Fannie Mae (FNMA)

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It is important to remember HUD's central role of promoting policies that were detrimental to the GSE's in the lead-up to the financial crisis when reading this article.

An organisation committed to winding down mortgage finance groups Fannie Mae and Freddie Mac launched on Monday with a call for the US government to respect investors’ rights as more groups push mortgage finance reform on to the agenda for the November midterm elections.

The Coalition for Mortgage Security, which includes former housing and urban development [HUD] undersecretary Ken Blackwell as one of its directors, declined to provide information about its funding but echoed the views of several hedge funds fighting the government over the value of their shares.

From the FCIC Report, http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf

Initiated by Congress in 1992 and pressed by HUD in both the Clinton and
George W. Bush Administrations, the U.S. government’s housing policy sought to
increase home ownership in the United States through an intensive effort to reduce
mortgage underwriting standards. In pursuit of this policy, HUD used (i) the
affordable housing requirements imposed by Congress in 1992 on the government-sponsored
enterprises (GSEs) Fannie Mae and Freddie Mac, (ii) its control over the
policies of the Federal Housing Administration (FHA), and (iii) a “Best Practices
Initiative” for subprime lenders and mortgage banks, to encourage greater subprime
and other high risk lending. HUD’s key role in the growth of subprime and other
high risk mortgage lending is covered in detail in Part III.

Ultimately, all these entities, as well as insured banks covered by the CRA,
were compelled to compete for mortgage borrowers who were at or below the median
income in the areas in which they lived. This competition caused underwriting
standards to decline, increased the numbers of weak and high risk loans far beyond
what the market would produce without government influence, and contributed
importantly to the growth of the 1997-2007 housing bubble.

When the bubble began to deflate in mid-2007, the low quality and high
risk loans engendered by government policies failed in unprecedented numbers.
The effect of these defaults was exacerbated by the fact that few if any investors—
including housing market analysts—understood at the time that Fannie Mae and
Freddie Mac had been acquiring large numbers of subprime and other high risk
loans in order to meet HUD’s affordable housing goals.

Alarmed by the unexpected delinquencies and defaults that began to appear
in mid-2007, investors fled the multi-trillion dollar market for mortgage-backed securities (MBS), dropping MBS values—and especially those MBS backed by
subprime and other risky loans—to fractions of their former prices. Mark-to-market
accounting then required financial institutions to write down the value of
their assets—reducing their capital positions and causing great investor and creditor
unease. The mechanism by which the defaults and delinquencies on subprime and
other high risk mortgages were transmitted to the financial system as a whole is
covered in detail in Part II.
In this environment, the government’s rescue of Bear Stearns in March of
2008 temporarily calmed investor fears but created a significant moral hazard;
investors and other market participants reasonably believed after the rescue of
Bear that all large financial institutions would also be rescued if they encountered
financial difficulties. However, when Lehman Brothers—an investment bank even
larger than Bear—was allowed to fail, market participants were shocked; suddenly,
they were forced to consider the financial health of their counterparties, many of
which appeared weakened by losses and the capital writedowns required by mark-to-
market accounting. This caused a halt to lending and a hoarding of cash—a
virtually unprecedented period of market paralysis and panic that we know as the
financial crisis of 2008.
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The AH goals put Fannie and Freddie into direct competition
with the FHA, which was then and is today an agency within HUD that functions as
the federal government’s principal subprime lender.

Over the next 15 years, HUD consistently enhanced and enlarged the AH
goals. In the GSE Act, Congress had initially specified that 30 percent of the GSEs’
mortgage purchases meet the AH goals. This was increased to 42 percent in 1995,
and 50 percent in 2000. By 2008, the main LMI goal was 56 percent, and a special
affordable subgoal had been added requiring that 27 percent of the loans acquired
by the GSEs be made to borrowers who were at or below 80 percent of area median
income (AMI). Table 10, page 510, shows that Fannie and Freddie met the goals in
almost every year between 1996 and 2008.
There is very little data available concerning Fannie and Freddie’s acquisitions
of subprime and Alt-A loans in the early 1990s, so it is difficult to estimate the GSEs’
year-by-year acquisitions of these loans immediately after the AH goals went into
effect. However, Pinto estimates the total value of these purchases at approximately
$4.1 trillion (see Table 7, page 504). As shown in Table 1, page 456, on June 30,
2008, immediately prior to the onset of the financial crisis, the GSEs held or had
guaranteed 12 million subprime and Alt-A loans. This was 37 percent of their total
mortgage exposure of 32 million loans, which in turn was approximately 58 percent
of the 55 million mortgages outstanding in the U.S. on that date. Fannie and Freddie,
accordingly, were by far the dominant players in the U.S. mortgage market before
the financial crisis and their underwriting standards largely set the standards for the
rest of the mortgage financing industry.

