Washington Seems Eager To Create Another Housing Crisis

Washington seems to be setting up the nation to relive the housing and financial crisis of 2008-2009. That last crisis, of course, had lots of moving parts and reflected many bad decisions, but behind it all was Washington’s long insistence prior to the collapse that banks and other lenders extend more and more mortgage credit to lower-income people, the so-called sub-prime borrower. As the government for years laid on this pressure, the proportion of risky, sub-prime loans in the system grew making the system increasingly vulnerable. In the end, when many of these precarious borrowers failed to meet their obligations, all these lenders and those financial players who were vulnerable to them – in other words all in the financial system – collapsed. Now, 15 years on, the Biden administration is again pushing for more lending to lower-income borrowers and accordingly inviting another such disaster.

On the surface, the new effort looks very different from what existed earlier in this century. The essentials, however, and the effect will be the same. Leading up to the last crisis, Washington used regulatory powers to guide lenders toward sub-prime borrowers, rewarding lenders that followed the government’s lead and punishing those who resisted. The new approach relies on what is called the Loan Level Price Adjustment (LLPA) rule. It would subsidize mortgage fees for lower-income borrowers, those with low credit scores who are unable to offer substantial down payments. Those subsidies would extend to the cost of mortgage insurance, which is typically required when a buyer puts relatively little cash down. The rule would raise the funds to offer this support by charging higher fees to those with better credit scores and who are willing to make higher down payments on properties.

The aim is indisputably a worthy one – to bring more lower-income people into home ownership and thereby give them more of a stake in their community and an important leg up on the path to wealth creation. Worthy as the goal is, however, the new LLPA rule would fail to serve its intentions and bring other ills with it as well.

Fairness, or, to use a word much more common these days, equity, is one such consideration. It seems fundamentally unfair to press higher fees on borrowers who are more likely to repay their loan than on those who are less likely to repay it. It would further seem ill advised to effectively penalize (at least relatively) those who may have postponed their purchase for years in order to amass a larger down payment and who also imposed on themselves the financial discipline necessary to earn a high credit score.

There is a more important economic problem. The new rule, by increasing the proportion of borrowers that are more prone to default, would expose the country’s financial system to an ever-greater probability of widespread losses, in other words, the very same risks that led to the 2008-09 crisis.

To be sure, reduced fees will offer low-income borrowers some relief on their costs and to that extent, make it easier for them to meet their financial obligations. But these fees are only a small part of the cost of home ownership. The size of the mortgage and the interest rate on it constitute a greater portion of the burden. And then, of course, there are also the incidental repairs, a leaky roof, for instance, the failure of home appliances, accidents, and a long list of other expenses with which all home owners are familiar. These costs fall on all, but a low-income person, already only just able to meet even a subsidized payment structure, will, when faced with such expenses, more likely fail to meet the terms of the mortgage. If enough of these borrowers fail, the lenders will find themselves in the same kind of precarious financial position that developed in 2008.

It will take time to develop the full amount of risk involved. Right now, there are relatively few such sub-prime loans on the books for mortgage lenders or elsewhere in the financial system. The bankers seem to have longer memories than the people in Washington. The problem may never develop. It seems that recently the Federal Housing finance Agency (FHFA) has put the effort on pause. If the rule change does go ahead, it will take time to develop a critical mass of risky loans. The risk, however, will growth with each passing week, and then the slightest economic setback, much less the recession that is highly likely to develop soon, could bring on the loan failures and a return to the mess that all, save Washington it sees, remember all too well.