The American Mortgage System: Crisis and Reform

Introduction

I n t r o d u c t i o n Marvin M. Smith and Susan M. Wachter Erica and James are the best of friends. They went to the same schools, grew up in the same neighborhood, and got jobs at the same company. Their spouses work together, their children play together, and their families celebrate Fourth of July together. On paper, a mortgage lender would have trouble differentiating them. They have the same household income, the same credit score, and are the same age. But that is where their similarities end. Imagine we are in 2005: Erica pays 6.9 percent in mortgage interest each year. She can pay off the principal as early and as often as she likes, and she has no balance payable when the loan is due. James pays 8 percent interest annually.1 If he tries to “prepay ” his mortgage principal, he gets hit with a significant prepayment penalty , and he will face a “balloon” balance at the end of his contract. Erica has a prime mortgage and James’ mortgage is subprime.2 How did these nearly identical homeowners receive such divergent treatment ? The answer to that question is one of the most pressing reasons that we must reinvent the American mortgage system. Successful homeownership requires the availability of appropriate mortgage products. In the years leading up to the housing bubble, homebuyers frequently accepted mortgages that were not only wrong for them but catastrophic for the economy as a whole. When the housing market crumbled, so did a cornerstone of the American dream for many families. Restoring the promise of this dream requires an unflinching inspection of lending 2 Marvin M. Smith and Susan M. Wachter institutions and the right tools to repair the structures that support solid home purchases in the future. The aftermath of the bubble has been devastating: house prices fell 30 percent; nearly 14 percent of mortgages are either delinquent or in foreclosure ; housing starts fell by 68 percent; and house values declined by $9 trillion .3 In September 2008, the U.S. government put Fannie Mae and Freddie Mac—the traditional pivots of the nation’s housing finance structure—into conservatorship to avoid bankruptcy and systemic collapse. In the three decades prior to the collapse, American homeownership benefited from falling interest rates, low macroeconomic volatility, and large capital flows from foreign investors. The coming years are not likely to be so generous. Erica and James, and millions like them, lived through a revolution in housing finance but “recent events suggest that, just as in 1789, a revolution has produced a terror.”4 From the moment that Salomon Brothers traded the first mortgage-backed security almost three decades ago, the forces constraining mortgage originators have loosened at an exponential rate.5 From 1997 to 2006, that unraveling fueled a 71 percent increase in real home prices, an asset sector that hadn’t appreciated in real terms since the end of World War II.6 The federal government pushed Fannie, Freddie, and commercial banks to issue more mortgages to low-income and minority households.7 Investment banks devoted increasing resources to securitizing mortgages. The new “private-label securitization” barely resembled the market once dominated by Fannie and Freddie. In the pursuit of greater market share, Wall Street traders engaged in a “race to the bottom,” securitizing ever riskier mortgages. Nonstandard mortgages, such as teaser rates and no creditworthiness requirements, began to overtake the long-term, fixed-rate mortgage that had dominated America’s unique system for six decades.8 For a sustainable mortgage system, redesign is necessary. This volume offers hope that such a redesign is possible. Perhaps the best place to start is to separate innovations that increased—and sustained—homeownership from those that merely increased profits and risk. It may seem wise to abandon a system that has cost taxpayers billions of dollars, but we must not allow the memory of this crisis to blind us to the difficult decisions that lie ahead. The American mortgage system is broken, but some proposed alternatives would only leave consumers with a higher-risk burden. With interest rates preparing to rise and sovereign debt at nosebleed levels, consumers need the long-term, fixed-rate mortgage now more than ever. Introduction 3 How to create such a system and safeguard it from recurrences of the recent catastrophe is the focus of this volume. The questions it proposes and attempts...