The Community Reinvestment Act. In 1995, the regulations under the
Community Reinvestment Act (CRA) were tightened. As initially adopted in
1977, the CRA and its associated regulations required only that insured banks
and S&Ls reach out to low-income borrowers in communities they served. The
new regulations, made effective in 1995, for the first time required insured banks
and S&Ls to demonstrate that they were actually making loans in low-income
communities and to low-income borrowers. A qualifying CRA loan was one made
to a borrower at or below 80 percent of the AMI (Area Median Income), and thus was similar to the loans
that Fannie and Freddie were required to buy under HUD’s AH goals.
In 2007, the National Community Reinvestment Coalition (NCRC), an
umbrella organization for community activist organizations, reported that between
1997 and 2007 banks that were seeking regulatory approval for mergers committed
in agreements with community groups to make over $4.5 trillion in CRA loans.
A substantial portion of these commitments appear to have been converted into
mortgage loans, and thus would have contributed substantially to the number
of subprime and other high risk loans outstanding in 2008. For this reason, they
deserved Commission investigation and analysis. Unfortunately, as outlined in Part
III, this was not done.
Accordingly, the GSE Act put Fannie and Freddie, FHA, and the banks
that were seeking CRA loans into competition for the same mortgages—loans to
borrowers at or below the applicable AMI (Area Median Income).
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The conventional explanation for the financial crisis is the one given by Fed
Chairman Bernanke in the same speech at Morehouse College quoted at the outset
of Part II:
Saving inflows from abroad can be beneficial if the country that receives those inflows
invests them well. Unfortunately, that was not always the case in the United States
and some other countries. Financial institutions reacted to the surplus of available
funds by competing aggressively for borrowers, and, in the years leading up to the crisis,
credit to both households and businesses became relatively cheap and easy to obtain. One
important consequence was a housing boom in the United States, a boom that was
fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of
this lending was poorly done, involving, for example, little or no down payment by the
borrower or insufficient consideration by the lender of the borrower’s ability to make the
monthly payments. Lenders may have become careless because they, like many people
at the time, expected that house prices would continue to rise--thereby allowing
borrowers to build up equity in their homes--and that credit would remain easily
available, so that borrowers would be able to refinance if necessary. Regulators did not
do enough to prevent poor lending, in part because many of the worst loans were made
by firms subject to little or no federal regulation. [Emphasis supplied]
In other words, the liquidity in the world financial market caused U.S. banks
to compete for borrowers by lowering their underwriting standards for mortgages
and other loans. Lenders became careless. Regulators failed. Unregulated originators
made bad loans. One has to ask: is it plausible that banks would compete for
borrowers by lowering their mortgage standards? Mortgage originators—whether
S&Ls, commercial banks, mortgage banks or unregulated brokers—have been
competing for 100 years. Th at competition involved offering the lowest rates and
the most benefits to potential borrowers. It did not, however, generally result in or involve the weakening of underwriting standards. Those standards—what made
up the traditional U.S. mortgage—were generally 15 or 30 year amortizing loans to
homebuyers who could provide a downpayment of at least 10-to-20 percent and had
good credit records, jobs and steady incomes. Because of its inherent quality, this
loan was known as a prime mortgage.
There were subprime loans and subprime lenders, but in the early 1990s
subprime lenders were generally niche players that made loans to people who
could not get traditional mortgage loans; the number of loans they generated was
relatively small and bore higher than normal interest rates to compensate for the
risks of default. In addition, mortgage bankers and others relied on FHA insurance
for loans with low downpayments, impaired credit and high debt ratios. Until the
1990s, these NTMs were never more than a fraction of the total number of mortgages
outstanding. Th e reason that low underwriting standards were not generally used is
simple. Low standards would result in large losses when these mortgages defaulted,
and very few lenders wanted to hold such mortgages. In addition, Fannie and
Freddie were the buyers for most middle class mortgages in the United States, and
they were conservative in their approach. Unless an originator made a traditional
mortgage it was unlikely that Fannie or Freddie or another secondary market buyer
could be found for it.
This is common sense. If you produce an inferior product—whether it’s a
household cleaner, an automobile, or a loan—people soon recognize the lack of
quality and you are out of business. This was not the experience with mortgages,
which became weaker and riskier as the 1990s and 2000s progressed. Why did this
happen?
In its report, the Commission majority seemed to assume that originators of
mortgages controlled the quality of mortgages. Much is made in the majority’s report
of the so-called “originate to distribute” idea, where an originator is not supposed to
care about the quality of the mortgages because they would eventually be sold off .
The originator, it is said, has no “skin in the game.” The motivation for making poor
quality mortgages in this telling is to earn fees, not only on the origination but in
each of the subsequent steps in the securitization process.
This theory turns the mortgage market upside down. Mortgage originators
could make all the low quality mortgages they wanted, but they wouldn’t earn a
dime unless there was a buyer. The real question, then, is why there were buyers
for inferior mortgages and this, as it turns out, is the same as asking why mortgage
underwriting standards, beginning in the early 1990s, deteriorated so badly. As
Professor Raghuram Rajan notes in Fault Lines, “[A]s brokers came to know that
someone out there was willing to buy subprime mortgage-backed securities without
asking too many questions, they rushed to originate loans without checking the
borrowers’ creditworthiness, and credit quality deteriorated. But for a while, the
problems were hidden by growing house prices and low defaults—easy credit
masked the problems caused by easy credit—until house prices stopped rising and
the flood of defaults burst forth.”
Who were these buyers? Table 1, reporting the number of NTMs outstanding
on June 30, 2008, identified government agencies and private organizations required
by the government to acquire, hold or securitize NTMs as responsible for two-thirds of these mortgages, about 19 million. The table also identifies the private sector as
the securitizer of the remaining one-third, about 7.8 million loans. In other words,
if we are looking for the buyer of the NTMs that were being created by originators
at the local level, the government’s policies would seem to be the most likely culprit.
The private sector certainly played a role, but it was a subordinate one. Moreover,
what the private sector did was respond to demand—that’s what the private sector
does—but the government’s role involved deliberate policy, an entirely different
matter. Of its own volition, it created a demand that would not otherwise have been
there.

The deterioration in mortgage standards did not occur—contrary to the
Commission majority’s apparent view—because banks and other originators
suddenly started to make deficient loans; nor was it because of insufficient regulation
at the originator level. The record shows unambiguously that government regulations
made FHA, Fannie and Freddie, mortgage banks and insured banks of all kinds into
competing buyers. All of them needed NTMs in order to meet various government
requirements. Fannie and Freddie were subject to increasingly stringent affordable
housing requirements; FHA was tasked with insuring loans to low-income borrowers
that would not be made unless insured; banks and S&Ls were required by CRA to
show that they were also making loans to the same group of borrowers; mortgage
bankers who signed up for the HUD Best Practices Initiative and the Clinton
administration’s National Homeownership Strategy were required to make the same
kind of loans. Profit had nothing to do with the motivations of these firms; they
were responding to government direction. Under these circumstances, it should
be no surprise that underwriting standards declined, as all of these organizations
scrambled to acquire the same low quality mortgages.

