Systemic Risk in the Housing Market
Systemic Risk in the Housing Market
Credit rating and analysis of collateralized debt obligations and all structured finance products are part of the smooth function of the secondary market for mortgage loans. A credit rating agency is a company that analyzes issuers of debt and debt-like securities and gives them an overall credit rating which measures the issuer’s ability to satisfy its debt obligations. There are more than 100 major rating agencies around the world, and three of the largest and most-important ones in the United States are Fitch Ratings, Moody’s and Standard & Poor’s. A debt issuer’s credit rating is very similar to the FICO score of an individual rated by the Fair Isaac Corporation widely used in the United States by institutional lenders. Of greater importance to the housing market, the credit rating agencies also analyze and rate the creditworthiness of the various tranches of collateralized debt obligations traded in the secondary mortgage market.
Credit ratings are widely used by investors because they provide a convenient tool for comparing the credit risk among various investment alternatives. The analysis of risk is crucial in determining the interest rate a syndicator will need to offer to attract sufficient investment capital, or from the other side of the transaction, it is important to the investor who is comparing the interest rates being offered by various investments. The ratings agencies provide this critical, third-party analysis both sides of the transaction can rely upon for unbiased, accurate information. When the ratings agencies are doing their job well, there is greater efficiency in capital markets as syndicators of securities are obtaining maximum market values, and investors are minimizing their risks. This efficiency in the capital markets leads to better resource utilization and stronger economic growth.
Unfortunately for many investors in collateralized debt obligations during The Great Housing Bubble, the ratings agencies did not provide an accurate or credible rating of many CDO tranches. When the housing market pricing declined, many CDO tranches were subsequently downgraded. In defense of the agencies, they were providing an analysis of risk based on existing market conditions. Their reports contained caveats concerning downside risks in the event market conditions changed, but this list of risks is standard in any analysis and widely ignored by investors who are counting on the rating to be a market forecasting tool rather than the market reporting tool it really is. Credit rating agencies are not in the business of market forecasting or evaluating systemic risks.
One of the major failings of the credit markets in The Great Housing Bubble was the failure to take a holistic view and evaluate the systemic risks involved. A typical credit analysis reviews various risk parameters and attempts to rate the impact of each. The implicit assumption is that the total risk is equal to the sum of the parts; however this is not necessarily the case. Synergy is when the whole is greater than the sum of its parts, and there is a strong synergy in default risk in collateralized debt obligations that became apparent during The Great Housing Bubble. The credit rating agencies failed to identify this risk synergy until after the fact.
The risk of default in a tranche of a collateralized debt obligation is directly related to the default risk in the underlying mortgage notes. There are six general areas of credit default risk that may be evaluated independently, but their interactions are often synergistic in nature: creditworthiness risk, high combined-loan-to-value default risk, high debt-to-income ratio risk, fraud and misrepresentation risk, investment perception risk, and market valuation risk. Of these general areas of risk market valuation is most responsible for creating synergistic effects and amplifying default rates. Since many of the more “innovative” loan programs entered the market during a time of rising prices, there was no history of performance of these securities in other market conditions making it very difficult to assess the impact a down market would have on default rates. As it turns out, exotic loan programs do not perform very well in any conditions other than a raging bull market.
Every mortgage loan that is originated contains an evaluation of the creditworthiness of the borrower who is responsible for making timely mortgage note payments. The most common evaluation tool is the FICO score. Prime borrowers have the highest FICO scores, they are considered the lowest default risk, and they receive the lowest interest rates as a result. Subprime borrowers have the lowest FICO scores, they are considered the highest default risk, and they receive the highest interest rates. This is the best documented and most carefully evaluated risk parameter. Before many of the loan programs were introduced during the Great Housing Bubble, FICO scores strongly correlated with default rates. This correspondence broke down in the price decline when the bubble popped because the other risk factors proved to have a greater influence.
High CLTV Defaults
The combined-loan-to-value (CLTV) is the total debt of all mortgage obligations as a percentage of the appraised value of a particular property. A high CLTV generally corresponds to a low downpayment, but as resale values fell in the market crash, the CLTV rose for many borrowers as a consequence of falling prices. Although all borrowers with high CLTV loan balances show high default rates, it is important to distinguish between those borrowers who had a high CLTV because of a low downpayment and those who had a high CLTV because of falling values. Even though downpayments are a sunk cost and irrelevant to the market value of a house, it does have a strong psychological impact on the behavior of homeowners. People who put little or no money of their own money into the purchase of real estate exhibit greater default rates because they are not losing much of their money. Most people really do not care if the lender loses money, particularly if they will not have to repay the lender for the loss. When a borrower has less of their money in a transaction they are less likely to sacrifice to stay current on their mortgage note obligations, and they are more likely to default if resale values decline, particularly if their payments are greater than the cost of a comparable rental.
