PolicyCast: A Free Marketer Looks at Housing Policy

Kirk Willison, Arch MI’s Vice President for Government and Industry Relations:

With Democrats controlling both the White House and Congress, many housing advocates are looking to the federal government to address the shortcomings of the nation’s housing markets, such as racial inequity and a shortage of homes. Then there is Edward Pinto of the American Enterprise Institute. Pinto is that voice crying out in the wilderness, suggesting that the federal government is largely responsible for housing’s woes and isn’t well equipped to solve them with just a few exceptions. One of those instances is the role the government could play in helping lower-income homebuyers build equity more quickly, thus reducing their risks of default.

In this the first of a two-part interview with Pinto, the Arch MI PolicyCast asked him about his LIFT Home (the Low-Income First-Time Homebuyer) mortgage concept that is catching the attention of both Republicans and Democrats on Capitol Hill, and he offered a history lesson on the ways the federal government has undermined homeownership opportunities for low-income and minority families. In a future episode of the PolicyCast, Ed shares his views on how the government should remake Fannie Mae and Freddie Mac — views that, again, leave Pinto standing outside of the mainstream, a place where he is clearly comfortable.

Well, Ed Pinto, thank you very much for agreeing to appear on the Arch Mortgage Insurance PolicyCast. I want to provide my viewers really with the wide range of policy views, Ed, and certainly yours, I think, is a voice that people are going to find thought provoking. So, welcome.

Edward J. Pinto, American Enterprise Institute (AEI) Senior Fellow and Director of the AEI Housing Center:

Well, thank you for inviting me, and it’s always a pleasure and I appreciate the opportunity.

Willison:

Well, I’d like to discuss three topics today. One, how to sustainably build generational wealth for low-income households through homeownership. Secondly, the missteps that local, state and federal governments have made that have really constricted the supply of housing and really limited opportunities for minority families to build wealth. And, finally, your thoughts on the perils of recasting Fannie and Freddie as utilities serving the housing finance purposes. But first, let’s chat a little bit about your professional life, Ed. I know that you’re co-director of the Center for Housing Risk at the American Enterprise Institute or AEI as it’s fondly known here in Washington, but you’ve also worked at Fannie Mae in a particular interest, I guess, to those of us who are in the mortgage insurance industry, at MGIC as well. Why don’t you start by telling us a bit about your role at the AEI?

Pinto:

Okay. So, I joined AEI about 11 years ago as a research fellow, resident fellow. And after a couple years, I decided that we needed to focus on housing more precisely. That’s my area of expertise. So with a colleague, we founded the (AEI) Housing Center, which I’m now the director of. And we’ve basically decided that we wanted to build a database of information about the housing market that was really unparalleled, and we’ve been doing that for many years. So, we put out a lot of research, and it’s a lot of research based on a data set that we’ve built ourselves that we’ve assembled from 20 different suppliers of data. It allows us to turn that data … that information into knowledge, and then turn that knowledge into action.

My background is as an attorney. I have a background in affordable housing. I was general counsel for six years after having been an attorney for a couple years at the Michigan State Housing Development Authority. I then went to MGIC, Mortgage Guaranty Insurance Corporation, a fellow mortgage insurer. I then went to Fannie Mae where I held two positions: one as the head of marketing and product management and the other as Executive Vice President and Chief Credit Officer. And then I did consulting for many, many years, including with GE Mortgage Capital and Gemco, now Genworth. So, I’ve been involved in the mortgage industry for decades and decades in many different capacities and, therefore, I have seen a lot.

Willison:

People who know you might call you a libertarian when it comes to housing finance, someone who thinks that the government’s role should be limited so that the private sector is competitive. Is that fair?

