Housing And Mortgage Markets May Have Recovered, But Risks RemainKnowledge Wharton
This week, the world is remembering what is called “Lehman Weekend.” A decade ago, on September 15, 2008, the giant investment bank filed for bankruptcy, triggering what is now called the Great Recession. Lehman’s problems originated in portfolios of risky, subprime housing mortgages that it had bought, and for which it was ultimately unable to find buyers. After Lehman collapsed, government interventions saved Bear Stearns, AIG, Fannie Mac and Freddie Mac, while other banks crippled by subprime loans got help through the Troubled Asset Relief Program (TARP), a $700 billion recapitalization effort.
Today, 10 years on, lending has become more stringent. Banks have become increasingly risk-averse; default rates have fallen; regulatory compliance costs to prevent unhealthy lending have soared; and the banking and financial services sector is in better health. Home prices are prohibitively high in many markets, and median income levels haven’t risen sufficiently to create strong, new demand.
Even so, causes for concern do exist, say experts at Wharton and elsewhere. Their biggest source of anxiety is that the government-sponsored Fannie Mae and Freddie Mac, despite being under receivership, do not have deep enough reserves to withstand another crisis. Meanwhile, Congress continues to drag its feet over structural reforms. Second, another round of defaults on home mortgage payments seems inevitable as the current, 10-year-long economic recovery appears to be nearing its end. Third, efforts by the Trump administration to weaken regulatory oversight, such as at the Consumer Financial Protection Bureau (CFPB), could leave the financial system more vulnerable to future shocks.
A Safer System
Wharton finance professor Richard Herring, who also directs the school’s Financial Institutions Center, notes that the Great Recession revealed that banks were “gravely undercapitalized and too dependent on their ability to borrow to manage their liquidity needs.” He points out that the Federal Deposit Insurance Corporation insisted on banks maintaining a leverage constraint as part of capital requirements that protected the U.S. from the worst of this leverage binge, but the FDIC had no control over the leverage of investment banks. As a result, they could grow their balance sheets irresponsibly.
“The worst of loans are made in the best of times.” –Richard Herring
In the housing sector, some major changes since the crisis “probably make us safer,” notes Joseph Gyourko, a Wharton real estate professor who also oversees the school’s Samuel Zell and Robert Lurie Real Estate Center. “One change is that we’re back to a more normal homeownership rate of 63% to 64%. It got up to 69% at the height of the boom, when we had a lot of financially fragile households owning that we don’t today. I suspect most of those households are more financially secure now than at the top of the boom.” Gyourko believes the lower home ownership rate reflects more stringent underwriting after the crisis. “We’re made to [have] larger down payments, and house prices have gone up. In that sense, people have more equity.”
The Dodd-Frank Act brought the biggest corrective actions after the crisis. Among its creations was the CFPB, and it pushed lenders towards more responsible lending with more rigorous credit appraisal criteria. “The creation of the CFPB suggested that lawmakers learned an important lesson from the financial crisis, namely that consumers are often uninformed and can be manipulated into risky or even predatory mortgage products,” notes Wharton real estate professor Benjamin Keys. “Its creation was a recognition that the alphabet soup of regulators covering different parts of the mortgage market led to a race to the bottom in terms of oversight and regulatory arbitrage as lenders sought the least regulated corporate structures.”
Keys says that the housing sector is better equipped today than it was before the previous crisis, “if only because of the restrictive lending standards that have been implemented during the last decade. Default rates are low, and risky borrowers have been locked out of the mortgage market since 2008,” he notes. “There are also fewer instances of aggressive home equity borrowing pushing borrowers to at or above 100% LTV (loan-to-value ratios, or the size of the borrowing relative to the value of the home). As a result, the market is less levered, as is lending to borrowers who are on the precipice of financial hardship.”
Keys lists some of the key lessons learned from the crisis. “The overly-exuberant expectations about house prices have been replaced by more realistic beliefs about future house prices,” he says. “The pendulum of lending standards has swung from being overly generous to overly stingy. On all dimensions of underwriting, it was easy to take out loans during the boom years. Lower credit scores, smaller down payments and lower incomes were all features of that market. In today’s market, higher credit scores and stronger ability to repay standards have led to very tight credit, not only relative to those years of excess but also to the more reasonable lending standards of the late 1990s.”
“The pendulum of lending standards has swung from being overly generous to overly stingy.” –Benjamin Keys
Keys points out that delinquency rates for Fannie Mae and Freddie Mac are less than 1%, “which shows that the agencies are unwilling to take on any but the safest customers.” Ginnie Mae guarantees housing loans backed by government agencies such as the Department of Veterans Affairs and the Federal Housing Administration, while Fannie Mae and Freddie Mac buy mortgage loans from commercial banks and thrift banks (or smaller banks), respectively.
