HUD's Housing Goals for the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) for the Years 2005-2008 and Amendments to HUD's Regulation of Fannie Mae and Freddie Mac

DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

24 CFR Part 81

[Docket No. FR-4790-F-03]

RIN 2501-AC92

HUD's Housing Goals for the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) for the Years 2005-2008 and Amendments to HUD's Regulation of Fannie Mae and Freddie Mac

AGENCY:

Office of the Assistant Secretary for Housing—Federal Housing Commissioner, HUD.

ACTION:

Final rule.

SUMMARY:

Through this final rule, the Department of Housing and Urban Development establishes new housing goal levels for the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) (collectively, the government sponsored enterprises, or GSEs) for calendar years 2005 through 2008. The new housing goal levels are established in accordance with the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (FHEFSSA) and govern the purchase by Fannie Mae and Freddie Mac of mortgages financing low- and moderate-income housing, special affordable housing, and housing in central cities, rural areas and other underserved areas. This rule also establishes new subgoals for the GSEs' acquisitions of home purchase loans that qualify for each of the housing goals. The final rule also establishes a new regulatory section relating to GSE data integrity, amends and adds certain definitions, provides a method for imputing the distribution of GSE-purchased mortgages that lack income data, prohibits goals credit for purchases of loans in transactions with an option to dissolve the purchase in less than one year, and makes a technical change to the counting rules to clarify HUD's rules on double counting of loans.

EFFECTIVE DATE:

January 1, 2005.

FOR FURTHER INFORMATION CONTACT:

Sandra Fostek, Director, Office of Government Sponsored Enterprises, Office of Housing, Room 3150, telephone 202-708-2224. For questions on data or methodology, contact John L. Gardner, Director, Financial Institutions Regulation Division, Office of Policy Development and Research, Room 8212, telephone (202) 708-1464. For legal questions, contact Paul S. Ceja, Deputy Assistant General Counsel for Government Sponsored Enterprises/RESPA, Office of the General Counsel, Room 9262, telephone 202-708-3137. The address for all of these persons is Department of Housing and Urban Development, 451 Seventh Street, SW., Washington, DC, 20410. Persons with hearing and speech impairments may access the phone numbers via TTY by calling the Federal Information Relay Service at (800) 877-8399.

SUPPLEMENTARY INFORMATION:

I. General

A. Authority

HUD's authority to regulate the GSEs is established under:

(1) The Federal National Mortgage Association Charter Act (“Fannie Mae Charter Act”), which is Title III of the National Housing Act, section 301

et seq.

(12 U.S.C. 1716

et seq.

);

(2) The Federal Home Loan Mortgage Corporation Act (“Freddie Mac Act”), which is Title III of the Emergency Home Finance Act of 1970, section 301

et seq.

(12 U.S.C. 1451

et seq.

);

(3) FHEFSSA, enacted as Title XIII of the Housing and Community Development Act of 1992 (Pub. L. 102-550, approved October 28, 1992) (12 U.S.C. 4501-4641); and

(4) Section 7(d) of the Department of Housing and Urban Development Act (42 U.S.C. 3535(d)).

B. Background: Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac were chartered by the Congress as GSEs. Pursuant to section 301 of the Fannie Mae Charter Act (12 U.S.C. 1716) and section 301(b) of the Freddie Mac Act (12 U.S.C. 1451), the GSEs were chartered expressly to:

(1) Provide stability in the secondary market for residential mortgages;

(2) Respond appropriately to the private capital market;

(3) Provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing; and

(4) Promote access to mortgage credit throughout the nation (including central cities, rural areas, and other underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing.

Fannie Mae and Freddie Mac engage in two principal businesses: (1) Purchasing and otherwise investing in residential mortgages, and (2) guaranteeing securities backed by residential mortgages. As a result of their status as GSEs, Fannie Mae and Freddie Mac receive significant explicit benefits that are not enjoyed by fully private shareholder-owned corporations in the mortgage market. These benefits include:

• Conditional access to a $2.25 billion line of credit from the U.S. Treasury (

see

section 306(c)(2) of the Freddie Mac Act and section 304(c) of the Fannie Mae Charter Act);

• Exemption from the securities registration requirements of the U.S. Securities and Exchange Commission and the State securities regulatory agencies (

see

section 306(g) of the Freddie Mac Act and section 304(d) of the Fannie Mae Charter Act);

1

and

1

Fannie Mae and Freddie Mac have both announced their intention voluntarily to register their common stock with the Securities and Exchange Commission (SEC) under section 12(g) of the Securities Exchange Act of 1934. Fannie Mae's registration became effective March 31, 2003. Freddie Mac has stated that it will complete the process of voluntarily registering its common stock once it resumes timely reporting of its financial results.

• Exemption from all State and local taxes except property taxes (

see

section 303(e) of the Freddie Mac Act and section 309(c)(2) of the Fannie Mae Charter Act).

While the securities that the GSEs guarantee, and the debt instruments they issue, are explicitly not backed by the full faith and credit of the United States, and nothing in this rule should be construed otherwise, such securities and instruments trade at yields only a few basis points over those of U.S. Treasury securities with comparable terms. These securities also offer yields lower than those for securities issued by fully private firms that are more highly capitalized but otherwise comparable. In addition, the market does not require that individual GSE securities be rated by a national rating agency. Consequently, the GSEs are able to fund their operations at lower cost than other private firms with similar financial characteristics. In a recent report, the Congressional Budget Office (CBO) estimated that this funding advantage for the year 2003 resulted in a $19.6 billion annual combined subsidy for both GSEs. Of this amount, CBO estimated that the GSEs retained about $6.2 billion, or approximately one-third of the subsidy, for their officers and

shareholders, while the remainder accrued to borrowers.

2

2

“Updated Estimates of the Subsidies to the Housing GSEs,” attachment to a letter from Douglas Holtz-Eakin, Director, Congressional Budget Office, to the Honorable Richard C. Shelby, Chairman, Committee on Banking, Houseing, and Urban Affairs, United States Senate, April 8, 2004. A related recent study is Wayne Passmore, “The GSE Implicit subsidy and Value of Government Ambiguity,” Board of Governors of the Federal Reserve System. Finance and Economics Discussion Series, FEDS Working Paper 2003-64, December 2003.

In return for the public benefits they receive, Congress has mandated in the GSEs' Charter Acts that the GSEs carry out public purposes not required of other private sector entities in the housing finance industry. These statutory mandates obligate the GSEs to work to ensure that everyone in the nation has a reasonable opportunity to enjoy access to the mortgage financing benefits resulting from the activities of these enterprises.

With respect to these public purposes, Congress does not simply expect the GSEs to strive toward achievement of these purposes but rather to “lead the mortgage finance industry” and to “ensure that citizens throughout the country enjoy access to the public benefits provided by these federally related entities.” (

See

S. Rep. No. 102-282, at 34 (1992).)

C. Statutory and Regulatory Background

The statutory and regulatory background applicable to the chartering of Fannie Mae and Freddie Mac and HUD's regulatory authority over these two GSEs were set out in detail in the preamble to HUD's proposed rule published on May 3, 2004 (69 FR 24228). Therefore, this background information is not repeated here in the preamble to this final rule. Interested members of the public should refer to Section I.A. of the preamble to the proposed rule at pages 69 FR 24228 through 69 FR 24230 for this information.

D. The Proposed Rule

On May 3, 2004, HUD published a proposed rule setting forth new housing goal levels for Fannie Mae and Freddie Mac. (

See

69 FR 24228.) HUD's rule proposed to increase the level of the housing goals (“Housing Goals”) for the purchase by Fannie Mae and Freddie Mac of mortgages financing low- and moderate-income housing, special affordable housing, and housing in central cities, rural areas, and other underserved areas. The rule also proposed to establish new subgoals for the GSEs' acquisitions of home purchase loans that qualify for each of the housing goals.

In addition to soliciting public comments on the proposed goal levels and new subgoals, the rule solicited public comments on several other issues related to the housing goals, including: (1) Provisions relating to GSE data integrity, such as verification, certification, treatment of errors, omissions or discrepancies, and other enforcement authority; (2) amended definitions of “underserved area,” “metropolitan area” and “minority,” and a new definition of the term “home purchase mortgage”; (3) a method for imputing the distribution of GSE-purchased mortgages that lack income data; and (4) other changes related to the GSEs' bulk purchases of seasoned loans. More detailed information about HUD's proposals can be found in the preamble to HUD's May 3, 2004, proposed rule.

E. This Final Rule—Overview

Under this 2004 rulemaking, the Department is setting new, higher levels for the Housing Goals, accompanied by subgoals under each of the Housing Goals for purchases of home purchase mortgages (

i.e.

, excluding refinance mortgages) on owner-occupied properties in metropolitan areas. (The subgoals are referred to in this rule as the “Home Purchase Subgoals.”)

The Department's purpose in setting higher Housing Goals and in establishing new Home Purchase Subgoals in this final rule is to encourage the GSEs to facilitate greater financing and homeownership opportunities for families and neighborhoods targeted by the Housing Goals. The final rule establishes levels of the Housing Goals that will bring the GSEs to a position of market leadership in a range of foreseeable economic circumstances related to the future course of interest rates and consequent fluctuations in origination rates on home purchase and refinance mortgages—both multifamily and single-family.

For each goal, HUD has projected goal-qualifying percentages of mortgage originations in terms of ranges that cover a variety of economic scenarios. The objective of HUD's Housing Goals is to bring the GSEs' performance to the upper end of HUD's market range estimate for each goal, consistent with the requirement in FHEFSSA that HUD should consider the GSEs' ability to lead the market for each goal.

To enable the GSEs to achieve this leadership, the Department has established staged increases in Housing Goal levels for 2005, which will increase further, year-by-year through 2008, to achieve the ultimate objective for the GSEs to lead the market under a range of foreseeable economic circumstances by 2008.

The staged increases established by this rule, are consistent with the statutory requirement that HUD consider the past performance of the GSEs in setting the Housing Goals. Staged annual increases in the Goals will provide the GSEs with the opportunity to adjust their business models, so as to meet the required 2008 levels without compromising other business objectives and requirements.

The Department believes that the Home Purchase Subgoals established by this final rule are necessary and warranted. Increasing homeownership is a national priority. The past average performance of the GSEs in the home purchase market has been below market levels. As further discussed below, the GSEs must apply greater efforts to increasing homeownership for low- and moderate-income families, families living in underserved areas, and very-low income families and low-income families living in low-income areas. The addition of Home Purchase Subgoals to the regulatory structure will serve to better focus the GSEs' efforts in a clear and transparent manner. The Home Purchase Subgoals will better allow the government and public alike to monitor the GSEs' efforts in meeting the nation's homeownership needs. The increases in the levels of the Housing Goals, and the addition of the new Home Purchase Subgoals, are predicated upon the Department's recognition that the GSEs not only have the ability to achieve these Housing Goals and Subgoals but, also, that they are fully consistent with the statutory factors established under FHEFSSA. In addition, this rule is supported by the Department's comprehensive analyses of the size of the mortgage market, the opportunities available to the GSEs, America's unmet housing needs, and identified credit gaps.

In addition to the establishment of higher Housing Goals for the years 2005 through 2008, and the establishment of Home Purchase Subgoals, specific changes included in the final rule from the provisions included in the May 3, 2004, proposed rule are as follows:

(1) The final rule expands the existing provisions to permit the GSEs to impute incomes or rents when data are missing for some purchases, addressing the market's expanding use of low documentation mortgages;

(2) The final rule provides that goals credit is available for purchases of loans in transactions involving seller dissolution options, such as repurchase

agreements, only when the option provides for a minimum one-year lockout period;

(3) The final rule clarifies the proposed provisions regarding HUD's procedures for correcting errors, omissions and discrepancies in current year-end data and in remedying material overstatements of housing goals performance for prior years;

(4) The final rule changes the scope of the proposed certification statement that the GSEs must provide to make it closer to the certification used by the Office of Federal Housing Enterprise Oversight (OFHEO), the GSEs' financial safety and soundness regulator; and

(5) The final rule makes a technical correction to the special counting rules prohibiting double counting of GSE purchases of seasoned mortgages toward the housing goals.

In developing these regulations, the Department was guided by, and re-affirms, the following principles established in the Housing Goals 1995 final rule (published on December 1, 1995 at 60 FR 1846):

(1) The GSEs should fulfill FHEFSSA's intent that they lead the industry in ensuring that access to mortgage credit is made available for very low-, low- and moderate-income families and residents of underserved areas. HUD recognizes that, to lead the mortgage industry over time, the GSEs will have to stretch to reach certain Housing Goals and to close gaps between the secondary mortgage market and the primary mortgage market for various categories of loans. This recognition is consistent with the Congressional directive that “the enterprises will need to stretch their efforts to achieve” the goals. (

See

S. Rep. No. 102-282, at 35 (1992).)

(2) The Department's role as a regulator is to set broad performance standards for the GSEs through the Housing Goals, but not to dictate the specific products or delivery mechanisms the GSEs will use to achieve a Housing Goal. Regulating two exceedingly large financial enterprises in a dynamic market requires that HUD provide the GSEs with sufficient latitude to use their innovative capacities to determine how best to develop products to carry out their respective missions. HUD's regulations are intended to allow the GSEs the flexibility to respond quickly to market opportunities. At the same time, the Department must ensure that the GSEs' strategies address national credit needs, especially as they relate to housing for low- and moderate-income families and housing located in underserved geographical areas. The addition of Home Purchase Subgoals to the regulatory structure provides an additional means of encouraging the GSEs' affordable housing activities to address identified, persistent credit needs while leaving to the GSEs the specific approaches used to meet these needs.

(3) Discrimination in lending continues to limit access to credit for purchasing homes by racial and ethnic minorities. Troublesome gaps in homeownership remain for minorities even after record growth in affordable lending and homeownership during the nineties. Studies indicate that, over the next few years, minorities will account for a growing share of the families seeking to buy their first home. HUD's analyses indicate, however, that Fannie Mae and Freddie Mac account for a disproportionately small share of the minority first-time homebuyer market. The GSEs have a responsibility to promote access to capital for minorities and others who are seeking their first homes, and to demonstrate the benefits of such lending to industry and borrowers alike. The GSEs also have an integral role in eliminating predatory mortgage lending practices.

(4) In addition to the GSEs' purchases of single-family home mortgages, the GSEs also must continue to assist in the creation of an active secondary market for mortgages on multifamily rental housing. Affordable rental housing is essential for those families who cannot afford to become, or who choose not to become, homeowners. For this reason, the GSEs must assist in making capital available to assure the continued development of single-family and multifamily rental housing.

II. Discussion of Public Comments

A. Overview of Public Comments

At the close of the public comment period on July 16, 2004, which was extended an additional two weeks beyond the original public comment deadline of July 2, 2004, HUD had received 302 comments, which are in HUD's docket file for this rule. In addition to the public comments received on the rule, during the public comment period, HUD met with representatives of several organizations, including Fannie Mae and Freddie Mac, to accommodate oral presentation of concerns about the rule. HUD's docket file for this rule contains information on the dates of these meetings, the attendees, and the subject discussed.

Of the public comments received on the proposed rule, the most detailed comments were those submitted by the two directly affected GSEs, Fannie Mae and Freddie Mac. Neither GSE was supportive of the higher goal levels proposed for 2005-2008, nor did either support the creation of HUD's proposed Home Purchase Subgoals. The GSEs stated, among other comments that they made on the rule, that the effect of many goals and subgoals would be micromanagement of the GSEs. With their comments, the GSEs provided several appendices that provided alternative analyses of data and questioned the Department's methodology in determining market share for the three affordable housing goals, a key component for establishing the appropriate level of the housing goals and the subgoals.