1. HUD’s Central Role
In testimony before the House Financial Services Committee on April 14,
2010, Shaun Donovan, Secretary of Housing and Urban Development, said in
reference to the GSEs: “Seeing their market share decline (between 2004 and 2006)
as a result of (a) change of demand, the GSEs made the decision to widen their focus
from safer prime loans and begin chasing the non-prime market, loosening longstanding
underwriting and risk management standards along the way. This would
be a fateful decision that not only proved disastrous for the companies themselves
–but ultimately also for the American taxpayer.”
Earlier, in a “Report to Congress on the Root Causes of the Foreclosure
Crisis,” in January 2010, HUD declared “The serious financial troubles of the GSEs
that led to their being placed into conservatorship by the Federal government
provides strong testament to the fact that the GSEs were, indeed, overexposed to
unduly risky mortgage investments. However, the evidence suggests that the GSEs’
decisions to purchase or guarantee non-prime loans was motivated much more by
efforts to chase market share and profits than by the need to satisfy federal regulators.”
Finger-pointing in Washington is endemic when problems occur, and

61 Report to Congress on the Root Causes of the Foreclosure Crisis , January 2010, p.xii, www.
huduser.org/portal/publications/hsgfin/foreclosure_09.html

agencies and individuals are constantly trying to find scapegoats for their own
bad decisions, but HUD’s effort to blame Fannie and Freddie for the decline in
underwriting standards sets a new standard for running from responsibility.
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Despite the recent effort by HUD to deny its own role in fostering the
growth of subprime and other high risk mortgage lending, there is strong—indeed
irrefutable—evidence that, beginning in the early 1990s, HUD led an ultimately
successful effort to lower underwriting standards in every area of the mortgage
market where HUD had or could obtain influence. With support in congressional
legislation, the policy was launched in the Clinton administration and extended
almost to the end of the Bush administration. It involved FHA, which was under
the direct control of HUD; Fannie Mae and Freddie Mac, which were subject to
HUD’s affordable housing regulations; and the mortgage banking industry, which—
while not subject to HUD’s legal jurisdiction—apparently agreed to pursue HUD’s

62 Issue Brief: HUD’s Affordable Housing Goals for Fannie Mae and Freddie Mac, p.5.
63 Final Rule, http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf
64 HUD PDR, May 2005, HUD Contract C-OPC-21895, Task Order CHI-T0007, “Recent House Price
Trends and Homeownership Affordability”, p.85.
Peter J. Wallison 489

policies out of fear that they would be brought under the Community Reinvestment
Act through legislation. In addition, although not subject to HUD’s jurisdiction,
the new tighter CRA regulations that became effective in 1995 led to a process in
which community groups could obtain commitments for substantial amounts of
CRA-qualifying mortgages and other loans to subprime borrowers when banks
were applying for merger approvals.

By 2004, HUD believed it had achieved the “revolution” it was looking for:
Over the past ten years, there has been a ‘revolution in affordable lending’ that has
extended homeownership opportunities to historically underserved households.
Fannie Mae and Freddie Mac have been a substantial part of this ‘revolution in
affordable lending’. During the mid-to-late 1990s, they added flexibility to their
underwriting guidelines, introduced new low-downpayment products, and worked to
expand the use of automated underwriting in evaluating the creditworthiness of loan
applicants. HMDA data suggest that the industry and GSE initiatives are increasing
the flow of credit to underserved borrowers. Between 1993 and 2003, conventional
loans to low income and minority families increased at much faster rates than loans to
upper-income and nonminority families.
This turned out to be an immense error of policy. By 2010, even the strongest
supporters of affordable housing as enforced by HUD had recognized their error.
In an interview on Larry Kudlow’s CNBC television program in late August,
Representative Barney Frank (D-Mass.)—the chair of the House Financial Services
Committee and previously the strongest congressional advocate for affordable
housing—conceded that he had erred: “I hope by next year we’ll have abolished
Fannie and Freddie . . . it was a great mistake to push lower-income people into
housing they couldn’t afford and couldn’t really handle once they had it.” He then
added, “I had been too sanguine about Fannie and Freddie.
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What caused these conservative standards to decline? The Commission majority, echoing Chairman Bernanke, seems to believe that the impetus was competition
among the banks, irresponsibility among originators, and the desire for profit. The
majority’s report offers no other explanation.
However, there is no difficulty finding the source of the reductions in mortgage
underwriting standards for Fannie and Freddie, or for the originators for whom
they were the buyers. HUD made clear in numerous statements that its policy—in
order to make credit available to low-income borrowers—was specifically intended
to reduce underwriting standards. The GSE Act enabled HUD to put Fannie and
Freddie into competition with FHA, and vice versa, creating what became a contest
to lower mortgage standards. As the Fannie Mae Foundation noted in a 2000 report,
“FHA loans constituted the largest share of Countrywide’s [subprime lending]
activity, until Fannie Mae and Freddie Mac began accepting loans with higher LTVs
[loan-to-value ratios] and greater underwriting flexibilities.”
Under the GSE Act, the HUD Secretary was authorized to establish affordable
housing goals for Fannie and Freddie. Congress required that these goals include a
low and moderate income goal and a special affordable goal (discussed below), both
of which could be adjusted in the future. Among the factors the secretary was to
consider in establishing the goals were national housing needs and “the ability of
the enterprises [Fannie and Freddie] to lead the industry in making mortgage credit
available for low-and moderate-income families.” The Act also established an interim
affordable housing goal of 30 percent for the two-year period beginning January 1,
1993. Under this requirement, 30 percent of the GSEs’ mortgage purchases had to
be affordable housing loans, defined as loans to borrowers at or below the AMI.
Further, the Act established a “special affordable” goal to meet the
“unaddressed needs of, and affordable to, low-income families in low-income
areas and very low-income families.” This category was defined as follows: “(i) 45
percent shall be mortgages of low-income families who live in census tracts in which
the median income does not exceed 80 percent of the area median income; and
(ii) 55 percent shall be mortgages of very low income families,” which were later
defined as 60 percent of AMI. Although the GSE Act initially required that the
GSEs spend on special affordable mortgages “not less than 1 percent of the dollar
amount of the mortgage purchases by the [GSEs] for the previous year,” HUD raised
this requirement substantially in later years. Ultimately, it became the most difficult
affordable housing AH burden for Fannie and Freddie to meet.
Finally, the GSEs were directed to: “(A) assist primary lenders to make
housing credit available in areas with low-income and minority families; and (B)
assist insured depository institutions to meet their obligations under the Community
Reinvestment Act of 1977.” There will be more on the CRA and its effect on the
quality of mortgages later in this section.
Congress also made clear in the act that its intention was to call into question
the high quality underwriting guidelines of the time. It did so by directing Fannie
and Freddie to “examine—
(1) The extent to which the underwriting guidelines prevent or inhibit the purchase
or securitization of mortgages for houses in mixed-use, urban center, and
predominantly minority neighborhoods and for housing for low-and moderate income
families;
(2) The standards employed by private mortgage insurers and the extent to which
such standards inhibit the purchase and securitization by the enterprises of
mortgages described in paragraph (1); and
(3) The implications of implementing underwriting standards that—
(A) establish a downpayment requirement for mortgagors of 5 percent or less;
(B) allow the use of cash on hand as a source of downpayments; and
(C) approve borrowers who have a credit history of delinquencies if the borrower
can demonstrate a satisfactory credit history for at least the 12-month period
ending on the date of the application for the mortgage.”74
I could not find a record of reports by Fannie and Freddie required under
this section of the act, but it would have been fairly clear to both companies, and to
HUD, what Congress wanted in asking for these studies. Prevailing underwriting
standards were inhibiting mortgage financing for low and moderate income (LMI)
families, and would have to be substantially relaxed in order to meet the goals
of the Act. Whatever the motivation, HUD set out to assure that downpayment
requirements were substantially reduced (eventually they reached zero) and past
credit history became a much less important issue when mortgages were made
(permitting subprime mortgages to become far more common).
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Did Fannie acquire NTMs because these loans were profitable?
From time to time, commentators on the GSEs have suggested that the GSEs’
real motive for acquiring NTMs was not that they had to comply with the AH
goals, but that they were seeking the profits these risky loans produced. This could
have been true in the 1990s, but after the major increase in the AH goals in 2000
Fannie began to recognize that complying with the goals was reducing the firm’s
profitability. By 2007, Fannie was asking for relief from the goals.
The following table, drawn from a FHFA publication, shows the applicable
AH goals over the period from 1996 through 2008 and the GSEs’ success in meeting
them.