Then and Now: The Street View
The real estate mortgage lending industry emerged chastened from the crisis. “The lessons were definitely learned,” says Laxman Subramaniam, senior vice president, business intelligence and revenue management at Pacific Union Financial, an Irving, Tex.-based provider of residential mortgage loans. “Compliance costs went through the roof.” The cost for originating a loan, which used to be around $4,200 to $4,400 pre-crisis, rose to $6,000 by 2015 and is now at $8,400 a loan,” he says. Compliance costs cover the technology and staffing lenders need to spend on for the various checks regulators require.
According to Subramaniam, “Oversight is definitely tighter, and lenders are careful.” For example, all mortgage loan originators have to pass the so-called SAFE tests (Secure and Fair Enforcement for Mortgage Licensing) tests with a score of at least 75% to secure state licenses. SAFE was introduced as part of the Housing and Economic Recovery Act of 2008 as a response to the subprime crisis. Fair lending audits at the CFPB are common. A CFPB audit last year at one such lender was extensive and lasted a couple of months. Every quarter, lenders file fair lending reports and mortgage and credit review (MCR) reports. Mortgage lenders typically process loan packages that come to them through automated underwriting systems.
“Historically, in a rising-rate environment, the refinance market goes down but the purchase market actually keeps going up because the mentality is to buy a house before the next rate hike,” Subramaniam notes. Interest rate hikes drive home purchases. But this time around, the supply shortage has depressed home buying, despite two quarter-point rate increases this year and expectations of two more increases by the end of the year.
The appetite among large banks for securitized housing loan portfolios has weakened dramatically over the years, Subramaniam notes. “The private securitization market disappeared with the financial crisis.” The market is dominated by Ginnie Mae, Fannie Mae and Freddie Mac securities, he adds.
A small and growing segment is the so-called “non-QM” market of those made up of riskier, non-qualified mortgage portfolios. Interest-only loans that fall under the non-QM umbrella are still being made, but there is hardly any appetite in the securitization market, Subramaniam says. The non-QM market had about $50 billion in loans, or about 3% of the total market size as of March this year, according to a report in Housingwire.com. Rating agency Standard & Poor’s told the publication it considers the non-QM market safer than the subprime loans made in the pre-crisis years, and expects it to double or triple in size this year.
Loans to borrowers with FICO scores of below 620 are still being made today, but loans to borrowers with the “non-income, no-asset” profiles have ended, says Subramaniam. Similarly, adjustable-rate mortgages (ARM) still exist, but “teaser rates” (lower rates in the initial years that progressively increase) and “option ARMs,” (where borrowers get multiple monthly repayment options) are not being underwritten.
Reforming Fannie Mae and Freddie Mac
While many lessons have been learned from the 2008 crisis, the policy responses have not been effective on some fronts, according to Gyourko. “The housing market and the owners are safer now than they were in 2007,” he says. “But we’ve certainly done nothing to improve the safety of the mortgage insurance system centered on Fannie Mae and Freddie Mac.”
Weighed down by subprime loans in the last crisis, Fannie Mae and Freddie Mac were put under receivership in 2008. “They essentially are a ward of the U.S. Treasury,” Gyourko notes. A robust mortgage insurance system is important to guard against the downsides of a future crisis. “The good news right now is we have a growing economy, rising house prices and default rates are low. But a reasonable person would expect us to have a recession at some point in the future.”
Defaults occur when people lose their jobs, and if house prices fall, those who are unable to make their mortgage payments may not be able to sell their homes for more than the mortgage balance they owe on it, Gyourko explains. “That guarantees a default, unless one believes the business cycle has been outlawed,” he says. “We will have a downturn. We will have a rise in defaults in the future. The most disappointing response, policy-wise, is our inability to come up with a new mortgage insurance system that is properly financed and that has sufficient reserves to cover expected losses whenever the next downturn comes.”
According to data from the Urban Institute, as of last July outstanding mortgage-backed securities with Fannie Mae, Ginnie Mac and Freddie Mac made up 60.4% or $6.5 trillion of the total mortgage market. The rest is shared between unsecuritized first liens at the GSEs, commercial banks and other lenders (30%), second liens (5.2%) and private-label securities (4.3%)
“The most disappointing response, policy-wise, is our inability to come up with a new mortgage insurance system that is properly financed and that has sufficient reserves to cover expected losses whenever the next downturn comes.” –Joseph Gyourko
Jeb Hensarling, chairman of the House Financial Services Committee, noted in a Wall Street Journal opinion piece last week that Fannie Mae and Freddie Mac haven’t reformed much since the 2008 crisis when they bought loans where homeowners had made down payments of as little as 3%, suggesting little incentive to make regular repayments. “Today, propped up by taxpayers in conservatorship, they remain thinly capitalized, still securitize half of new mortgages, and are buying high-risk 3%-down loans,” he wrote. He noted that back in 2008, the two agencies were caught up in scandals involving conflicts of interest and lobbying. “And—surprise!—they are once again embroiled in similar scandals. As Yogi Berra said, it’s déjà vu all over again.”