The GSEs did not object to HUD's special affordable multifamily subgoal levels for 2005-2008, but other commenters (mostly public advocacy groups) recommended that HUD increase the levels of these subgoals.

In addition to the GSEs, the commenters included national and regional housing industry organizations, nonprofit organizations, alliances, councils, and advocacy organizations involved in housing or housing issues, lenders, academic researchers, Members of Congress, state and local government officials, and two individuals.

In large measure, except for several nonprofit organizations and public advocacy groups that favored higher goals, the majority of commenters were not supportive of HUD's proposed goals, especially in the outer years when the goal levels would reach their highest levels. A particular concern cited by a number of commenters was the potential for adverse impact on middle-income borrowers, particularly higher interest rates and fees. Another concern raised by the commenters was the possibility of unintended consequences for the industry. Many commenters, including the GSEs, urged HUD to exclude all single-family refinances from the calculation of the goals.

The Department received fewer comments that addressed other proposals in the rule, such as those regarding data integrity, large-scale transactions involving seasoned loans, the treatment of missing income data, and modifying the definition of rural underserved areas. For those commenters who submitted comments on these proposals, the reactions were generally mixed.

With respect to HUD's proposals for new data integrity provisions, the majority of those who commented on the new data integrity proposals were generally supportive of the concept and acknowledged the need for some sort of data verification process. However, two

industry-related commenters expressed concern about the potential for HUD's proposals to result in increased reporting burdens for lenders. The GSEs' comments also reflected several concerns about the data integrity provisions, mainly with respect to definitions, procedures, and enforcement.

The GSEs favored generous proxy provisions for the treatment of missing income data and submitted several suggestions. The majority of commenters on this issue, consisting chiefly of nonprofit and advocacy organizations, opposed using proxies, and several favored an outright ban on purchasing “no income” subprime mortgages.

With regard to large-scale transactions involving seasoned loans, the GSEs commented that they should receive housing goals credit and that no change in HUD's current definition of “mortgage purchase” was warranted. However, a group of industry-related organizations opposed providing goals credit for seasoned loans, as did several advocacy organizations. Commenters offered no alternative definitions for “mortgage purchase” in HUD's regulations.

All but one commenter who addressed the issue of HUD's rural underserved area definition favored changing this definition to one that is census tract-based, rather than county-based. Those commenters favoring conversion to a tract-based definition believed that county-level data do not show disparities in service that the GSEs should address. The dissenting commenter felt that lenders serving rural areas would face operational difficulties and expenses in shifting to a tract-based orientation.

In addition to comments on its proposals related to housing goals, HUD received other comments on subjects pertaining to HUD's regulatory authority over the GSEs but which were not related to the rule's proposals on housing goals (for example, comments on new program authority, monitoring and reporting procedures, and public access to GSE mortgage data). Because these comments raised issues outside the scope of the May 3, 2004, proposed rule, they are not addressed in this final rule.

A discussion of the general and specific comments on the rule, as well as HUD's responses to these comments, follows in subsequent sections in this preamble, as well as in the Appendices to this Final Rule. While comments are summarized, not all the comments are addressed explicitly in this preamble. HUD is appreciative of the full range of public comments received and acknowledges the value of all of the comments submitted in response to the proposed rule.

B. Subpart A—General

In the May 3, 2004, rule, HUD proposed to add a definition of “home purchase mortgage” in connection with its proposal to specify Home Purchase Subgoals under each of the three Housing Goals, to revise the definitions of “metropolitan area” and “minority” to conform HUD's regulations to changes in data collection practices made by the Office of Management and Budget (OMB), and to modify the current definition of “underserved area” with respect to the delineation of underserved portions of non-metropolitan areas.

1. Home Purchase Mortgage

HUD proposed to insert a definition of “home purchase mortgage” for purposes of specifying the Home Purchase Mortgage Subgoals. Since no comments bearing directly on this definition were received and the Department has retained the subgoal concept in this final rule, the definition is adopted.

2. Metropolitan Area

HUD proposed to alter the definition of “metropolitan area” to reflect a change in the definition of “metropolitan area” recently promulgated by OMB, in which the concept of “Primary Metropolitan Statistical Area” was removed. No comments were received on this proposed change; accordingly, it is adopted.

3. Minority

HUD proposed to alter the definition of “minority” to reflect changes in standards for the classification of federal data on race and ethnicity previously promulgated by OMB and implemented in the 2000 census and in data collection under the Home Mortgage Disclosure Act in 2004. No comments were received on this proposed change; accordingly, it is adopted.

4. Underserved Area

HUD proposed to alter the definition of “underserved area” to provide for the specification of underserved areas outside of metropolitan areas at the census tract level rather than at the county level.

For properties in non-metropolitan (rural) areas, mortgage purchases have counted toward the Underserved Areas Housing Goal where such purchases finance properties that are located in underserved counties. This final rule incorporates a determination that mortgage purchases will count toward the Underserved Areas Housing Goal where such purchases finance properties that are located in underserved census tracts. These are defined as census tracts where either: (1) the median income in the tract does not exceed 95 percent of the greater of the median income for the non-metropolitan portions of the state or the median income of the non-metropolitan portions of the nation as a whole; or (2) minorities comprise at least 30 percent of the residents and the median income in the tract does not exceed 120 percent of the greater of the median incomes for the non-metropolitan portions of the state or of the nation as a whole.

HUD originally adopted its current county-based definition for targeting GSE purchases to underserved non-metropolitan areas primarily based on information that rural lenders did not perceive their market areas in terms of census tracts, but rather, in terms of counties. A further concern was an apparent lack of reliability of geocoding software applied to non-metropolitan areas.

Thirteen commenters endorsed HUD's proposed change in definition, observing that the change would produce more precise targeting and improved service toward underserved segments of the market within counties. One banking trade association advocated continuation of a county-based definition, stating that because the business perspective of community banks in rural areas is geared toward entire counties, there would be costs associated with monitoring the tract location of loans, and therefore, marketing toward borrowers at the tract level would be difficult.

Recent research summarized in Appendix B to this rule indicates that a tract-based system will improve the extent to which the underserved area definition distinguishes areas by key socioeconomic and demographic characteristics such as median family income, poverty, unemployment, school dropout rates, and minority populations. Under a tract-based definition underserved areas stand out more as areas of lower income and low economic activity and as having somewhat larger minority population proportions. A tract-based definition will also improve the targeting of the goal to areas with relatively greater housing needs. Based on these findings, which are detailed in Appendix B to this rule, HUD is adopting a re-specification of underserved areas within non-metropolitan (rural) areas to

be based on census tracts rather than counties.

C. Subpart B—Housing Goals

1. Overview

A substantial majority of the comments received criticized HUD's proposed levels of the housing goals on the basis that they would be difficult for the GSEs to achieve, particularly in periods of high refinance activity when higher-income borrowers comprise a relatively high proportion of mortgage borrowers. Several types of adverse consequences of such high goals were forecast, including diminution of availability of mortgage credit to some sectors of the mortgage market, unfavorable effects on neighborhood housing quality, and other adverse effects discussed below. This section of the final rule reviews the statutory factors the Department must consider in setting the level of the housing goals and the Department's determinations with regard to the levels of each of the housing goals as well as the proposed Home Purchase Subgoals.

2. Statutorily Required Factors in Setting the Levels of the Housing Goals and Subgoals

The Housing Goals and Home Purchase Subgoals being implemented by this final rule were established following consideration of the six factors required by statute to be considered in establishing goal levels and establishing subgoals. A summary of HUD's findings relative to each of the six statutory factors follows. More detailed discussion of these points is included in Appendices A, B, and C to this rule.

a. Demographic, Economic, and Housing Conditions

(i) Demographic Trends

Changing population demographics will result in a need for the primary and secondary mortgage markets to meet nontraditional credit needs, respond to diverse housing preferences and overcome information and other barriers that many immigrants and minorities currently face.

The U.S. Census Bureau has projected that the U.S. population will grow by an average of 2.5 million persons per year between 2000 and 2025, resulting in about 1.2 million new households per year. The aging of the baby-boom generation and the entry of the baby-bust generation into prime home-buying age will have a dampening effect on housing demand. Growing housing demand from minorities, immigrants and non-traditional homebuyers will help offset declines in the demand for housing caused by the aging of the population.

The continued influx of immigrants will increase the demand for rental housing, while those who immigrated during the 1980s and 1990s will be in the market for homeownership. Immigrants and minorities—who accounted for nearly 40 percent of the growth in the nation's homeownership rate over the past five years—will be responsible for almost two-thirds of the growth in the number of new households over the next 10 years.

Non-traditional households have become more important, as overall household formation rates have slowed. With later marriages, divorce, and non-traditional living arrangements, the fastest growing household groups are single-parent and single-person households. By 2025, non-family households will make up one-third of all households. The role of traditional 25-to-34 year-old married, first-time homebuyers in the housing market will be smaller in the current decade due to the aging of the population. Between 2000 and 2025, the Census Bureau projects that the largest growth in households will occur among householders who are age 65 and older.

As these demographic factors play out, the overall effect on housing demand will likely be continued growth and an increasingly diverse household population from which to draw new renters and homeowners. A greater diversity in the housing market will, in turn, require greater adaptation by the primary and secondary mortgage markets.

(ii) Economic and Housing Conditions

While most other sectors of the economy were weak or declining during 2001 and 2002, the housing sector showed remarkable strength. The housing market continued at a record pace during 2003.

In 2002, the U.S. economy moved into recovery, with real Gross Domestic Product (GDP) growing 2.2 percent, although measures of unemployment continued to rise before declining again in 2003. In October 2002, the average 30-year home mortgage interest rate slipped below 6 percent for the first time since the mid-1960s. Favorable financing conditions and solid increases in house prices were the key supports to record housing markets during both 2002 and 2003. By the end of 2003, the industry had set new records in single-family home permits, new home sales, existing home sales, low interest rates, and rates of homeownership. Other indicators—total permits, starts, completions, and affordability—reached levels that were among the highest in the past two decades.

The Administration's forecast for real GDP growth is 3.7 percent for 2005 and 3.1-3.4 percent in 2006-2009, while CBO projects that real GDP will grow at an average rate of 4.1 percent in 2005 and annual rates of 2.9-3.2 percent in 2006 through 2009.

3

The Administration projects the 10-year Treasury rate to average 5.1 percent in 2005 and 5.4-5.8 percent between 2006 and 2009 compared to its average of 4.6 percent in 2002 and 4.0 percent in 2003.

3

Fiscal Year 2005 Budget of the U.S. Government: Mid-Session review (July 30, 2004). Office of Management and Budget, also posted at

http://www.whitehouse.gov/omb

. The Budget and Economic Outlook: An Update, Washington, Congressional Budget Office, September 2004, also posted on

http://www.cbo.gov

.

Standard & Poor's expects housing starts to average 1.8 million units in 2004-2005. Fannie Mae projects existing home sales for 2004 at 6.1 million units, and for 2005 at 5.8 million, compared to their record level in 2003 of 6 million units.

(iii) Mortgage Market Conditions

Low interest rates and record levels of refinancing caused mortgage originations to soar from $2.0 trillion in 2001 to $2.6 trillion in 2002 and around $3.8 trillion in 2003. The Mortgage Bankers Association projects that mortgage originations will drop to $2.7 trillion in 2004 and $1.8 trillion in 2005, as refinancing returns to more normal levels.

4

4

Mortgage Bankers Association of America, MBA Mortgage Finance Forecast, September 17, 2004.

The volume of home purchase mortgages was $910 billion to $1.1 trillion between 1999 and 2001 before jumping to $1.2 trillion in 2002 and $1.3 trillion in 2003. As with housing starts, the home purchase origination market is expected to exhibit sustained growth.

b. National Housing Needs

(i) Affordability Problems

Data from the 2000 Census and the American Housing Survey demonstrate that there are substantial housing needs among low- and moderate-income families. Many of these households are burdened by high homeownership costs or rent payments and, consequently, are facing serious housing affordability problems. There is evidence of persistent housing problems for Americans with the lowest incomes. Since 1977 the percentage of U.S. households with worst case needs has hovered around five percent, with the worst year being 1983 (6.03 percent) and the best being 1999 (4.72 percent). The

proportion in 2001 was 4.77 percent, which is not significantly different from the 1999 figure. HUD's analysis of American Housing Survey data reveals that, in 2001, 5.1 million unassisted very-low-income renter households had “worst case” housing needs, defined as housing costs greater than 50 percent of household income or severely inadequate housing. Among these households, 90 percent had a severe rent burden, 6 percent lived in severely inadequate housing, and 4 percent suffered from both problems. Among the 34 million renters in all income categories, 6.3 million (19 percent) had a severe rent burden and over one million renters (3 percent) lived in housing that was severely inadequate.

(ii) Disparities in Housing and Mortgage Markets

Despite the strong growth in affordable lending over the past ten years, there are families who are not being adequately served by the nation's housing and mortgage markets. Serious racial and income disparities remain. The homeownership rate for minorities is 25 percentage points below that for whites. A major HUD-funded study of discrimination in the sales and rental markets found that discrimination still persists in both rental and sales markets of large metropolitan areas nationwide, although its incidence has generally declined since 1989. The most prevalent form of discrimination observed in the study against Hispanic and African-American home seekers was Hispanics and African Americans being told that housing units were unavailable when non-Hispanic whites found them to be available. Levels of consistent adverse treatment experienced by the nation's largest minority groups when they inquire about a unit advertised for sale in metropolitan areas nationwide in 2000-2001 were: African Americans 16.8 percent, Hispanics 18.3 percent, and Asians and Pacific Islanders 20.4 percent.

The study also found other worrisome trends of discrimination in metropolitan housing markets that persisted in 2000. Examples include geographical steering experienced by African-American homebuyers, and real estate agents who provided less assistance in obtaining financing for Hispanic homebuyers than for non-Hispanic whites.

5

Racial disparities in mortgage lending are also well documented. HUD-sponsored studies of the pre-qualification process conclude that African Americans and Hispanics risk unequal treatment when they visit mainstream mortgage lenders. Studies reveal higher mortgage denial rates for African Americans and Hispanics, even after controlling for applicant income and a host of underwriting characteristics, such as the credit record of the applicant.

6

However, substantial progress has been made since 1989.

5

Margery Austin Turner,

All Other Things Being Equal: A Paired Testing Study of Mortgage Lending Institutions,

The Urban Institute Press, April 2002. Appendix A includes further discussion of this study.

6

These studies are discussed in section B.1 of Appendix B.

The existence of substantial neighborhood disparities in homeownership and mortgage credit is also well documented for metropolitan areas. HUD's analysis of Home Mortgage Disclosure Act (HMDA) data shows that mortgage credit flows in metropolitan areas are substantially lower in high-minority and low-income neighborhoods and that mortgage denial rates are much higher for residents of these neighborhoods. Studies have also documented that mainstream lenders often do not operate in inner-city minority neighborhoods, leaving their residents with only high-cost lenders as options. Too often, residents of these same neighborhoods have been subjected to the abusive practices of predatory lenders.

These troublesome disparities mostly affect those families (minorities and immigrants) who are projected to account for almost two-thirds of the growth in the number of new households over the next 10 years.

