Why did Dodd-Frank effectively ban mortgage affordability products?
Mortgage affordability products produce short term results, but they are unstable, and widespread proliferation leads to millions of foreclosures.
Affordability products in the 00s were the financing panacea everyone in real estate hoped for. Widespread use of affordability products ushered in a new era of high home ownership rates, rapidly rising prices, and economic prosperity through “liberating” home equity. Everyone got rich: the agents, the brokers, the bankers, the buyers, the sellers, and everyone nearby who enjoyed a prosperous economy driven by the profligate behavior of their neighbors. It was the best of times.
Unfortunately, the “innovations” of the last housing bubble proved to be costly failures. These affordability products contained Ponzi finance alternatives such as negative amortization that allowed borrowers to service extremely large debts with tiny payments. The release of this Ponzi virus and the widespread distribution of its use served to inflate house prices to unreasonable levels relative to the borrowers ability to repay the loan. The astronomical default rates associated with these loans resulted in unprecedented levels of mortgage delinquency and foreclosures. In short, the rise and fall of Option ARM lending was the rise and fall of the housing bubble.
Faced with the devastation reaped by negative amortization loans, legislators rightly determined that an unregulated mortgage lending market lead to the development and release of a deadly mortgage virus. The crafted Dodd-Frank to set a standard mortgage product deemed safe (30-year conventional mortgages mostly), and Dodd-Frank designated any loan that does not conform to these safe standards do not obtain government backing and thereby the lender must hold the loan or sell it into a sparse secondary market. The lack of secondary market buyers keeps non-conforming loans from proliferating today.
Without the safe-haven protection of a qualified mortgage, borrowers endure high costs associated with fringe products like Option ARMs or other non-conforming loans. The high cost of these products prevents their widespread proliferation, which is what the legislators intended when they crafted Dodd-Frank.
Dodd-Frank didn’t actually make Option ARMs illegal, it just put them in a regulatory bucket that makes underwriting them much more expensive and risky for the underwriter. This added a check and balance to a system that previously ran amok.
Why do we need affordability products?
We all want affordable housing. There are numerous government programs designed to provide low-cost rental and ownership properties to people in all walks of life. Lenders, builders, realtors and buyers all benefit from affordable housing because affordability means an increase in transaction volumes and more money into the pockets of those dependent on the real estate market.
The difficult problem with affordable housing is how to provide it without making it unaffordable.
Finance is not the answer.
Most of those who worked in the mortgage business really believed the “financial innovation” meme. I contend that the entire idea is a fallacy. At its core, the belief among financiers is that affordability products reach more customers and permit home ownership for a larger number of people. The statistics during the Great Housing Bubble seem to warrant this enthusiasm.
Unfortunately, increasing the home ownership rate also dramatically increased prices and created an unsustainable bubble in both. Why is that? As with all macroeconomic concepts, it emerges from the microeconomic circumstances of individual borrowers and buyers. If you look back to the lending practices which endured the crash of the last housing bubble in the late 80s, you see that the financing arena was dominated by 30-year conventionally amortizing loans with 20% down payments and conservative debt-to-income ratios. This is the only loan program that has relatively low default rates even if prices decline.
So what happens when a new “affordability” product is introduced into this stable system?
Let’s look at an example. Assume our would-be buyer makes $100,000 a year and could qualify for a $300,000 loan using conventional financing. He saved $100,000 for a down payment and costs, and he’s looking to buy a $375,000 home. In our stable system, he would find a home relative to his income. If he is making the median income, then he would be able to afford a median priced home.
Now let’s say that lenders “innovate” and start offering interest-only loans with a 10-year fixed term followed by an interest rate reset and a recast to a fully amortized loan on the remaining 20-year schedule (sound familiar?) Our buyer is conservative and does not want to purchase on these risky terms and take the risk on future interest rates or the need to refinance later because he may not be able to afford the higher payment in 10 years.
However, other potential buyers will ignore these risks and embrace the new financial innovation because it allows them to buy a house they previously could not afford. The same payment on an interest-only schedule now finances 15% more money, so other potential buyers in the marketplace who are making $100,000 can now finance around $345,000 instead of $300,000.
When our conservative buyer goes out in the open market to bid on properties, he now finds himself being consistently outbid on properties. At this point, he has a choice to make: either embrace the new financial innovation and bid 15% higher for the same property, accept a lower quality property, or not buy a home.
The affordability product didn’t make houses more affordable, it made them less so.
Our stable system without affordability products saw annual appreciation of around 4% because this is how much incomes and rents were rising (this was true for most national markets outside of California,) and it reflects the amount of increased borrowing power available to homebuyers each year.
With appreciation only running at 4%, market participants do not get excited about making millions in real estate, nor are they worried about buying today because they may get priced out tomorrow.
Affordability products change all that.
With the introduction of interest-only borrowing to the system, prices can very quickly appreciate 15% as the financing system seeks a new equilibrium dominated by the new affordability product. This sudden and dramatic rise in appreciation can be the precipitating factor that ignites a housing price bubble.
Once people start drinking the appreciation kool aid, they begin to stretch their debt to income ratios to buy properties with the belief that the extra investment will be recouped by rising home values. Plus the fear of being priced out compels people to buy for fear of not being able to later. The value of real estate detaches from its fundamental value, and the perception of value is driven by appreciation alone.
Behavioral Finance Theory
The bubble of the late 80s became dominated by interest only products, and buyers began using DTIs well in excess of the normal 28% limit. However, that bubble rally was of much shorter duration and of much lower volume toward the peak, so the majority of owners still had conventional financing. Mortgage equity withdrawal was much less common, so not as many households were overextended. The result was a period of moderate foreclosure activity and slowly declining prices until affordability returned based on conventional financing products.
Debt-To-Income Ratio 1986-2006
What really sets the Great Housing Bubble apart was the “innovation” which took off in late 2003: the Option ARM. As you can see in the table above, the Option ARM, or negative amortization loan, allowed borrowers to finance twice amount a conventional mortgage would provide. Hence, prices were bid up to twice the price level sustainable with conventional mortgage financing.
In short, affordability products did not make prices more affordable, they inflated a massive housing bubble.
This fact is important because if the truth of affordability products is not recognized for what it is — a series of unstable loan programs that inflate house prices — these products may return to ravage our housing market again.
Affordability products do not help buyers get into homes, they prevent buyers from getting into homes under terms which are sustainable. Temporary home ownership is renting. Affordability products simply allow people to rent from a lender.
Perhaps some may sustain home ownership, but unless they were one of the first to embrace affordability products, and unless they refinanced later into a conventional mortgage, they will ultimately lose their illusion of home ownership and go back to renting from a landlord rather than the lender. What good came from all of that?