Oct012013

Tightening government lending standards would bring back private lending

With the US taxpayer still backing more than 90% of all mortgages in the United States, it’s good public policy to keep mortgage lending standards tight in order to prevent future losses. Despite this simple truth, many parties would like to see lending standards loosen so facilitate reflating the old housing bubble. Lenders want looser standards on government loans so they have less risk of a put-back loss. Both lenders and homeowners want to see looser standards on all loans to increase the size of the buyer pool to help push up prices. Politicians want to see looser lending standards to make lenders and homeowners happy, and they want to deflect complaints that they are shutting people out of home ownership. With all these calls for looser lending standards, its surprising that they have remained prudently tight for so long.

The reality is that government officials don’t want to see a repeat of the GSE bailouts and the upcoming FHA bailout. These bailouts are an embarrassing reminder of bad governance and poor decisions made in the past. Plus, they are costly. The few good stewards of the public coffers left in Washington are rightfully blocking any efforts to relax standards on government loans.

Eventually, the pressure to reduce government lending standards will lessen because private money will take a larger role in housing finance. As long as they underwrite loans that meet the qualifying mortgage standards, if they want to risk their money on those with marginal credit scores or spotty income histories, it’s their money to make or lose. As private capital returns, the government’s footprint in housing finance would get smaller, and lending standards will loosen incrementally until we find the proper balance between access to capital and the risk-adjusted cost of capital.

How Tighter Mortgage Standards Are Holding Back the Recovery

By Nick Timiraos — September 29, 2013, 9:10 PM

The housing recovery faces headwinds because it’s too hard to get a mortgage today, which in turn is restraining economic growth, and the government is partly to blame, according to a paper from a top economist and a former White House policy adviser.

The authors are quick to note that they aren’t advocating a return to the anything-goes school of lending that prevailed from 2004 until 2007, but they argue that the pendulum has swung from too far in the other direction.

There is some statistical support for their contention. The chart to the right shows the average FICO score over the last 15 years. We are clearly higher than before the housing bubble. However, I argue this is as it should be. It will take the return of private lending to the market to make loans to marginal borrowers to bring these numbers back down to historic levels prior to the housing bust.

The paper was written by Jim Parrott, a former housing advisor in the Obama White House who is now a senior fellow at the Urban Institute, a left-leaning think tank, and Mark Zandi, chief economist of Moody’s Analytics.

Mark Zandi isn’t adding any credibility to the report.

The clearest sign of tighter credit standards are seen in average credit scores, which in June stood nearly 50 points above their pre-housing bubble levels. Credit scores are not only higher, but they also understate the quality of recent borrowers, who have earned these scores during a much tougher environment. In the early 2000s, borrowers had an easier time building their credit because unemployment was low and home prices were rising. In other words, a 750 credit score coming out of the financial crisis counts for more it did ten years ago.

Easing lending standards to return credit scores to pre-bubble levels would boost home sales by around 450,000 units and new single-family home construction by around 275,000 units, according to estimates from Zandi. The increased construction and the benefit of higher home prices, he forecasts, would over time reduce the unemployment rate by 0.4 percentage points.

I don’t believe much of what Mark Zandi comes up with, but it does seem plausible that more homes would sell if more loans were given to marginal borrowers. Since loan originations are still languishing at 1990s levels, anything will help.

“Normalizing credit scores will not, by itself, get the economy back to full employment, but it would go a long way and, at the very least, cushion the negative fallout from rising interest rates,” the paper says.

This was obviously written to influence lawmakers. Take whatever projections and benefits they advocate and reduce them by 80%, and the results will much more closely match reality.

To be sure, not everyone agrees that credit standards are too tight. Some mortgage bankers have argued that borrowers simply have too much debt and that incomes aren’t growing fast enough. Rather than a “tight credit” problem, this counterargument goes, the country has a “weak borrower” problem.

That’s the reality of the situation. Lenders do not suffer from a lack of cash to loan out. About 80% of the money the federal reserve has printed over the last several years sits in the vaults of the major banks. They simply have no creditworthy borrowers to loan the money too. There are plenty of Ponzis who would be willing to accept from free money, but the banks are wisely not giving it to them.

Parrott and Zandi concede there’s little evidence that credit is tighter based on either average loan-to-value ratios and debt-to-income ratios. But they say there are other problems, particularly around banks’ verification of borrowers incomes, scrutiny of appraisals, and other factors that have led to a tighter credit box. They outline four basic explanations for tougher credit standards:

First, banks are naturally skittish to expand their tolerance for credit risk given what the country just went through.

As they should be.