Fraud and Misrepresentation Risk
Most purchasers of collateralized debt obligations did not realize there was a huge amount of fraud and misrepresentation in the underlying loans they were purchasing. High CLTV financing, particularly the widely offered 100% financing, became the ideal tool for fraud. A fraudulent transaction required a “straw buyer” willing to sacrifice their credit for a fee, an appraiser willing to inflate the houses value, and a realtor and a mortgage broker either willing to go along with the transaction for cash or too ignorant to see the truth. In the transaction, the straw buyer purchased a house for greater than its true market value, and the excess payment was used to pay off the corrupted parties. Fraud was much easier to commit with 100% financing because the bank loaned the full amount of an inflated appraisal. It is much harder to commit fraud when the bank only loans 80% of a property’s value. Most often the seller was in on the scam and was using the transaction to get out of a bad deal, but sometimes sellers were also innocent victims. The straw buyer had no intention of repaying the loan from the start, and the property quickly went into foreclosure.
A more common problem was misrepresentation of income. Stated-income loans, also known as “liar loans,” were very common during the bubble rally. People would simply make up a number that qualified them for a loan and state it on their mortgage application. One of the assumptions purchasers of CDOs made was that the originators of the underlying loans made sure the borrowers really made enough money to pay back the loan. Often times the extent of the loan originators due diligence was examining the borrower’s signature on the loan application and hoping they were telling the truth. This was a very serious problem for valuing an interest in a CDO because there was no way to accurately determine the viability of the income stream when the income of those responsible for paying the underlying mortgage notes was in doubt.
High DTI Defaults
The debt-to-income ratio is the total amount of payments compared to gross income expressed as a percentage. A lender evaluates the DTI of the mortgage loan as well as the total DTI of all borrower indebtedness when making a determination of creditworthiness. Historically, a borrower could not have a mortgage DTI in excess of 28% and a total DTI greater than 36% to qualify for a loan because debt burdens in excess of these figures proved to have high default rates. Despite the proven history of default of high DTIs, lenders widely ignored these guidelines in The Great Housing Bubble in the quest for more customers. During the rally, few of these people defaulted because they were offered even more debt through home equity lines of credit from which they could make mortgage payments, and the few who did get into financial problems simply sold their house to pay off the mortgage. During the rally, people were keen to take on mortgage debt because interest rates were low, and it was a necessary tool for obtaining real estate and its commensurate appreciation benefits. It did not matter if 50% of more of a borrower’s gross income was going toward debt service if the property itself was providing the additional income necessary to sustain the borrower’s lifestyle. Of course, this only works when prices are increasing rapidly. Once prices stopped rising, the property could no longer provide additional income, and the borrower had to make the crushing payments out of their work income. Without the benefits of appreciation, borrowers quickly found the burden of a high debt-to-income ratio overwhelming, and many borrowers defaulted because they payments were too much to handle – just as past history said they would be.
Investment Perception Risk
One of the biggest fallacies pushed on the general public was the notion that residential real estate was a great investment. This idea caused people to view houses as an investment and treat them accordingly. When the participants in a housing market perceive houses as an investment, they will more easily default on the loan than if they viewed the house solely as a family home. People develop emotional attachments to their family homes, and they will sacrifice much in order to keep it. People behave in a more businesslike manner when they view a house as an investment, and they are willing to give up the house if the investment does not perform as planned. Many people when faced with the reality that house prices were not going to go up and payments were going to continue to cause losses decided to stop making payments and let their investment go into foreclosure. Financially, it was the correct decision given the alternative of continuing to make payments on a losing investment. When the “Great American Dream” of home ownership was tainted by investment motives, it became a nightmare for all concerned.
Market Valuation Risk
The biggest risk faced by buyers of collateralized debt obligations is the default risk of the underlying mortgage when the collateral for the mortgage (the house) is overvalued in markets characterized by low affordability. The greatest risk of default is based on changes in the resale value of homes. All other default risk factors are masked when prices are increasing, and they are amplified when prices decline. Valuation risk is the ultimate synergistic factor.