(iii) Single-Family Market: Trends in Affordable Lending and Homeownership

Many younger, minority and lower-income families did not become homeowners during the 1980s due to slow growth of some earnings, high real interest rates, lower inflation, and continued increases in housing prices. Over the past 10 years, economic expansion, accompanied by low interest rates and increased outreach on the part of the mortgage industry, has improved affordability conditions for these families.

As this preamble and the appendices note, there has been a “revolution in affordable lending” that has extended homeownership opportunities to historically underserved households. The mortgage industry, including the GSEs, has offered more customized mortgage products, more flexible underwriting, and expanded outreach to low-income and minority borrowers.

HMDA data suggest that the industry and GSE initiatives are increasing the flow of credit to underserved borrowers. Between 1993 and 2002, conventional loans to low-income and minority families increased at much faster rates than loans to upper-income and non-minority families. Conventional home purchase originations to African Americans more than doubled between 1993 and 2002, and those to Hispanic borrowers more than tripled during this period. Home loans to low-income borrowers and to low-income and high-minority census tracts also more than doubled during this period.

Thus, the 1990s and the early part of the current decade have seen the development of a strong affordable lending market. Homeownership statistics show similar trends. After declining during the 1980s, the homeownership rate has increased every year since 1994, reaching a record mark of 69.2 percent in the second quarter of 2004.

The number of households owning their own home increased by 13.3 million between 1994 and 2003. Gains in homeownership rates during the period of 1994 to 2003 have been widespread, with the homeownership rate for African-American households increasing from 42.5 percent to 48.8 percent, for Hispanic households from 41.2 percent to 46.7 percent, for non-Hispanic white households from 70.0 percent to 75.4 percent, and for central city residents from 48.5 percent to 52.3 percent.

Despite the record gains in homeownership since 1994, a gap of approximately 25 percent in the homeownership rate prevails for African-American and Hispanic households as compared to white non-Hispanic households. Studies show that these lower homeownership rates are only partly accounted for by differences in income, age, and other socioeconomic factors.

In addition to low income, barriers to homeownership that disproportionately affect minorities and immigrants include: lack of capital for downpayment and closing costs; poor credit history; lack of access to mainstream lenders; little understanding of the home buying process; a limited supply of modestly priced homes in locations where these populations reside; and continued discrimination in housing markets and mortgage lending. These barriers are discussed in Appendix A to this rule.

(iv) Single-Family Market: Potential Homeowners

As already noted, the potential homeowner population over the next decade will be highly diverse, as growing housing demand from

immigrants (both those who are already in this country and those who are projected to arrive), minorities, and non-traditional homebuyers will help to offset declines in the demand for housing caused by the aging of the population.

Studies cited in Appendix A to this rule reveal that increased immigration during the 1990s directly accounted for 35 percent of the nation's rise in population during that decade, as a result of which the foreign-born population of the United States was 31.1 million in 2000. These trends do not depend on the future inflow of new immigrants, as immigrants do not, on average, enter the home purchase market until they have been in this country for eleven years. Fannie Mae staff have noted that there are enough immigrants already in this country to keep housing demand strong for several years.

Thus, the need for the GSEs and other industry participants to meet nontraditional credit needs, respond to diverse housing preferences, and to overcome the information barriers that many immigrants face will take on added importance. A new or recent immigrant may have no credit history or, at least, may not have a credit history that can be documented by traditional methods. In order to address these needs, the GSEs and the mortgage industry have been developing innovative products and seeking to extend their outreach efforts to attract these homebuyers, as discussed in Appendix A to this rule.

In addition, the current low homeownership rates in inner cities (as compared with the suburbs) also suggest that urban areas may be a potential growth market for lenders. As explained in Appendix A to this rule, lenders are beginning to recognize that urban borrowers and properties have different needs than suburban borrowers and properties.

Surveys indicate that these demographic trends will be reinforced by the fact that most Americans desire, and plan, to become homeowners. According to Fannie Mae's 2002 National Housing Survey, Americans rate homeownership as the best investment they can make, far ahead of 401(k) plans, other retirement accounts, and stocks. Forty-two percent of African-American families reported that they were “very or fairly likely” to buy a home in the next three years, up from 38 percent in 1998 and 25 percent in 1997. Among Hispanics and Hispanic immigrants, the numbers reached 37 percent and 34 percent, respectively. The survey also reported that more than half of Hispanic renters cite homeownership as being “one of their top priorities.”

Despite these trends, potential minority and immigrant homebuyers see more obstacles to buying a home than does the general public. Typically, the primary barriers to homeownership are credit issues and a lack of funds for a downpayment and closing costs. However, other barriers also exist, such as a lack of affordable housing, little understanding of the home buying process, and language barriers. Thus, the new group of potential homeowners will have unique needs.

The GSEs can play an important role in tapping this potential homeowner population. Along with others in the industry, they can address these needs on several fronts, such as expanding education and outreach efforts, introducing new products, and adjusting current underwriting standards to better reflect the special circumstances of these new households. These efforts are necessary for achieving the Administration's goal of expanding minority homeownership by 5.5 million families by the end of the decade.

The single-family mortgage market has been very dynamic over the past few years, experiencing volatile swings in originations (with the 1998 and 2001-2003 refinancing waves), witnessing the rapid growth in new types of lending (such as subprime lending), incorporating new technologies (such as automated underwriting systems), and facing serious challenges (such as predatory lending). Fannie Mae and Freddie Mac have played a major role in the ongoing changes in the single-family market and in helping the industry address the problems and challenges that have arisen.

The appendices to this final rule discuss the various roles that Fannie Mae and Freddie Mac have played in the single-family market. A wide range of topics is examined, including the GSEs' automated underwriting technology used throughout the industry, their many affordable lending partnerships and underwriting initiatives aimed at extending credit to underserved borrowers, their development of new targeted low-downpayment products, their entry into new markets such as the subprime market, and their attempts to reduce predatory lending. As that discussion emphasizes, the GSEs have the ability to bring increased efficiencies to a market and to attract mainstream lenders into markets. (Readers are referred to Appendices A, B, and C to this rule for further discussion of the GSEs' role in different segments of the single-family mortgage market.)

(v) Multifamily Mortgage Market

The market for financing of multifamily apartments has reached record volume. The favorable long-term prospects for apartments, combined with record low interest rates, have kept investor demand for apartments strong and have supported property prices despite recently high vacancy rates.

Fannie Mae and Freddie Mac have been among those boosting their volumes of multifamily financing and both have introduced new programs to serve the multifamily market. Fannie Mae and, especially (considering its earlier withdrawal from the market), Freddie Mac have rapidly expanded their presence in the multifamily mortgage market under the Housing Goals.

Freddie Mac has successfully rebuilt its multifamily acquisition program, as reflected by the increase in its purchases of multifamily mortgages: from $27 million in 1992 to $3.9 billion in 1998 and then rising to $9.5 billion in 2001, $10.7 billion in 2002, and $21.5 billion in 2003. Multifamily units accounted for 9.0 percent of all dwelling units (both owner and rental) financed by Freddie Mac between 1999 and 2003. Concerns regarding multifamily capabilities no longer constrain Freddie Mac's performance with regard to the Housing Goals.

Although Fannie Mae never withdrew from the multifamily market, it has stepped up its activities in this area substantially, with multifamily purchases rising from $3.0 billion in 1992 to $10.0 billion in 1999, and $19.1 billion in 2001, then declining slightly to $16.6 billion in 2002, and then rising markedly to $30.9 billion in 2003. Multifamily units accounted for 8.8 percent of all dwelling units (both owner and rental) financed by Fannie Mae between 1999 and 2003.

The increased role of Fannie Mae and Freddie Mac in the multifamily market has major implications for the Low- and Moderate-Income Housing and Special Affordable Housing Goals, since high percentages of multifamily units have affordable-level rents and can count toward one or both of these Housing Goals. However, the potential of the GSEs to lead the multifamily mortgage industry has not been fully developed. The GSEs' purchases between 1999 and 2002 accounted for less than 40 percent of the multifamily units that received financing during this period. Certainly there are ample opportunities and room for expansion of the GSEs' share of the multifamily mortgage market.

The GSEs' size and market position between loan originators and mortgage investors make them the logical institutions to identify and promote needed innovations and to establish standards that will improve market efficiency. As their role in the multifamily market continues to grow, the GSEs will have the knowledge and market presence to push simultaneously for standardization and for programmatic flexibility to meet special needs and circumstances, with the ultimate goal of increasing the availability and reducing the cost of financing for affordable and other multifamily rental properties.

The long-term outlook for the multifamily rental market is sustained, moderate growth, based on favorable demographics. The minority population, especially Hispanics, provides a growing source of demand for affordable rental housing. “Lifestyle renters” (older, middle-income households) are also a fast-growing segment of the rental population.

At the same time, the provision of affordable housing units will continue to challenge suppliers of multifamily rental housing as well as policy makers at all levels of government. Low incomes, combined with high housing expenses, define the difficult situation of millions of renter households. Housing cost reductions are constrained by high land prices and construction costs in many markets. Regulatory barriers at the state and local level have an enormous impact on the development of affordable rental housing. Government action—through land use regulation, building codes, and occupancy standards—is a major contributor to high housing costs.

Since the early 1990s, the multifamily mortgage market has become more closely interconnected with global capital markets, although not to the same degree as the single-family mortgage market. Loans on multifamily properties are still viewed as riskier by some than are mortgages on single-family properties, despite delinquency rates that in recent quarters have been lower than those on single-family mortgages.

There is a need for an ongoing GSE presence in the multifamily secondary market, both to increase liquidity and to advance affordable housing efforts. The potential for an increased GSE presence is enhanced by the fact that an increasing proportion of multifamily mortgages are now originated in accordance with secondary market standards. Small multifamily properties, and multifamily properties with significant rehabilitation needs, have historically experienced difficulty gaining access to mortgage financing, and the flow of capital into multifamily housing for seniors has been historically characterized by volatility. The GSEs can play a role in promoting liquidity for multifamily mortgages and increasing the availability of long-term, fixed-rate financing for these properties.

c. GSEs' Past Performance and Effort Toward Achieving the Housing Goals

Since the enactment of FHEFSSA and HUD's establishment in 1993 of the Housing Goals, both Fannie Mae and Freddie Mac have improved their affordable housing loan performance. However, the GSEs' mortgage purchases have generally lagged, and not led, the overall primary market in providing financing for affordable housing to low- and moderate-income families and underserved borrowers and their neighborhoods, indicating that there is more that the GSEs can do to improve their performance.

(i) Performance on the Housing Goals

The year 2001 was the first year under the higher levels of the Housing Goals established in the Housing Goals 2000 final rule. Fannie Mae met all three Housing Goals in 2001, 2002, and 2003. Freddie Mac met all three Housing Goals in 2001 and 2003. However, in 2002 HUD discovered that Freddie Mac had counted 22,371 housing units towards the Low- and Moderate Income Goal even though it had previously counted these same housing units towards the same goal in 2001. Freddie Mac also counted 22,424 housing units towards the Underserved Area Goal even though these units had also been credited towards the same goal in 2001. HUD's regulations prohibit double counting. To correct for these double-counting errors, the Department has adjusted its official performance results for Freddie Mac in 2002 by deducting the double-counted housing units, including all bonus point credit that had been awarded for most of these units, from the official performance results it had previously reported publicly. As a result of these adjustments, Freddie Mac continued to meet the Low- and Moderate-Income Goal in 2002. However, Freddie Mac fell short of the 31 percent target for the Underserved Areas goal by 90 units or 0.002 percent. Freddie Mac's 2002 goal performance results are described more fully in Tables 4, 6 and 8 in this preamble, including the accompanying footnotes.

(ii) The GSEs' Efforts in the Home Purchase Mortgage Market

The Appendices to this final rule include a comprehensive analysis of each GSE's performance in funding home purchase mortgages for borrowers and neighborhoods targeted by the three Housing Goals—special affordable and low- and moderate-income borrowers and underserved areas. The GSEs' role in the first-time homebuyer market is also analyzed. Because homeownership opportunities are integrally tied to the ready availability of affordable home purchase loans, the main findings from that analysis are provided below.

• Both Fannie Mae and Freddie Mac have increased their purchases of affordable home purchase mortgages since the Housing Goals were put into effect, as indicated by the increasing share of their business going to the three goals-qualifying categories. Between 1992 and 2003, the special affordable share of Fannie Mae's business almost tripled, rising from 6.3 percent to 17.1 percent, while the underserved areas share increased more modestly, from 18.3 percent to 26.8 percent. The figures for Freddie Mac are similar. The special affordable share of Freddie Mac's business rose from 6.5 percent to 15.6 percent, while the underserved areas share also increased but more modestly, from 18.6 percent to 24.0 percent.

• While both GSEs improved their performance, they have historically lagged the primary market in providing affordable home purchase mortgage loans to low-income borrowers and underserved neighborhoods. Freddie Mac's average performance, in particular, fell far short of market performance during the 1990s. Fannie Mae's average performance was better than Freddie Mac's during the 1993-2003 period as well as during the 1996-2003 period, which covers the period under HUD's currently-defined Housing Goals. Between 1993 and 2003, 12.2 percent of Freddie Mac's mortgage purchases were for special affordable borrowers, compared with 13.3 percent of Fannie Mae's purchases, 15.4 percent of loans originated by depositories, and 15.5 percent of loans originated in the conventional conforming market (without estimated B&C subprime loans).

7

7

Unless otherwise noted, the conventional conforming market data reported in this section exclude an estimate of B&C loans; the less-risky A-minus portion of the subprime market is included in the market definition. See section d below and Appendix D for a discussion of primary market definitions and the uncertainty surrounding estimates of the number of B&C loans in HMDA data. As noted there, B&C loans are much more

likely to be refinance loans rather than home purchase loans.

• Between 2001 and 2003, both Fannie Mae and Freddie Mac fell significantly below the market in funding affordable home purchase mortgage loans. During this period, special affordable loans accounted for 15.1 percent of Fannie Mae's purchases, 14.7 percent of Freddie Mac's purchases, and 16.2 percent of loans originated in the market; thus, the “Fannie-Mae-to-market” ratio was 0.93 and the “Freddie-Mac-to-market” ratio was also 0.91. During the same period, underserved area loans accounted for 24.7 percent of Fannie Mae's purchases, 23.1 percent of Freddie Mac's purchases, and 26.2 percent of loans originated in the market; the “Fannie-Mae-to-market” ratio was 0.94 and the “Freddie-Mac-to-market” ratio was only 0.88.

• While Freddie Mac has improved its affordable lending performance in the past two years, it has continued to lag the conventional conforming market in funding affordable home purchase loans for special affordable and low- and moderate-income borrowers and underserved neighborhoods targeted by the Housing Goals. In 2003, Freddie Mac's performance on the underserved areas goal was particularly low relative to both the performances of Fannie Mae and the market; in that year, underserved area loans accounted for only 24.0 percent of Freddie Mac's purchases compared with 26.8 percent of Fannie Mae's purchases and 27.6 percent of market originations.

• As noted above, Fannie Mae's average performance during past periods (

e.g.

