customers, often buying the AAA tranches of subprime and Alt-A pools that Wall Street put together. By 2007 they held $227 billion (one in six loans) in these nonprime pools, and approximately $1.6 trillion in low-quality loans altogether.

From 2005 through 2007, the GSEs purchased over $1 trillion in subprime and Alt-A loans, driving up the housing bubble and driving down mortgage quality. During these years, HUD's regulations required that 55 percent of all GSE purchases be affordable, including 25 percent made to low- and very low-income borrowers. Housing bubbles are nothing new. We and other countries have had them before. The reason that the most recent bubble created a worldwide financial crisis is that it was inflated with low-quality loans required by government mandate. The fact that the same government must now come to the rescue is no reason for gratitude.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI. Edward J. Pinto is a consultant to the mortgage finance industry.

Also Visit
AEIdeas Blog The American Magazine
About the Author


Peter J.


Edward J.
  • American Enterprise Institute (AEI) resident fellow Edward J. Pinto is the codirector of AEI’s International Center on Housing Risk. He is currently researching policy options for rebuilding the US housing finance sector and specializes in the effect of government housing policies on mortgages, foreclosures, and on the availability of affordable housing for working-class families. Pinto writes AEI’s monthly Housing Risk Watch, which has replaced AEI’s FHA Watch. Along with AEI resident scholar Stephen Oliner, Pinto is the creator and developer of the AEI Pinto-Oliner Mortgage Risk, Collateral Risk, and Capital Adequacy Indexes.

    An executive vice president and chief credit officer for Fannie Mae until the late 1980s, Pinto has done groundbreaking research on the role of federal housing policy in the 2008 mortgage and financial crisis. Pinto’s work on the Government Mortgage Complex includes seminal research papers submitted to the Financial Crisis Inquiry Commission: “Government Housing Policies in the Lead-up to the Financial Crisis” and “Triggers of the Financial Crisis.” In December 2012, he completed a study of 2.4 million Federal Housing Administration (FHA)–insured loans and found that FHA policies have resulted in a high proportion of working-class families losing their homes.

    Pinto has a J.D. from Indiana University Maurer School of Law and a B.A. from the University of Illinois at Urbana-Champaign.

  • Phone: 240-423-2848
    Email: edward.pinto@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: 202-419-5212
    Email: emily.rapp@aei.org

What's new on AEI

image The money in banking: Comparing salaries of bank and bank regulatory employees
image What Obama should say about China in Japan
image A key to college success: Involved dads
image China takes the fight to space
AEI on Facebook
Events Calendar
  • 21
  • 22
  • 23
  • 24
  • 25
Wednesday, April 23, 2014 | 12:00 p.m. – 1:30 p.m.
Graduation day: How dads’ involvement impacts higher education success

Join a diverse group of panelists — including sociologists, education experts, and students — for a discussion of how public policy and culture can help families lay a firmer foundation for their children’s educational success, and of how the effects of paternal involvement vary by socioeconomic background.

Event Registration is Closed
Thursday, April 24, 2014 | 12:00 p.m. – 1:30 p.m.
Getting it right: A better strategy to defeat al Qaeda

This event will coincide with the release of a new report by AEI’s Mary Habeck, which analyzes why current national security policy is failing to stop the advancement of al Qaeda and its affiliates and what the US can do to develop a successful strategy to defeat this enemy.

Friday, April 25, 2014 | 9:15 a.m. – 1:15 p.m.
Obamacare’s rocky start and uncertain future

During this event, experts with many different views on the ACA will offer their predictions for the future.   

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.