Lessons Not Fully Learned
Keys says he is concerned that “the Republican backlash against the CFPB has sharply weakened its ability to enforce the consumer protection laws that are on the books.” He describes the potential consequences of undermining the role of the CFPB. “This weakening of regulatory oversight comes at an especially troubling time.” He recalls that in 2003, when interest rates rose, many lenders looked for ways to bring in additional borrowers and continue origination of both purchase and refinance mortgages. “The timing of the rise of the non-agency securitization boom can be directly tied to increases in Treasury rates and the hunt for ‘affordable’ products,” Keys says. “This event was exactly when the regulatory framework failed, as subprime lenders were largely unchecked by a system that regulated entities rather than specific products.”
Today, Keys sees a similar setting. “We now see interest rates rising, which will eliminate the refinancing pipeline and lead to higher monthly payments for new borrowers, so it will be interesting to see if lenders pivot to new products and new tactics to keep originations flowing.” For instance, Detroit-based Quicken Loans, the country’s largest residential mortgage lender, earlier this year partnered with Airbnb, “enabling the property rental company’s hosts to use rental income on a primary residence to refinance their mortgages,” according to a press release. “Airbnb and Quicken Loans are firmly aligned to drive innovation in the real estate industry to dramatically improve and simplify client experience, as well as saving homeowners time and money,” it stated.
Keys notes that nonbanking financial institutions are originating “a large fraction of loans” and they immediately securitize them to Fannie Mae or Freddie Mac. “These nonbanks may not be able to withstand a downturn because they have little to no capital buffer, especially in their roles as servicers,” he warns.
More broadly, Herring says he is concerned about the unintended effects of the prolonged policy of near-zero interest rates. “It has led to a major distortion of financial decisions…. It has undoubtedly permitted several inefficient firms to continue operations beyond the point they would otherwise have become bankrupt. It has contributed to the rise in stock market values and it has led individual savers to take risks they do not understand to try to obtain a positive, inflation-adjusted return.”
Herring believes “the obsession” with the Great Recession and attempts to recover from that “have ignored the fundamental issues that must be addressed if we are going to succeed in sustaining a higher growth rate – education and investment in infrastructure, more broadly.”
After the anticipated interest rate increase in September, Subramaniam expected the yield curve inversion in the fourth quarter. “The last four times such an inversion occurred, a recession followed,” he says, although the Federal Reserve has argued against such correlations. “The bond market is signaling that the risk of recession is rising, but a downturn is far from imminent,” a Wall Street Journal report said, citing a recent paper by the Federal Reserve Board of San Francisco.
“An inversion of the yield curve — when short-term interest rates are higher than long-term rates — has been a reliable predictor of recessions,” the Fed report acknowledged. However, it said that spread “is still a comfortable distance from a yield curve inversion” and questioned its “cause and effect” assumption, saying it “leaves open important questions.” Against that backdrop, Subramaniam expects in the foreseeable future a fall in home buying and therefore of mortgage originations. “The mortgage industry is undergoing a huge consolidation to accommodate the low volumes, and extreme cost-cutting,” he says. He points to reports of Wells Fargo letting go 600 people, and Capital One laying off 286 employees in Texas on top of 950 layoffs announced last year.
“Nonbanks may not be able to withstand a downturn because they have little to no capital buffer, especially in their roles as servicers.” –Benjamin Keys
The overall outlook for the mortgage market is “not very rosy,” according to Keys. Interest rates are still low by historical standards, but because many borrowers locked in low rates over the last five years, there will be “very little demand for refinancing,” he predicts. “In addition, there may be cases of ‘lock-in,’ where borrowers are unwilling to sell starter homes and move up the property ladder because doing so would mean losing their low interest rate and exchanging it for a higher rate — presumably on a larger mortgage.”
Higher construction costs, made worse by the trade wars, are hurting affordability and have brought it to a 10-year low, National Association of Home Builders (NAHB) chairman Randy Noel told Housingwire.com. “In fact, only 57.1% of new and existing homes sold between the months of April and June were affordable to families earning the U.S. median income of $71,900 … the lowest reading since mid-2008,” the report said, citing the NAHB/Wells Fargo Housing Opportunity Index. First-time homebuyers find it difficult to buy in markets like Houston or pockets of California, Subramaniam notes.
“House price inflation is an incredibly potent signal of us being in a bubble, of us being on the verge of a crisis,” Wharton management professor Natalya Vinokurova told Knowledge@Wharton in a recent interview on her research papers, including one titled “Failure to Learn from Failure: The 2008 Mortgage Crisis as a Déjà Vu of the Mortgage Meltdown of 1994.” “When you have too much money chasing too few attractive options, you end up in the bubble. And the bubble will have to burst.”
Home prices are rising for a few reasons, according to Subramaniam. One is the short supply of houses. Construction activity is down because of a labor shortage. Unemployment rates have stayed low, but most of the new jobs are in construction that millennials and young Americans don’t want. The U.S. tariff wars with China, the European Union and Canada, are expected to show up in higher prices of especially steel and aluminum, and therefore higher construction costs.
The markets with the tightest supply of homes are along the coasts, according to Wharton’s Gyourko, and he attributed the shortage mostly to local government restrictions on new construction. They include Boston, New York and Washington, D.C., on the east coast, and Seattle, Portland, San Francisco, Los Angeles and San Diego on the west coast. “These markets have become severely supply constrained, and in the recovery [since 2008], a disproportionate share of the growth occurred in those markets – growth in jobs and demand.”
Gyourko says the housing shortage is “an important policy issue. We have to figure out a way to get more supply in those markets, because they contain many of our most productive firms in the business sector, and they are going to keep growing. I worry that you’re going to price not just the poor out of those markets – you’re going to price out the middle class.” A case in point: In San Francisco, where the tech boom has created significant job growth in recent years, housing prices have been soaring astronomically. In the first six months of 2018 alone, the median housing price went up by $205,000.
Agenda for Congress
What can be done to strengthen Fannie Mae and Freddie Mac? “Some would argue for their privatization, but I don’t think that will work,” notes Gyourko. “Homeownership is too important, and the government’s [has] to be involved as a backstop. What you have to do is price the default risk appropriately and capitalize Fannie Mae and Freddie Mac so that they can withstand a downturn.” What is stopping the government from providing the requisite capital? “The problem is, Congress doesn’t want to raise taxes to provide the capital for these [companies] to operate safely. That’s why they were unsafe in the last crisis. In a sense they’re not as unsafe now because they are owned by the Treasury, [which will] just cover the losses out of tax revenues. There won’t be any default risk, though it will be costly to the taxpayers.”
“The mortgage industry is undergoing a huge consolidation to accommodate the low volumes, and extreme cost-cutting.” –Laxman Subramaniam
Hensarling, who plans to bring two major housing finance reform bills, wants to permanently repeal government-sanctioned monopolies and implicit guarantees of Fannie Mae and Freddie Mac. He wants to replace them with Ginnie Mae, which in addition to its current role would also back private mortgage-backed securities with “market-priced guarantees” from so-called “credit enhancers” who would be financially strong, with “banklike capital.” Under his plan, eligible loans would need a minimum 5% down payment and have a maximum loan-to-value ratio of 85%, capping the amount of money homebuyers could borrow relative to the value of their homes. He says his plan would create no new government guarantees, protect tax payers better since they would be in the “last-loss position behind layers of diversified private capital,” in addition to increasing liquidity, lowering costs, enhancing competition and reducing the risk of institutions growing too big to fail.
Could another recession be on the way in the future? And if so, what are the principal risk factors that could tip the U.S. economy into a slowdown? According to experts, several indicators could serve as potential warning signals that might have ripple effects across the housing sector, as a WSJ graphic captures them. First, wage levels are not encouraging, and inflation-adjusted median household income is currently just above its 2008 levels. Second, home prices have been rising in recent months. Third, higher government debt could mean reduced ability to effectively manage future shocks. Fourth, asset concentration among banks hasn’t changed much with the 10 largest banks holding more than half the total; and fifth, consumer debt continues to rise.
Herring notes that public memory is short and past mistakes may be repeated. “I have grave concerns over the longer term. Inevitable complacency will arise as the memory of the great recession recedes and many of the managers and regulators who lived through the period retire. It is crucial to remember that the worst of loans are made in the best of times.”
“If we were to be faced with the same problems that became apparent in the spring of 2007, I do think that we have built stronger defenses,” Herring says. “But of course, crises seldom repeat themselves. It is impossible to forecast [what will cause] the next financial crisis. It could arise from a trade war that spirals out of control and depresses world growth. … Or it might be a shock that is more specific to the financial system, such as a cyberattack that disrupts the payment system or destroys records of who owes what to whom.” He acknowledges that little can be done to prepare for such situations. “Stronger capital and liquidity positions are helpful, but they are surely not enough.”
Article by Knowledge@Wharton