, 1993-2003, 1996-2003, 1999-2003) has been below market levels. However, it is encouraging that Fannie Mae markedly improved its affordable lending performance relative to the market during 2001, 2002, and 2003, the first three years under the higher housing goal targets that HUD established in the GSE Final Rule dated October 2000. Over this three-year period, Fannie Mae led the primary market in funding special affordable and low- and moderate-income home purchase mortgage loans but lagged the market in funding underserved areas home purchase loans. In 2003, Fannie Mae's increased performance placed it significantly above the special affordable market (a 17.1 percent share for Fannie Mae compared with a 15.9 percent share for the market) and the low-mod market (a 47.0 percent share for Fannie Mae compared with a 44.6 percent share for the market). However, Fannie Mae continued to lag the underserved areas market in 2003 (a 26.8 percent share for Fannie Mae compared with a 27.6 percent share for the market). These data are based on the “purchase year” approach, that is, Fannie Mae's performance is based on comparing its purchases of all home purchase loans (both seasoned loans and newly-originated mortgages) during a particular year with loans originated in the market in that year. When Fannie Mae's performance is measured on an “origination year” basis (that is, allocating Fannie Mae's purchases in a particular year to the year that the purchased loan was originated), Fannie Mae also led the 2003 market in funding special affordable and low- and moderate-income loans, and lagged the market in funding underserved area loans.

• Appendix A compares the GSEs' funding of first-time homebuyers with that of primary lenders in the conventional conforming market. Both Fannie Mae and Freddie Mac lag the market in funding first-time homebuyers, and by a rather wide margin. Between 1999 and 2002, first-time homebuyers accounted for 27 percent of each GSE's purchases of home purchase mortgages, compared with 38 percent for home purchase mortgages originated in the conventional conforming market. For minority first-time homebuyers, the GSE ratio was 6.2 percent, compared to a market originations ratio of 10.6 percent. For African-American and Hispanic first-time homebuyers, the GSE ratio was 3.8 percent, compared to a market originations ratio of 6.9 percent. For first-time homebuyers, particularly first-time minority homebuyers, both GSEs substantially lag the private conventional conforming market.

• The GSEs account for a small share of the market for important groups such as minority first-time homebuyers. Considering all mortgage originations (both government and conventional) between 1999 and 2001, it is estimated that the GSEs purchased only 14 percent of all loans originated for African-American and Hispanic first-time homebuyers, or one-third of their share (42 percent) of all home purchase loans originated during that period. Considering conventional conforming originations during the same time period, it is estimated that the GSEs purchased only 31 percent of loans for African-American and Hispanic first-time homebuyers, or about one-half of their share (57 percent) of all home purchase loans in that market. A large percentage of the lower-income loans purchased by the GSEs had relatively low loan-to-value ratios and consequently high downpayments, which may explain the GSEs' limited role in the first-time homebuyer market.

Appendix A to this rule provides evidence that there is a significant population of potential homebuyers who are likely to respond well to increased homeownership opportunities produced by increased GSE purchases in this area. Immigrants and minorities, in particular, are expected to be a major source of future homebuyers.

d. Size of the Mortgage Market That Qualifies for the Housing Goals

The Department has estimated the size of the conventional, conforming market for loans that would qualify under each Housing Goal category based on 2000 Census data and geography. These estimates, which are changed slightly from estimates reported in the proposed rule, are as follows:

• 51-56 percent for the Low- and Moderate-Income Housing Goal

• 23-27 percent for the Special Affordable Housing Goal

• 35-39 percent for the Underserved Areas Housing Goal

These market estimates exclude the B&C (

i.e.

, subprime loans that are not A-minus grade) portion of the subprime market. The estimates, expressed as ranges, allow for economic and market affordability conditions that are more adverse than recent conditions. The market estimates are based on several mortgage market databases such as HMDA and American Housing Survey data. The Department's estimates of the size of the conventional mortgage market for each Housing Goal are discussed in detail in Appendix D to this rule.

The GSEs have room for growth in serving the affordable housing mortgage market. The Department estimates that the two GSEs' mortgage purchases accounted for 55 percent of the total (single-family and multifamily) conventional, conforming mortgage market between 1999 and 2002. In contrast, GSE purchases comprised 48 percent of the low- and moderate-income market, 48 percent of the underserved areas market, and a still smaller 41 percent of the special affordable market. Thus, the remaining 52-59 percent of the Goals-qualifying markets have not yet been touched by the GSEs.

The GSEs' presence in mortgage markets for rental properties, where much of the nation's affordable housing is concentrated, is below that in the single-family-owner market. The GSEs' share of the total rental market

(including both single-family and multifamily) was also less than 40 percent between 1999 and 2002. Obviously, there is room for the GSEs to increase their presence in the single-family rental and multifamily rental markets.

Table 1 summarizes the Department's findings regarding GSE performance relative to market projections for 2005-2008 and the Housing Goal levels for 2005-2008.

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The analysis for 2005 and later reflected in Table 1 is based on 2000 Census data on area median incomes and minority concentrations, using the metropolitan area boundaries specified by OMB in June 2003. This affects the market percentages for all three Housing Goals, as well as the figures on area median incomes and minority percentage figures that will be used to measure GSE performance on the Housing Goals beginning in 2005. The greatest effect of the updated data is on the Underserved Areas Housing Goal. Expressing this goal in terms of 2000 Census data adds approximately 5 percentage points to the Housing Goal and market levels, compared with analysis using 1990 Census data with Metropolitan Statistical Areas (MSAs) as defined prior to 2000.

The GSEs' baseline performance figures in Table 1 exclude the effects of the bonus points for small multifamily and single-family two-to-four unit owner-occupied properties and the Temporary Adjustment Factor (TAF) for Freddie Mac that were applied in official scoring toward the Housing Goals in 2001-2003. The Department did not extend these adjustments beyond 2003.

Table 1 reveals several features of HUD's Housing Goals. First, it is evident from this table that the 2005 level (22 percent) for the Special Affordable Housing Goal is below the low end (23 percent) of HUD's projected market range for 2005-2008. The 2005 level (52 percent) of the Low- and Moderate-Income Housing Goal is slightly above the low-end (51 percent) of HUD's market estimate range.

Second, the 2005 Underserved Areas Housing Goal level (37 percent) is consistent with the market range (35-39 percent) now projected by HUD for the Housing Goals using 2000 Census data.

Third, the GSEs' performance on all of the Housing Goals was significantly below the market averages for 1999-2002. Appendix D to this rule provides market estimates for the years 1999-2002 under different assumptions about the multifamily mix (

i.e.

, newly-mortgaged multifamily units as a share of all financed dwelling units). The estimates differ between the two home purchase years (1999 and 2000) and the heavy refinance years (2001 and 2002). For the low-mod goal, the estimates average approximately 56 percent for the two home purchase years and 52 percent for the two heavy refinance years, with an overall 1999-2002 low-mod average of 54 percent (five percentage points above Fannie Mae's performance and seven percentage points above Freddie Mac's performance). The market estimates for the underserved areas goal average slightly over 37 percent (38 percent during the two home purchase years and 36 percent during the two heavy refinance years), or approximately 2-4 percentage points above the GSEs' performance (see Table 1). The higher Housing Goals are intended to move the GSEs closer to or within the market range for 2005, and to the upper end of the market range projection by 2008.

An analysis of the GSEs' mortgage purchases by property type shows that they have had much less presence in the “goals-rich” rental segments of the market, as compared with the “less-goals-rich” owner segment of the market. As shown in Figure 1, GSE mortgage purchases represented 37 percent of single-family and multifamily rental units financed between 1999 and 2002. This figure is much lower than their 61 percent market share for single-family owner-occupied properties. (Figure 2 provides unit-level detail comparing the GSEs' purchases with originations in the conventional conforming market.)

Typically, about 90 percent of rental units in single-family rental and multifamily properties qualify for the Low- and Moderate-Income Housing Goal, compared with about 44 percent of owner units. Corresponding figures for the Special Affordable Housing Goal are almost 60 percent of rental units and 16.4 percent of owner units. Thus, one reason that the GSEs' performance under the Low- and Moderate-Income Housing and Special Affordable Housing Goals has fallen short of HUD's market estimates is that the GSEs have had a relatively small presence in the two rental market segments, notwithstanding that these market segments are important sources of affordable housing and important components in HUD's market estimates.

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In the overall conventional conforming mortgage market, rental units in single-family properties and in multifamily properties represented approximately 25 percent of the overall mortgage market between 1999 and 2002, 42 percent of the units that collateralize mortgages qualifying for the Low- and Moderate-Income Housing Goal, and 56 percent of the units that collateralize mortgages qualifying for the Special Affordable Housing Goal. Yet between 1999 and 2002, units in such properties accounted for only 17 percent of the GSEs' overall purchases, 32 percent of the GSEs' purchases meeting the Low- and Moderate-Income Housing Goal, and 44 percent of the GSEs' purchases meeting the Special Affordable Housing Goal.

8

Continuing weakness in GSE purchases of mortgages on single-family rental and multifamily properties has been a significant factor underlying the shortfall between GSE performance and that of the primary mortgage market.

8

These percentage shares are computed from Table A.30 in Appendix A. Note that B&C loans are excluded from these data. See also Table A.31b in Appendix A.

e. Ability of the GSEs To Lead the Industry

An important factor in determining the overall Housing Goal level is the ability of the GSEs to lead the industry in making mortgage credit available for Housing Goals—qualifying populations and areas.

The legislative history of FHEFSSA reflects Congress's strong concern that the GSEs need to do more to benefit low- and moderate-income families and residents of underserved areas that lack access to credit. (

See, e.g.

, S. Rep. No. 102-282, at 34.) The Senate Report on FHEFSSA emphasized that the GSEs should “lead the mortgage finance industry in making mortgage credit available for low- and moderate-income families.” (

Id.

)

Thus, FHEFSSA specifically requires that HUD consider the ability of the GSEs to lead the industry in establishing the level of the Housing Goals. FHEFSSA also clarified the GSEs' responsibility to complement the requirements of the CRA (

see

section 1335(a)(3)(B) of FHEFSSA, 12 U.S.C. 4565(a)(3)(B)), and fair lending laws (

see

section 1325 of FHEFSSA, 12 U.S.C. 4545) in order to expand access to capital to those historically underserved by the housing finance market.

While leadership may be exhibited through the GSEs' introduction of innovative products, technology, and processes, and through their establishment of partnerships and alliances with local communities and community groups, leadership must always involve increasing the availability of financing for homeownership and affordable rental housing. Thus, the GSEs' obligation to “lead the industry” entails leadership in facilitating access to affordable credit in the primary market for borrowers at different income levels, and with different housing needs, as well as in underserved urban and rural areas.

Because the GSEs' market presence varies significantly by property type, the Department examined whether the GSEs have led the industry in three different market sectors served by the GSEs: single-family-owner, single-family rental (those with at least one rental unit and no more than four units in total), and multifamily rental.

The GSEs' purchases between 1999 and 2002 financed almost 61 percent of the approximately 36 million owner-occupied units financed in the conventional conforming market during that period. The GSEs' state-of-the-art technology, staff resources, share of the total conventional conforming market, and financial strength strongly suggest that they have the ability to lead the industry in making home purchase credit available for low-income families and underserved neighborhoods. From the analysis in Appendices A-D to this rule, it is clear that the GSEs are able to improve their performance and lead the primary market in financing Housing Goals—qualifying home purchase mortgages. In fact, Fannie Mae's improved performance in 2003 is evidence of this potential, as it led the market in funding home purchase loans for special affordable and low- and moderate-income families.

As discussed in Appendix A to this rule, there are a wide variety of quantitative and qualitative indicators that demonstrate that the GSEs have ample, indeed robust, financial strength to improve their affordable lending performance. For example, the combined net income of the GSEs has risen steadily over the last 15 years, from $888 million in 1988 to $12.7 billion in 2003. This financial strength provides the GSEs with the resources to lead the industry in making mortgage financing available for families and neighborhoods targeted by the Housing Goals.

9

9

As discussed in Appendix D, the GSEs questioned HUD's historical estimates of the multifamily market as too high. Section C of Appendix D discusses these comments and responds. As indicated in Table A.30, multifamily loans accounted for 14.8 percent of all financed units in the market, excluding B&C loans. As reported in Section G of Appendix A and Sections F-H of Appendix D, HUD also conducted sensitivity analyses that reduced its 1999-2002 multifamily shares for the market by approximately two percentage points. As a result, 1999-2002 multifamily units decreased from 7,018,044 units to 5,991,036 units (reducing the multifamily share from 14.8 percent to 12.6 percent). With these reduced multifamily market numbers, the GSEs' share of the multifamily market increased from 35 percent to 41 percent. The GSEs also accounted for higher shares of the goals-qualifying

multifamily

market: 42 percent for low-mod units, 34 percent for underserved area units, and 37 percent for special affordable units. In this case, the GSEs' shares of the

overall

goals-qualifying markets (including single-family-owner, single-family-rental, and multifamily mortgages) increased as follows: low-mod—from 48 percent (see right column of Table A.30 in Appendix A) to 50 percent (see right column of Table A.31b in Appendix A); underserved areas—from 48 percent to 50 percent; and special affordable—from 41 percent to 43 percent.

As noted above, the GSEs have been much less active in providing financing for the rental housing market. Between 1999 and 2002, the GSEs financed 4.5 million rental dwelling units, which represented 37 percent of the 12 million single-family and multifamily rental dwelling units that were financed in the conventional market during this period. Thus, the GSEs' share of the rental mortgage market was just three-fifths of their share of the market for mortgages on single-family owner-occupied properties.

Clearly there is room for the GSEs to increase their presence in the single-family rental and multifamily rental markets. As explained above, these markets are an important source of low- and moderate-income housing since these units qualify for the Housing Goals in a greater proportion than do single-family owner-occupied properties. Thus, Fannie Mae and Freddie Mac can improve their performance on each of the three Housing Goals if they increase their purchases of mortgages on rental properties.

As discussed below in Section II.C.4 of this preamble with respect to the Home Purchase Subgoals, both GSEs should be able to lead the market for single-family owner-occupied properties in all three housing goal categories—special affordable, low- and moderate-income, and underserved areas. The GSEs are already dominant players in this market, which, unlike the rental markets, is their main business activity. However, as already discussed, research studies conducted by HUD and academic researchers conclude that except for Fannie Mae's recent performance on the special affordable and low- and moderate-income categories, the GSEs have not led the primary market in financing owner-

occupied housing for low-income families, for first-time homebuyers, or for properties located in underserved areas.

As discussed above, the Housing Goals established by this rule are quantitative measures of how well the GSEs are serving low- and moderate-income homebuyers. HUD received comments on this factor from Freddie Mac and one other commenter. The commenter stated that, in addition to measuring leadership through the purchase of goal-qualifying mortgages, Fannie Mae and Freddie Mac's leadership should be measured in more qualitative ways such as their “development of products and technologies that the private sector may not be willing or able to do as well.” This commenter asserted that through the qualitative leadership of the GSEs, homeownership opportunities are expanded and costs lowered for all potential purchasers, including those in more affordable markets.

With respect to the issue of leadership, Freddie Mac contended in its comments on the proposed rule that HUD misinterpreted the “leading the industry” statutory factor and asserted that “[t]here is no intimation in the Act or its legislative history that Congress intended industry leadership to be determined based on the enterprises purchases of goal-qualifying mortgages.” Moreover, Freddie Mac commented that the GSEs are statutorily mandated to “facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes.” Freddie Mac stated that the overall public purpose of the GSEs is to facilitate the operation of, and provide ongoing assistance to, the secondary market for residential mortgages. To the extent that the proposed goals inhibit or endanger Freddie Mac's ability to accomplish its general purpose of bringing liquidity and stability to the residential mortgage market, Freddie Mac contended that its ability to “lead the market” is in jeopardy. While the Department recognizes the degree of qualitative leadership provided by the GSEs, the Department also believes that their expertise and substantial financial resources allow them to lead quantitatively as well.

f. Need To Maintain the Sound Financial Condition of the GSEs

Based on HUD's economic analysis prepared for this final rule (Economic Analysis) and review by OFHEO, the Department has concluded that the Housing Goals in this final rule will not adversely affect the sound financial condition of the GSEs. Further discussion of this issue is found in the Economic Analysis.

