Sep172015

Five ways to reduce taxpayer risk in the mortgage market

Dodd-Frank accomplished much to reduce taxpayer risk, but more should be done to get taxpayers out of the mortgage insurance business.

government_housing_market

The US taxpayer insures over 70% of the mortgage market through the GSEs and FHA. This is an unacceptably high level of exposure, particularly given the multi-trillion dollar size of the US mortgage market. Reducing this exposure is difficult because removing the guarantees will increase mortgage costs, reduce loan balances, and make it much more difficult for buyers to finance today’s near-bubble-peak prices, a major goal of lenders and loanowners alike.

Any change to mortgage lending will disrupt the housing market, so any change must be phased in slowly. The overriding strategy should be to limit the growth of mortgage balances and allow equity to accumulate in properties, providing a buffer against any shocks to the market. Without limits to mortgage loan balances, we are certain to have Ponzi borrowers who game the system to get free money they never intend to repay. Unfortunately, this concept is sacrilege to the lending industry which wants to divert every penny of borrower income to debt service payments.

1. Cap secured borrowing at 80% LTV

Many people don’t understand what caused the housing bubble because of misinformation in the mainstream media and politically motivated books on the subject. The reality is quite simple: Desire for mortgage equity withdrawal inflated the housing bubble.

The real culprit in a housing bubble was expanding home mortgage balances — people took on more debt and bid up prices. But why did they do it? The short answer is to capture appreciation, but the full truth is more nuanced.

In order for home price appreciation to motivate people to pay stupid prices and inflate housing bubbles, they need a way to access this appreciation. The more immediate and plentiful this access to money, the more motivated buyers are to borrow and cash out. Mortgage equity withdrawal is the doorway to appreciation; it makes houses very desirable and very valuable.

Texas was one of the few states which did not participate in the housing bubble. This was surprising because Texas was a major participant in the commercial bubble of the late 80s and early 90s. The reason Texas didn’t participate in the residential housing bubble is because they have laws prohibiting mortgage equity withdrawal beyond an 80% LTV.

Since Texans didn’t have unlimited access to the housing ATM, they didn’t bother bidding up home prices. What would have been the point? People aren’t motivated to acquire intangible wealth like they are to acquire free money they can spend.

The Texas experience clearly showed the individual incentives matter a great deal. California inflated a massive housing bubble because we permitted unfettered access to HELOC booty, and as property values went up, property taxes didn’t, thanks to Proposition 13. (Texas has very high property taxes.)

Gothic-PiratesIn addition to limiting mortgage equity withdrawal, California should consider changing Proposition 13 to trigger a reassessment with every refinancing of a residential property. A borrower can’t argue to the Assessor the property isn’t more valuable after obtaining an appraisal to get a HELOC. If HELOC money cost the borrower more in property taxes, the State would benefit, and borrowers would have less incentive to raid the housing ATM.

2. Limit appraised values by rental cashflow

Back in 2012, I noted that rental parity analysis in appraisals would prevent another housing bubble. Prices collapsed during the housing bubble because prices became greatly detached from their fundamental valuation of income and rent. This occurred because the comparative-sales approach enables prices to rise based on the irrational exuberance of buyers.

If lenders would have limited their lending based on the income approach, and if they would not have loaned money beyond what the rental cashflow from the property could have produced, any price bubble would have to have been built with buyer equity, and lender and investor funds would not have been put at risk.

Since lender and investor risk is now taxpayer risk, every effort should be made to establish the rental cashflow value of real estate and limit loan balances accordingly.

3. Permanently ban interest-only and negative amortization loans

When the credit crunch hit as house prices collapsed, negative amortization loans were discontinued almost immediately. It took a little longer for the market to turn against interest-only loans, but those ultimately went away as well. In a fed whitewash paper on housing, they actually defend the use of these loan programs — or at least their failure to regulate them.

Fortunately, these loan programs were effectively banned by Dodd-Frank, but just as liar loans reemerged though Dodd-Frank loopholes, it is still possible for negative amortization and interest-only loans to come back as well.

At this point, we can only hope lenders don’t lose their minds again and bring back these Ponzi loans. We need stiffer regulations against such loans to prevent these Ponzi scheme loans from inflating future housing bubbles and putting taxpayer funds at risk.

4. Base payment qualification standards on maximum allowable interest rate

When qualifying people for loans, lenders are supposed evaluate a borrower’s ability-to-repay, but they provided a loophole for adjustable-rate mortgages. In the promissory note, if the rate is adjustable, there is a cap on the maximum interest rate the borrower can be charged. This maximum theoretical payment is what lenders should be required to use when qualifying a borrower.

As it stands, a borrower’s ability to repay is only evaluated for the first five years of the term. When interest rates go up after the five-year term, payments can become unaffordable and the borrower may default. Right now that risk is ostensibly on the borrower, but since we know they can walk without recourse, that puts the risk back on the lender who in turn will transfer the loss to the US taxpayer.

5. Limit front-end debt-to-income ratios to 31%

During the housing bubble, lenders allowed borrowers to pledge completely unrealistic portions of their income toward housing payments. Many borrowers in the early loan modification programs had debt-to-income ratios over 70%! After taxes, that leaves nothing at all. Only continued Ponzi borrowing sustains such high debt-to-income ratios.

The first round of loan modifications reduced borrowers front-end DTIs to 38%, which was a significant improvement for many, but since the Ponzi loans were not forthcoming, even a 38% DTI proved too much. Nearly all of the early loan mods failed.

Finally, the government set loan modification targets and GSE loan qualification guidelines at 31%. This is still above the previous standard of 28%, but it is at least manageable without Ponzi borrowing, albeit with very little disposable income left over.

Right now, 31% DTIs are the standard because the government is the only game in town. However, there is nothing to prevent lenders from approving DTIs as high as 43% in the future. Since this will inflate prices, it will enable Ponzi borrowing, and the entire mortgage Ponzi scheme could inflate all over again. We need strict regulations limiting debt-to-income ratios on all residential home loans.

Would implementing these five policies prevent future housing bubbles?

These policies wouldn’t necessary prevent future housing bubbles, but they will do one very important thing: these policies will prevent the US taxpayer from picking up the tab for the next one. That alone makes these policies necessary for implementation.

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