Sep182012

Potential government-induced mortgage credit crunch in 2013

To understand the credit crunch, and why we might have another one, I have a visualization exercise for you that I originally posted back in 2007:

Imagine a room with 100 people representing the pool of subprime borrowers. These are new entrants to the market. They were previously unable to buy due to bad credit, lack of savings, and other reasons. All of them are told they are going to bid on an asset that never goes down in value, and they will be given the ability to borrow unlimited funds (stated-income “liar loans”) The only caveat is the borrowed money must be paid back when the asset is sold (not that they care, they already have bad credit). Imagine what happens?

People start to buy the asset, and prices rise. Others in the room seeing the rising prices come to believe that the value of the asset never declines, and they join in the bidding. As the bidding drives prices even higher, a manic quality takes over the bidding and people compete with each other, often bidding higher than the asking prices. Nobody wants to be left out. There are fortunes to be made. Greed drives prices upward at a staggering rate. As the last of the 100 people buy, prices are very high, everyone has made money, and it looks as if prices will continue to rise forever . . .

Then something strange happens: there is nobody left to make a purchase. (A key indication of the end of a speculative mania is a huge decline in sales, as was witnessed over 2006 and 2007). Transaction volume drops off dramatically, and prices stop their dizzying ascent. Nobody is particularly alarmed at first, but a few of the more cautious sell their assets to pay off their loans. Since there are no more new buyers, the first selling actually causes prices to drop. This is unprecedented: prices have never declined! Most ignore the problem and comfort themselves with the history of rising prices; however, a few are spooked by this unprecedented drop and sell the asset. This selling drives prices even lower. Now those who still own the asset become worried, some continue to deny that there is a problem, and some get angry about the price declines. Some of the late buyers actually owe more than they paid for the asset. They sell the asset at a loss. The lenders now lose some money and refuse to loan any more money to be secured against the asset. Now there are even fewer buyers and a large group of owners who all want to sell before prices drop any lower. Panic selling ensues. Everyone wants to sell at the same time, and there are no buyers to purchase the asset. Prices fall dramatically. This asset which was sought after at any price is now for sale at any price, and there are few takers. People in the market rightfully believe the asset will continue to decline. Owners of the asset have accepted the new reality; they are depressed and despondent.

In any group of people, there are always a few who do not believe the “prices always rise” narrative. Some recognize that asset prices cannot rise indefinitely and cannot stay detached from their fundamental valuations. These people witness the rally and the resulting crash without participating. They wait patiently for prices to drop back to fundamental values, and then these people buy. As these new buyers enter the market, prices stop their steep descent and market participants start to hope again. It takes a while to work off the inventory for sale in the market, so prices tend to flatten at the bottom for an extended period of time; however, just as spring follows winter, appreciation returns to the market in time, and the cycle begins all over again.

What is written above is true of any asset whether it be stocks, bonds, houses or tulips. In this case, it is the local housing market, and the room of new buyers represents subprime borrowers, but the concepts are universal. One phenomenon somewhat unique to the housing market is the forced sale due to foreclosure (stocks have margin calls). Even if the psychological factors at work during the panic could somehow be quelled, the forced sales from foreclosures would drive down prices anyway. True panic is not required to crash a housing market, only dropping prices and an inability to make payments.

Though that was written five years ago, haven’t we witnessed all of those stages play out since then? The reports I generate each month show prices at or below their historic norms relative to rental parity. The market is turning from despair to a grim acceptance of lower prices as we bounce along the bottom.

The chart below is two years old, so we are one or two steps further along, but we still haven’t reached the point where private sector deleveraging is stopped. There is some question as to whether we have made any progress given the renewed quantitative easing.

Mortgage Putback Threat Reduced for Lenders Under New Rules

By Clea Benson – Sep 11, 2012 9:25 AM PT

The U.S. overseer of Fannie Mae and Freddie Mac (FMCC), seeking to reduce the threat that banks will have to buy back flawed mortgages from the two firms, laid out new rules designed to spur lending and ease the housing crunch.

The changes will apply to future loans, not those that are the subject of current bank complaints that the taxpayer-owned companies are being too aggressive in forcing them to buy back loans made at the height of the housing bubble, the Federal Housing Finance Agency said today in a statement.

The GSEs are aggressively pursuing lenders and forcing them to buy back their bad loans from the housing bubble. That isn’t going to stop. What lenders are looking for is more certainty about what they face  on loans they are originating today and in the future.

The new system, which takes effect on Jan. 1, should give banks more certainty about future costs by flagging potentially faulty mortgages earlier, FHFA said. Fannie Mae and Freddie Mac will use data collected on the loans they buy to spot potential defects, and will review samples within three months of purchase instead of waiting until borrowers default.