3. Determinations Regarding the Levels of the Housing Goals

There are several reasons why the Department, having considered all the statutory factors as well as the comments on the May 3, 2004, proposed rule, is increasing the levels of the Housing Goals. The following sections describe these reasons and discuss and respond to comments received by HUD regarding the levels of the housing goals.

a. HUD's Market Analysis

Summary of Comments and HUD's Determination.

As part of the process of establishing goals, HUD estimates the size of the conventional conforming mortgage market. In this process, HUD separately analyzes the markets for several different categories of mortgage loans: single-family owner-occupied housing units, rental units in two-to-four unit properties where the owner occupies one unit, rental units in one-to-four-unit investor-owned properties, and rental units in multifamily (five or more units) properties. This categorization is necessary because the data sources differ for the various categories, and it is also desirable because goals-qualifying shares of units vary markedly by category. HUD described its methodology for analyzing each category in Appendix D to the proposed rule, and the GSEs commented on that analysis. Other commenters expressed concern about the magnitude of the goals, but did not discuss the analysis on which the goals calculations were based.

(i) Multifamily Share of the Mortgage Market

An important component of HUD's calculation process is estimating the number of multifamily units financed each year as a percentage share of the total number of dwelling units financed (often referred to as the “multifamily mix”); this is important because of the high proportions of multifamily units, which qualify for credit under all three goals. Section C of Appendix D to this Final Rule provides a detailed discussion of estimates of the size of the multifamily mortgage market, including estimates by HUD, the GSEs, and other researchers. As explained in Appendix D, comprehensive data on the annual volume of multifamily mortgage originations are much less available than similar data on single-family mortgage originations. This introduces a degree of uncertainty into the market sizing analysis and highlights the need for sensitivity analyses to show the effects of different multifamily mixes on the size of the goals-qualifying markets. As explained below, HUD's market analysis focused on multifamily mixes between 13.5 percent and 16.0 percent, with a baseline of 15 percent. This range and baseline is consistent with HUD's historical estimates of the multifamily mix reported in Table D.5b of Appendix D. For example, between 1995 and 2002, HUD estimated that the multifamily mix was in the 14-16 percent range.

In its comments, Fannie Mae estimated a multifamily mix of 12.3 percent, stating that HUD's range is too high for current conditions in the multifamily market. Fannie Mae cited the current high vacancy rates for multifamily properties and the fact that the population aged 20 to 34 will not begin to increase until after 2007; this age group tends to be predominantly renters. Fannie Mae also projected a low multifamily refinance volume, because of a recent peak in multifamily originations; these recent originations will not be able to refinance easily under their current contracts until 2008 or later.

At Freddie Mac's request, ICF Consulting also calculated the multifamily mix. In its best estimate, ICF projected an average of 14.2 percent over the 2005-2008 period, ranging between 13.7 percent and 14.7 percent in individual years, while recognizing that the actual outcomes may be higher or lower. ICF projected multifamily refinancings based on the number of units financed eight, nine, and ten years ago, because 10-year balloon mortgages are the most common multifamily mortgages, and prepayment possibilities are limited by yield maintenance agreements in their current mortgage contracts.

In Appendix D to this rule, HUD reviews the evidence provided by the GSEs in their comments. HUD notes that the 2001 Residential Finance Survey (RFS) has recently been published by the Census Bureau, and that the RFS provides higher estimates of the multifamily mix for 1999-2001 (the most recent years available) than either Fannie Mae or ICF. The RFS data and other data analyzed in Appendix D to this rule suggest that 15.0 percent is a reasonable baseline, particularly in a home purchase mortgage market environment, with a relatively small volume of refinanced mortgage originations. HUD also notes that the ICF average of 14.2 percent is fairly close to HUD's estimate of 15.0 percent. HUD therefore continues to use 15.0 percent as the best estimate of the

projected share of multifamily mortgages over the 2005-2008 period. HUD reports the goals-qualifying shares of mortgage originations on the basis of this estimate in Appendix D to this rule. HUD also publishes sensitivity analyses using other estimates of the multifamily mix, including 12.3 percent (Fannie Mae estimate), 13.5 percent (low end of HUD's range), 14.2 percent (ICF's best estimate), and 16.0 percent (high end of HUD's range). Using this range of multifamily mix estimates, the estimate of the goals-qualifying share of mortgage originations varies by about 1.5 to 2.5 percentage points for the low-mod goal, by about 1.0 percentage point for the underserved areas goal, and by about 1.2 to 1.7 percentage points for the special affordable housing goal. The estimate varies depending on other market factors.

As also discussed in Appendix D to this final rule, the multifamily mix is even lower during heavy refinance environments, as single-family owner refinance loans dominate both the market and the GSEs' purchases. This makes it more difficult for the GSEs to meet specific Housing Goal targets. As discussed in section b below of this preamble, HUD is soliciting public comments on how to structure and implement a regulatory provision to take account of the effects of high volumes of refinance loans in some years on the GSEs' ability to achieve the Housing Goals.

(ii) Single-Family Rental Share of the Mortgage Market

HUD also estimated the distribution of mortgage originations for single-family properties, defined as structures with one-to-four units. In Appendix D to this rule, HUD disaggregates single-family mortgage originations into three categories: those on owner-occupied single-family homes, those on structures with two to four units having one unit owner-occupied, and those on structures with one to four rental units owned by investors. HUD bases this categorization on the fact that the rental units in the latter two categories qualify at much higher rates for the housing goals.

HUD uses two data sources in Appendix D to estimate the size of the investor category, the Residential Finance Survey (RFS) and the Home Mortgage Disclosure Act database (HMDA). HMDA provides data only on the investor category. The investor share of HMDA single-family loans averaged 7.8 percent over 1993-2003, and 8.3 percent over the recent period of 1999-2003. The share of investor loans has also been rising for home purchase loans; it was 9.6 percent over 1993-2003 and 11.2 percent over 1999-2003. The RFS for 2001 reported a larger share of investor loans than HMDA, 13.4 percent compared to 7.8 percent. The RFS also reported larger investor shares for 1999 and 2000.

In the proposed rule, HUD estimated the investor share of the single-family market at 10 percent, based on HMDA data and the 2001 RFS, which was then the most recent available. HUD also considered alternatives of 8 percent and 12 percent. Both GSEs and ICF commented that HUD should use HMDA data rather than RFS data, and should use a lower investor share in setting the goals. While they agreed with HUD that the RFS provides the most accurate estimate of the true investor share of the market, they stated that lender reporting of investor loans to the GSEs is conceptually closer to HMDA data, which are based on lender reports. They commented that the actual opportunities available to the GSEs in the single-family investor loan market are best measured by data that lenders report, based on actual loan applications.

Fannie Mae stated that HUD's two highest alternatives exceed the highest investor share ever reported in HMDA. Fannie Mae cited research indicating a reporting bias in HMDA, due to “hidden investors.” At the time of loan origination, a property may be owner-occupied or intended for owner-occupancy, but may become rental shortly after origination. Fannie Mae stated that the same bias exists in its own reporting. The hidden investors cannot be identified at the time of origination.

Freddie Mac stated that investors have an incentive to claim falsely that they are owner-occupants because investor properties are subject to higher underwriting standards and loans tend to carry higher interest rates. Freddie Mac concluded that HUD should measure the opportunities that are actually available in the market to the GSEs, which are best measured by lender-reported HMDA data.

In this rule, HUD has adopted HMDA data as the basis for its calculation of the investor share of single-family mortgage originations. The GSEs make a valid argument that lender-reported data at the time of origination measures the investor loans that are available for them to purchase; HMDA provides that data. As discussed in Appendix D to this rule, HUD projects the investor share to be 8.5 to 9.0 percent (based on HMDA) during the 2005-2008 home purchase environments, rather than 10 percent. HUD also reports sensitivity analyses for higher and lower investor shares of 8.0 and 9.5 percent. Using this range of single-family investor share estimates, the estimate of the goals-qualifying share of mortgage originations varies by about 1.5 percentage points for the low-mod goal, and by 0.5 percent or less for the other two goals. The estimate varies depending on other market factors.

In the proposed rule, HUD estimated that the share of the single-family market consisting of two-to-four units properties with one unit owner-occupied was 2.0 percent of all single-family mortgages. This category is reported only in the RFS. The 2001 RFS reports that this category comprised 1.5 percent of all single-family mortgages. Because the RFS calculates a higher share of investor mortgages in the single-family market (13.4 percent) than HUD employs in this rule (8.5 to 9.0 percent), it is necessary to adjust the 2001 RFS figure upward.

The RFS reports that 85.1 percent of all single-family mortgages were for owner-occupied homes. The estimated share of two-to-four units properties with one unit owner-occupied in the single-family market is calculated at 1.73 percent (

i.e.

, 1.5 percent/[1.5 percent + 85.1 percent]). This figure lies between Fannie Mae's share of about 2.0 percent over 1999-2003 and Freddie Mac's share of about 1.5 percent. In this final rule, HUD uses a share of 1.6 percent. Sensitivity analyses for 2.0 percent are reported in Appendix D to this rule.

Similarly, the single-family owner-occupied share is adjusted upward to take account of the lower share of investor loans, from 85.1 percent to 89.9 percent.

The estimated market share range for each of the three goals categories is as follows: 51-56 percent for the Low- and Moderate-Income Goal, 35-39 percent for the Underserved Areas Goal, and 23-27 percent for the Special Affordable Goal. These estimates are one percentage point below the market ranges reported in the Proposed Rule, for the reasons discussed above and detailed in Sections F-H of Appendix D. The top ends of the market ranges were reduced as follows: from 57 percent to 56 percent for the low- and moderate-income market; from 40 percent to 39 percent for the underserved areas market; and from 28 percent 27 percent for the special affordable market. Accordingly, the 2008 goals were also reduced by one percentage point from those included in the Proposed Rule. In the Final Rule, the Low- and Moderate-Income Goal increases from 52 percent in 2005 to 56 percent in 2008, as

compared with an increase of 52 percent to 57 percent in the Proposed Rule. In the Final Rule, the Underserved Areas Goal increases from 37 percent in 2005 to 39 percent in 2008, as compared with an increase of 38 percent to 40 percent in the Proposed Rule. In the Final Rule, the Special Affordable Goal increases from 22 percent in 2005 to 27 percent in 2008, as compared with an increase of 22 percent to 28 percent in the Proposed Rule.

b. Attainability of the Goals in a High Refinance Environment

Summary of Comments.

A common theme of many of the public comments was concern about the volatility of the mortgage market and how such volatility makes setting Housing Goals a delicate and risky proposition.

These commenters indicated that the goals proposed by HUD would be unattainable, particularly in a high refinance environment when a large portion of the mortgage market is comprised of refinance loans rather than home purchase mortgages.

Fannie Mae and others suggested that including single-family refinance mortgages in goals calculations creates tension between liquidity goals and affordable housing goals by taking the emphasis away from increasing purchase money mortgages (and therefore homeownership) and placing the focus instead on meeting high goals.

Freddie Mac, several trade associations, a financial organization and consumer advocacy groups also expressed concern that inclusion of single-family refinances jeopardizes the GSEs' abilities to increase homeownership through acquisitions of purchase money mortgages because the focus would be on attaining goals rather than providing affordable home purchases for the target population.

One trade association, however, asserted that removing refinance mortgages from the goals calculations would only serve to encourage the GSEs to buy refinance loans instead of home purchase loans. By buying refinance loans, the GSEs could effectively ignore housing goals and both “jeopardize the safety and soundness of the GSEs due to the higher default rate of refinance loans and increase the minority housing gap due to the lower rate of minority borrowers for refinance loans.”

Other commenters suggested that the final rule should include mechanisms for making adjustments to the goals if there are changes in market conditions including a surge or drop in refinance volume. These commenters asserted that the GSEs' ability to successfully meet the goals should not be contingent upon interest rate stability. One suggestion that was offered for dealing with market mix fluctuations (

i.e.,

between home purchase and refinance loans) was to remove from both the numerator and denominator “any mortgage activity in excess of the percentage of home refinance loans used by HUD for estimating the size of this market (

i.e.,

above 35%).”

Another commenter stated that “HUD should simply set goals that require the GSEs to lead the market, whatever the market turns out to be.” This commenter explained that “if 50% of home purchase loans are to low-moderate income borrowers in 2005, then HUD should expect that a slightly higher percentage than this, say 51%, of Fannie's and Freddie's home purchase loans should fit in the purchase category of loans to low-moderate income borrowers.”

HUD's Determination.

This final rule retains the approach of the May 3, 2004, proposed rule, in which the level of each Housing Goal will increase year-by-year so that by 2008 each goal will match the top of the market range established in section 2.d, above.

The last three years have shown unprecedented volumes of refinance activity. For both GSEs, refinance loans accounted for 64 percent of all loans on single-family owner-occupied properties in 2001.

10

The refinance shares increased to 70 percent for Fannie Mae and 73 percent for Freddie Mac in 2002, and rose even further last year, to 79 percent for Fannie Mae and 82 percent for Freddie Mac. These unexpected record refinance rates made it more challenging for the GSEs to attain the housing goals in the past few years, as discussed elsewhere in this Preamble. The goals in HUD's proposed rule for the latter part of the 2005-2008 period would be even more challenging if (contrary to current expectations) very high refinance rates are experienced in those years.

10

By way of comparison, the refinance rate was 29 percent for both Fannie Mae and Freddie Mac in 2000.

HUD received a number of public comments seeking a regulatory solution to the issue of the ability of the GSEs to meet the housing goals during a period when refinances of home mortgages constitute an unusually large share of the mortgage market. HUD is not addressing the refinance issue as a regulatory change in this final rule. Elsewhere in today's

Federal Register,

HUD is publishing an Advance Notice of Proposed Rulemaking that advises the public of HUD's intention to consider by separate rulemaking a provision that recognizes and takes into consideration the impact of high volumes of refinance transactions on the GSEs' ability to achieve the housing goals in certain years, and solicits proposals on how such a provision should be structured and implemented. HUD believes that it would benefit from further consideration and additional public input on this issue. HUD also notes that FHEFSSA provides a mechanism by which HUD can take into consideration market and economic conditions that may make the achievement of housing goals infeasible in a given year. (

See

12 U.S.C. 4566(b).)

c. Bonus Points

The Housing Goals 2000 final rule provided for the award of bonus points (double credit) toward the Housing Goals for both GSEs' mortgage purchases that financed single-family, owner-occupied two-to-four unit properties and 5-50 unit multifamily properties. The rule also established a temporary adjustment factor (TAF) that awarded Freddie Mac 1.2 units credit for each multifamily unit in properties over 50 units for calendar years 2001 through 2003. (Congress increased the level of the TAF to 1.35 per unit under section 1002 of Public Law 106-554.)