TABLE SHOWN IN FCIC REPORT

As the table shows, Fannie and Freddie exceeded the AH goals virtually each
year, but not by significant margins. They simply kept pace with the increases in the
goals as these requirements came into force over the years. This alone suggests that
they did not increase their purchases in order to earn profits. If that was their purpose
they would have substantially exceeded the goals, since their financial advantages
(low financing costs and low capital requirements) allowed them to pay more for
the mortgages they wanted than any of their competitors. As HUD noted in 2000:
“Because the GSEs have a funding advantage over other market participants, they
have the ability to underprice their competitors and increase their market share.”
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It is important to recognize what was happening. Fannie, and the banks and
S&Ls under CRA, were now competing for the same kinds of NTMs [Non-Traditional Mortgages], and were
doing so by lowering their mortgage underwriting standards and adding flexibilities
and subsidies. Simply as a result of supply and demand, all of the participants in
this competition were required to pay higher prices for these increasingly risky
mortgages. The banks and S&Ls that acquired these loans could not sell them,
without taking a loss, when market interest rates were higher than the rates on the
mortgages. This is the first indication in the documents that the FCIC received
from Fannie that competition for subprime loans among the GSEs, banks, S&Ls,
and FHA was causing the underpricing of risk—one of the principal causes of the
mortgage meltdown and thus the financial crisis.
In January 2003, Fannie began planning for how to confront HUD before the
next round of increases in the AH goals, expected to occur in 2004. In an “Action
Plan for the Housing Goals Rewrite,” dated January 22, 2003, Fannie staff reviewed
a number of options, and concluded that “Fannie should strongly oppose: goals
increases and new subgoals.” (Slide 35)
In March 2003, as Fannie prepared for new increases in the AH goals, its
staff prepared a presentation, perhaps for HUD or for policy defense in public
forums. The apparent purpose was to show that the goals should not be increased
significantly in 2004. Slide 5 stated:
In 2002, Fannie Mae exceeded all our goals for the 9th straight year. But it was probably
the most challenging environment we’ve ever faced. Meeting the goals required heroic
4th quarter efforts on the part of many across the company. Vacations were cancelled.
The midnight oil burned. Moreover, the challenge freaked out the business side of
the house. Especially because the tenseness around meeting the goals meant that we
considered not doing deals—not fulfilling our liquidity function—and did deals at
risks and prices we would not have otherwise done. [emphasis supplied]

