Mar072016

Conforming loan limits inhibit higher home prices

Conforming loan limits create intense buyer competition at under-limit prices and restrict home price increases need to bail out underwater borrowers.

a_house_deflationThe FHA and the GSEs exist to provide subsidized mortgages to lower- and middle-income Americans. The conforming loan limit is put in place to limit the size of loans insured by the FHA and the GSEs to ensure these loans are targeted to the borrowers they’re intended to subsidize.

Prior to establishment of the FHA and later of the GSEs, lenders often wouldn’t make home loans to lower-income Americans, or the cost of these loans was so high, lower-income borrowers couldn’t afford it. The FHA and the GSEs succeeded in opening a market for these borrowers, and by bundling these mortgages into mortgage-backed securities, they helped facilitate the flow of capital to all areas of the country.

Contrary to the lies spouted by the political right, the housing bubble was not inflated by the FHA or the GSEs making conforming loans to poor borrowers. House prices bubbled up everywhere primarily due to the widespread use of the Option ARM loan, a private loan that allowed borrowers to finance ten times their income. The loans that inflated the housing bubble were not government-backed.

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During the housing bubble, the conforming loan limit became superfluous because as prices rose higher, these loans couldn’t finance the sums required to buy homes, and lenders were eager to provide toxic loans like the Option ARM to people with no income, no jobs, and no assets, including no money down. Conforming loans were relatively rare during the housing mania.

Once the folly of the Option ARM became apparent through sky-high default rates, this product was abruptly removed from the market. However, this credit crunch left a giant void behind. House prices were elevated to ten-times income prices by the Option ARM, and without it, people could only finance four-times their household income. Prices were bound to fall.

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In order to prevent house prices from falling further, Congress and the federal reserve implemented policies designed to increase access to cheap credit for those few buyers who could still qualify for home loans.

The federal reserve acted first. Ben Bernanke lowered interest rates to zero, and started buying mortgage-backed securities in order to drive mortgage rates down from 6.5% in 2006 to 3.35% before they bottomed. Cutting mortgage rates in half doubled the amount people could afford to finance on the same income, and this did much to close the affordability gap left behind when the Option ARM was removed.

When the Option ARM collapsed, it took most private lending along with it. Lending without a government guarantee became scarce, and with the low conforming loan limit on government guaranteed loans, the low mortgage rates couldn’t translate into larger mortgage balances unless the conforming limit was raised.

Congress acted next by instructing the Federal Home Finance Agency, the entity put in charge of the GSEs in conservatorship, to “temporarily” raise the conforming loan limit to price levels that would support bubble-era prices in the most bubblicious markets. It should surprise no one that these “temporary” measures are still in place seven years later.

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Last week, I published a Story of a self-reliant Gen-Xer’s first time home purchase. That story reveals something very important about how the housing market functions today.

In the story, the protagonist relayed his experience looking for homes both below and above the conforming limit. He found that competition was fierce for those properties within reach of the conforming limit, but this competition dropped of considerably if he looked just above. Why is that?

The hard cap on FHA and GSE loans means borrowers must use private financing in what’s known as a jumbo loan. Lenders who originate these loans have stricter standards than the FHA or the GSEs, and most importantly, they required at least 10% and most often 20% down; most buyers lack the down payments.

Many potential homebuyers who have the income to qualify for loans much larger than the conforming limit don’t get these loans because they fail to meet the down payment requirements.

Over the next several years, I believe we will see two trends emerge in response to this situation: (1) Jumbo lenders will start lowering down payment requirements, and (2) pressure will mount to raise the conforming loan limit.

Lower down payment requirements

Why don’t borrowers have the down payments? First, many people don’t save anything, much less the 20% of a home purchase. Second, the housing bust wiped out the equity savings of millions of people, trapping them in their starter homes. Third, the Great Recession wiped out the savings of many who struggled to make ends meet.

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Since the major limitation to making more loans is not qualifying income, competition among lenders will prompt them to lower their down payment standards to gain market share. In late 2014, the GSEs announced they would start buying mortgages with as little as 3% down. However, with costly private mortgage insurance required, it’s not superior to an FHA loan. In late 2015, one credit union in San Francisco offers loans up to $2,000,000 with no money down. This loan will also be costly, as it should be to compensate for the tremendous risk involved.

While Dodd-Frank does a good job of cracking down on the worst lending products, it’s notable failure is the lack of a down payment requirement. This loophole is large enough to potentially inflate another housing bubble — or at least reflate the old one.

Raise the conforming limit

The myopic self-interest of realtors, homebuilders and lenders compels them to lobby for a higher conforming limit so they can originate large loans and pass the risk on to the US taxpayer. Since Congress accomplished nothing over the last eight years on mortgage finance reform, it’s difficult to place all the blame on foolish real estate industry insiders. As long as the current system remains in place, the US taxpayer is 100% liable for loans originated by the FHA and GSEs, which includes most loans under the conforming loan limit. Taxpayers should want to see this limit be as low as possible, zero being ideal.

Since raising the conforming limit would allow lenders to make riskless profits, and since it would increase the income and profits for realtor and homebuilders, it’s safe to assume lenders, realtors, and homebuiders will lobby fiercely and persistently to raise the conforming limit. How long will the lingering memories of the housing bust prevent legislators from giving in to these never-ending demands?

The bubble market quandary

The current conforming limit is low relative to incomes and current borrowing power. Therefore, it concentrates competition on houses prices below the conforming limit while leaving a glut of higher priced homes on the market. The lack of inventory is not a universal problem. The Housing inventory is abundant at prices buyers can’t afford, which is the real problem.

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Due to cloud inventory restrictions, many sellers couldn’t lower their price even if they wanted to (most don’t). Much of the cloud inventory is typical entry-level housing suspended at prices above the conforming limit. These are the people who are truly trapped. Due to the low conforming limit, a new first-time homebuyer can’t finance the amount necessary to allow these trapped buyers to move on and up. The result is first-time homebuyer participation at near record lows, bidding wars on properties priced below the conforming limit, and a glut of inventory above it.

In 2014 I predicted the pressure would mount to lower FHA loan fees about six weeks before the surprise announcement. It wasn’t insider information, it was good analysis and lucky timing. I’m predicting now that pressure will mount to raise the conforming loan limit. These limits are generally adjusted in November, and since this is an election year, it’s not likely we will see a change between now and then, but the lobbying will continue, so it’s only a matter of time.

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