The Housing Goals 2000 final rule made clear that both of these measures were temporary, intended to encourage the GSEs to increase their efforts to meet financing needs that had not been well served. During the three years for which the temporary bonus points and TAF were established, HUD expected the GSEs to develop new, sustainable business relationships and purchasing strategies for the targeted needs. Data indicate that, because both GSEs did increase their financing of units targeted by the bonus points and the TAF, the original objectives were met. The Department determined at the end of the three years (2001-2003) not to extend the bonus points or the TAF.

Summary of Comments.

A number of non-GSE commenters, including organizations representing affordable housing and consumer groups, trade associations, organizations representing racial and ethnic minorities, other organizations, and both Fannie Mae and Freddie Mac, recommended that the Department reinstate the award of bonus points for the GSEs which were established for 2001-2003 but which the Department did not continue after the end of 2003. Various non-GSE commenters, in addition to recommending reinstatement, also suggested that HUD develop new bonus point incentives for other unmet housing needs, such as manufactured

housing, rural housing, or tax credit properties or for particular groups,

e.g.

, Native Americans, other minority populations, or persons with disabilities.

Fannie Mae recommended that HUD provide bonuses for targeted business such as extremely low-income households,

i.e.,

those with incomes less than 30% of area median income (AMI); first-time homebuyers; manufactured housing; rural areas; and small multifamily properties. Freddie Mac suggested that instead of purchase money subgoals, the Department could provide bonus point incentives for these mortgages. Freddie Mac stated that the bonus points for two-to-four unit and 5-50 unit properties provided an extremely effective incentive. Freddie Mac indicated that other markets that could be assisted by bonus points are rural and manufactured housing. Freddie Mac noted that the Department's concern that bonus points obfuscate the GSEs' actual goals-qualifying performance is easily remedied by having the GSEs report two numbers, one with and one without the bonuses.

HUD's Determination.

The Department has fully considered the comments suggesting the re-introduction of bonus points, as well as other types of targeted incentives for the GSEs' mortgage purchases, and has determined not to reinstate the bonus points for the years covered by this rule. The position of the Department discussed in the preamble of the proposed rule (

see

69 FR 24228, 24232) remains unchanged; that is, the continued use of the bonus points “would only result in misleading information about the extent to which the GSEs are, in fact, meeting the Housing Goals.” In addition, the Department reiterates that the “decision to increase the levels of the Housing Goals substantially in a staged manner * * * and, at the same time, not renew the bonus points or TAF, will ensure that the GSEs continue to address the areas formerly targeted by these measures'' (

see

69 FR 24228, 24232).

d. Appropriate Levels of the Goals

In the May 3, 2004, proposed rule, HUD set the Goals to increase to levels at or near the high end of the estimated market range for each goal category by 2008. A large number of commenters expressed concern that these goal levels were set too high, and could have deleterious consequences for the mortgage market as a whole, or for specific sectors of the market.

Fannie Mae commented that a high allocation of affordable mortgage credit will take away from the broad middle class, especially in high-housing cost regions. For example, Fannie Mae asserted that if the special affordable housing goal had been set at 28 percent in 2003, then it would have needed to greatly curtail support to the overall market to meet that goal. Fannie Mae concluded that such manipulation does not promote stability and limits liquidity, and that it can shut out working middle class borrowers, contribute to higher interest rates and lower conforming loan limits.

Many commenters, including Freddie Mac, also claimed that setting the goals at a high percentage may lead to denominator management. They state that denominator management would occur if a GSE purposely abstained from buying mortgages in the markets that are not goals-eligible, rather than increasing its purchases in markets that are goals-eligible. Freddie Mac contended that this may be necessary if goals are set above the market percentage of available goal-qualifying loans. One financial institution observed that denominator management “will be exacerbated by the fact that the GSEs do not operate in the primary market and do not have any direct control over the origination strategies of their customers.”

In addition to the allocation problems discussed above, the GSEs stated that the liquidity requirements in their charters imply that they must stand ready to buy any and all conventional, conforming residential mortgages. They contend that denominator management is in direct conflict with these provisions, and goals set higher than market originations could force the GSEs to refuse to purchase mortgages that are not eligible. This, in turn, could reduce liquidity in the market. Knowing that the GSEs would no longer stand willing and able to purchase all conventional, conforming mortgages, other market participants might be less willing to hold these mortgages in their portfolios, and general liquidity would decline. The GSEs further asserted that changing market forces could cause swings in prices and trading volumes, and these temporary disturbances could create unstable markets, increase risk, and reduce the willingness of investors to invest in the sector. Thus, the GSEs maintained that denominator management decreases market stability.

The GSEs pointed to specific historical examples that describe their positive influence on stability. They maintained that during the 1990-1991 recession, the GSEs advised that they stood ready to purchase mortgages while many industry participants curtailed their purchase programs. Using historical trends in prices, the GSEs asserted that their presence in the mortgage market explains why mortgage-backed securities have a more stable price trend than commodity markets. They warned that because of denominator management resulting from unrealistic goals, they could not buy mortgage-backed securities and encourage stability in a financial crisis.

The GSEs further contended that if they reduce their willingness to buy non-goals eligible mortgages, it will be harder for borrowers whose incomes marginally exceed goals eligibility requirements to obtain financing since the two income-based Housing Goals compare the incomes of the borrower or resident to area median income. For example, the combined incomes in a working family may just disqualify that family's loan for eligibility under the low- and moderate-income goal even though each individual's income would not be considered to be affluent. The GSEs and other commenters provided examples of working families in the middle class, such as “teacher/fireman” households, that could encounter difficulties in financing a home.

Moreover, the commenters asserted that non-goal qualifying households may have higher costs associated with available financing since these mortgages would be less likely to be purchased by a GSE. Freddie Mac asserted that HUD did not take this into account in its cost/benefit analysis.

Furthermore, commenters claimed that denominator management may contribute to higher interest rates and, as a result, harm the precise borrowers that HUD is trying to help. These commenters stated that if denominator management reduces liquidity then the supply of mortgage funds will decline and interest rates will rise. The GSEs contended that if they are less willing to buy mortgages under all conditions, then investors will be less willing to provide funds to the market. As a result, the GSEs claimed that as investors seek out safer instruments, home mortgage interest rates will rise, and this rise in home mortgage rates will harm even those borrowers that are still goals-eligible.

Several commenters expressed concern about the effect of the goals on high cost markets. One commenter explained that while the goals are set with a national standard, a market level analysis “reveals a pronounced shortage of affordable mortgages in high cost housing markets.” Commenters stated that the GSEs' current loan purchasing patterns demonstrate that market affordability already has an impact on goals-related purchases. The

commenters expressed concern that high cost markets could see even tighter credit if the proposed goals are enacted.

The GSEs note that under HUD's May 3, 2004, proposed rule, the goal levels rise to levels at the top of HUD's market range in 2008 and stabilize there. They state that the projected market range concept is one in which HUD projects market levels of loans generated within each goal category will fluctuate within the range, depending on relative volumes of single-family refinance loans relative to other loans, interest rates and other macroeconomic and housing market conditions. The GSEs express the concern that, in any particular year, they could be confronted with goal levels that are several percentage points higher than the market percentages of goal-qualifying loans, or goal levels that are at the market percentages. The GSEs state that if HUD's proposed Housing Goals are retained, they foresee years when the goal levels will be attainable only by means of “denominator management” in which they limit their purchases of loans that do not qualify for the goals.

HUD's Determination.

Many of the comments expressed concern about the goal levels established for the last year or two of the period covered by this rule. In these years, the goals are set at the market levels estimated by HUD. Also, since they are the later years, market projections are necessarily more imprecise. In particular, the possibility of a decline in mortgage interest rates in those years raises the possibility of another boom in refinancing, and thus greater difficulty for the GSEs to meet the housing goals without denominator management. The comments relating to middle-income borrowers are predicated on the difficulty of foreseeing refinance volatility. Recent years have seen large unexpected home refinance rates. Since higher income homeowners disproportionately engage in refinancing, inclusion of refinance loans in the denominator increases the difficulty of GSE goals performance. A middle-income borrower just above the low/mod bracket would be less attractive to the GSEs in high refinance years. As noted in section II.C.3.b., HUD is considering in a separate rulemaking a provision that recognizes and takes into consideration the impact of high volumes of refinance transactions on the GSEs' ability to achieve the housing goals in certain years. HUD also notes that FHEFSSA provides a mechanism by which HUD can take into consideration market and economic conditions that may make the achievement of housing goals infeasible in a given year. (

See

12 U.S.C. 4566(b).)

With regard to the effects of the goals on high-cost markets, HUD notes that the overall presence of the GSEs in these markets depends on the conforming loan limit, which has been established by Congress for all states, including states deemed to be “high-cost areas.” With regard to HUD's housing goals more specifically, the low- and moderate-income and special affordable goals are based on borrower income relative to area median income, thus a mortgage for a lower-income family in a high-income metropolitan area will count towards the goals in the same manner as a mortgage for a lower-income family in a low-income area. Underserved areas are defined in terms of median family income in a census tract relative for median income in the area; thus a mortgage for a family living in a lower-income tract in a high-income metropolitan area will count towards the goals in the same manner as a mortgage for a family living in a lower-income tract in a low-income area. Thus HUD concludes that its housing goals will have no adverse impact on borrowers or neighborhoods in areas with high housing costs.

e. Consequences of the Goals for FHA

Fannie Mae, Freddie Mac, several trade associations, two advocacy groups and two financial institutions expressed concern over the impact HUD's proposed goals would have on the future solvency of the FHA program. One trade association asserted that “excessive goals will push GSEs to expand into the least-risky part of the FHA market and put into question FHA's long-term viability.”

The aforementioned commenters reiterated this point by stating that unrealistically high goals would compel the GSEs to increase competition with FHA for higher credit quality borrowers and would therefore further undermine the FHA program in the long-run. One advocacy group asserted that not only will these goals encourage the GSEs to compete with FHA more in the single family sector but in the multifamily sector as well.

Freddie Mac and Fannie Mae agreed that they would be compelled to more aggressively compete with FHA in procuring top-quality borrowers. Freddie Mac stated that the GSEs would take as many as “

1/3

of all FHA borrowers.” Freddie Mac and two trade associations further contended that such a loss to the FHA program would be seen in the increasing expenses to the remaining FHA borrowers. As the FHA program loses better quality loans to the GSEs, the result would be “higher fees to FHA borrowers or government subsidies to pay claims, effectively making FHA the lender of last resort,” said one trade association.

One financial institution stated that the so-called competition for goals-qualifying loans would not be between traditional conventional lenders vying for loans with a separate group of traditional FHA lenders, but rather an acceleration of product competition within a single group of existing lenders who originate for both markets. This commenter stated that 12 of the top 15 (by volume) FHA/VA lenders are also among the top 15 conventional lenders and indicated that the increased product competition would not result in a net increase in goals-qualifying loans, but in a shift from FHA to the GSEs of FHA's relatively lower risks.

HUD's Determination.

The Department agrees with many of these commenters that improvements in technology, such as the widespread use of commercial credit scores, mortgage scores, and automated underwriting systems, have fundamentally changed the way lenders process loan applications in recent years. Where once rules-based underwriting distinctions between prime conventional and FHA loans were fairly clear, in recent years, with the new technology, these distinctions have become blurred. For example, loan applications with payment-to-income ratios above conventional market guidelines were once clearly candidates for FHA financing because FHA would accept applicants with higher payment-to-income ratios. However, today, the same application would be processed using an automated underwriting system (AUS) that scores the application based on the totality of the application's risk factors. What once may have been an unacceptable payment-to-income ratio for a prime conventional loan may now be acceptable if the application contains offsetting low risks in other key areas such as borrower cash reserves, loan-to-value ratio, or commercial credit scores.

In addition to these technological changes, FHA made several changes to its underwriting guidelines in FY 1995 in order to promote increased homeownership opportunities among low-income and minority homebuyers. By doing so, FHA modestly increased the risk characteristics of its post-1995 books of business, but it succeeded in raising FHA's proportion of first-time homebuyers from 60.9 percent in fiscal year 1994 to 73.0 percent in fiscal year 2003. During the same period (fiscal years 1994 to 2003), FHA's proportion of minority borrowers increased from 24.8 percent to 33.0 percent, and has since remained at this level, or higher.

The new technology may allow the conventional market to identify lower risk loan applications that historically have come to FHA. However, the ability to identify risks does not, in and of itself, equate to shifts in market share from FHA to conventional lenders. Better pricing for borrowers by the conventional market is required to lure lower risk borrowers from FHA. If conventional lenders use the new technology to not only evaluate risks but also to price according to risk, then there may be some shift from FHA to the conventional market. Such a shift can produce tangible benefits for borrowers in the form of lower cost mortgage financing.

The Department does not believe it is FHA's mission to compete with the private sector. Rather, FHA's mission is to complement the conventional market, using FHA's cost of capital advantage where it can have the most benefit in creating homeownership opportunities for those households who might not otherwise be served by the prime conventional market.

HUD gauges the soundness of FHA's insurance funds in several ways. The statutorily mandated annual independent actuarial review of FHA's principal single-family insurance fund, the Mutual Mortgage Insurance Fund (MMIF), provides the Department, and the public, with an outside expert's estimate of the capital ratio of the overall fund, and the economic value of new business coming into the fund. The capital ratio indicates whether the existing books of business (current portfolio) are financially sound, while the economic value estimates of new business show whether if the marginal impact of new loans insured is adding or detracting from the financial health of the fund.

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Specifically, the Fiscal Year 2003 actuarial review estimated the economic value of the MMIF at the end of Fiscal Year 2003 to be $22.7 billion and the fund's capital ratio to be 5.21 percent—the eighth full year this ratio has exceeded the Congressionally mandated minimum of 2.0 percent. The economic value of new loans endorsed for insurance during 2003 was estimated by FHA's independent actuary to be $2.8 billion, indicating new business coming into FHA is further contributing to FHA's reserves.

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“Economic value” is the net present value of the fund's reserves plus expected future cash flows, and the “capital ratio” is economic value divided by insurance-in-force.

In comparison, the Fiscal Year 2002 actuarial review estimated the economic value and capital ratio of the MMIF at $22.6 billion and 4.52 percent, respectively. The increases in both measures for Fiscal Year 2003 were driven by the large positive economic value the actuary placed on a record dollar volume of new loans FHA insured in FY 2003 along with the rapid prepayment of older loans, keeping the end-of-year insurance-in-force (denominator of the capital ratio) down.

With regard to the GSEs taking multifamily business away from FHA, the Department notes that there are many differences between the types of multifamily mortgages FHA insures and those the GSEs purchase. For newly constructed multifamily properties, FHA insures the loan from the start of construction while GSE multifamily loan products generally do not. The GSEs do have forward commitment programs that can be used for new construction, but the purchase of the permanent loan by the GSEs generally requires the property to achieve minimum sustained occupancy levels, whereas FHA does not have this requirement. However, it is possible that the new goals will provide incentives for the GSEs to expand and refine their forward commitment products to be more attractive in the market for new multifamily housing. This could be a benefit to the market.

The greatest potential impact of the higher housing goals on FHA's multifamily business may come from a reduction in two of FHA's programs that address the purchase or refinance of existing properties. The first is the Section 223(f) program, which insures mortgages for the purchase or refinance of existing (over three year old) properties that are not currently financed with an FHA mortgage. This program accounted for about $0.8 billion in endorsements for FHA during Fiscal Year 2003, and is expected to produce about $0.5 billion in endorsements during Fiscal Year 2004. FHA's 223(f) business is estimated to be profitable to FHA—it is estimated to have a credit subsidy (net present value of all cash flows from the insurance contract at the time of endorsement) of negative 3.0%.

