The 2008 Financial crisis was a costly lesson in the dangers that come with subsidizing risk. Fannie Mae and Freddie Mac are well recognized as the principal creators of moral hazard by reimbursing investors that held mortgage-backed securities when homeowners failed to make payments on their mortgages. Yet only five years after the worst of the crisis, the Department of Housing and Urban Development (HUD) is insistent on bringing the same ruinous incentives into multifamily rental real estate. Like Fannie and Freddie in the run up to the financial crisis, HUD’s newest program intends to subsidize lending to rental properties in the name of housing affordability.
At an event hosted by the Center for American Progress, HUD Secretary Shaun Donovan made the case for his agency’s plans in the coming months to address what he sees as America’s looming crisis in rental housing affordability. Following the 2008 crisis, the multifamily market experienced a surge in demand as homeowners saw their housing values vanish. In addition, banks withdrew the supply of credit available to finance homeownership as they raised standards to qualify for mortgages. In reaction to increased demand for multifamily rental housing and years of underinvestment in multifamily properties, the price of multifamily units has risen. Between 2009 and 2013, the percentage of vacant multifamily units declined from 8 percent to 5 percent, while the cost of rent has risen by over 9 percent. Shaun Donovan and President Obama see addressing this problem as part of their larger mission of addressing, “the defining challenge of our time: the widening opportunity gap.”
HUD’s attempt to confront this apparent crisis is a program they are proposing called the Small Multifamily Building Risk Share Initiative. This initiative would facilitate a risk-sharing agreement with Community Development Finance Institutions (CDFI’s), which are small private financial institutions that typically lend to low-income communities. As an agency within HUD, the Federal Housing Administration (FHA) will assume 50 percent of the risk on each multifamily property loan a qualified CDFI will underwrite. Upon a mortgage’s default, HUD commits to pay for half of the losses on the outstanding mortgage.
Eligible projects are those where 40 percent of its units are occupied by families that make 60 percent or less than the surrounding area’s median income. According to the program’s description, this risk-sharing agreement will “encourage” CDFIs into the low-income lending market by providing access to long-term funding. In the case of Florida, one of the states hit hardest by the collapse of the housing bubble, just under 1.5 million families, or 20 percent of the population would be eligible for these FHA subsidized multifamily units .
This is not the first time that HUD has instituted a risk-sharing agreement to facilitate mortgage financing. As part of the 1992 National Housing Act, a similar risk-sharing agreement was made between HUD and Fannie Mae and Freddie Mac. Fannie and Freddie, however, have stringent standards that determine which multifamily loans they will guarantee and securitize.
The borrower’s property management experience, financial capacity, and history of debt repayment are all scrutinized. Potential landlords have to put down a 20 percent down payment on their mortgage. In addition, cash flow from rents would need to generate income that was 25 percent in excess of mortgage payments. Unlike the single-family real estate market, multifamily rental housing never suffered a reduction in minimum financing standards under Fannie Mae and Freddie Mac. These properties did not experience a surge in unqualified tenants and did not face the aftermath of tenants failing to make regular payments. The multifamily side of the Fannie and Freddie’s portfolio was a rare bright spot on the otherwise tarnished balance sheets of the Government Sponsored Entities. Because of these standards, less than 1 percent of multifamily loans in their portfolio have been in delinquency.
By reimbursing lenders for mortgages in default, HUD will bring the same moral hazard that wreaked havoc on the single-family residential market into multifamily real estate. Without bearing the risk of their lending decisions, CDFIs will likely reduce the standards necessary to qualify for loans. This may temporarily benefit low-income tenants by lowering the cost of rent. But attracting less qualified developers that carry a greater risk of default will damage the financial positions of multifamily lenders, which are essential for financing the construction of rental properties for low-income families.
Rather than subsidizing demand for housing, a more constructive approach to addressing housing affordability would be for policy-makers at the state and local level to loosen restrictions that constrain the supply of land available for housing. Researchers at Harvard University Kennedy’s School of Government released a report in 2012 chronicling factors that affect income differences between residents of different states. One of the most important factors they found was the ease with which labor could move from low-income areas to jobs in high-income areas. Until 1980, the gap between America’s poorest and wealthiest states shrank on average by 1.8 percent per year. After 1980, this virtuous cycle ended with the imposition of land-use restrictions on the supply of land that could be developed for residential purposes. By restricting the supply of land, these zoning laws raised the costs that migrants from low-income states face when moving to high-income areas. They concluded that fluid labor mobility explained 30 percent of the decrease in hourly wage inequality that occurred between 1940 and 1980. And if workers were not barred from moving to high-income areas by zoning restrictions that raised the cost of housing, income inequality since 1980 would be 10 percent less than it is today. Other research has shown that the increase in the price of housing is not a national phenomenon, but isolated in areas where heavy zoning laws are imposed:
The problem of housing affordability is very real and if policy-makers are interested in alleviating it, they should consider allowing market forces to function, rather than recreating the same artificial incentives that led to the housing bubble we are only beginning to claw our way back from.