Tag Archives: Great Depression

Ensuring Sustainable Homeownership

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My short article, Ensuring That Homeownership Is Sustainable, was just published in the Westlaw Journal, Bank & Lender Liability. It opens,

The Federal Housing Administration has suffered as a result of many of the same unrealistic underwriting assumptions that led to problems for many lenders during the 2000s. It, too, was harmed by a housing market as bad as any since the Great Depression.

As a result, the federal government announced in 2013 that the FHA would require the first bailout in the agency’s history. While facing financial challenges, the FHA has also come under attack for the poor execution of policies designed to expand homeownership opportunities.

Leading commentators have called for the federal government to stop having the FHA do anything but provide liquidity to the low end of the mortgage market.

These critics rely on a few examples of agency programs that were clearly failures, but they do not address the FHA’s long history of undertaking comparable initiatives.

 In fact, the FHA has a history of successfully undertaking new homeownership programs. However, it also has operational flaws that should be addressed before it undertakes similar future homeownership initiatives.

INTRODUCTION TO THE FHA

Mortgage insurance is a product that is paid for by the homeowner but protects the lender if the homeowner defaults on the mortgage. The insurer pays the lender for losses it suffers from the homeowner’s default. Mortgage insurance is typically required for borrowers who have limited funds for down payments.

The FHA provides mortgage insurance for loans on single family and multifamily homes, and it is the world’s largest government mortgage insurer. Other significant providers are the Department of Veterans Affairs and private companies known as private mortgage insurers.

Mortgage insurance makes homeownership possible for many households that would otherwise not be able to meet lenders’ underwriting requirements.

Just like much of the federal housing infrastructure, the FHA has its roots in the Great Depression. The private mortgage insurance industry, like many others, was decimated in the early 1930s. Companies in the industry began to fail as almost half of all mortgages went into default. The government created the FHA to replace the PMI industry, which remained dormant for decades.

In the Great Depression, the housing markets faced problems that were similar to those faced by the same markets in the late 2000s. These problems included rapidly falling housing prices, widespread unemployment and underemployment, the rapid tightening of credit and — as a result of all of those trends — much higher default and foreclosure rates.

The FHA noted in its second annual report, issued in 1936, that the “shortcomings of the old system need no recital. It financed extensive overselling of houses at inflated values, to borrowers unable to pay for them.” Needless to say, the same could be said of our most recent housing bust.

Over its lifetime, the FHA has insured more than 40 million mortgages, helping to make homeownership available to a broad swath of American households. Indeed, the FHA mortgage has been essential to America’s transformation from a nation of renters to one of homeowners.

The early FHA created the modern American housing finance system, as well as the look and feel of post-war suburban communities through the construction standards the agency set for the new houses it insured.

The FHA has also had many other missions over the course of its existence — and a varied legacy to match.

Beginning in the 1950s, the FHA’s role changed from serving the entire mortgage market to focusing on certain segments. This changed mission had a major impact on everything the FHA did, including how it underwrote mortgage insurance and for whom it did so.

In recent years, the FHA has come under attack for poorly executing some of its attempts to expand homeownership opportunities, and leading commentators have called for the federal government to stop assigning such mandates to the agency. They argue that the FHA should focus only on providing liquidity for the portion of the mortgage market that serves low- and moderate-income households.

These critics rely on a couple of examples of failed programs, such as the Section 235 program enacted as part of the Housing and Urban Development Act of 1968 and the American Dream Downpayment Assistance Act of 2003.

Those programs required borrowers to make only tiny and sometimes even nominal down payments. The government enacted the Section 235 program in response to the riots that burned through American cities in the 1960s. It was intended to expand homeownership opportunities for low-income households, particularly black ones.

The American Dream program was also geared to increasing homeownership among lower-income and minority households. The crux of the critique of these programs is that they failed to ensure that borrowers had the capacity to repay their mortgages, leading to bad results for the FHA and borrowers alike.

Notwithstanding these failed initiatives, the FHA has a parallel history of successfully undertaking new homeownership programs. These successes include programs for veterans returning home from World War II, a mission that was later handed off to the VA.

At the same time, historically the FHA has clearly suffered from operational failures that should be addressed in the design of any future initiatives.

Unfortunately, the agency has not really grappled with its past failures as it moves beyond the financial crisis. To properly address operational failures, the FHA must first identify its goals. (6-7, footnote omitted)

Foreclosure Body Count

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Case Western’s Matt Rossman has posted Counting Casualties in Communities Hit Hardest by the Foreclosure Crisis (forthcoming in the Utah Law Review) to SSRN. The abstract reads,

Recent statistics suggest that the U.S. housing market has largely recovered from the Foreclosure Crisis. A closer look reveals that the country is composed not of one market, but of thousands of smaller, local housing markets that have experienced dramatically uneven levels of recovery. Repeated waves of home mortgage foreclosures inundated certain communities (the “Hardest Hit Communities”), causing their housing markets to break rather than bend and resulting in what amounts to a permanent transition to a lower value plateau. Homeowners in these predominantly low and middle income and/or minority communities who endured the Foreclosure Crisis lost significant equity in what is typically their principal asset. Public sector responses have largely ignored this collateral damage.