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The second is the Section 223(a)(7) program, which insures mortgages for FHA-to-FHA refinances—that is, the refinance of an existing FHA-insured mortgage. Section 223(a)(7) is used, for example, to refinance loans previously insured under FHA's most used programs—

i.e.

, Section 221(d)(4) new construction/substantial rehabilitation, and Section 223(f). FHA endorsed over $2.1 billion in Section 223(a)(7) loans during Fiscal Year 2003, and is expected to endorse about $1.4 billion during Fiscal Year 2004. As with the Section 223(f) program, FHA's Section 223(a)(7) program is also profitable to FHA—operating with an estimated negative credit subsidy of 2.2%.

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A negative credit subsidy of 3.0 percent means that the net present value of FHA's revenues (premiums, fees, recoveries from claims paid, etc.) will exceed the net present value of FHA's program costs (claims and related expenses) by 3.0 percent of the total insured mortgage amount.

If FHA does lose some multifamily market share from its purchase or refinance programs for existing housing as a result of the goals, it would not likely have any significant impact on FHA overall.

f. Consequences of the Goals for the Multifamily Market

Summary of Comments.

Several organizations commented on potential adverse consequences if the housing goals are set too high. Fannie Mae and Freddie Mac, among others, cited the recent high vacancy rates for multifamily rental housing as an example that increased lending by the GSEs at this time would encourage overbuilding.

Others stated that the multifamily market is already flush with capital and that inappropriate goals could promote overly aggressive bidding for loans and reckless lending.

One trade association stated that the increased presence of the two GSEs would promote a duopsony (a market with only two buyers) that would hinder competition in the multifamily mortgage market.

Other commenters suggested that increased loan purchases by the GSEs would skim the highest credit-quality loan from other mortgage lenders, and reduce the credit quality of multifamily loans remaining in the portfolios of pension funds or insured through FHA.

Another commenter stated that increased goals pressure on the GSEs would cause them to concentrate on large properties, where a single loan would contribute more toward goal attainment.

HUD's Determination.

One of HUD's objectives in promulgating this final rule is to promote the availability of mortgage credit to affordable properties at the lowest possible cost. It is not the intent of this rule to promote the maximum flow of credit to this market, regardless of housing and mortgage market conditions.

Increased competition for business, as intended by the rule, should bring benefits to borrowers, and therefore renters, through lower interest rates and more attractive non-price terms. Such increased competition does not imply impaired credit quality or lax

underwriting. As the GSEs compete more aggressively for multifamily business and gain market share, the market will not necessarily grow one-for-one with every additional loan purchased by the GSEs. It is likely that the market impacts will be more on the pricing of multifamily credit and less on the volume of credit supplied. Lower pricing of credit in and of itself does not promote overbuilding; its one unambiguous effect is to reduce the cost of supplying housing to consumers.

Demand for multifamily mortgages will be responsive to cyclical macroeconomic factors. Beyond these influences, demand for multifamily housing will be supported by favorable demographics. In its comments on the proposed rule, Fannie Mae highlighted the prospective growth in the number of people ages 20 through 34 in arguing that the demographics do not become clearly favorable to rental demand until late in this decade. But fewer than half of all renter households are headed by someone of this age, and more comprehensive estimates and projections suggest a steadier path of moderate growth in the demographic component of demand for multifamily housing.

Interest rates clearly will be important for the future path of mortgage lending, as noted by Fannie Mae, Freddie Mac, and other commenters. The historically low interest rates of recent years have spurred lending in both the multifamily and single-family markets. If interest rates should rise in the future, the volume of mortgage lending presumably would be lower than if rates were to remain at current levels. But the effect of higher rates on the GSEs' ability to achieve the housing goals is less clear. Because the goals are established in terms of shares of the GSEs' business, rather than levels, a key question is how higher interest rates would affect the relative demand for single-family and multifamily mortgage credit. Because of differences in prepayment provisions and other characteristics between single-family and multifamily mortgage lending, multifamily credit demand might drop off proportionally less than would single-family credit demand in response to higher rates.

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This in turn would make it easier to attain the goal levels if interest rates were to increase from current levels.

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This is suggested by recent experience of below-average multifamily mix in years where the volume of single-family refinancings has been high. Further support is provided by evidence of a relationship between interest rates and the multifamily share of the net change in residential mortgage debt between 1975 and 2002.

Regarding the market structure implications of increased GSE multifamily activity, HUD estimates that the GSEs purchased slightly less than one-third of the dollar volume of conventional multifamily loan originations during 2001-2003 (see Table D.2). There is room for increasing this market share without producing the duopsony alluded to in the previously cited comments. Furthermore, if the GSEs do increase their market penetration, it is because they are offering multifamily borrowers more attractive products or pricing than are their competitors, including the pension funds and FHA programs alluded to by some commenting organizations. The borrower and, ultimately, the rent-paying affordable housing resident benefit from these more attractive products and pricing.

In summary, the Department's determination is that the Housing Goal levels established by this rule are prudent and will improve the availability and pricing of credit for affordable multifamily properties. For the reasons stated above, it is the Department's view that the rule will not have the adverse consequences mentioned in some comments on the proposed rule.

g. Consequences of the Goals for the Single-Family Rental Market

Summary of Comments.

Several community organizations raised concerns about encouraging the single-family rental market. They asserted that the goals should target families who want to live in the financed houses, as opposed to the investors who purchase these homes. In these commenters' view, investors take affordable housing stock off the market, which raises the price for low and moderate-income first-time homebuyers. They claimed that homeownership should be stressed because home equity is a large component of the disparity that exists in household net wealth between ethnic groups.

Some commenters cited studies that suggest homeownership has beneficial neighborhood effects relative to investor-owned properties. According to one cited study, absentee landlords are much more likely to let housing stock decline but homeowners are much more likely to invest in the upkeep of their homes. In the view of one of these organizations, the incentives that the GSEs receive for rental housing should be to promote multifamily developments, not single-family homes.

HUD's Determination.

HUD considered many factors related to the single-family rental market. Single-family rentals are another source of affordable housing. Also, the capital provided by investors can help maintain demand for single-family homes in underserved neighborhoods. While some commenters complained that this raises the cost to first-time homebuyers, investors also help to maintain the liquidity and value of owner-occupied homes. Further, there are some investors who make it their business to renovate the housing stock and resell the properties. On balance, HUD found no compelling evidence that single-family rentals should be excluded from goals eligibility.

h. Consequences of the Goals for the Subprime Market

Summary of Comments.

Both GSEs indicated that they would need to increase their purchase of subprime loans to meet the higher goals. Freddie Mac stated that the increased affordable housing goals created tension in its business practices between meeting the goals and conducting responsible lending practices.

In the past, Fannie Mae and Freddie Mac have voluntarily decided not to purchase subprime loans with features such as single-premium life insurance and prepayment penalty terms that exceed three years, or to purchase loans subject to the Home Ownership and Equity Protection Act (HOEPA). Freddie Mac indicated that the increased goals would limit its ability to influence subprime lending practices. More specifically, Freddie Mac claimed that, to meet the higher housing goals, it might not have the option in the future of turning away subprime loans that have less desirable loan terms than the subprime business it currently purchases.

Several commenters suggested that if the GSEs are pushed to serve more of the subprime market, they will skim a significant portion of the lower-risk borrowers from that market. The resulting smaller subprime market would include the neediest borrowers. The commenters stated that these higher risk borrowers would pay more because lower risk borrowers would not be present to subsidize them, and the market's high fixed costs would be distributed across fewer borrowers.

One industry group also suggested that a significantly smaller subprime market for private lenders would drive some lenders out of business and translate into less competition.

While some industry commenters welcomed the entrance of the GSEs into the subprime market because their presence would bring stability and standardize business practices, the

commenters also expressed concern that unrealistically high goals could force the GSEs to jump into the market in a manner that negatively distorts underwriting and pricing. These commenters contended that the GSEs could bring capital and standards up, but that they must gradually and carefully enter the subprime market to have a positive effect. They strongly urged HUD to lower the goals to encourage the GSEs to expand their subprime activities at a measured pace.

Some commenters suggested that bonus points, or other incentives for the GSEs' purchases of certain nonprime loans, could foster more deliberate and prudent purchases by the GSEs of subprime loans. One lender also suggested that incentives could be granted to the GSEs for other underserved market segments, such as manufactured homes, minority first time buyers, and nonprime first-time buyers.

HUD's Determination.

To date, the GSEs' involvement in the subprime market has benefited two types of borrowers: “A” risk and “near A” risk. The first group consists of borrowers with risk profiles similar to “A” borrowers, but receive mortgages from a subprime lender. The GSEs” outreach and education efforts increase the likelihood that “A” borrowers will use cheaper prime lenders for refinance mortgages, and reduce their reliance on subprime firms. The second group, borrowers who are near A credit risks, has growing access to mortgage products offered by the GSEs as these borrowers are increasingly served by GSE seller/servicers.

The GSEs have been prudent in their pursuit of subprime lending, focusing on the top part of the market, the “A-minus” and “Alt A” segments. A-minus mortgages are typically those where borrowers have less than perfect credit. Alt A mortgages are originated to borrowers who cannot document all of the underwriting information in the application but generally have FICO scores similar to those in the prime market. The GSEs' subprime products are integrated into their automated underwriting systems and are approved based on mortgage scoring models. These models have proven over the years to be an effective tool in limiting risk layering. The GSEs charge lenders higher fees for guaranteeing these loans. As a result these higher risk loans are priced above those offered to prime borrowers but below what subprime lenders would otherwise charge for these loans.

The GSEs' presence in the subprime mortgage market benefits many low-income and minority borrowers whose risk profiles differ markedly from borrowers who qualify for prime mortgage products. Millions of Americans with less than perfect credit or who cannot meet some of the tougher underwriting requirements of the prime market for reasons such as inadequate income documentation, limited downpayment or cash reserves, or the desire to take more cash out in a refinancing than conventional loans allow, rely on subprime lenders for access to mortgage financing. If the GSEs reach deeper into the subprime market, more borrowers will benefit from the advantages that greater stability and standardization create.

i. Consequences of the Goals for Mortgage Defaults; Neighborhood Impacts

Summary of Comments.

HUD received several comments concerning the impact of mortgage default rates on neighborhoods. Comments from mortgage insurance companies highlighted that the higher goals will likely lead to more expanded affordable housing products as well as higher foreclosures. Affordable products present challenges to borrowers and lenders. For borrowers, qualifying for an affordable mortgage does not insure they have a clear understanding of the risks of homeownership. Where aggressive affordable products are aimed at qualifying borrowers for home loans rather than qualifying families for homeownership, lenders need to be cautious of products that test the limits of borrowers' credit capabilities. Affordable products that have been introduced into the market under favorable economic conditions can experience increasing defaults and foreclosures during periods of higher interest rates, higher unemployment and/or lower house price appreciation rates. One commenter indicated that 15 percent or more of borrowers in some affordable housing products could experience default in an economic downturn.

As defaults on affordable products rise, inner city neighborhoods can be especially hard hit. A large number of foreclosures in an area may lead to abandoned properties. While foreclosures devastate borrowers who lose their homes and damage borrowers' credit history, foreclosures also weaken the neighborhoods where the properties are located.

The potential for affordable lending products to result in higher foreclosure during a less prosperous economic environment was echoed in Freddie Mac's comments. Its comment discussed how too many defaults in one neighborhood can lead to serious blight and disinvestment in the community. One commenter recommended that HUD establish safeguards against aggressive affordable products. The commenter suggested that HUD deny Housing Goal credit for GSE mortgage purchases that experience early-term serious defaults (

e.g.,

delinquent 90 days or longer within 12 months of the date of origination).

The GSEs and community groups cautioned that the struggle to meet high goals for low-income groups could cause the GSEs to relax underwriting standards and/or extend loans to people who are unprepared. For example, the commenters pointed out that FHA default rates are higher than the conventional conforming market. High goals would encourage the GSEs to enter markets served by FHA. This incentive to extend credit to unprepared low-income people would rise if unexpected refinances decreased the proportion of goals-eligible units produced in the market.

HUD's Determination.

HUD carefully reviewed the comments regarding mortgage default rates. The Department believes that the GSEs' presence in underserved markets will be beneficial for neighborhoods. The GSEs have improved their underwriting methods to better identify risks in these markets, and also have instituted homebuyer education programs. An increased role for the GSEs' seller-services in inner-city neighborhoods will improve competition, reduce high-cost lending, and reduce predatory lending. As described in Appendix A, families living in inner-city, high-minority neighborhoods often have to rely on subprime lenders as their main source of mortgage credit. Studies indicate that many of these borrowers obtaining high-cost loans could qualify for lower-cost, prime mortgage credit. An active GSE effort in these neighborhoods will encourage traditional, mainstream lenders to increase their lending activities in these historically underserved areas. This will offer additional funding options for those lower-income and minority borrowers who today may have to take out a high-cost loan in order to purchase or renovate a home or to refinance an existing mortgage. Reductions in predatory lending reduce the costs of mortgages and the chances of default. As a result, the Department believes that GSE participation is a net benefit to lower income neighborhoods.

j. Consequences of the Goals for Residents of Puerto Rico

Summary of Comments.

Several associations stated that HUD's proposed affordable housing goals could be disadvantageous to residents of Puerto Rico, alleging that less than 10 percent of loans that are originated in the Puerto Rican market would qualify for the goals. These commenters were concerned that the GSEs might be unable to buy loans from Puerto Rico, and urged HUD to take special measures to ensure that owner and rental housing production are not deleteriously affected by the demographic and economic differences that exist between the mainland markets and the Puerto Rico market.

HUD's Determination.

Loans purchased by the GSEs for properties in Puerto Rico are counted in the same manner as loans purchased on properties in any other location. Since underserved areas are defined as low-income and/or high-minority census tracts in metropolitan areas or counties in non-metropolitan areas, the overwhelming majority of loans purchased by the GSEs on properties in Puerto Rico count toward that goal. In fact, in 2003, Fannie Mae reported that 95 percent of the units it financed in Puerto Rico qualified for the underserved areas goal; the corresponding figure for Freddie Mac was 98 percent.

Relatively few of the loans in Puerto Rico that are purchased by the GSEs qualify for the two income-based goals. Despite this, HUD does not believe that the final housing goals will adversely affect Puerto Rico. In 2003, Puerto Rico accounted for only 0.2 percent of all units financed by Fannie Mae and only 0.1 percent of all units financed by Freddie Mac. Thus overall performance on these broad national goals is not materially affected by the characteristics of loans purchased by the GSEs in Puerto Rico.

Apparently many lower-income families in Puerto Rico rely on consumer finance companies for financing their homes. Since such financing is typically more expensive to borrowers than traditional mortgages, this suggests that the GSEs could play an important role, working with mortgage originators, to better develop the mortgage market in Puerto Rico.

4. Determinations Regarding the Specification and Levels of the Home Purchase Subgoals

a. Overview

Given that the past average performance of the GSEs in the home purchase market has been below market levels, and the Administration's emphasis on increasing homeownership opportunities, including those for low- and moderate-income and minority borrowers, HUD proposed to set Home Purchase Subgoals for GSE mortgage purchase activities to increase financing opportunities for low- and moderate-income, underserved, and special affordable borrowers who are purchasing single-family homes.