Pinto:

I view myself as just a pure and simple. I like free markets, and I believe that owners of property will make better decisions on what to do with that property and what to charge for it than the government. And I have studied the government’s involvement going back in zoning to 1921 when the federal government, literally in the Department of Commerce through the Department of Commerce, created the current zoning regime we have, which is the one-unit, single-family detached home virtually everywhere and outlawing everything else in large swaths of the country. Some people may like that, but that was not the way the country was set up. That was not the normal way. Normally, you would have single-family residences, you’d have some townhouses, row houses, you’d have duplexes, triplexes, quadplexes and small apartment buildings, all intermixed.

I’m in a neighborhood in Charlotte right now that where I’m speaking from, and the zoning allows all of that, and it’s a constantly changing neighborhood. Highest and best use is a very important concept in real estate. Zoning, by definition, says “We’re not going to allow you to go to highest and best use. We’re not going to allow you to replace the single-family house with a two- or three- or four-unit structure. What you can do is build a McMansion.” So, one of the things that’s happened in this country, you know, is we end up with larger and larger and larger new homes, which is not the way to provide the housing supply that we need for our population.

Willison:

Look I want to talk about that in a bit, just a down the line here a bit, but … you believe there’s some rule for the federal government in boosting family wealth as it is associated with homeownership … If we could just talk about your concept for using government subsidies to buy down interest rates for low-income borrowers. It’s attracting the attention of people on the left and the right, including the likes of Senator Mark Warner, a Democrat of Virginia, and Richard Green, the progressive housing economist from (the University of South Carolina) USC, who is my most recent PolicyCast guest. So, can you take us back to the genesis of this idea and what you’ve done to kind of till the soil since then?

Pinto:

So, the genesis goes back to my study, again, of housing finance and looking at FHA. When FHA was developed back in the 30s, it had a maximum loan term of 20 years and a down payment of 20%. Actually, that wasn’t all that advanced at the time, Sears Roebuck was selling kit houses with 15-year loans with 20% down in the 20s and early 30s. Thrifts were making loans with 20% down with 12- and 15-year terms. FHA just took it and standardized it around 20% down and 20 years. And, in most cases, it ended up having a monthly payment that was not too dissimilar to the other way you could do it, which was a combined first and second. You got a first mortgage from somebody an institution, and you got a second mortgage from the seller.

The seller would charge an upcharge on the interest rate in order to get back any risk premium that they were taking. They’d also raise the price of the house in order to do that. So, FHA came around and replaced that, and the way FHA described it in their earliest pamphlet was buying a house for 15 or 20 years was like buying a house and renting it to yourself because so much of your monthly payment went into principal repayment that it was going from your income pocket, which is your left pocket, to your right pocket, which is your asset pocket. The interest was going off your balance sheet, it was being paid to a third party. So, the more principal you paid yourself, the more it was like you were buying a house and renting it yourself.

So, when I was looking at what happened in the aftermath of the financial crisis and when I was looking at what FHA was doing in 2013 and 2014, where they were continuing to make very risky loans with very high leverage, I said, “We need a different way of doing this because this isn’t the way to build wealth.” So, I came up with the concept of a wealth-building home loan, which was basically take a 20-year loan, and use some of the tools we have in the toolbox, which is a 20 year loan with a little lower interest rate. It has a …  lower default rate and other things. You could perhaps repurpose the down payment for a buydown because the default rate on a 20-year loan is so much lower than on a 30-year loan. At the end of the first year, you’re at or beyond the savings, equity savings, that you’d have with a 30-year loan.

So, it had all of these features that you could rejigger and make it come almost to the point where you could have the same monthly payment. We ended up getting a bunch of lenders, mostly small banks and credit unions, making these loans, but we never could get a secondary market going. We got a number of the mortgage insurance companies insuring these, but we never could get the secondary market. FHA wanted to have nothing to do with it. Fannie and Freddie turned us down, even though during the Obama Administration some of the officials in the administration were pushing FHFA and Fannie and Freddie to look at this … but they said no. So, basically it became a boutique product.