As the ten-year mark since the onset of the Foreclosure Crisis approaches, this Article argues that homeowners in the Hardest Hit Communities should be able to deduct the damage to their home values caused by the Crisis from their federal taxable income. This means overcoming the tax code’s usual normative assumption that a decline in a home’s value represents consumed wealth and, thus, is fully taxable. To do so, this Article likens the rapid, unusual and enduring plunge in home values experienced by homeowners in the Hardest Hit Communities to casualty losses – i.e. damages to personal property caused by a sudden force like a storm or a hurricane – which are deductible. The IRS and most courts have insisted this deduction is limited to physical damage. This Article carefully dissects the law and principles underlying the deduction to reveal that the physical damage requirement is overbroad and inequitable. When viewed in the larger context of other recent tax code interventions that allow those who have experienced personal financial harm due to a crisis to reduce their income tax base accordingly, home value damage in the Hardest Hit Communities actually fits comfortably within the concept of a casualty loss.

Notwithstanding its normative and equitable fit, the casualty loss deduction poses several administrative challenges in its application to the Foreclosure Crisis. This Article addresses each challenge in turn, explaining the extent to which the Treasury Department and the IRS, through administrative action and/or a careful application of case law precedent, can resolve it. The Article also identifies and grapples with the distributional reality that the casualty loss deduction, in its current form, provides a small or no return on lost home equity for a sizable number of low and middle income homeowners, which would make it a problematic method of recovery for homeowners in the Hardest Hit Communities. To make the deduction a better and more equitable fit under the circumstances, this Article identifies two, larger-scale modifications the federal government could adopt: (i) changing the method by which a casualty loss is valued for damage caused by the Foreclosure Crisis and/or (ii) lifting the floors and limits Congress has over time imposed on the deduction, as it has done for those taxpayers most heavily impacted by several recent hurricanes and droughts.

The article offers a creative response to ameliorate an aspect of the foreclosure crisis. Rossman concludes, “Once these homeowners are considered equally worthy of claiming a casualty loss, the question then shifts to how the IRS, the Treasury Department and/or Congress can best adapt and address the administrative and distributional challenges attendant to utilizing the casualty loss deduction in this context. These challenges are not insurmountable barriers, but rather issues to be carefully considered and strategically addressed.” (67)

I can certainly imagine some of those challenges, such as how to reliably identify a “permanent transition to a lower value plateau,” but articles of this type are just what we need as we try to figure out how to address housing crises of this magnitude.  While there was a big gap between the housing crises of the Great Depression and the Great Depression we can be sure that there will be another such event at some point in the 21st century.

The Marvel of NYC’s Water Supply

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Another school holiday, another museum. The family and I went to the Queens Museum. Although I am a lifelong New Yorker, I had never been there before. It is a great, small museum, with just a few galleries. It is right smack in the middle of Flushing Meadows-Corona Park. The museum is a stone’s throw of the majestic Unisphere, which is even more amazing from close up. We had gone to see the survey of Zhang Hongtu‘s work, which was very good. But readers of this blog would likely be more interested in two exhibits on long-term loan to the museum. The first is From Watersheds to Faucets: The Marvel of New York City’s Water Supply System:

For the 1939 World’s Fair, city agencies were invited to produce exhibits for the New York City Pavilion, now the Queens Museum. Each exhibit shared “what the various branches of municipal government are doing to serve the citizens of today.”

To educate New Yorkers about the water supply system, the Department of Water Supply, Gas, and Electricity, created the relief map now displayed at the Queens Museum. A team of cartographers began work in 1938 with a depression-era budget of $100,000, roughly $1.5 million in today’s dollars. But at 540 square feet, the model was too big for the allotted space. Ten years later, it made its only public appearance in the City’s Golden Anniversary Exposition at Manhattan’s Grand Central Palace.

In 2008, after decades in storage, the 27-piece relief map was in desperate need of conservation. The model was sent to McKay Lodge Fine Arts Conservation Lab in Oberlin, Ohio and restored to its original brilliance. In collaboration with the New York City Department of Environmental Protection, it will now remain on long-term loan in its originally intended home in the New York City Building.

The second exhibit is pretty famous and it is very cool to see up close: the Panorama of the City of New York, the biggest full-scale architectural model in the world. The Panorama was commissioned for the 1964 World’s Fair. The museum has kept the Twin Towers on the Panorama, which is pretty powerful, once you notice it.

