September 27, 2010
In past recessions, the housing and
mortgage sector, stimulated by the lower interest rates generated by an
easier monetary policy, was a source of strength that led the economy
out of the recession. Not this time. Despite the fact that the easing of
monetary policy has been more aggressive than in any prior recession,
and included unprecedented purchases of mortgage-backed
securities by the Federal Reserve, the spark has fallen on wet
grass.
Sales of new and existing homes are
lower today than at any time in the last decade. House prices have not
rebounded as they were expected to do. The volume of mortgage refinances
has fallen far short of predictions based on past relationships.
Monetary
Easing Has Failed
In
a recent article I pointed out that the interest rates that mortgage
borrowers actually pay have not declined as much as published rate
series suggest because so few borrowers qualify for the lowest rates.
Published rate series have a downward bias because they don’t cover
potential borrowers who are priced out of the market.
While interest rates on prime loans have
declined, the rate penalties for less-than-prime conventional loans
(those not FHA or VA) have increased. As one illustration, before the
crisis, the FICO score of borrowers taking loans with 70%
loan-to-value ratios could be very low without affecting the
rate. Today, a borrower taking a 70% loan needs a FICO score
of 740 to get the lowest rate, with a score of 640 the rate will be .5%
to .625% higher, and with a score of 600 conventional loans are not
available at any price. This can be largely attributable to the
post-crisis policies of Fannie Mae and Freddie
Mac, as noted below.
In addition, underwriting
requirements have become extremely tight. Minimum credit scores
have been raised, maximum ratios of loan amount to property value (LTV)
have been reduced, and documentation rules have become much stricter.
Full documentation has become the rule for every borrower, and
underwriters no longer have discretion to use their judgment in
difficult cases.
The impact of these changes has been
reinforced by a pervasive downward bias in appraisals,
a complete turn-around from the upward bias that prevailed before the
financial crisis. Where a reported 90% LTV before the crisis was
probably closer to 95%, today it is closer to 85%.
The turn-around in appraisal bias is a
key to much of what has happened. Expectations of lenders and investors
have done a 180, from unbridled optimism that home prices will keep
rising, thereby validating liberal lending terms, to hesitancy and
caution lest the period of home price declines not be over. Much of the
tightening in lending terms reflects this major swing in expectations.
The same thing happened in the early 1930s, except that in that period
mortgage lending came to a complete halt because there were no Federal
agencies supporting the market -- they had yet to be created.
The Housing Finance System Is Now
Less Responsive to Monetary Easing
The recent financial crisis,
furthermore, transformed the housing finance system in some fundamental
ways that have made the system less responsive to monetary easing by the
Federal Reserve. First, the private mortgage-backed
security market imploded, leaving only markets in securities guaranteed
by the Federal Government. Conventional mortgage lenders are now almost
completely dependent on guarantees from Fannie Mae and Freddie Mac to be
able to sell their mortgages.
Second, those agencies have made
extensive use of the representations and warranties provided by lenders
doing business with them to require the repurchase of loans made in
pre-crisis years that have gone bad, As a result, in order to avoid
possible violations which could trigger buy-backs in the future, lenders
today impose more restrictive underwriting rules than those of the
agencies.
Third, the crisis eliminated some large
mortgage lenders, including Countrywide, Washington Mutual, Indy Mac and
Wachovia. These firms were heavily into third party originations
–acquiring mortgages through brokers and small lenders, and selling them
into secondary markets. This has left significant market power in the
hands of the three remaining behemoths serving this market: Wells Fargo,
Chase and Bank of America.
Insiders tell me that the market power
of these firms is enhanced by the lower guaranty fees they pay to Fannie
and Freddie relative to the fees paid by smaller firms. I am also told
that the behemoths are enjoying profit margins many times larger than
those that were common in third party originations before the crisis.
Larger margins are embedded in the rates paid by borrowers.
Finally, the crisis wiped out the
capital of Fannie Mae and Freddie Mac, which on September 6, 2008 were
placed into conservatorships. The Federal Housing Finance Agency
(FHFA), which had been their regulator, was appointed the
conservator. Its charge was to “preserve and conserve the Company’s
assets and property and to put the Company in a sound and solvent
condition”.
Consequences of Conservatorship
The agencies have followed this charge
exactly, posting prices and underwriting rules designed to maximize
their net revenue. If their income statements separated out operations
since conservatorship, the agencies would be extremely
profitable. This fact is obscured in the actual statements, however,
because large profits on current operations are swamped by losses on
loans purchased before the crisis.
A major consequence of revenue
maximization by the agencies is that there is a very sizeable group of
borrowers who are current on their existing loans and
should be able to refinance or
buy homes but can’t. Either they can’t meet draconian underwriting
rules, or they are priced out of the market by the heavy penalties
imposed on less-than-pristine mortgages.
Two strategically important groups have
been particularly hard hit. One is the self-employed, who are
predominantly the small business owners who are a major potential source
of employment growth. The other are investors who buy homes to resell at
a profit, and who are desperately needed right now to buy foreclosed
homes sold by lenders.
Thanks to Alan
Boyce.