It didn’t take off, unfortunately. But, we also had developed a secondary approach, which was called LIFT Home, which was designed to provide some type of assistance through a tax credit or other assistance from the federal government to lower-income homebuyers. And, that assistance would level the playing field between the 30-year loan and the 20-year loan. And, it means you have, you need a buydown of about 1.5% to 1.75% in order to equalize those two payments. Remembering, of course, that the mortgage insurance premium be a bit lower and that the interest rate is also going be a bit lower in a 20-year loan. Taking all that into account, you’d need to buy the rate down by about 1.75%. So, we started resurfacing that and socializing that idea about six months ago.

Turns out, there were some other people that had remembered the talking that we had done, the plowing of the field back five or six years ago. We started talking to (people) on the other side of the political spectrum, started talking this up. So, we started talking together about this idea, and we basically came up together with the idea of LIFT Home, but now it would be focused on first-generation homebuyers with incomes below a certain level that we would, instead of starting with a tax credit, it would start with Treasury being able to buy these loans at an effective discount in order to make the originator whole. They’d make a secondary market in these by selling them out as Ginnie Mae securities and get the pump primed. And, after a couple of years, the hope is it would convert to some type of tax credit or other assistance.

Then, the secondary market could take it over or primary lenders could portfolio them. Whatever we want to do would become just a part of the market. The only certain way to build wealth is to have a shorter-term loan. And then, if you’re a lower-income, first-generation homebuyer … this would be a good use of money by the federal government because the alternative that’s being talked about and still being talked about is down-payment assistance. But, if you do down payment assistance, that’s going to increase demand and if you increase demand in a market that is already, by any definition, the strongest sellers’ market in the history that I’m aware of in the United States is going back 70 or more years. You’d only be making it worse because that increased demand, that financial assistance that would increase the demand would immediately get capitalized into higher prices.

Willison:

Do you think if this product had been available in the mid-aughts, we would we have suffered the same degree and as we did on the housing crisis?

Pinto:

No, because our research shows that the 20-year loan, using Fannie and Freddie data, had half the default rate after adjusting for all the credit risk parameters —had half the default rate of 30-year loans.

Willison:

The new administration and Congress, they’re both giving considerable attention to racial inequity. FHA’s government-insured portfolio holds the loans of many more borrowers than are at the GSEs, certainly, as a percentage of their portfolio. Do you think FHA insurance premiums will be reduced now?

Pinto:

No. First of all, let’s talk about FHA. We have a separate but unequal housing finance system in this country. We say if you’re lower income, the way we’re going to make housing affordable for you is we’re going to increase leverage. We’re going to get higher debt ratios, lower down payments and worse credit scores. And, we took loan terms out to 30 years. We tried 40, every time we try 40, it crashes and burns. That’s been our approach for, as I said, close to 70 years. It hasn’t worked. The homeownership rate today is not much different than it was in 1960, 63. The black homeownership rate is about the same as it was, hasn’t hardly changed. So, it hasn’t done what everybody said it was going to do. Again, when I look at the work of land economists back in 50, 60 or 70 years ago, they would write and say, “Why is it that the people that are supposed to be helped by these programs don’t get helped?”

And the answer is, the money gets soaked up by — the term I use is the government mortgage complex, Fannie Mae, Freddie Mac, all of the entities that are involved in homebuilding, financing, building and originating loans, they are all getting paid largely a percentage of the sales price or the mortgage amount. So, they’re not hurt by house prices going up and mortgages going up. When down payments go down, that’s good because the balance goes up and they’re narrowly not looking at what impact this is having on potential homebuyers. So, what we have is the ratio of home prices, median home prices and median income, which used to be a little over two in this country back in the 1950s, then it got to three, eventually it got up close to six … right before the financial crisis, then came back down to the mid-threes. Now, it’s creeping, you know, back up again. It’s probably in the low fours. And in California, in many metros, it’s approaching 10. What that does is it squeezes out the lower-income households. That’s why the homeownership rate can’t go up. They just can’t afford these homes, and they can’t afford the homes because we’re not building enough of them.

