Residential Magazine

Grappling with Unintended Consequences

Disastrous results can occur during the push and pull of enacting well-meaning regulations

By Dick Lepre

People in the mortgage origination business wrestle daily with regulations. There may be no industry that faces more government regulations than the mortgage business. Regulations add to the cost of loan origination and also, due to the associated expenses, discourage the creation of new mortgage lenders and banks.

Civics instructors teach that there are three branches of the federal government: executive, legislative and judicial. This creates checks and balances, meaning that each of the three branches can, in some manner, prohibit the others from becoming too powerful.

For practical purposes, there is a fourth branch of government — the three above plus the regulatory branch. The regulatory branch contains a massive residue of laws. Congress makes laws with the approval of the executive branch and in so doing creates a new regulatory agency tasked to assure the intentions of these laws are followed. It is the regulatory branch that details what the rules are. And history shows that originators need to pay close attention to what happens in this arena.

Agencies implement regulations with good intentions in mind. The problem is that these regulations almost always have unintended consequences, some of which can be disastrous.

Mortgage mess

Typically, agencies implement regulations with good intentions in mind. The problem is that these regulations almost always have unintended consequences, some of which can be disastrous.

The example most relevant to the mortgage and housing industries is the National Homeownership Strategy of 1995 through the U.S. Department of Housing and Urban Development (HUD). The policy identified the lack of cash for downpayments and closing costs as a major impediment for potential homebuyers, and it mandated the private and public sector to creatively overcome this.

By 2007, Fannie Mae and Freddie Mac were required by HUD to show that 55% of their annual mortgage purchases involved loans to borrowers with low to moderate incomes. Moreover, 38% of all purchases had to be from underserved areas, usually inner cities, and 25% had to involve purchases of loans that were made to low-income and very low-income borrowers.

After the Great Recession, the federal government formed the Financial Crisis Inquiry Commission, which essentially denied that HUD’s mandate for the government-sponsored enterprises (GSEs) to weaken their lending standards was responsible for their demise. The commission determined that part of the problem was insufficient regulation and it placed the blame on Wall Street’s creation of securities consisting of subprime loans. That was indeed part of the problem but not the entire problem.

The federal government dictated that mortgage lending standards be lowered and, once those lower standards had disastrous effect, placed the blame on lenders. By 2008, 56% of all mortgages were subprime. The story that this was done by private-label securitization ignores the fact that when the liquidity crisis happened, 76% of all high-risk mortgages were on the books of government agencies.

Although there have been steady arguments about whether the GSEs or private securitization were mainly responsible for the mortgage mess, it would serve well to look at some numbers. Losses on loans held by Fannie, Freddie and the Federal Housing Administration (FHA) were about $206 billion. Losses for banks and thrifts were about $217 billion so, indeed, private losses were slightly higher.

Although government and private losses were comparable, there was one very significant difference. Fannie and Freddie had about $70 billion in shareholder equity while private banks had $1.3 trillion in shareholder equity. While some banks were insolvent, the banking system was not. The GSEs, on the other hand, were rendered insolvent by the loan losses they suffered as a result of HUD’s mandate.

Regulations not only prevent housing from being built but also increase the prices of the homes that are built.

Regulatory obstacles

What has been happening lately with housing is entirely different. New-home construction has not recovered after the recession. In January 2007, housing starts fell below their natural level of 1.5 million and have never returned there. The term “natural level” refers to the number of starts necessary to accommodate increased population, as well as units lost to fires and other disasters, or those that were scrapped.

It is easy to understand why starts fell to an annualized pace of 478,000 units in April 2009, because financing was tough to come by and there was little incentive for developers to build homes when they didn’t think they could sell them. More recently, the low number of housing starts has not been due to a fear the units could not be sold or rented. Rather, land-use regulations and zoning have prevented housing from being built in markets where jobs have been added.

Some adverse effects are unaffordable prices, longer commutes and certain industries (such as restaurants) being unable to hire because workers cannot afford to live close enough to the jobs. This is something that has happened at the local level, but not because of a mandate at a national level.

The San Francisco Bay Area, which has a population of 7 million, had a total of 266 new homes, condominiums and townhouses sold in January 2019. This is because zoning and land-use regulations in the Bay Area are not conducive to building.

There is an underlying factor here which is not often discussed. If a city adds housing, it gets increased revenue from property taxes, but it then has to spend money on services for the increased population. This includes expenses for police, fire and emergency personnel, as well as schools. With commercial real estate, however, a city receives increased property taxes and jobs, but it doesn’t need to spend as much on services. To put it another way, adding housing tends to be revenue neutral. Adding commercial space is revenue positive to local governments.

Regulations not only prevent housing from being built but also increase the prices of the homes that are built. The National Association of Homebuilders (NAHB) estimates that regulations imposed by all levels of government account for an average of 32.1% of development costs for multifamily homes, and 24.3% of the cost of a single-family residence.

The California Building Standards Commission has required that new single-family homes and multifamily buildings up to three stories must have solar panels starting in 2020. Although solar may be a good option in some places, mandating it makes homes more expensive.

And although some of these regulations add something of value, they have the effect of making homeownership less affordable to many people. They also discourage new construction. The worst part of the added burden of regulations is not the cost of solar panels or double-pane windows. Rather, it is about delays related to land development. On average, a builder experiences a 6.6-month regulatory delay to be able to develop a lot, according to the NAHB. In tightly regulated areas, this delay can be as long as five years. If the land was purchased with a loan, the interest accrued by regulatory delay is added to the price of the homes built.

The California Environmental Quality Act requires that local agencies consider the environmental impacts of a new housing development before approving it. This has three adverse effects: It adds to costs by making homes less affordable, it can be abused by people who want to prevent others from living in their community and it delays projects by an average of 2.5 years, according to the nonpartisan Legislative Analyst’s Office.

• • •

Each of these regulations were implemented with high-minded ideals. Each had or are having unexpected and lamentable results. A cynic could say that the modus operandi of regulatory agencies amounts to making rules and, if those rules cause a disaster, forming a committee to make more rules and create new agencies.


  • Dick Lepre

    Dick Lepre is a loan agent for CrossCountry Mortgage LLC. He has been in the mortgage business since 1992 and has been writing a weekly email newsletter on macroeconomics, mortgages and housing since 1995. Lepre (NMLS No. 302379) is from New York City, but he has lived in the San Francisco Bay Area since 1968. He has a degree in physics from Notre Dame. Follow him on Twitter @dicklepre. 

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