Oct132014

Mortgage standards of 1990s were normal and prudent

Lenders retreated to the normal, safe and prudent lending standards of the 1990s in the wake of the housing bust.

Lending standards don’t evolve through a process of innovation; they move in cycles. Lending standards start from a position of stability, and over time, competition drives lenders to lower standards and experiment with riskier loan programs until the entire system becomes unstable. Then some economic disruption, or as happened in 2007, large numbers of borrowers default, and the entire system crumbles, a credit crunch ensues, and lending standards retreat to the stable levels where they started.

Despite how obvious and predictable this cycle is, the lending industry repeats their mistakes every few decades. In the latest go-round, lenders touted their “innovation” with exotic loan products, and they sold these toxins far and wide. Now that these loans achieved the highest default rates ever recorded, it is safe to say the “innovations” were a dismal failure. I find it astonishing a group of intelligent bankers came up with the Option ARM and expected a positive outcome.

option arm development team

Many in the lending industry think their work is like science that continually advances. It’s not. It is far more akin to assembly line work where the same widgets are pumped out year after year. When lenders start to innovate, trouble is brewing; in fact, I believe promoting financial innovation will lead to another housing bubble.

king_conformingThe last significant advancement in lending was the widespread use of 30-year amortizing loans that came into favor after World War II. Prior to that time, home loans were interest-only, short-term loans with very high equity requirements (50% was most common.)

The large number of interest-only loans proved problematic in the Great Depression as many out-of-work owners defaulted. A mechanism had to be found to get new buyers into the markets and allow them to pay off the loan. The answer was the 30-year, fixed-rate amortizing loan.

To say this was an innovation is a stretch as this loan has been around as long as banking has existed, but it did not become widely used until equity requirements were lowered. The lenders were willing to lower the equity requirements as long as the loan was amortizing because their risk would decline as time went by and the loan balance was paid off.

Over the last 60 years since World War II ended, a number of experimental loan programs have been attempted. These include, interest-only loans, adjustable rate loans, and negative amortization loans among others.

Innovative loans consistently fail for one simple reason: if payments can adjust higher, people will default. It’s really that simple. The Option ARM is certainly the most sophisticated loan ever developed. It’s a dismal failure, not because it isn’t sophisticated, but because it has embedded within it the possibility (probability, no — near certainty) of an increasing payment. Any loan program that has the possibility of a higher future payment will fail because there will be a certain number of people who cannot afford the higher payment.planet_banks

Here is where the lenders lie to themselves and to the general public after a financial debacle like the Savings and Loan problems of the 1980s or our recent housing bubble: they blame the collapse and the high default rates on some outside factor rather than the terms and conditions the lenders created all by themselves. They don’t admit the failure of millions of borrowers was really a failure of lenders because they created “innovative” loan products most borrowers couldn’t handle.

The inevitable end to any failed lending innovation is a credit crunch and a return to stable lending products known to be stable: the 30-year conventional mortgage. They also return to stable underwriting standards with things like income verification and assessing a borrower’s past history of repayment. Compared to the bubble years, this is regression and a tightening of credit. In reality, it’s merely returning to what’s safe and prudent, a lender behavior typical at the bottom of the credit cycle.

Tightest Credit Market in 16 Years Rejects Bernanke’s Bid

By Prashant Gopal, Oct 8, 2014 6:06 AM PT

James Bregenzer, a 31-year-old marketing strategist in Chicago, was rejected for a mortgage in May after successfully financing two previous home purchases. The hitch this time: his monthly payment would have been $100 more than the lender was willing to approve.

So what? Whether it’s $10, $100, or $1,000, if the borrower can’t afford the payment, they can’t afford it. There has to be a threshold, and there will always be borrowers who fall just outside of it.credit-crunch

Bregenzer is in good company. Standards in the U.S. are so high and inflexible that former Federal Reserve Chairman Ben S. Bernanke, now a Brookings Institute fellow-in-residence with a net worth of at least $1.1 million, said at a conference last week that he couldn’t refinance his house in Washington. Even some doctors struggle to get home loans if they’re self-employed.

“We asked if we could go over by $100 and were told that’s just not going to work,” said Bregenzer, who bought his first home before getting married in 2008. “The process of buying a home used to be stupid easy. Now, my wife and I were buying a home with two salaries, we make a heck of a lot more than I used to, and I have to go into great and terrible detail to show documentation.”

Oh no! The horror of it. He had to document his income to a lender considering loaning him several hundred thousand dollars. Shouldn’t his qualifications and income be verified?

And notice the false assertion that despite making more money he couldn’t get a loan. Don’t you suspect he is borrowing a lot more than he did last time?BenHelicopter

Lenders are continuing to tighten the credit vise on homebuyers after five straight years of economic expansion, imposing the toughest standards since at least 1998, according to a new index by CoreLogic Inc. …

It is clear that credit is quite tight relative to normal,” said Mark Fleming, chief economist at Irvine, California-based CoreLogic.

That depends on how you define normal. Personally, I define it as the period when lending was dominated by 30-year conventional mortgages — the 50-year period from 1945 to 1995. When a standard endures that long, and the housing market was stable because of it, then that’s what credit terms should be like. Returning to the 1990s standards should be welcomed because it will also instill stability into what has been a volatile housing market.

Doesn’t the assertion that credit is tight sound like lending industry shilling? It does to me.

While banks shouldn’t revert to the loose credit standards of the housing bubble, it’s possible for lenders to expand credit while still being prudent, as they did in the late 1990s, he said. …

That is the standard nonsense lenders and realtors generally spout. The reality is they do want the loose standards of the housing bubble because lending standards never got in the way of transaction income during the bubble. And with taxpayers now insuring these loans, the industry has every incentive to demand lower standards to boost their incomes.Ben-Bernanke-Las_Vegas

Bernanke’s RejectionProfessionals with established careers whose earnings fluctuate may no longer be considered good credit risks and are having trouble getting conventional financing. This includes self-employed professionals, doctors with their own practices and nurses who cannot show two years with an employer because they’ve shifted jobs multiple times, said Michael Slavin, chief executive officer of Privlo Inc., an online provider of real estate loans for borrowers with complex finances. …

Obviously, people who have variable income or shift jobs frequently are poor credit risks. Many of these people default on their mortgage obligations. Perhaps it turns out well for most people, but the percentage for whom it turns out worse is high enough to cause lenders to lose money. It should be more difficult for them to get loans.

Bernanke, who is no longer on the Fed payroll, has a net worth of $1.1 million to $2.3 million, and income of $150,000 to $1.1 million from textbook royalties in 2013, according to disclosure forms he filed this year as he was leaving the Fed. …

“I recently tried to refinance my mortgage and I was unsuccessful in doing so,” the former Fed chairman said in a speech in Chicago.

“It’s entirely possible” that lenders “may have gone a little bit too far on mortgage credit conditions,” he told a conference of the National Investment Center for Seniors Housing and Care.

bagholderShould Bernanke get special treatment? He fits a profile of borrowers who have defaulted in large numbers in the past. How do you separate the wheat from the chaff?

“In good times, everybody is optimistic and neglects the downside risk,” said Itzhak Ben-David, finance professor at the Fisher College of Business at Ohio State University. “After a major shock, people are too cautious. Nobody wants to have the risk of holding the hot potato.”

And with Uncle Sam still insuring over 80% of the loans originated today, you and I will end up holding the bag if it all blows up again.

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