The Distorted DNA of Your Community
You are made principally of carbon. So is every other living thing on earth, from plants to animals to bacteria and DNA itself. There is a reason for this: At a molecular level, carbon is a really flexible element. It can bind with and be adapted to other elements in many different ways. The stunning diversity of living organisms that we experience is only possible because of the flexibility of life's most essential building block: carbon.
What if carbon were not as flexible? What if it didn't have four electrons and thus could not form double and triple bonds or the many complex chains of carbon atoms that we find in life? What we'd see is that life -- if it formed at all -- would have far less diversity. There would be much less variation, much less ability to adapt and, thus, life itself would be far more fragile than we have come to experience it.
The DNA of our cities is composed of many things, but a principle component is financing. The way we finance buildings -- the options that are made available in the marketplace -- shapes everything else. Make those options flexible and we'll get a broad diversity of housing types, styles and price points in an adaptable marketplace. Make those options rigid and narrowly-focused and we'll get large distortions in supply and demand along with communities that are inherently fragile.
“If you’re frustrated about the lack of choice in housing, distorted pricing, issues of affordability, gentrification and blight, you’re going to want to pay attention this week.”
This week at Strong Towns we are going to focus on the findings of a report published by Regional Plan Association. The report identifies a very narrow set of federal housing rules that were adopted during the Great Depression. These rules came about for logical reasons but, played out over subsequent generations, have created incredible distortions in the U.S. housing market. If you're frustrated about the lack of choice in housing, distorted pricing, issues of affordability, gentrification and blight, you're going to want to pay attention this week. We're going to explain the financing element that shapes the DNA of your community.
The National Housing Act of 1934 was passed during the depths of the Great Depression. The act created the Federal Housing Administration (FHA), an organization that sought to stabilize housing prices. Before the FHA, home financing was primarily handled by local banks. To limit risk, those local banks (which were investing the savings of other community members) kept mortgage terms short -- three to five years -- and required really high down payments in order to maintain a safe loan to value ratio. When housing prices fell, banks refused to offer refinancing without additional capital -- which many did not have -- and lots of homeowners were driven into foreclosure. An excess supply of repossessed houses along with a lack of people able to make huge down payments only accelerated the decline.
As part of the New Deal, the FHA offered insurance to local banks which allowed them to issue mortgages with less money down and longer payment terms. The immediate effect of this was to increase home ownership rates. In 1940, the US home ownership rate was 44%. By 1950, that had climbed to 55%. The FHA today is still a major insurer of home mortgages.
In order to limit risk, the FHA placed some reasonable-sounding limitations on what they (more precisely: we, as taxpayers) were willing to insure. While some practices, such as redlining, were later made illegal (although it still remains a problem), others continue to be in force. For example, a home being mortgaged may not have more than 25% of the floor area used for commercial purposes. That means the family business, the one that was built up over generations, where there is a building with the business on the first floor and the home on the second, is too risky to insure. A local bank is on their own for that kind of thing. The new suburban house out on the edge of town, however, meets the guidelines perfectly and can easily attain federal backing.
Another rule concerns the amount of income that can be derived from a commercial use. Let's say you live in the quintessential city building -- a first floor retail store and a second story home -- and the mortgage for it would be $1,000 per month. Let's say the business, which has been there for decades, pays $1,000 a month in rent and has never been late for a rent payment. Seems like not much risk. However, to limit their exposure to commercial volatility, the FHA would only allow the home owner to claim $150 of that rent as income towards the mortgage. They would need to show, within income to debt ratios, that they had other sources of income to cover the payment.
The end result of this is pretty simple to grasp. One kind of dwelling was suddenly easy to finance at very generous terms. Other kinds of dwellings suddenly became less competitive as they were not easy to finance and the terms were far more onerous. When one approach is made easy and the other is made difficult, the outcome is not surprising.
The new DNA of community finance that was set up within FHA rules was then supercharged in a genetic replicator by the Federal National Mortgage Association, also known as Fannie Mae, which was established in 1938. Fannie Mae was set up to accelerate the lending process by creating a secondary market for conforming mortgages, loans that met the FHA guidelines. This allowed local banks to sell those mortgages and then use the capital freed up to make more loans.
So by the start of World War II, one could walk into a local bank and get a loan on a single family home on the edge of town. That loan would require less money down and have far lower payments and interest rates than almost any mixed use property on the market. The bank could then rid themselves of whatever tiny bit of risk might remain on this federally insured package by selling the loan, at a small profit, to Fannie Mae which, in turn, would package the loan up with lots of other loans into a security and then sell that to investors, generating more demand for that kind of conforming property.
Fannie Mae become a publicly traded company in 1968 and then was forced to "compete" with another government-sponsored entity, the Federal Home Loan Mortgage Corporation or Freddie Mac, two years later. These two organizations supercharged the market for loans that conformed with FHA guidelines -- almost exclusively single family homes -- to the point where, by 2008, they owned 44% of all mortgages in the US, trillions of dollars worth.
There is no secondary market for that mixed use building with the retail store on bottom and the home up above. It's not because there is no market demand. It's because that building style -- a simple approach that has been the tried and true backbone of community finance for thousands of years -- does not conform to federal housing guidelines.
“There is no free market for housing.”
A free market is one where prices are established in a competitive marketplace free from manipulation or coercion. There is no free market for housing. The federal government long ago decided what elements your community DNA would be made of. That affects everything.
This week we're going to shine a light on these housing policies. We're going to hear from people that have been directly impacted by them. We're going to talk to experts and non-experts, from policy wonks to home builders to people who just want to make their community a little better. We're going to ask you to help us reveal the awesome potential that lies dormant in our communities, potential that a change in policy would unleash. And, yes, we're going to offer some specific policy suggestions for change.
You can follow the entire conversation at www.strongtowns.org/housing.
Charles Marohn (known as “Chuck” to friends and colleagues) is the founder and president of Strong Towns and the bestselling author of “Escaping the Housing Trap: The Strong Towns Response to the Housing Crisis.” With decades of experience as a land use planner and civil engineer, Marohn is on a mission to help cities and towns become stronger and more prosperous. He spreads the Strong Towns message through in-person presentations, the Strong Towns Podcast, and his books and articles. In recognition of his efforts and impact, Planetizen named him one of the 15 Most Influential Urbanists of all time in 2017 and 2023.