Second, ultralow interest rates spurred a refinancing boom, giving banks more mortgage business than they can handle. That boosted profits, minimizing the need to compete for home-purchase loans, which tend to be more time consuming. There are already some signs that big declines in refinancing will lead banks to ease up lending standards at the margins.

Given the huge numbers of layoffs in mortgage lending over the last 6 years, it’s a stretch to say banks have more business than they can handle. However, it is true that lenders are starting to relax standards to originate more loans now that the refinance business has evaporated.

Third, it’s become more expensive to process loans that default. While banks typically sell to other investors the mortgages they make, they often hold onto what’s known as the mortgage “servicing”—that is, the process of collecting loan payments on behalf of investors. Because the foreclosure crisis has led to higher costs associated with servicing delinquent loans, the easiest way to avoid against having to service a defaulted loan, of course, is to make risk-free loans.

So let me get this straight. They are complaining that bad loans increase their costs, so they aren’t making bad loans anymore? Isn’t that what we want? Do we want them to make bad loans at low cost? That doesn’t sound like a good business model to me.

Fourth, banks have faced demands from investors and mortgage insurers to repurchase loans that are later found to run afoul of agreed-upon underwriting standards. Fannie Mae and Freddie Mac have forced banks to repurchase tens of billions of delinquent mortgages since 2009. Parrott and Zandi explain:

This aggressive turn is not itself a problem. Under normal circumstances, lenders could adapt to changing regulatory conditions by improving their quality control or raising prices to reflect increase risk.

The problem is that Fannie, Freddie and the [Federal Housing Administration] have stepped up their put-backs in ways that lenders cannot address adequately through better underwriting or pricing. This includes disagreements over judgment calls made by lenders or their agents; changes in circumstances occurring after the underwriting process has been completed; small mistakes that bear little relation to either the credit risk or the subsequent default; and inconsistent interpretations of the rules.

The upshot is that because lenders can’t predict how they could be penalized, they’ve chosen to lend less.

Isn’t that the nature of lending. Don’t circumstances change after underwriting that causes borrowers to default? Life happens, right? Why should originators be immune to these happenings?

They could easily make the rules clear and transparent. In addition to their other standards, simply state that if for any reason the loan fails within one-year of origination, the originating lender must buy it back. That clears up all the ambiguity, and it puts all the origination risk where it should be — on the originating lender.

This last point is the most important, the authors said, because it’s the one where policymakers can exercise the most control.

But the problem is difficult to solve because it’s not as easy as changing specific lending criteria. As it is, banks are putting in place standards that go beyond those required by Fannie, Freddie or the FHA. What’s needed instead, the authors argue, is better clarity around when banks could be forced to take back loans. Regulators overseeing those housing entities, they write, “must embrace the challenge with a good deal more urgency” than they have so far.

Regulators do not need to relax these standards. They should be going out of their way to increase costs and tighten standards even further. That’s what will finally bring private lending back to home finance. By continually tightening standards at the GSEs, regulators create opportunity on the fringes for more private lending. This protects the US taxpayer will simultaneously encouraging more private lending with private capital. That’s a win-win as far as I’m concerned.

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720 RYAN Ave La Habra, CA 90631

$509,900 …….. Asking Price
$499,000 ………. Purchase Price
6/29/2004 ………. Purchase Date

$10,900 ………. Gross Gain (Loss)
($40,792) ………… Commissions and Costs at 8%
============================================
($29,892) ………. Net Gain (Loss)
============================================
2.2% ………. Gross Percent Change
-6.0% ………. Net Percent Change
0.2% ………… Annual Appreciation

Cost of Home Ownership
——————————————————————————
$509,900 …….. Asking Price
$17,847 ………… 3.5% Down FHA Financing
4.28% …………. Mortgage Interest Rate
30 ……………… Number of Years
$492,054 …….. Mortgage
$136,682 ………. Income Requirement

$2,429 ………… Monthly Mortgage Payment
$442 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$106 ………… Homeowners Insurance at 0.25%
$554 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
============================================
$3,531 ………. Monthly Cash Outlays

($630) ………. Tax Savings
($674) ………. Principal Amortization
$28 ………….. Opportunity Cost of Down Payment
$147 ………….. Maintenance and Replacement Reserves
============================================
$2,402 ………. Monthly Cost of Ownership

Cash Acquisition Demands
——————————————————————————
$6,599 ………… Furnishing and Move-In Costs at 1% + $1,500
$6,599 ………… Closing Costs at 1% + $1,500
$4,921 ………… Interest Points at 1%
$17,847 ………… Down Payment
============================================
$35,965 ………. Total Cash Costs
$36,800 ………. Emergency Cash Reserves
============================================
$72,765 ………. Total Savings Needed
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