“Lenders want more certainly about their risk exposure, and the enterprises want to ensure the quality of the loans,” Edward J. DeMarco, FHFA’s acting director, said yesterday in a North Carolina speech where he outlined the changes.

Regulators including FHFA and the Federal Reserve have said that banks are shutting out otherwise eligible borrowers and demanding higher credit scores than necessary because they are afraid Fannie Mae and Freddie Mac will force them to repurchase loans if they become delinquent.

As I pointed out a few days ago, Some creditworthy families will always be denied mortgages. It is not possible to give everyone a loan. We tried that back in 2005, and it didn’t turn out very well.

‘Lending Defensively’

David Stevens, president and chief executive officer of the Mortgage Bankers Association, said the rules probably will give banks more confidence that they won’t be forced to buy back loans unless there are serious problems with origination.

“Obviously, we need to see the details, but anything in this direction is really important, because lenders today are lending defensively,” he said today in a telephone interview. …

As they should be. What’s shocking to me is that anyone thinks otherwise. Lenders are supposed to be careful who they lend money to because they want to get their money back. Lending aggressively leads to losses, and since we are discussing government-backed loans, we all want lenders to be lending defensively.

Under the new rules, the companies won’t force lenders to repurchase defaulted loans if borrowers have made 36 months of consecutive on-time payments. Banks will be protected from buyback requests after only 12 months of payments for certain types of loans, such as those originated under the federal government’s Home Affordable Refinance Program, DeMarco said in the Raleigh, North Carolina, speech.

I love how the government changes the bar to suit their purposes. For loan buybacks, in order to protect taxpayers, the borrowers must make three years of payments. Fair enough. For loan modifications, the government wants to see 12 months of payments. Anyone should be able to do that. If they can pay rent, they should be able to pay a loan. However, for propaganda purposes, the government considers a loan modification “permanent” after only three payments. Apparently, they know many of these “permanent” loan modifications are going to fail, so they make the lender wait 12 months to get off the hook for the losses.

…“What you’re going to see is a surge in more audits, rather than less, just as companies are getting comfortable that the worst is behind them,” Rood said in a telephone interview yesterday.The early reviews may cause lenders to raise underwriting standards instead of loosening them, Jaret Seiberg, senior policy analyst at Guggenheim Partners, said today.

“This is why we still see the putback policy as yet another factor that could add to what we worry will be a government-induced credit crunch in 2013,” Seiberg wrote in a market commentary. “How big of a factor this is will largely depend on how those initial loan reviews go.”

Once a credit crunch gets started, it doesn’t stop until standards tighten to the point only the most qualified borrowers are given loans. That’s why now, a full five years after the credit crunch gripped the market, standards are still tightening. Only when borrowers stop defaulting on new loans will the process of tightening stop. Neither banks nor the government is keen to lose money on bad loans, so standards get tighter and tighter until the losses stop. That’s how the credit cycle works.

In the wake of the housing bubble, Fannie Mae and Freddie Mac have been reviewing files on defaulted loans originated between 2005 and 2009 for signs of faulty underwriting. In the first two quarters of this year, the two government-sponsored enterprises asked banks to buy back mortgages with an unpaid principal balance of $18.9 billion.

In 2008 we bailed out the banks and told them to loan money. They didn’t. And for good reason. There weren’t many creditworthy borrowers as evidenced by the billions in loan buybacks from this period. The forced buybacks are an essential feedback mechanism in the system. It’s the only thing ensuring good underwriting in an era of insured securitization.

Banks usually end up paying about half of the unpaid principal balance when a putback demand is successful, according to the companies.

A strong incentive indeed.

… Bank of America Corp., Wells Fargo & Co., JPMorgan Chase & Co., Citigroup Inc. and Ally Financial Inc., set aside almost $3 billion to buy back bad home loans in the first half of 2012, according to data compiled by Bloomberg. Regional lenders including Atlanta-based SunTrust Banks Inc. said they set aside at least $1.3 billion for such loan repurchases in the same period, exceeding their total for all of 2011.In his speech at the American Mortgage Conference, DeMarco outlined future steps FHFA will take to shrink Fannie Mae and Freddie Mac’s footprint in the mortgage market.

The fees the enterprises charge to lenders to guarantee loans, which will have increased by 20 basis points by the end of the year, will continue to be raised, he said.

As loan costs go up, either bank margins go down, or borrower costs go up. If borrower costs go up, loan balances get smaller, and the housing market faces a new headwind. One of many it will contend with over the next several years.

Eventually, credit standards will ease somewhat. Once lenders fear losses less, they will loosen their standards, and we will begin the cycle all over again. Hopefully, this time, taxpayers won’t be on the hook for the losses. Right now, we are.