By September 2004, it was becoming clear that continuing increases in
the AH goals were having a major adverse effect on Fannie’s profitability. In a
memorandum to Brian Graham (another Fannie official), Paul Weech, Director of
Market Research and Policy Development, wrote: “Meeting the goals in difficult
markets imposes significant costs on the Company and potentially causes marketdistorting
behaviors. In 1998, 2002, and 2003 especially, the Company has had
to pursue certain transactions as much for housing goals attainment as for the
economics of the transaction.”
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On May 5, 2006, a Fannie staff memo to the Single Family Business Credit
Committee revealed the serious credit and financial problems Fannie was facing
when acquiring subprime mortgages to meet the AH goals. The memo describes
the competitive landscape, in which “product enhancements from Freddie Mac,
FHA, Alt-A and subprime lenders have all contributed to increased competition
for goals rich loans…On the issue of seller contributions [in which the seller of the
home pays cash expenses for the buyer] even FHA has expanded their guidelines
by allowing 6% contributions for LTVs up to 97% that can be used toward closing,
prepaid expenses, discount points and other financing concessions.”
The memorandum is eye-opening for what it says about the credit risks
Fannie had to take in order to get the goals-rich loans it needed to meet HUD’s
AH requirements for 2006.
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This does not solve all the major problems with the AH goals. In the sense
that the goals enable the government to direct where a private company extends
credit, they are inherently a form of government credit allocation. More significantly,
the competition among the GSEs, FHA and the banks that are required under the
CRA to find and acquire the same kind of loans will continue to cause the same
underpricing of risk on these loans that eventually brought about the mortgage
meltdown and the financial crisis. This is discussed in the next section and the
section on the CRA.
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4. Competition Between the GSEs and FHA
for Subprime and Alt-A Mortgages
One of the important facts about HUD’s management of the AH goals
was that it placed Fannie and Freddie in direct competition with FHA, an agency
within HUD. This was already noted in some of the Fannie documents cited above.
Fannie treated this as a conflict of interest at HUD, but there is a strong case that
this competition is exactly what HUD and Congress wanted. It is important to
recall the context in which the GSE Act was enacted in 1992. In 1990, Congress had
enacted the Federal Credit Reform Act.138 One of its purposes was to capture in the
government’s budget the risks to the government associated with loan guarantees,
and in effect it placed a loose budgetary limit on FHA guarantees. For those in
Congress and at HUD who favored increased mortgage lending to low income
borrowers and underserved communities, this consequence of the FCRA may have
been troubling. What had previously been a free way to extend support to groups
who were not otherwise eligible for conventional mortgages—which generally
required a 20 percent downpayment and the indicia of willingness and ability to
pay—now appeared to be potentially restricted. Requiring the GSEs to take up the
mantle of affordable housing would have looked at the time like a solution, since
Fannie and Freddie had unlimited access to funds in the private markets and were
off -budget entities.
Looked at from this perspective, it would make sense for Congress and HUD
to place the GSEs and FHA in competition, just as it made sense to put Fannie and
Freddie in competition with one another for affordable loans. With all three entities
competing for the same kinds of loans, and with HUD’s control of both FHA’s
lending standards and the GSEs’ affordable housing requirements, underwriting
requirements would inevitably be reduced. HUD’s explicit and frequently expressed
interest in reducing mortgage underwriting standards, as a means of making
mortgage credit available to low income borrowers, provides ample evidence of
HUD’s motives for creating this competition.
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Despite its reductions in required downpayments, FHA’s market share vis-a
vis the GSEs began to decline. According to GAO data, in 1996, FHA’s market
share among lower-income borrowers was 26 percent while the GSEs’ share was
23.8 percent. By 2005, FHA’s share was 9.8 percent, while the GSEs’ share was 31.9
percent. It appears that early on Fannie Mae deliberately targeted FHA borrowers
with its Community Homebuyer Program (CHBP). In a memorandum prepared
in 1993, Fannie’s Credit Policy group compared Fannie’s then-proposed CHBP
program to FHA’s requirements under its 1-to-4 family loan program (Section
203(b)) and showed that most of Fannie’s requirements were competitive or better.

