Mar302017

Regulating mortgage debt-to-income ratios helps prevent Ponzi schemes

Debt-to-income ratios must be limited because beyond a certain point, rising debt service becomes a Ponzi scheme.

In The Great Housing Bubble, I wrote about how we could prevent the next housing bubble:

Loans for the purchase or refinance of residential real estate secured by a mortgage and recorded in the public record are limited by the following parameters based on the borrower’s documented income and general indebtedness and the appraised value of the property at the time of sale or refinance:

  1. All payments must be calculated based on a 30-year fixed-rate conventionally-amortizing mortgage regardless of the loan program used. Negative amortization is not permitted.
  2. The total debt-to-income ratio for the mortgage loan payment, taxes and insurance cannot exceed 28% of a borrower’s gross income.
  3. The total debt-to-income of all debt obligations cannot exceed 36% of a borrower’s gross income.
  4. The combined-loan-to-value of mortgage indebtedness cannot exceed 90% of the appraised value of the property or the purchase price, whichever value is smaller except in specially sanctioned government programs.

The primary focus of my proposal was to limit lending to amounts buyers could afford to pay back. Eliminating toxic loan programs and keeping equity in the property help keep prices stable, but limiting debt-to-income ratios are critical to preventing delinquencies and foreclosures which ultimately ravage the housing market.

Limitations on the debt-to-income ratio and combined-loan-to-value prevent bubbles in the housing market and insulate the banking system from risk. Borrowers will not police themselves.

People will commit large percentages of their income to house payments when prices are rising quickly; however, they do this out of fear of being “priced out” and greed to make a windfall from appreciation — beliefs that inflate bubbles. Borrowers cannot sustain payments above the traditional parameters for debt service without either defaulting or causing severe declines in discretionary spending. The former is bad for the banks, and the latter is bad for the entire economy.

During the housing mania, bankers completely lost their minds and ignored the amount of debt they were issuing relative to the borrower’s income. Banks everywhere simultaneously began running Ponzi schemes which imploded and took the world economy down with it.

In a Ponzi scheme, borrowers rely on fresh infusions of debt to service debt and fuel consumption. Borrowers do not have the income to do either of those things, so the influx of new debt is essential to keeping the system going. When lenders withhold this debt, borrowers abruptly stop making debt service payments, and lenders respond by increasing interest rates, demanding repayment, and curtailing new debt issuances — a credit crunch.

I noted back in 2008 that the California economy is dependent upon Ponzi borrowers. Economists struggled to explain the lackluster recovery from the Great Recession, but in reality, it’s quite simple: California’s HELOC economy collapsed due to the elimination of the free-money stimulus banks gave homeowners. Even a massive government spending program is no enough to make up for millions of homeowners irresponsibly spending hundreds of thousands of dollars each.

There is no question something should be done to prevent asset bubbles in general and housing bubbles in particular. Houses have historically been a reservoir of retirement savings, although lenders have worked to ruin that with unrestricted mortgage equity withdrawal. The stability of house prices is paramount if we are to have a functioning economic system.

Even the federal reserve noticed that the ratio of U.S. household debt to disposable personal income started to rise rapidly during the mania, providing regulators with a timely warning of a potentially dangerous buildup of household leverage. Unfortunately, they failed to heed this warning.

For any early warning system to work, regulators and the banking industry must accept that fact that financial innovation is folly. Part of the reason everyone ignored the obvious warning signs of excessive debt is because they believed the financial innovation meme. If policymakers come to believe that the next Ponzi loan program is a viable financial innovation, we will watch the debt-to-income ratio grow wildly out of control, and we will be assured everything will be okay — until it isn’t.

The simplest solution is to focus on regulating debt-to-income ratios. It’s a simple, measurable mathematical relationship that’s hard to ignore, which is probably why Dodd-Frank limited debt-to-income ratios on home loans at 43% of borrower income.