September 27, 2010
In past recessions, the housing and
mortgage sector, stimulated by the lower interest rates generated by an
easier monetary policy, was a source of strength that led the economy
out of the recession. Not this time. Despite the fact that the easing of
monetary policy has been more aggressive than in any prior recession,
and included unprecedented purchases of mortgage-backed
securities by the Federal Reserve, the spark has fallen on wet
grass.
Sales of new and existing homes are
lower today than at any time in the last decade. House prices have not
rebounded as they were expected to do. The volume of mortgage refinances
has fallen far short of predictions based on past relationships.
Monetary Easing Has Failed
In
a recent article I pointed out that the interest rates that mortgage
borrowers actually pay have not declined as much as published rate
series suggest because so few borrowers qualify for the lowest rates.
Published rate series have a downward bias because they don’t cover
potential borrowers who are priced out of the market.
While interest rates on prime loans have
declined, the rate penalties for less-than-prime conventional loans
(those not FHA or VA) have increased. As one illustration, before the
crisis, the FICO score of borrowers taking loans with 70%
loan-to-value ratios could be very low without affecting the
rate. Today, a borrower taking a 70% loan needs a FICO score
of 740 to get the lowest rate, with a score of 640 the rate will be .5%
to .625% higher, and with a score of 600 conventional loans are not
available at any price. This can be largely attributable to the
post-crisis policies of Fannie Mae and Freddie
Mac, as noted below.
In addition, underwriting
requirements have become extremely tight. Minimum credit scores
have been raised, maximum ratios of loan amount to property value (LTV)
have been reduced, and documentation rules have become much stricter.
Full documentation has become the rule for every borrower, and
underwriters no longer have discretion to use their judgment in
difficult cases.
The impact of these changes has been
reinforced by a pervasive downward bias in appraisals,
a complete turn-around from the upward bias that prevailed before the
financial crisis. Where a reported 90% LTV before the crisis was
probably closer to 95%, today it is closer to 85%.
The turn-around in appraisal bias is a
key to much of what has happened. Expectations of lenders and investors
have done a 180, from unbridled optimism that home prices will keep
rising, thereby validating liberal lending terms, to hesitancy and
caution lest the period of home price declines not be over. Much of the
tightening in lending terms reflects this major swing in expectations.
The same thing happened in the early 1930s, except that in that period
mortgage lending came to a complete halt because there were no Federal
agencies supporting the market -- they had yet to be created.
The Housing Finance System Is Now
Less Responsive to Monetary Easing
The recent financial crisis,
furthermore, transformed the housing finance system in some fundamental
ways that have made the system less responsive to monetary easing by the
Federal Reserve. First, the private mortgage-backed
security market imploded, leaving only markets in securities guaranteed
by the Federal Government. Conventional mortgage lenders are now almost
completely dependent on guarantees from Fannie Mae and Freddie Mac to be
able to sell their mortgages.
Second, those agencies have made
extensive use of the representations and warranties provided by lenders
doing business with them to require the repurchase of loans made in
pre-crisis years that have gone bad, As a result, in order to avoid
possible violations which could trigger buy-backs in the future, lenders
today impose more restrictive underwriting rules than those of the
agencies.
Third, the crisis eliminated some large
mortgage lenders, including Countrywide, Washington Mutual, Indy Mac and
Wachovia. These firms were heavily into third party originations
–acquiring mortgages through brokers and small lenders, and selling them
into secondary markets. This has left significant market power in the
hands of the three remaining behemoths serving this market: Wells Fargo,
Chase and Bank of America.
Insiders tell me that the market power
of these firms is enhanced by the lower guaranty fees they pay to Fannie
and Freddie relative to the fees paid by smaller firms. I am also told
that the behemoths are enjoying profit margins many times larger than
those that were common in third party originations before the crisis.
Larger margins are embedded in the rates paid by borrowers.
Finally, the crisis wiped out the
capital of Fannie Mae and Freddie Mac, which on September 6, 2008 were
placed into conservatorships. The Federal Housing Finance Agency
(FHFA), which had been their regulator, was appointed the
conservator. Its charge was to “preserve and conserve the Company’s
assets and property and to put the Company in a sound and solvent
condition”.
Consequences of Conservatorship
The agencies have followed this charge
exactly, posting prices and underwriting rules designed to maximize
their net revenue. If their income statements separated out operations
since conservatorship, the agencies would be extremely
profitable. This fact is obscured in the actual statements, however,
because large profits on current operations are swamped by losses on
loans purchased before the crisis.
A major consequence of revenue
maximization by the agencies is that there is a very sizeable group of
borrowers who are current on their existing loans and
should be able to refinance or
buy homes but can’t. Either they can’t meet draconian underwriting
rules, or they are priced out of the market by the heavy penalties
imposed on less-than-pristine mortgages.
Two strategically important groups have
been particularly hard hit. One is the self-employed, who are
predominantly the small business owners who are a major potential source
of employment growth. The other are investors who buy homes to resell at
a profit, and who are desperately needed right now to buy foreclosed
homes sold by lenders.
Thanks to Alan Boyce.