FHA also appears to have tried to lead the GSEs. In 1999—just before the
AH goals for Fannie and Freddie were to be raised—FHA almost doubled its
originations of loans with LTVs equal to or greater than 97 percent, going from 22.9
percent in 1998 to 43.84 percent in 1999.141 It also offered additional concessions on
underwriting standards in order to attract subprime business. The following is from
a Quicken ad in January 2000 (emphasis in the original), which is likely to have
been based on an FHA program as it existed in 1999:
Borrowers can purchase with a minimum down payment. Without FHA insurance,
many families can’t afford the homes they want because down payments are a major
roadblock. FHA down payments range from 1.25% to 3% of the sale price and are
significantly lower than the minimum that many lenders require for conventional or
sub-prime loans.
With FHA loans, borrowers need as little as 3% of the “total funds” required. In
addition to the funds needed for the down payment, borrowers also have to pay
closing costs, prepaid fees for insurance and interest, as well as escrow fees which
include mortgage insurance, hazard insurance, and months worth of property taxes.
A FHA-insured home loan can be structured so borrowers don’t pay more than 3% of
the total out-of-pocket funds, including the down payment.
The combined total of out-of-pocket funds can be a gift or loan from family
members. FHA allows homebuyers to use gifts from family members and non-profit
groups to cover their down payment and additional closing costs and fees. In fact,
even a 100% gift or a personal loan from a relative is acceptable.
FHA’s credit requirements are flexible. Compared to credit requirements established
by many lenders for other types of home loans, FHA focuses only on a borrower’s last
12-24 month credit history. In addition, there is no minimum FICO score - mortgage
bankers look at each application on a case-by-case basis. It is also perfectly acceptable
for people with NO established credit to receive a loan with this program.
FHA permits borrowers to have a higher debt-to-income ratio than most insurers
typically allow. Conventional home loans allow borrowers to have 36% of their gross
income attributed to their new monthly mortgage payment combined with existing
debt. FHA program allows borrowers to carry 41%, and in some circumstances, even
more.
.
.
.
Whether a conscious policy of HUD or not, competition between the GSEs
and FHA ensued immediately after the GSEs were given their affordable housing
mission in 1992. The fact that FHA, an agency controlled by HUD, substantially
increased the LTVs it would accept in 1991 (just before the GSEs were given their
affordable housing mission) and again in 1999 (just before the GSEs were required
to increase their affordable housing efforts) is further evidence that HUD was
coordinating these policies in the interest of creating competition between FHA
and the GSEs. The effect was to drive down underwriting standards, which HUD
had repeatedly described as its goal.
.
.
.
5. Enlisting Mortgage Bankers and Subprime
Lenders in Affordable Housing
In 1994, HUD began a program to enlist other members of the mortgage
financing community in the effort to reduce underwriting standards. In that year,
the Mortgage Bankers Association (MBA)—a group of mortgage financing firms
not otherwise regulated by the federal government and not subject to HUD’s legal
authority—agreed to join a HUD program called the “Best Practices Initiative.”
The circumstances surrounding this agreement are somewhat obscure, but at least
one contemporary account suggests that the MBA signed up to avoid an effort by
HUD to cover mortgage bankers under the Community Reinvestment Act (CRA),
which up to that point had only applied only to government-insured banks.
In mid-September [1994], the Mortgage Bankers Association of America whose
membership includes many bank-owned mortgage companies, signed a
three-year master best-practices agreement with HUD. The agreement consisted
of two parts: MBA’s agreement to work on fair-lending issues in consultation
with HUD and a model best-practices agreement that individual mortgage banks
could use to devise their own agreements with HUD.The first such agreement,
signed by Countrywide Funding Corp., the nation’s largest mortgage bank, is
summarized [below]. Many have seen the MBA agreement as a preemptive strike
against congressional murmurings that mortgage banks should be pulled under the
umbrella of the CRA.
.
.
.
Countrywide was by far the most important participant in the HUD
program. Under that program, it made a series of multi-billion dollar commitments,
culminating in a “trillion dollar commitment” to lend to minority and low income families, which in part it fulfilled by selling subprime and other NTMs to Fannie and
Freddie. In a 2000 report, the Fannie Mae Foundation noted: “FHA loans constituted
the largest share of Countrywide’s activity, until Fannie Mae and Freddie Mac began
accepting loans with higher LTVs and greater underwriting fl exibilities.” In late
2007, a few months before its rescue by Bank of America, Countrywide reported that
it had made $789 billion in mortgage loans toward its trillion dollar commitment.
.
.
.
6. The Community Reinvestment Act
The most controversial element of the vast increase in NTMs between 1993
and 2008 was the role of the CRA.149 The act, which is applicable only to federally
insured depository institutions, was originally adopted in 1977. Its purpose in part
was to “require each appropriate Federal financial supervisory agency to use its
authority when examining financial institutions to encourage such institutions to
help meet the credit needs of the local communities in which they are chartered
consistent with the safe and sound operations of such institutions.” The enforcement
provisions of the Act authorized the bank regulators to withhold approvals for such
transactions as mergers and acquisitions and branch network expansion if the
applying bank did not have a satisfactory CRA rating.
CRA did not have a substantial effect on subprime lending in the years after
its enactment until the regulations under the act were tightened in 1995. The 1995
regulations required insured banks to acquire or make “flexible and innovative”
mortgages that they would not otherwise have made. In this sense, the CRA and
Fannie and Freddie’s AH goals are cut from the same cloth.
There were two very distinct applications of the CRA. The first, and the one
with the broadest applicability, is a requirement that all insured banks make CRA
loans in their respective assessment areas. When the Act is defended, it is almost
always discussed in terms of this category—loans in bank assessment areas. Banks
(usually privately) complain that they are required by the regulators to make
imprudent loans to comply with CRA. One example is the following statement by a
local community bank in a report to its shareholders:
Under the umbrella of the Community Reinvestment Act (CRA), a tremendous
amount of pressure was put on banks by the regulatory authorities to make loans,
especially mortgage loans, to low income borrowers and neighborhoods. The
regulators were very heavy handed regarding this issue. I will not dwell on it here
but they required [redacted name] to change its mortgage lending practices to meet
certain CRA goals, even though we argued the changes were risky and imprudent.
On the other hand, the regulators defend the act and their actions under it,
and particularly any claim that the CRA had a role in the financial crisis. The most
frequently cited defense is a speech by former Fed Governor Randall Kroszner on
December 3, 2008, in which he said in pertinent part:
Only 6 percent of all the higher-priced loans [those that were considered CRA loans
because they bore high interest rates associated with their riskier character] were
extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their
assessment areas, the local geographies that are the primary focus for CRA evaluation
purposes. This result undermines the assertion by critics of the potential for a
substantial role for the CRA in the subprime crisis. [emphasis supplied]
There are two points in this statement that require elaboration. First, it
assumes that all CRA loans are high-priced loans. This is incorrect. Many banks, in
order to be sure of obtaining the necessary number of loans to attain a satisfactory
CRA rating, subsidized the loans by making them at lower interest rates than
their risk characteristics would warrant. This is true, in part, because CRA loans
are generally loans to low income individuals; as such, they are more likely than
loans to middle income borrowers to be subprime and Alt-A loans and thus sought
after by FHA, Fannie and Freddie and subprime lenders such as Countrywide; this
competition is another reason why their rates are likely to be lower than their risk
characteristics. Second, while bank lending under CRA in their assessment areas
has probably not had a major effect on the overall presence of subprime loans in the
U.S. financial system, it is not the element about CRA that raises the concerns about
how CRA operated to increase the presence of NTMs in the housing bubble and in
the U.S. financial system generally. There is another route through which CRA’s role
in the financial crisis likely to be considerably more significant.
In 1994, the Riegle-Neal Interstate Banking and Branching Effi ciency Act for
the first time allowed banks to merge across state lines under federal law (as distinct
from interstate compacts). Under these circumstances, the enforcement provisions
of the CRA, which required regulators to withhold approvals of applications for
banks that did not have satisfactory CRA ratings, became particularly relevant
for large banks that applied to federal bank regulators for merger approvals. In a
2007 speech, Fed Chairman Ben Bernanke stated that after the enactment of the
Riegle-Neal legislation, “As public scrutiny of bank merger and acquisition activity
escalated, advocacy groups increasingly used the public comment process to protest
bank applications on CRA grounds. In instances of highly contested applications,
the Federal Reserve Board and other agencies held public meetings to allow the
public and the applicants to comment on the lending records of the banks in
question. In response to these new pressures, banks began to devote more resources
to their CRA programs.” This modest description, although accurate as far as it
goes, does not fully describe the effect of the law and the application process on
bank lending practices.
In 2007, the umbrella organization for many low-income or community
“advocacy groups,” the National Community Reinvestment Coalition, published a
report entitled “CRA Commitments” which recounted the substantial success of its
members in using the leverage provided by the bank application process to obtain
trillions of dollars in CRA lending commitments from banks that had applied to
federal regulators for merger approvals. The opening section of the report states
(bolded language in the original):
Since the passage of CRA in 1977, lenders and community organizations have
signed over 446 CRA agreements totaling more than $4.5 trillion in reinvestment
dollars flowing to minority and lower income neighborhoods.
Lenders and community groups will often sign these agreements when a lender has
submitted an application to merge with another institution or expand its services.
Lenders must seek the approval of federal regulators for their plans to merge or
change their services. The four federal financial institution regulatory agencies will
scrutinize the CRA records of lenders and will assess the likely future community
reinvestment performance of lenders. The application process, therefore, provides an
incentive for lenders to sign CRA agreements with community groups that will improve
their CRA performance. Recognizing the important role of collaboration between lenders
and community groups, the federal agencies have established mechanisms in their
application procedures that encourage dialogue and cooperation among the parties in
preserving and strengthening community reinvestment. [emphasis supplied]
A footnote to this statement reports:
The Federal Reserve Board will grant an extension of the public comment period
during its merger application process upon a joint request by a bank and community
group. In its commentary to Regulation Y, the Board indicates that this procedure
was added to facilitate discussions between banks and community groups regarding
programs that help serve the convenience and needs of the community. In its
Corporate Manual, the Office of the Comptroller of the Currency states that it will
not offer the expedited application process to a lender that does not intend to honor a
CRA agreement made by the institution that it is acquiring.