The two exhibits together give you a sense of the grandeur of a world-class city both in itself and within its broader physical context. Another thing to put on your NYC bucket list.

Principal-ed Reduction

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The Urban Institute’s Housing Finance Policy Center has issued a report, Principal Reduction and the GSEs: The Moment for a Big Impact Has Passed. It opens,

The Federal Housing Finance Agency (FHFA) prohibits Fannie Mae and Freddie Mac (the government-sponsored enterprises, or GSEs) from unilaterally reducing the principal balance of loans that they guarantee, known as principal reduction. When director Ed DeMarco established the prohibition, he was concerned that reducing principal would cost the GSEs too much, not only in setting up the systems required to implement it, but also— and to him more important — in encouraging borrowers to default in order to receive the benefit. DeMarco’s position generated significant controversy, as advocates viewed principal reduction as a critical tool for reducing borrower distress and pointed out that the program the Obama administration had put forward to provide the relief had largely eliminated the cost to the GSEs, including the moral hazard. We believe that at the time the advocates had the better side of the argument.

The FHFA is now revisiting that prohibition, though in a very different economic environment than the one faced by Director DeMarco. Home prices are up 35.4 percent since the trough in 2011, adding $5 trillion in home equity and reducing the number of underwater homeowners from a peak of 25 percent to 10 percent. This means that far fewer borrowers would likely benefit under a GSE principal reduction program today. (1, footnote omitted)

Principal reduction was highly disfavored at the start of the financial crisis as it was perceived as a sort of giveaway to irresponsible borrowers. Some academics have disputed this characterization, but it probably remains a political reality.

In any event, I think this report has the analysis of the current situation right — the time for principal reduction has passed. But it is worth considering the conditions under which it might be appropriate in the future (for that next crisis, or the one after that). The authors make four  assumptions for a politically feasible principal reduction program:

  1. borrowers must be delinquent at the time the program is announced, in order to avoid the moral hazard of encouraging borrowers to default;
  2. borrowers must be underwater;
  3. the house must be owner-occupied; and
  4. the principal reduction is in the economic interest of Fannie and Freddie.

It is worth noting that during the Great Depression, the federal government figured out ways to reduce the burden of rapidly dropping house prices on lenders and borrowers alike without resorting to principal reduction much. Borrowers benefited from longer repayment terms and lower interest rates. Below-market interest rates are similar to principal reduction because they also reduce monthly costs for borrowers. They are also politically more feasible. It would be great to have a Plan B stored away at the FHFA, the FHA and the VA that outlines a systematic response to a nation-wide drop in housing prices. It could involve principal reduction but it does not need to.

Dodd-Frank and Mortgage Reform at Five

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The Department of Treasury has issued a report, Dodd-Frank at Five Years: Reforming Wall Street and Protecting Main Street. The report is clearly a political document, trumpeting the achievements of the Obama Administration. It is interesting nonetheless. It opens,

When President Obama took office in January 2009, the U.S. economy was in crisis. The nation was shedding more than 750,000 jobs per month, and confidence in our financial system had been shaken to its core. The worst financial crisis since the Great Depression exposed a toxic mix of excessive risk-taking, shoddy lending practices, inadequate capital levels, unstable funding, and weaknesses in regulatory oversight. A collapsing financial system choked off credit to consumers seeking to purchase a car, a home, groceries, or to finance an education. Nearly 9 million Americans lost their jobs, and over 5 million lost their homes. Nearly $13 trillion of families’ wealth was destroyed, wiping out almost two decades of gains.

In response to the crisis, the Administration released a proposed set of reforms in June 2009. Congress held numerous hearings and crafted legislation based on the Administration’s proposal, incorporating ideas from both Republicans and Democrats throughout the process. On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law, a historic and comprehensive set of financial reforms, which put in place critical new protections for consumers, investors, and taxpayers. Five years later—as a result of Dodd-Frank and other Wall Street reforms—our financial system is stronger, safer, more resilient, and more supportive of sustainable economic growth. Regulators also have better tools to deal with financial shocks when they occur, to protect Main Street and taxpayers from Wall Street recklessness.

Critics of reform have claimed that Wall Street Reform would deter lending and choke off the recovery. But, today it is clear that the opposite is true. Reform has served as a building block for economic growth, providing Americans with safe places to invest their savings and enabling banks to lend to individuals, businesses, and communities. Only a financial system strong enough to withstand a major financial shock is capable of promoting sustainable economic growth. Five years after the President signed Wall Street Reform into law, nearly all of the major elements of financial reform are in place. Today, our financial system is safer and stronger as a result of these hard-won reforms, and our economy is in a far better position to continue growing and creating jobs. (1)

I was struck by the fact that the report does not address the biggest financial reform failure of the last five years, the lack of reform of the housing finance system.  Fannie and Freddie remain in conservatorship, putting the housing finance system at risk of another crisis.

