Mar262014

24% of new government-backed loans violate qualified mortgage rules

Exempt from qualified mortgage rules, the GSEs and FHA originate 24% of new loans with debt-to-income ratios that exceed the 43% limit.

4.2.7Not long ago, Senators unveiled a Fannie Freddie reform plan. The politicians in Washington recognize that the US taxpayer must not remain responsible for over 80% of home loans, but the parties disagree on how to remove this backing and potentially wind-down the GSEs. The basic dilemma is the cost of money: withdrawing the government backing will increase the cost of money in order to attract private capital. Raising the cost of money is raising mortgage interest rates, and Higher mortgage interest rates lead to lower sales or lower prices, neither alternative is palatable in Washington.

A seldom-discussed problem associated with winding down the GSEs is the removal of their exemption to the qualified mortgage rules. The new mortgage regulations change how real estate markets work, and private lenders must conform to these new standards or be subject to capital withholding rules most loan originators want to avoid. One of the most restrictive of these standards is the 43% limit on back-end debt-to-income ratios, a problem so large I recently asked, Will lenders circumvent the 43% debt-to-income cap? They will probably try.

The 43% debt-to-income cap was put in for one simple reason: debts in excess of 43% can’t be sustained. Borrowers who must pay more than 43% of their gross income toward debt service have very little left over for discretionary spending. The payments are so onerous that only Ponzis can manage it — and Ponzis manage by borrowing money to make debt-service payments, an unsustainable financial strategy doomed to fail when the greater-fool lender fails to play along.

dti

Given the problems borrowers face when debt-to-income ratios exceed 43%, the government shouldn’t back these loans because the borrowers are likely to default; however, the government does still back these loans, a great many of them. In fact, 24% of the supposedly safe new loans have debt-to-income ratios above 43%, and the FHA has a whopping 16% of its loans with debt-to-income ratios exceeding 50%!

dti 2

Given the desire of everyone in Washington to reflate the housing bubble to bail out the banks from the last housing bubble, it doesn’t seem likely they will wind down the GSEs. Removing the GSEs from the mortgage landscape would cause interest rates to rise, thereby reducing borrowing power, and it would remove the exemption the GSEs currently use to originate overly large loans — despite the obvious risk of default. Perhaps they will pass this burden on to the FHA or the new entity that replaces the GSEs, but if they don’t, loan balances will get smaller, which will lead to lower sales or lower prices.

Mortgage Risk Index-March 2014 Release

March 21, 2014

Download (PDF, 174KB)

24% of all purchase loans have a debt-to-income ratio greater than the CFPB’s Qualified Mortgage rule limit of 43%, a new series high.

To put the February level of 11.6% in perspective, the NMRI for loans originated in 1990, when prudent underwriting standards predominated, was about 6%.  In contrast, the NMRI for the exceptionally risky 2007 vintage of loans was about 19%.  Consequently, the January level indicates that housing risk is substantially higher today than in 1990, but does not approach the level in 2007 when credit standards were the loosest in many decades.

mortgage safety

Many complain today’s lending standards are too tight. Obviously, that is not the case. Standards are tighter today than 2007, but in 2007 we had no standards, so returning to any standard at all requires tightening. What I find interesting is how this study quantifies it. The standards today are still twice as loose as the prudent days of the 1990s.

From the report:

reasons for caution

I recently wrote about the credit cycle in Troubling evidence of new Coastal California housing bubble. As the authors of this study point out, there is constant pressure to lower standards both from the market, as lenders compete for business, and from politicians who want to boost the home ownership rate. This constant pressure is what drove previous housing cycles. I also recently opined the new mortgage regulations change how real estate markets work and the new mortgage regulations will prevent future housing bubbles, but I could be wrong.

If standards do loosen up again, it’s worth noting that one of the main reasons subprime lending fails is because subprime borrowers default in large numbers.

stressed redefault rates

The subprime business model can still work if down payments are very large because the high default rates don’t become large default losses when the borrower (really the banker) has an equity cushion. So new loans have a good equity cushion, right?

low down payment

So is California at risk? Will lenders get whacked again on new bad loans that reflated the housing bubble? It depends on what you believe about today’s home prices, overvalued or fairly valued?

mortgage risk

Personally, I believe house prices are not currently overvalued; a spring house price rally may inflate new housing bubble, but today, prices are appropriate given rent levels and today’s mortgage interest rates.

[dfads params=’groups=3&limit=1&orderby=random’]

[listing mls=”PW14061234″]