In its report, the NCRC listed all 446 commitments and includes the
following summary list of year-by-year commitments:
Table 13.
Year Annual Dollars
($ millions)
Total Dollars
($ millions)
2007 12,500 4,566,480
2006 258,000 4,553,980
2005 100,276 4,298,980
2004 1,631,140 4,195,704
2003 711,669 2,564,564
2002 152,859 1,852,895
2001 414,184 1,700,036
2000 13,681 1,285,852
1999 103,036 1,272,171
1998 812,160 1,169,135
1997 221,345 356,975
1996 49,678 135,630
1995 26,590 85,952
1994 6,128 59,362
1993 10,716 53,234
1992 33,708 42,518
1991 2,443 8,811
1990 1,614 6,378
1989 2,260 4,764
1988 1,248 2,504
1987 357 1,256
1986 516 899
1985 73 382
1984 219 309
1983 1 90
1982 6 89
1981 5 83
1980 13 78
1979 15 65
1978 0 50
1977 50 50
The size of these commitments, which far outstrip the CRA loans made in
assessment areas, suggests the potential significance of the CRA as a cause of the
financial crisis. It is noteworthy that the Commission majority was not willing even
to consider the significance of the NCRC’s numbers. In connection with its only
hearing on the housing issue, and before any research had been done on the NCRC
statements, the Commission published a report absolving CRA of any responsibility
for the financial crisis.

To understand CRA’s role in the financial crisis, the relevant statistic is the $4.5
trillion in bank CRA lending commitments that the NCRC cited in its 2007 report.
(This document and others that are relevant to this discussion were removed from
the NCRC website, www.ncrc.org, after they received publicity but can still be found
on the web). One important question is whether the bank regulators cooperated
with community groups by withholding approvals of applications for mergers and
acquisitions until an agreement or commitment for CRA lending satisfactory to
the community groups had been arranged. It is not difficult to imagine that the
regulators did not want the severe criticism from Congress that would have followed
their failure to assist community groups in reaching agreements with and getting
commitments from banks that had applied for these approvals. In statements in
connection with mergers it has approved the Fed has said that commitments by
the bank participants about future CRA lending have no influence on the approval
process. A Fed official also told the Commission’s staff that the Fed did not consider
these commitments in connection with merger applications. The Commission did
not attempt to verify this statement, but accepted it at face value from a Fed staff
official. Nevertheless, there remains no explanation for why banks have been making
these enormous commitments in connection with mergers, but not otherwise.
The largest of the commitments, in terms of dollars, were made by four banks
or their predecessors—Bank of America, JPMorgan Chase, Citibank, and Wells
Fargo—in connection with mergers or acquisitions as shown in Table 14 below.

Table 14. Announced CRA Commitments in Connection
with a Merger or Acquisition by Four Largest Banks and Their Predecessors
Final bank Acquired or merged bank/entity
with a corresponding
announcement of a CRA commitment
CRA commitment (year
announced and dollar amount)
Wells Fargo First Union acquired by Wachovia
SouthTrust acquired by
Wachovia
2001 ($35 b.)
2004 ($75 b.)
JPMorgan
Chase
Chemical merges with
Manufacturers Hanover
NBD acquired by First Chicago
Home Savings acquired by
Washington Mutual
Dime acquired by
Washington Mutual
Bank One acquired by JPMorgan Chase
1991 ($72.5 m.)
1995 ($2 b.)
1998 ($120 b.)
2001 ($375 b.)
2004 ($800 b.)
Bank of
America
Continental acquired by Bank of America
Bank of America (acquired by NationsBank,
which kept the Bank of America name).
Bank of Boston
acquired by Fleet
Fleet
1994 ($1 b.)
1998 ($350 b.)
1999 ($14.6 b.)
2004 ($750 b.)
Citibank Travelers
Cal Fed
1998 ($115 b.)
1998 ($115 b.)
2002 ($120 b.)
Compiled by Edward Pinto from the NCRC 2007 report CRA Commitments, found at http://www.
community-wealth.org/_pdfs/articles-publications/cdfi s/report-silver-brown.pdf , NCRC testimony
regarding Bank of America’s $1.5 trillion in CRA agreements and commitments in conjunction with its
2008 acquisition of Countrywide found at http://www.house.gov/apps/list/hearing/fi nancialsvcs_dem/
taylor_testimony_-_4.15.10.pdf .

Given the enormous size of the commitments reported by NCRC, the key
questions are: (i) how many of these commitments were actually fulfilled by the
banks that made them, (ii) where are these loans today, and (iii) how are these loans
performing?
Currently, in light of the severely limited Commission investigation of this
issue, there are only partial answers to these questions.
Were the loans actually made? The banks that made these commitments
apparently came under pressure from community groups to fulfill them. In an
interview by Brad Bondi of the Commission’s staff , Josh Silver of the NCRC noted
that community groups did follow up these commitments.
Bondi: Who follows up…to make sure that these banks honor their voluntary
agreements or their unilateral commitments?