I was also struck by the following passage:

In the run-up to the financial crisis, abusive lending practices and unclear underwriting standards resulted in risky mortgages which hurt consumers and ultimately threatened financial stability. Wall Street Reform bans many of the abusive practices in mortgage markets that helped cause the crisis, and requires lenders to determine that borrowers can repay their loans. (2)

My recollection from academic conferences over the course of the last six or seven years is that many leading academics denied the link between abusive lending practices and systemic risk. It seemed pretty clear to me, but I was in the minority on that one. I am glad to see that at least the Treasury agrees with me.

AG Lynch on Wall Street

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Institutional Investor quoted me in Will New Attorney General Loretta Lynch Shake up Wall Street? It opens,

Those unhappy with the lack of personal accountability for the 2008–’09 financial crisis are running out of time to see justice served: In the U.S., the statute of limitations for many bank-related criminal charges is ten years. But the recent appointment of Loretta Lynch as the first black woman to the post of attorney general could present a window of opportunity.

Given mounting public frustration over the failure to punish financial executives who helped push the world to the brink of another Great Depression, Lynch may be well positioned to act where her predecessor, Eric Holder, was unsuccessful. The U.S. Department of Justice has often talked up its efforts to hold individuals responsible for crimes they may have committed, but there hasn’t been much progress. Last year, however, saw an uptick in the size of bank settlements related to the crash, including a $16.65 billion deal with Bank of America Corp. and a $7 billion agreement with Citigroup.

Some industry observers believe Lynch, who turns 56 on Thursday, could use this momentum to target people. “If she does anything differently [than Holder did], she may push her folks to try to make those cases against individuals higher up the corporate ladder,” says Glen Kopp, former assistant U.S. attorney in the Southern District of New York and a New York–based partner in the white-collar practice at law firm Bracewell & Giuliani.

Lynch’s critics have griped that she may be not be strict enough with Wall Street. They point to her 1980s stint with law firm Cahill Gordon & Reindel, which has counted among its clients BofA, Credit Suisse Group and HSBC Holdings, and to a spell early last decade at Hogan & Hartson (now Hogan Lovells), where she practiced white -collar criminal defense.

Detractors say both positions, as well as her tenure at the Federal Reserve Bank of New York from 2003 to 2005, have compromised her ability to prosecute big banks by establishing relationships that she may not wish to jeopardize as attorney general. During Lynch’s lengthy confirmation process, Republicans criticized her for being too soft on HSBC in a 2012 settlement; the British bank agreed to pay $1.92 billion in a money-laundering case after New York and federal authorities decided that criminal charges might bring down the institution.

But many in the legal community believe the more likely outcome will be somewhere in the middle.

“The financial industry will be dealing with an extremely well-informed AG who will seek to balance the competing concerns that arise when investigating and prosecuting large enterprises like those that dominate Wall Street,” says David Reiss, a professor at Brooklyn Law School with expertise in property, mortgage lending and consumer financial services matters.

HAMP-ered Foreclosure Prevention

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The Special Inspector General for the Troubled Asset Relief Program (SIGTARP) released a report, Treasury’s Opportunity to Increase HAMP’s Effectiveness by Reaching More Homeowners in States Underserved by HAMP. The Introduction opens,

TARP’s signature foreclosure prevention program, the Home Affordable Modification Program (“HAMP”), has struggled to reach the expected number of homeowners Treasury envisioned for the program. According to Treasury, TARP’s housing support programs were intended to “help bring relief to responsible homeowners struggling to make their mortgage payments, while preventing neighborhoods and communities from suffering the negative spillover effects of foreclosure.” Treasury announced that HAMP itself aimed “to help as many as three to four million financially struggling homeowners avoid foreclosure by modifying loans to a level that is affordable for borrowers now and sustainable over the long term,.” The only long-term sustainable help provided through HAMP is a permanent mortgage modification, which become effective after the homeowner successfully completes a trial period plan. Through December 31, 2014, according to Treasury data, 1,514,687 homeowners have been able to get into a more affordable permanent HAMP modification (of which, 452,322 homeowners, or 29%, subsequently redefaulted on their HAMP modifications), while there have been 6,165,544 foreclosures nationwide over the same period based on CoreLogic data.” (1, footnotes omitted)

There is a lot of soul searching in this report about why HAMP has been so ineffective and the report offers tweaks to the program to improve it. But perhaps the problem is structural — a program like HAMP was never really in a position to make a bigger impact on the foreclosure crisis.

When compared to the federal government’s intervention during the Great Depression, HAMP seems too modest. President Roosevelt’s Home Owners’ Loan Corporation bought out mortgages from banks in bulk and then refinanced them on more attractive terms than the private sector offered. HAMP, on the other hand, has trouble getting homeowners to apply to the program in the first place.

Bottom line: HAMP is too retail and what we needed and need is something that could be done wholesale.