There are three methods of appraising the resale value of residential real estate: the sales comparison approach, the cost approach, and the income approach. The sales comparison approach uses recent sales of similar properties in the market because comparable sales reflect the behavior of typical buyers in the marketplace. The cost approach determines market value by calculating the replacement cost of an identical structure plus the cost of the land or lot upon which the house would sit. The income approach determines market value by analyzing market rents of comparable properties and applies the gross rent multiplier of expected rents. Most lenders give the greatest weight to the comparable sales approach when establishing market value before applying any loan-to-value limitations to the loan amount. The income approach is generally only considered for non-owner occupied homes. The three-test approach to appraising market value as used during the Great Real Estate Bubble is fraught with risk and seriously flawed.
The comparative sales approach reinforces delusive behavior and irrational exuberance of a financial mania. If everyone is overpaying for real estate, the comparative sales approach simply enables greater fools to continue overpaying for real estate. Since market prices for houses which serve as loan collateral fall to fundamental valuations based on income after the financial mania runs its course, mortgages originated based on the comparative sales approach have a great deal of market risk not reflected in the pricing of collateralized debt obligations based on the underlying mortgage loans.
The cost approach has an even greater level of market risk. The cost of a structure may represent a relatively small percentage of the market value of real estate in high-value markets. In some of the most overvalued markets during the bubble, the replacement cost of the structure may have been $250,000 while the value of the underling land was $450,000; however, since the market value of land is a residual calculation based on the market value of the property, the value of the land cannot be determined independently of the house situated on it. Either the comparative sales approach or the income approach must first be applied to establish the market value of the property before any calculation of the market value of the land can be determined. In short, since the cost approach is dependent upon another valuation method, it is not useful as an independent method of property valuation. Also, since the valuation of land is extremely sensitive to small changes in the valuation of the property, the cost approach is misleading with respect to the valuation of residential real estate.
The only reliable method for the valuation of residential real estate is the income approach, and it is the only approach that is widely ignored by the lending community. It has been demonstrated in previous residential market bubbles in California and in major metropolitan areas in other states that once a price decline begins, prices fall to fundamental valuations based on income and rent. The reason for this is once the speculative investment incentive is removed from the market, buyers do not support prices until there is a new reason for them to buy: they save money versus renting. Comparative rents are the fundamental valuation of residential real estate. Mortgage default risk is low only when market prices are in line with comparative rents or when market prices are increasing. Default risk is low when prices are in line with rents because a property can be converted from owner-occupied to a rental unit and the payment can still be covered. Default risk is low when prices are rising because a borrower experiencing financial difficulty can always sell the property to repay the loan. Unfortunately, once market prices increase beyond the level of comparative rents, they will go through a period of decline back to comparative rent levels; therefore, if lenders continue to use the comparative sales approach, they will enjoy a temporary period of low market risk while prices increase and another painful period of losses when prices decrease. As was demonstrated in the aftermath of The Great Housing Bubble, these periods of lender losses can imperil the entire banking and financial system. The only way to prevent the pain of loss is to recognize the end-game risks when prices are increasing and choose not to participate in that lending environment. Many lenders did not participate in the crazy lending of The Great Housing Bubble, and they were not damaged in the aftermath; however, the hunger for mortgage loans from the CDO market compelled many lenders to join in or get buried by their competitors. The only real market-based solution to the problem of originating bad loans must come from the CDO market.
The CDO Market Solution
The solution to preventing future bubbles in the residential real estate market lies in the market for collateralized debt obligations. The government sponsored entities created the secondary mortgage market in the 1970s, and the CDO market is the extension of this market bringing large amounts of investment capital to residential real estate. During the Great Housing Bubble the CDO market did not properly evaluate the risk of default on the underlying mortgage notes they pooled. If the CDO market evaluates mortgage default risk based on the income approach rather than the comparative sales approach, the performance of CDOs will be greatly improved, and investor confidence will return to the market. It is only after the risks are properly evaluated that capital will return to this market. If the CDO market evaluates risk based on the income approach, the lenders that originate loans hoping to sell them to CDOs will be forced to do the same. If lenders originate loans based on the income approach, the irrational exuberance that creates financial bubbles will not be enabled. People would still be free to overpay for houses with their own money, but the scope and scale of financial bubbles will be limited to the funds of buyers, and the banking system will not be imperiled by the foolishness of the market masses when prices fall to fundamental valuations based on rent and income.