Looser lending standards won’t inflate another housing bubble
Lenders lower standards to qualify more borrowers and increase business, a precursor to another bubble, but only if risk is again mispriced.
The recipe for a housing bubble takes many ingredients, and loose lending standards are one of them; however, it requires a gross mispricing of risk and enormous capital flows into unstable loans before prices get pushed up into bubble territory.
Let’s assume for a moment all qualification standards were eliminated and anyone who wanted to borrow money could get a loan, similar to what happened in 2004 through 2006. Would this cause a housing bubble? In my opinion, it would not. It would inflate prices, and it would cause a great deal of downward substitution of quality to get a property, but it wouldn’t necessarily create a housing bubble as long as loans were based on verifiable income and reasonable debt-to-income ratios on conventionally amortizing mortgages.
The loose lending standards of 2004-2006 allowed many people to buy homes, but it was the combination of liar loans, unlimited debt-to-income ratios, and negatively amortizing loans that allowed the army of borrowers to finance loan balances double what they should have been. Remember, housing demand is measured two ways: total number of buyers, and total amount those buyers can put toward housing. Increasing the number of borrowers can inflate prices through the substitution effect, but increasing the total amount buyers can put toward housing is what sends prices orbital.
Toxic loan programs like the option ARM were not invented during the housing bubble; they were long-standing niche products with a hefty price tag to properly price the risk of default. It was the gross mispricing of risk on Wall Street that created an insatiable demand for these products that drove the price down and put these weapons of financial destruction in the hands of unqualified borrowers. Prices wouldn’t have inflated nearly so much during the housing bubble if the risk hadn’t been mispriced through ruinous credit default swaps and collateralized debt obligations given AAA ratings by a corrupted rating system.
It’s right to be concerned about the return of some dangerous loan products. I expressed my belief that the new mortgage regulations will prevent future housing bubbles because the “Ability to Repay” rules will prevent reckless lending, but I could be wrong. These toxic loan products don’t conform to the new mortgage regulations, so right now they are very expensive and uncommon. If Wall Street misprices risk yet again, they could fund these non-conforming loans and inflate another housing bubble. We must pin our hopes on changes at the ratings agencies, new regulations, and institutional memory on Wall Street — we all have reason to worry.
Banks Ease Standards Enacted After the Housing Boom Turned to Bust in Sign of Rising Confidence
By Nick Timiraos and AnnaMaria Andriotis
The credit freeze is starting to thaw.
Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market.
While standards remain tight by historical measures, lenders have started to accept lower credit scores and to reduce down-payment requirements. …
One such lender is TD Bank, Toronto-Dominion Bank’s U.S. unit, which on Friday began accepting down payments as low as 3% through an initiative called “Right Step,” geared toward first-time buyers and low- and moderate-income buyers. TD initially launched the program last year with a 5% down payment. It keeps the product on its books and doesn’t charge for insurance. Borrowers also don’t need to put down any of their own cash if a family, state or nonprofit group provides a down-payment gift.
This is an interesting development considering the FHA specifically banned the practice of down payment assistance because the default rates were 4 times higher; further, with no equity cushion, the default losses were much larger. My guess is that this loan carries a hefty price tag and has other onerous requirements.
The changes also are a recognition by lenders that the business of refinancing old mortgages, which had been a huge profit center for banks, is nearly tapped out. To generate future profits, banks will have to compete for borrowers who may not have perfect credit or large down payments. …
For now, economists and lenders say there are few signs of any return to the carelessness of the past decade’s destructive credit bubble. “Credit is loosening, but it is loosening from a tight starting point,” said Mr. Fratantoni of the MBA.
Bankers make money by making loans. With loan production at 20-year lows, some reduction of standards was inevitable if they want to remain in business.
The competition for new business is prompting some lenders to offer toxic loan products again — at a high price. From a recent email a reader forwarded me…
Adjustable-rate mortgages — the apocalyptical financial product of the recent economic collapse — are coming back in a big way. Of course, the banks insist that this time it’ll be different. At the moment, they’re targeting only high-net worth borrowers. According to a study that was developed for The Wall Street Journal, during the fourth quarter of 2013, roughly one-third of mortgages that ranged between $400,000 and $1 million, and nearly two-thirds of those over $1 million, were adjustable-rate mortgages.
But U.S. banks are under earnings pressure these days. Profit margins are shrinking, in part because demand for loans — mortgages in particular — has fallen off as interest rates have begun to rise and the economic recovery remains uncertain. Consequently, it’s reasonable to anticipate that lenders will once again rationalize their way to broadening the scope of their marketing efforts by relaxing credit underwriting standards . It also helps that ARMs end up shifting to borrowers the interest rate risk the lenders would otherwise have to take with fixed-rate loans.
The main reason lenders offer ARMs has nothing to do with helping borrowers. In fact, since the ability to repay rules require them to qualify the borrower at the maximum contractually allowed rate during the first five years, it doesn’t function as an affordability product. What it does accomplish is lower a borrowers payment somewhat while also transferring all the interest-rate risk onto the borrower. Generally, it’s a foolish move borrowers make due to myopia.
When interest rates are stable and low — as they’ve been these past few years — conventional loans rule. But when the economy starts to crank and rates begin to move, which is beginning to happen now, adjustable loans can become awfully tempting for both borrowers and lenders. The hook is a low monthly payment to start — often, meaningfully lower than for a fixed-rate loan. Later on, of course, you’re playing with fire.
The issue is how much heat can you stand? Start by asking yourself these questions:
How much room do I have in my budget for a bigger monthly payment in the event that interest rates move up?
What if credit becomes tighter or if interest rates move up so much that I can’t refinance my way out of the loan?
What if I can’t sell my house for a price that’s high enough to pay off the debt I have against it?
Then they’ll petition for a loan modification and likely get it.
It’s always better to plan for the worst rather than to be caught off guard by it.
Borrowers don’t appraise the risks. Everyone blithely assumes everything will go their way, and in our new era of mortgage moral hazard, they also correctly deduce they will be given a loan modification if things really go awry, particularly if enough of their neighbors make the same stupid decision and they all need help.
Although most prefer conventional loans to ARMs — because budgeted loan payments aren’t something many consumers like to see change — there are those who don’t mind playing with financial fire for other reasons (they expect to sell the house before the first adjustment period comes to pass, for instance). If you’re one of them, consider one last bit of advice: Don’t be greedy! Interest rates are still unusually low. Is the $100 or $200 payment advantage I described above really worth the downside risk? When rates are at rock bottom, it’s all downside risk.
I’ve been adamant in my opposition to using adjustable-rate mortgages, but with the moral hazard of inevitable loan modifications, I can no longer say it will likely cost people their homes. Of course, lenders will make those loan modifications totally in their favor, and they will drain all the borrower’s resources, the borrowers will at least keep living in the bank’s house, probably indefinitely.
Also, adjustable-rate mortgages can actually be better than fixed-rate mortgages if the contractual cap isn’t too high. The problem with ARMs has historically been the contractual cap is so high that borrowers can easily get in over their heads. If this contractual limit isn’t much higher than current rates on fixed-rate mortgages, the adjustable may be the way to go because the downside risk is minimal. Finding the ARM with a low contractual limit is another issue, and it may carry other costs that make it a poor choice. The details matter.
Looser lending standards are part of the complex puzzle that inflates dangerous housing bubbles, but it’s also a natural part of the credit cycle, and not necessarily destabilizing to the housing market or the broader economy. If we start to see a proliferation of non-conforming loans funded by Wall Street, then we need to be very vigilent because that sets up the market for a structural failure.