Willison:

That brings up the next topic that we wanted to talk about. You recently testified before the Senate Banking, Housing and Urban Affairs Committee, and you discussed the legacy of errant federal zoning policies that really continue to impact the housing supply. Do you want to share some of those examples?

Pinto:

Sure. So, what many people might not know is that the current zoning regime in the United States that’s used, which is called Euclidean Zoning, named after the case in Ohio, Euclid, Ohio, back in 1927. But, that structure of zoning type — zoning districts — particularly one-unit, single-family detached zoning, was promoted by the federal government, by the Commerce Department. Herbert Hoover was Secretary of Commerce in the early 1920s. The purpose was to drive up house prices to make them too expensive for minorities. That was the purpose. I have done research that documented that that was the purpose. And that was what the federal government foisted on (us), you know, what we’re suffering through today.

Willison:

Well, we saw the same instance with redlining and how FHA was created.

Pinto:

Exactly. So, the redlining actually came after this. What happened if you, in 1920, said, “I want to build a duplex,” nobody would’ve thought (anything). They would’ve thought, that’s perfectly normal. In fact, in 1920, the thought was you couldn’t stop someone from building a duplex next to a one-unit, single-family house. That would be taking their property rights away. But the only way you could have made housing expensive enough to keep Black homebuyers from being able to buy them was to restrict to single-family detached on certain size lots with certain size side yards, front yards, backyards, you know, all of these things, certain building sizes. All of this stuff was designed to drive up the price, and it was very successful. Then FHA comes in, in 1934, and basically picks up the mantle from the Commerce Department.

Actually, the federal government for the first time becomes a major force in housing finance during the Great Depression, and they decide that they’re actually going to have underwriting requirements. They have a 500-page underwriting manual, and there’s about a page and a half. I actually added up all the little snippets that relate to this, but the page and a half basically says you can’t have … integrated neighborhoods. If Blacks move into a neighborhood, it’s not really eligible for FHA. You can’t have Blacks going to schools that whites are going to, that’s not eligible, all these things. And, in fact, if you were a locality like Los Angeles was, and you had a zoning ordinance that didn’t meet FHA standards, they threatened to take away FHA financing from Los Angeles City. Los Angeles City caved in the late 30s and changed their zoning so that it met the requirements that FHA had. This continued.

The redlining came about because, as I understand it, the city of Chicago took one of the maps that FHA would create and the Homeowner’s Loan Corporation would create, and they used a red pencil just to color code different areas. And the areas that ended up being the ones that were kind of off limits for lending used a red pencil, and that became redlined. The reason that this happened was because Blacks couldn’t move into the newer neighborhoods, they were literally zoned out. And then there were also legal restrictions in the form of covenants against Blacks moving in there. They also prevented Southern Italians and Jews and others from moving in. This was all going on during this time period. But in reality, what would happen in the urban areas is that Blacks that were moving up from the South, they were lower income. They could only afford relatively low rents. And so they were required, and, in fact, ended up in very low-rent districts that were poor quality. There were interspersed, these were rental houses. There weren’t a lot of apartment buildings back in the 1920s and 1930s. Half of the people lived in areas where the homeownership rate was 50%, which meant the other half was renters and they were largely houses. And the lower quality houses were in certain areas and those Blacks tended to live in those areas. The condition of those houses was very poor, and they really didn’t qualify for the 20-year mortgage, which is what FHA was doing at the time. Therefore, FHA said these don’t have the economic life left in them to finance. It happened that it also fit the goal of keeping Blacks out of housing.