Specifically, the Department proposed Home Purchase Subgoals for home purchase loans that qualify for the Housing Goals. The purpose of the Home Purchase Subgoals is to ensure that the GSEs focus on financing home purchases for the homeowners targeted by the Housing Goals. The Department believes that the establishment of Home Purchase Subgoals will place the GSEs in an important leadership position in the Housing Goals categories, while also facilitating homeownership. The GSEs have years of experience in providing secondary market financing for single-family properties and are fully capable of exerting such leadership.

The focus of these Subgoals on home purchase loans meeting the Housing Goals will also help address the racial and income disparities in homeownership that exist today. As noted earlier, although minority homeownership has grown, the homeownership rate for African-American and Hispanic families is still approximately 25 percentage points below that for non-Hispanic white families. The focus of the Subgoals on home purchase will also increase the GSEs' support of first-time homebuyers, a market segment where they have lagged primary lenders.

Summary of Comments.

Fannie Mae claimed that the proposed Subgoals are not necessary and are, in fact, duplicative of the broader goals structure. Fannie Mae asserted that it is already a leader in financing home purchases, even in a period of aggressive refinancings. In addition, Fannie Mae stated that subgoals add complexity to the mortgage market and contribute to a loss of liquidity, and suggested that the proposed Subgoals do not reflect recent market experience because affordability may decline and HUD may mistreat missing data when formulating subgoals. Fannie Mae also stated that HUD improperly exercised its authority in proposing the Subgoals.

Specifically, Fannie Mae contended that a complex subgoal structure harms liquidity and that when Fannie Mae needs to stretch in one market to meet a goal, it may have to reduce its willingness to purchase mortgages in another market. Fannie Mae stated that conflicts between the goals arise because the goals are set as a percentage of business, and fulfilling the numerator of one goal adds to the denominator of the other goals. Fannie Mae asserted that the GSEs could be forced to abstain from buying non-goal eligible mortgages that would count in the denominator, but that would not benefit its calculation of goals performance in the numerator. In Fannie Mae's view, its own abstention from buying implies an illiquid market.

Other commenters affirmed Fannie Mae's comments and expressed concern that, given the market leadership of the GSEs, the manner in which home purchases are counted toward the Subgoals could distort the lending market.

In addition, both Fannie Mae and Freddie Mac asserted that FHEFSSA requires that HUD consider each of the six statutory factors set forth in sections 1332(b) and 1334(b) of the statute in setting the levels of any Subgoals within those Housing Goals. Freddie Mac objected to the home purchase Subgoals because it claimed these Subgoals would constitute micromanagement of the GSEs' business decisions. Freddie Mac also noted that, in the past, HUD has declined to implement subgoals for that very reason.

Several commenters expressed the view that HUD had overestimated available purchase money mortgages and noted that if Subgoals on these types of mortgages are set too high, adverse market distortions will occur.

Other commenters contended that, regardless of the level of the Subgoals, a subgoal that targets home purchase mortgages unfairly allocates credit toward home buying rather than mortgage refinances. These commenters asserted that this credit allocation is unfair in that it penalizes borrowers who want to lower mortgage costs or improve their homes. They also contended that credit allocation that promotes purchase mortgages could push refinance borrowers into high-cost loans rather than conforming, GSE-eligible mortgages. To combat such effects, one organization suggested separate subgoals for both purchase money mortgages and refinances, with the overall low- and moderate-income goal as the weighted average of the different subgoals.

Commenters also objected to mortgage purchase subgoals targeting only those loans originated in metropolitan areas because this geographic limitation allocates credit at the expense of residents of rural communities. The commenters stated that Congress

charged the GSEs in their charters to “promote access to mortgage credit throughout the Nation (including central cities, rural areas, and underserved areas).” One commenter stated that the lack of detailed HMDA data in rural areas makes market size estimates difficult, but suggested that other data from private vendors could provide acceptable measures (without offering any specific sources).

HUD's Determination.

Home purchase is a high national priority. The comments received and research reviewed document many studies revealing the desire of Americans to own their own home. HUD finds that the proposed home purchase subgoal furthers the statutory objectives of FHEFSSA. HUD set the level of the home purchase subgoal prudently. Details of HUD's methodology are found in Appendices A and D of this final rule and in chapter 3 of the Economic Analysis that accompanies the rule. Rather than distorting the market, the home purchase subgoal facilitates the desire of many Americans to use the market to acquire their own home.

Several commenters asked HUD to extend the counting for the home purchase subgoal to rural areas even though data for rural areas is sparse. HUD disagrees. Although HMDA data for rural areas has improved, it is still too incomplete to support extending the counting system. Alternative sources from private lenders are similarly flawed. While HMDA's reporting of non-metropolitan areas has improved over the years, it continues to be unreliable. In 2001, 3,757 (3,280 of which were small banks) of the 4,394 non-metropolitan-area banks did not report under HMDA. In that same year, 324 (246 of which were small thrifts) of the 458 non-metropolitan-area thrift institutions did not report under HMDA.

Except for Fannie Mae's recent performance in the Special Affordable and Low- and Moderate-Income categories, the GSEs have lagged the market in purchasing single-family, owner-occupied loans that qualify for the Housing Goals. In 2003, Fannie Mae continued to lag the market in financing properties located in underserved areas while Freddie Mac lagged the market in all three goals-qualifying categories. The Department's analysis reveals that there is ample room for both Fannie Mae and Freddie Mac to improve their performance in purchasing home loans that qualify for the Housing Goals, particularly in important market segments such as the minority, first-time homebuyer market.

Both GSEs' funding of mortgages for first-time homebuyers lags the market's provision of funding for these families, and the lag is particularly large for first-time minority homebuyers. Table 2 compares the GSEs' funding of mortgages for first-time homebuyers with market loan originations for first-time homebuyers. This table shows that first-time homebuyers represented 37.6 percent of market loan originations, compared with 26.5 percent of the GSEs' purchases; thus, the GSEs fell substantially short of the market originations ratio for first-time homebuyers, over the period 1999-2001.

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For minority first-time homebuyers, the GSE ratio was 6.2 percent, compared to a market originations ratio of 10.6 percent. For African-American and Hispanic first-time homebuyers, the GSE ratio was 3.8 percent, compared to a market originations ratio of 6.9 percent. For first-time homebuyers, particularly first-time minority homebuyers, both GSEs substantially lag the private conventional conforming market.

As detailed in Appendix A to this rule, evidence suggests that there is a significant population of potential homebuyers who are likely to respond well to increased homeownership opportunities produced by increased GSE purchases in this area. Immigrants and minorities, in particular, are expected to be a major source of future homebuyers. Furthermore, studies indicate the existence of a large untapped pool of potential homeowners among the rental population. Indeed, the GSEs' recent experience with new outreach and affordable housing initiatives confirms the existence of this potential.

The Department therefore is establishing through this rule Subgoals for home purchase loans that qualify for the three Housing Goals to encourage the GSEs to take a leadership position in creating homeownership financing opportunities within the categories that Congress expressly targeted with the Housing Goals.

b. HUD's Determinations Regarding the Home Purchase Subgoals

Under FHEFSSA, HUD is authorized to establish nonenforceable Subgoals within the Low- and Moderate-Income Housing Goal and the Underserved Areas Housing Goal. HUD also is authorized under FHEFSSA to establish enforceable Subgoals within the Special Affordable Housing Goal. The Administration has proposed, as part of GSE regulatory reform, that Congress authorize HUD to establish a separate Home Purchase Goal that would include enforceable components. Pending the enactment of any such legislation, HUD is establishing the Home Purchase Subgoals described in this final rule under its current statutory authority.

HUD stated in the preamble to the proposed rule that in setting a subgoal, “[c]urrent law does not require that HUD consider the statutory factors set forth in FHEFSSA prior to establishing or setting the level of Subgoals.” (69 FR 24244.) HUD's interpretation of this portion of FHEFSSA is unchanged. Each of the subsections identifying the factors for consideration indicates that the factors are to be considered in setting each respective goal; no mention is made of the subgoals. However, despite the absence of any statutory requirement to consider the listed factors in setting the levels of the subgoals, HUD has nevertheless carefully considered each of these factors in setting the subgoal levels in this final rule.

The following sections provide an overview of HUD's reasons for establishing the Subgoals, which are detailed in the Appendices to this rule.

(i) The GSEs Have the Ability To Lead the Market

The GSEs have the ability to lead the primary market for mortgages on single-family owner-occupied properties, which are the GSEs' principal line of business. Both GSEs have long experience in the home purchase mortgage market, and therefore there is no issue of the degree to which they have penetrated this market. In addition, because the Subgoals focus on homeownership opportunities and, thus, do not include refinance loans, there is no issue regarding potentially large year-to-year changes in refinance mortgage volumes, which affect the magnitude of the denominator in calculating performance percentages under the Housing Goals, as experienced in the heavy refinance years of 1998 and 2001-2003.

Both GSEs have not only been operating in the single-family owner mortgage market for years, they have been the dominant players in that market, funding 57 percent of mortgages on single-family owner-occupied residences financed between 1999 and 2002. As discussed in Section G of Appendix A to this rule, their underwriting guidelines are industry standards and their AUS are widely used in the mortgage industry.

(ii) The GSEs' Performance Relative to the Market

Even though the GSEs have had the ability to lead the home purchase market, their past average performance (1993-2003, 1996-2003, and 1999-2003) has been below market levels. During 2002 and 2003, Fannie Mae improved its performance enough to lead the special affordable and low-mod markets for home purchase loans, but Fannie Mae continued to lag the primary market in funding homes in underserved areas. The subgoals will ensure that Fannie Mae maintains and further improves its above-market performance in the special affordable and low-mod markets, and also becomes a market leader in funding underserved areas. Freddie Mac, although it has also improved its recent performance, continues to lag behind the primary market on all housing goal categories. The subgoals will ensure that Freddie Mac erases its gaps with the market and takes a leadership position as well. The type of improvement needed for Freddie Mac to meet these new subgoals was demonstrated by Fannie Mae during 2001-2003. For example, Fannie Mae increased its low-mod purchases from 40.8 percent of its single-family-owner business in 2000 to 45.3 percent in 2002 to 47.0 percent in 2003.

(iii) Disparities in Homeownership and Credit Access Remain

HUD notes that there remain troublesome disparities in our housing and mortgage markets, even after the “revolution in affordable lending” and the growth in homeownership that has taken place since the mid-1990s. As noted previously in the discussion of the goals, the homeownership rate for African-American and Hispanic households remains 25 percentage points below that of white households. In 2002, the mortgage denial rate for African-American borrowers was over twice that for white borrowers, even after controlling for the income of the borrower.

HUD also notes that there is growing evidence that inner city neighborhoods are not always being adequately served by mainstream lenders. Some have concluded that a dual mortgage market has developed in our nation, with conventional mainstream lenders serving mainly white families living in the suburbs and FHA and subprime lenders serving minority families concentrated in inner city neighborhoods. In addition to the unavailability of mainstream lenders, families living in high-minority neighborhoods generally face many additional hurdles, such as lack of cash for a downpayment, credit problems, and discrimination.

Immigrants and minorities are projected to account for almost two-thirds of the growth in the number of new households over the next ten years. As emphasized throughout this preamble and the Appendices to this rule, changing population demographics will result in a need for the primary and secondary mortgage markets to meet nontraditional credit needs, respond to diverse housing preferences and overcome information and other barriers that many immigrants and minorities face. HUD finds that the GSEs must increase their efforts towards providing financing for these families.

(iv) There Are Ample Opportunities for the GSEs To Improve Their Performance in the Home Purchase Market

Home purchase loans that qualify for the Housing Goals are available for the GSEs to purchase, which means they can improve their performance and lead the primary market in purchasing loans for lower-income borrowers and properties in underserved areas. Three indicators of this have already been discussed.

First, the affordable lending market has shown an underlying strength over the past few years that is unlikely to vanish (without a significant increase in interest rates or a decline in the economy). Since 1999, the shares of the home purchase market accounted for by the three Housing Goal categories are as follows: 16.3 percent for special affordable, 31.4 percent for underserved areas, and 44.1 percent for low- and moderate-income.

Second, market share data reported in section G of Appendix A to this rule show that almost half of newly-originated loans that qualify for the Housing Goals are not purchased by the GSEs. As noted above, the situation is even more extreme for special sub-markets, such as the minority first-time homebuyer market where the GSEs have only a minimal presence. In terms of the overall mortgage market (both conventional and government), the GSEs funded only 24 percent of all first-time homebuyers and 17 percent of minority first-time homebuyers between 1999 and 2001. Similarly, during the same period, the GSEs funded only 40 percent of first-time homebuyers in the conventional conforming market, and only 33 percent of minority first-time homebuyers in that market.

Finally, the GSEs' purchases that can count toward the Subgoal are not limited to new mortgages that are originated in the current calendar year. The GSEs can purchase loans from the substantial, existing stock of affordable loans held in lenders' portfolios, after these loans have seasoned and the GSEs have had the opportunity to observe their payment performance. In fact, based on Fannie Mae's recent experience, the purchase of seasoned loans is at present one strategy employed for purchasing Housing Goals-qualifying loans and meeting the goals.

The current low homeownership rate of minorities and others living in inner cities suggests that there will be considerable growth in the origination of CRA loans in urban areas. For banks and thrifts, selling their CRA originations will free up capital to make new CRA loans. As a result, the CRA market segment provides an opportunity for the GSEs to expand their affordable lending programs. As explained in Appendix A to this rule, Fannie Mae and Freddie Mac have already started developing programs to purchase CRA-type loans on a flow basis as well as after they have seasoned.

While the GSEs can choose any strategy for leading the market, this leadership role can likely be accomplished by building on the many initiatives and programs that the enterprises have already started, including: (1) Their outreach to underserved markets and their partnership efforts that encourage mainstream lenders to move into these markets; (2) their incorporation of greater flexibility into their purchase and underwriting guidelines, (3) their development of new products for borrowers with little cash for a downpayment and for borrowers with credit blemishes or non-traditional credit histories; (4) their targeting of important markets where they have had only a limited presence in the past, such as the markets for minority first-time homebuyers; (5) their purchases of both newly-originated and seasoned CRA loans; and (6) their use of automated underwriting technology to qualify creditworthy borrowers that would have been deemed not creditworthy under traditional underwriting rules.

The experience of Fannie Mae and Freddie Mac in the subprime market indicates that they have the expertise and experience to develop technologies and new products that allow them to enter new markets in a prudent manner. Given the innovativeness of Fannie Mae and Freddie Mac, other strategies will be available as well. In fact, a wide variety of quantitative and qualitative indicators suggest that the GSEs have the expertise, resources and financial strength to improve their affordable lending performance enough to lead the home purchase market for special affordable, low- and moderate-income, and underserved areas loans. The recent improvement in the affordable lending performance of the GSEs, and particularly Fannie Mae, further demonstrates the GSEs' capacity to lead the home purchase market.

c. Structure and Levels of the Home Purchase Subgoals

Under this rule, performance on the Home Purchase Subgoals will be calculated as Housing Goal-qualifying percentages of the GSEs' total purchases of mortgages that finance purchases of single-family, owner-occupied properties located in metropolitan areas, based on the owner's income and the location of the property. Specifically, for each GSE the following Subgoals would apply. (A “home purchase mortgage” is defined as a residential mortgage for the purchase of an owner-occupied single-family property.)

• 45 percent of home purchase mortgages purchased by the GSE in metropolitan areas must qualify under the Low- and Moderate-Income Housing Goal in 2005, with this share rising to 46 percent in 2006 and 47 percent in both 2007 and 2008;

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