Unfinished Business: Reform of Mortgage Market, Part I
Lending standards and mortgage availability have been major constraints to the housing recovery.
The purpose of this article is to focus on one of the factors constraining the housing recovery: the dearth of available mortgage credit to many households because of the extremely tough lending standards since 2008. This month, Part I will address the major sources of the problem. Next month, Part II will provide a road map for what could happen under the new Trump administration.
Currently, the primary focus in the media has been about the risk to the housing recovery posed by rising interest rates. At current interest rate levels, affordability has almost never been better. While the expected modest rise in interest rates combined with higher house prices will lower affordability, we expect housing affordability to remain favorable by historic standards over the next few years.
Tough lending standards have held back single family housing sales and starts despite favorable affordability. According to a study done at the Urban Institute, tough credit standards kept about five million households from being able to secure a mortgage between 2009 and 2014.
Mortgage Market After the 2008 Financial Crisis
After the financial crisis in 2008, the government took on the task of first salvaging the overall system so the world would not plunge into a depression. The primary culprit in creating the crisis was the creative mortgage instruments that helped to feed the housing bubble through easy lending standards. The bubble was fed by a surge in private security mortgage pools that masked the risk of some of the very risky loans. But, the government agencies played a role as well.
To salvage the financial system, the U.S. government was obligated to first bail out the banks that were “too big to fail” and then to save the two primary government-backed mortgage entities, Fannie Mae and Freddie Mac. These agencies provide a crucial function for the U.S. mortgage sector since they broaden the amount of capital that flows into the market through security pools. Because of these agencies, the U.S. has a 30-year fixed rate mortgage with no pre-payment penalty. No other country in the world has this type of mortgage. They are too risky for a private firm because of the duration and the ability to pre-pay without a penalty if interest rates fall.
Since 2008, there has been a lot of discussion about reducing the government’s role in the mortgage business. But, this has not happened. In the peak go-go years of 2005 and 2006, mortgage originations were $2.5 trillion. The private market (private label securities and bank portfolio) was over 60% of the originations. (Private securities are where most of the very risky mortgages, such as the Alt A and Subprime mortgage, were securitized). Currently, annual mortgage originations are about $1.5 trillion, down 40% from the peak. But more importantly, over 60% of mortgage originations are government-backed.
Nearly 60% of outstanding mortgages now sit in an agency security pool. Thus, rather than fixing the problem after 2008, the government now is THE mortgage market for most households.
So what happened? After salvaging the system, the government then went about passing legislation to insure that it would not happen again. First, a piece of legislation called the Dodd-Frank bill was enacted. This bill was to insure that banks would maintain enough capital to survive even a serious economic downturn.
The bank has to run a “Stress Test” to determine if the bank has adequate capital to survive a serious economic downturn. The legislation also made sure the mortgage originator shared in the risk of a mortgage default. During the housing bubble period, banks could originate loans to marginal borrowers with a low down-payment and sell it either to a private security pool or to Fannie Mae or Freddie Mac. Once they sold it, they were not at risk if the loan went into foreclosure. As a result, banks were willing to make a loan to an individual even though they had a low credit score and very low down payment. Things got so bad that in 2005 and 2006, banks were not even checking to make sure the applicant actually had the income needed to secure the loan. (At the time, we jokingly called these “liar loans,” since applicants put in higher income and lower debt numbers in order to qualify.)
Dodd-Frank fixed this problem by making banks liable if a loan they created and sold to a government agency went bad. Under the provisions of the Dodd-Frank bill, a bank can be at risk if the loan goes into default. If for instance, Fannie Mae purchased a loan and found the loan originator (bank) had not done proper work in the origination, then the loan could go back to the originator—called a Put Back Clause. Even minor errors in the application could put the banks at risk. Some mortgage analysts believe this rule is one of the primary reason lending standards are so tough.
Because of the Put Back Rule, banks now originate mortgages primarily for their own portfolio. The mortgage origination business has shifted to non-bank companies.
Banks now account for less than 10% of FHA loans, but generated 62% of those mortgages in 2010. The non-bank companies (such as Quicken Loans) need the liquidity provided by the agencies to survive. Unfortunately, these mortgage or finance companies do not have to keep reserves like banks, so it is not clear what will happen if mortgages are pushed back to them in a serious downturn. One industry observer calls the FHA surge a train wreck waiting to happen, because of the risky loans and lack of reserves.
To keep Fannie Mae and Freddie Mac afloat in 2008, they were effectively taken over by the Federal Government. The government injected $190 billion to build up their capital reserves and placed them in a holding position called Conservatorship. The holding spot was meant to be temporary. A new oversight agency, the Federal Housing Finance Agency, was created to manage the transition back to health and eventually eliminate the government’s role.
Unfortunately that has not happened. In 2012 the Treasury decided to take all of the profits from Fannie and Freddie. As a result, they have been unable to rebuild capital. The justification was to pay back taxpayers without whose help they would have gone bankrupt. But the government has been fully paid back—taking over $240 billion through 2015.
This leads to the next reason for tough lending standards. Because of the lack of capital reserves, Fannie and Freddie have insisted on tough lending standards to keep default risk low. Because they dominate the mortgage market, they define what is a conforming loan that can be securitized.
Current lending standards are a result of policy actions taken after 2008 to insure that we do not repeat that crisis. Unfortunately, the legacy of these actions are extremely tough lending standards and are due to:
- • The Dodd-Frank bill
- • The dominance of Fannie Mae and Freddie Mac in the mortgage market
The correction for these problems will be complex and challenging. Some potential approaches and the implications are discussed in the April issue of LBM Journal.