So, the system that we have that started in the 50s of how we’re going to make housing more affordable, is we’re going to just add leverage. We’re not actually going to do anything to keep the prices from going up out of reach. We’re just going to make it so you can buy more houses with your same income by taking on more leverage. So, the housing debt ratio back in the 1960s for FHA might have been 16, which meant you spent 16% of your income on principal, interest, taxes and insurance. Today, that average percentage is 28 for FHA. So, even though interest rates are lower today than they were in the 1960s. What we’ve done is driven up the price of houses so much, and we’ve tried to make up for it with this leverage.

And that comes back to the 20-year loan. The one way to cure this is to figure out a way how to get back to the 20-year loan where you actually build up equity and you’re not driving prices up at the same time. But, we also have to deal with the problem of supply, and we’re living with this legacy of the zoning. That zoning ended up in California in the 50s and 60s and 70s, leading to constraints on building, particularly along the coast in California, that then rippled through the entire West of the country. If you look today at those median house prices and median income, you’ll see that the places that are way above average are Boston, New York and a couple other places, but they’re mostly in California, Seattle, Oregon and Washington. Even in places like Idaho and Nevada and other places like Denver have all had big increases. It’s all because of what’s going on in California … and has spread eastward from California and has driven up house prices. That’s, to some extent, why we’re seeing these massive house price increases today.

Willison:

What are the steps policymakers should do to resolve the supply-and-demand disequilibrium?

Pinto:

So, what can be done? Well, I think first of all, you have to tamp down the demand, because it’s going to take a long time for the supply to come online. I’ll come back to supply, but you have to tamp down demand. So, something I learned a long time ago, the first law of hole is stop digging. So, we’re digging a bigger and bigger hole for pushing lower-income potential first-time homebuyers out of the market. We should stop doing that — interest rates need to go up some. I know that sounds like heresy to the housing finance industry, but they don’t need 3% interest rates to sell these houses. They’re just pushing prices up even further. The Fed, should stop buying Fannie and Freddie Securities. Why are they doing that?

They don’t need to do that to keep this market. The market’s going gangbusters without it. What it would do is, potentially, reduce the house price inflation from 15%, maybe to 8%. That’s better than 15%. 8% is still too much, but 15% is crazy, and that’s where we are today. So, we ultimately need more supply. The federal government has been horrible at figuring out how to add to supply. I’ve gone back and looked at every program the federal government has done since the 1930s about adding supply, both multi-family and single-family and, in general, they have failed. If you define failure as being, we end up with too few homes relative to the number of people we have. House prices and rents are going up faster than incomes. The goal should be to have house prices and rents staying in line with incomes. Car prices have stayed in line with incomes.

A lot of things have stayed in line with incomes, but what hasn’t has been house prices and rents. It’s because of both the programs that the federal government has instituted and the zoning restrictions that don’t allow almost (anything) to be built. What we’re suggesting is something called light-touch density. Light-touch density says we don’t need to be building large apartment buildings and low-income housing tax credit apartment buildings in suburban areas and things like that. What we do need to allow is the two- three- and four-unit buildings and some townhouses to be built in single-family areas. We’ve researched this. We’ve found examples where you can increase density by a fair amount and still end up with a single-family-looking area because the density you’re introducing is what we call light touch.

We think that because of the zoning policies put in place by the federal government a hundred years ago, we have stopped the building. We prevented the building of about 8 million units, and we need those millions and millions of units. If we had them, house prices would not be going up by 15%. They might be going up by 3%, which is fine. House prices can go up by 3% when incomes are going up by 2%, they can go up by 3.5% when incomes are going up by 2%. They can’t go up by 15% when incomes are going up by 2% or 3%. That just doesn’t work.

Now, again, because of the low leverage, I don’t think it’s going to lead to a financial crisis directly, but it’s going to lead to a human crisis because it’s going to perpetuate the problems that we’ve had for many years in terms of lower-income households getting pushed out of the market. Particularly, it’s going to keep Black and Hispanic households from getting that toehold and getting on the way to build wealth (through) owning a home because they’re not even going to be able to get on that first rung of the ladder thanks to the policies that are, have been implemented just in the last 15 months.