Silver: Actually part of some of these CRA agreements was meeting with the bank two
or three times a year and actually going through, ‘Here’s what you’ve promised. Here’s
what you’ve loaned.’ That would happen on a one-on-one basis with the banks and the
community organizations.
Nevertheless, when the Commission staff asked the four largest banks (Bank
of America, Citibank, JPMorgan Chase and Wells Fargo) for data on whether the
merger-related commitments were fulfilled and in what amount, most of the banks
supplied only limited information. They contended that they did not have the
information or that it was too difficult to get, and the information they supplied was
sketchy at best.
In some cases, the information supplied to the Commission by the banks,
in letters from their counsel, reflected fewer loans than they had claimed in press
releases to have made in fulfillment of their commitments. The press release
amounts were JPMorgan Chase (including WaMu, $835 billion), Citi ($274 billion),
and Bank of America ($229 billion), totaled $1.3 trillion in CRA loans between
2001 and 2008, and had been presented to the Commission by Edward Pinto in the
Triggers memo. No Wells Fargo press releases could be found, but in response
to questions from the Commission Wells provided a great deal of data in spread
sheets that could not be interpreted or understood without further discussion with
representatives of the bank. However, the Commission terminated the investigation
of the merger-related CRA commitments in August 2010, before the necessary data
could be gathered. For this reason, the Wells data could not be unpacked, interpreted
in discussion with Wells officials, and analyzed.
After I protested the limited efforts of the Commission on this issue in
October 2010, the Commission made a belated attempt to restart the investigation
of the merger-related CRA commitments in November. However, only one bank
had responded by the deadline for submission of this dissenting statement. As with
the bank responses, additional work was required to understand the information
received, and there was no time, and no Commission staff , to follow up.
As a result of the dilatory nature of the Commission’s investigation, it was
impossible to determine how many loans were actually made under their merger related
CRA commitments by the four banks and their predecessors. This in
turn impeded any effort to find out where these loans are today and hence their
delinquency rates. It appears that in many instances the Commission management
constrained the staff in their investigation into CRA by limiting the number of
document requests and interviews and by preventing the staff from following up
with the institutions that failed to respond adequately to requests for data.
Where are these mortgages today? Where these loans are today must necessarily
be a matter of speculation. Some of the banks told the FCIC staff that they do not
distinguish between CRA loans and other loans, and so could not provide this
information. Under the GSE Act, Fannie and Freddie had an affirmative obligation
to help banks to meet their CRA obligations, and they undoubtedly served as a
buyer for the loans made by the largest banks and their predecessors pursuant to
the commitments. In a press release in 2003, for example, Fannie reported that it
had acquired $394 billion in CRA loans, about $201 billion of which occurred in
2002. This amounted to approximately 50 percent of Fannie’s AH acquisitions for
that year.
In the Triggers memo, based on his research, Pinto estimated that Fannie and
Freddie purchased about 50 percent of all CRA loans over the period from 2001
to 2007 and that, of the balance, about 10-15 percent were insured by FHA, 10-15
percent were sold to Wall Street, and the rest remain on the books of the banks that
originated the loans. Many of these loans are likely unsaleable in the secondary
market because they were made at rates that did not compensate for risk or lacked
mortgage insurance—again, the competition for these loans among the GSEs, FHA
and the banks operating under CRA requirements inevitably raised their prices and
thus underpriced their risk. To sell these loans, the banks holding them would have
to take losses, which many are unwilling to do.
What are the delinquency rates? Under the Home Mortgage Disclosure Act
HMDA), banks are required to provide data to the Fed from which the delinquency
rates on loans that have high interest rates can be calculated. It was assumed that
these were the loans that might bear watching as potentially predatory. When Fannie
and Freddie, FHA, Countrywide and other subprime lenders and banks under CRA
are all seeking the same loans—roughly speaking, loans to borrowers at or below
the AMI—it is likely that these loans when actually made will bear concessionary
interest rates so that their rate spread is not be reportable under HMDA. It’s just
supply and demand. Accordingly, the banks that made CRA loans pursuant to their
commitments have no obligation to record and report their delinquency rates, and
as noted above several of the large banks that made major commitments recorded
by the NCRC told FCIC staff that they don’t keep records about the performance of
CRA loans apart from other mortgages.
However, in the past few years, Bank of America has been reporting the
performance of CRA loans in its annual report to the SEC on form 10-K. For
example, the bank’s 10-K for 2009 contained the following statement: “At December
31, 2009, our CRA portfolio comprised six percent of the total residential mortgage
balances, but comprised 17 percent of nonperforming residential mortgage loans.
This portfolio also comprised 20 percent of residential net charge-off s during 2009.
While approximately 32 percent of our residential mortgage portfolio carries risk
mitigation protection, only a small portion of our CRA portfolio is covered by
this protection.” This could be an approximation for the delinquency rate on the
merger-related CRA loans that the four banks made in fulfilling their commitments,
but without definitive information on the number of loans made and the banks’
current holdings it is impossible to make this estimate with any confidence. In a
letter from its counsel, another bank reported serious delinquency rates on the loans
made pursuant to its merger-related commitments ranging from 5 percent to 50
percent, with the largest sample showing a 25 percent delinquency rate.

158 “Fannie Mae Passes Halfway Point in $2 Trillion American Dream Commitment; Leads Market in
Bringing Housing Boom to Underserved Families, Communities” http://findarticles.com/p/articles/mi_m0EIN/is_2003_March_18/ai_98885990/pg_3/?tag=content;col1 .
159 Triggers memo, p.47.
160 Bank of America, 2009 10-K, p.57.
532 Dissenting Statement

Further investigation of this issue is necessary, including on the role of
the bank regulators, in order to determine what effect, if any, the merger-related
commitments to make CRA loans might have had on the number of NTMs in the
U.S. financial system before the financial crisis.

IV. CONCLUSION
This dissenting statement argues that the U.S. government’s housing policies
were the major contributor to the financial crisis of 2008. These policies fostered the
development of a massive housing bubble between 1997 and 2007 and the creation
of 27 million subprime and Alt-A loans, many of which were ready to default
as soon as the housing bubble began to deflate. The losses associated with these
weak and high risk loans caused either the real or apparent weakness of the major
financial institutions around the world that held these mortgages—or PMBS backed
by these mortgages—as investments or as sources of liquidity. Deregulation, lack of
regulation, predatory lending or the other factors that were cited in the report of the
FCIC’s majority were not determinative factors.
The policy implications of this conclusion are significant. If the crisis could
have been prevented simply by eliminating or changing the government policies
and programs that were primarily responsible for the financial crisis, then there
was no need for the Dodd-Frank Wall Street Reform and Consumer Protection Act
of 2010, adopted by Congress in July 2010 and often cited as one of the important
achievements of the Obama administration and the 111th Congress.
The stringent regulation that the Dodd-Frank Act imposes on the U.S.
economy will almost certainly have a major adverse effect on economic growth
and job creation in the United States during the balance of this decade. If this was
the price that had to be paid for preventing another financial crisis then perhaps
it’s one that will have to be borne. But if it was not necessary to prevent another
crisis—and it would not have been necessary if the crisis was caused by actions of
the government itself—then the Dodd-Frank Act seriously overreached.
Finally, if the principal cause of the financial crisis was ultimately the
government’s involvement in the housing finance system, housing finance policy in
the future should be adjusted accordingly.

http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf