The Mortgage Risk Nobody is Talking About
Is it possible we will repeat history?
It's been a decade since Lehman Brothers collapsed and the mortgage market tanked with Fannie and Freddie taken over by the U.S. government. Have we learned anything since the last collapse? Is the mortgage market better off than it was before?
The stated goal of the Government Sponsored Entities is to increase homeownership rates.
This has been the objective under both Republican and Democratic administrations. This is a noble goal as there are many positive societal impacts with increased homeownership rates.
But there is a catch.
HOW TO INCREASE HOMEOWNERSHIP
Today, wage growth has been nearly stagnant while home prices have continued to surge. Simultaneously, treasury yields have increased, driving mortgage rates higher. People are making the same salaries they did 10 years ago, despite home prices outpacing inflation and wage gains.
With wages stagnant and mortgage rates increasing, how can homeownership increase?
Leave it to the government to solve this conundrum.
CHANGE THE STANDARDS
Just like the last crisis, loose underwriting standards took down banks, brokerages, homeowners and investors. So, are we going to replay history and make the same mistakes again?
To increase the rate of homeownership, the government has been loosening lending standards to help more borrowers qualify for mortgages.
HOW DO WE KNOW?
Nearly 40 percent of all purchases over the last 12 months were down payment loans – this includes more than 1.5 million borrowers. Borrowers, putting between 5 percent and 9 percent down, grew at double the market average. More than 35 percent of all lending by government-sponsored entities backed by American taxpayers were subprime – less than 10 percent down – up from 5 percent in 2010.
WHAT IS SUBPRIME LENDING + WHY IS IT IMPORTANT?
Subprime lending (or non-prime) is any loan in which the borrower puts less than 20 percent down and/or doesn't meet traditional credit or income guidelines. Regardless of credit or other rations, in the last crisis we saw loan-to-value was the No. 1 indicator of a loss.
WHY IS 20 PERCENT THE MAGIC NUMBER?
Let's look at what occurred during the last recession. Remember prices can decrease. The last recession was evidence that borrowers with less than 20 percent down were more likely to default on their loans.
In a recession, with values dropping if you put only 5 percent down, the borrower is underwater almost immediately. In other words, the house is worth less than is owed. It doesn't take a deep recession to see a 5 percent to 10 percent drop. A little hiccup in the economy could knock prices down, especially in high-price areas like Colorado's Front Range, where borrowers are spending large portions of their income on housing.
Even if default rates are at the lowest since the recession and underwriting is more challenging, while credit scores are higher, none of these arguments hold water.
Subprime is back and the new lender in town is the taxpayer.
As a private lender and riding out the last mortgage crisis with no bailout, we quickly learned what happens in a market downturn. We had a unique perspective, witnessing how our lending practices performed under stress. We lend our own funds, look at every property and service our loans. We get to see the entire loan cycle , as opposed to many banks that pool their loans and sercuritize them, offloading the risk to other parties. As the crisis unfolded, we spread out the portfolio based on credit, income, loan-to-value, etc. The lower the loan-to-value, the higher probability of a positive resolution.
WHAT HAPPENS IN A DOWNTURN?
A cascading effect occurs; the market falls, dampens consumer confidence, deceases consumer spending and businesses cut back to accommodate the lower spending. Borrowers that have equity in their commercial or residential property are considerably more likely to make a payment. In the last crisis, there were a considerable number of "strategic defaults" where the borrower could make a payment but chose not to since the house was underwater.
The theory goes: Why throw good money away when I can go rent or buy another house for less than what I currently owe?
This is a simplistic explanation for what happened in the last crisis and what could happen again. The depth of how this plays out in the next crisis is the question.
What does this have to do with Fannie/Freddie purchasers of residential mortgages? With 35 percent of mortgages originated demanding less than 10 percent down, the probability of a major default has been amplified. It is highly likely there will need to be a bailout by U.S. taxpayers to the tune of $100 billion or more – not including bailouts of FHA or VA, which also make subprime loans with down payments less than 5 percent.
WE HAVEN'T LEARNED OUR LESSON
The Federal Housing Finance Agency released its annual progress report summarizing the activities of the GSEs in 2017. One of the items highlighted was:
HIGH LTV REFINANCES: The GSEs announced in August a new refinancing program aimed at borrowers with high-LTV loans. The new offering will give borrowers with high-LTV loans who are current on their mortgage an opportunity to refinance. The GSEs explained these borrowers are typically unable to refinance when their LTV ratio is higher than the limits on other existing refinance products.
They surmised: “giving underwater and highly leveraged borrowers the opportunity to refinance, not only will it benefit the borrower, but also lowers the default risk”
How is this possible? The GSEs are not only making subprime loans that have a substantially higher likelihood of default, but they are also refinancing subprime loans giving the borrowers cash out further increasing the LTV and future losses from defaults.
It is perplexing that we are repeating the same mistakes that led to the collapse of various banks a decade ago. GSEs, which we, as the taxpayer are guaranteeing, are the new risk in town. They have increased their subprime lending from 5 percent in 2010 to 35 percent in 2018. At the end of the day, there is a price to pay for the loosening of standards. The federal housing authority pegs this number at close to $100 billion.
Get your checkbooks ready because all of us will be on the hook for the bill.