Should we worry about declining borrower standards in mortgage lending?

Lenders lower standards to qualify more borrowers and increase business, a precursor to another bubble, but only if risk is again mispriced.

Nemo_loan_teaser_rateLet’s assume for a moment all qualification standards were eliminated and anyone who wanted to borrow money could get a loan, similar to what happened in 2004 through 2006. Would this cause a housing bubble? In my opinion, it would not. It would inflate prices, and it would cause a great deal of downward substitution of quality to get a property, but it wouldn’t necessarily create a housing bubble as long as loans were based on verifiable income and reasonable debt-to-income ratios on conventionally amortizing mortgages.

The loose lending standards of 2004-2006 allowed many people to buy homes, but it was the combination of liar loans, unlimited debt-to-income ratios, and negatively amortizing loans that allowed the army of borrowers to finance loan balances double what they should have been. Remember, housing demand is measured two ways: the total number of buyers, and the total amount those buyers can put toward housing. Increasing the number of borrowers can inflate prices through the substitution effect, but increasing the total amount buyers can put toward housing is what sends prices orbital.

Toxic loan programs like the option ARM were not invented during the housing bubble; they were long-standing niche products with a hefty price tag to properly price the risk of default. It was the gross mispricing of risk on Wall Street that created an insatiable demand for these products that drove the price down and put these weapons of financial destruction in the hands of unqualified borrowers.


House prices would have remained reasonable during the mania if risk were properly priced. Wall Street investors lost their minds with credit default swaps and collateralized debt obligations blesssed with AAA ratings by a corrupted rating system.

It’s right to be concerned about the return of some dangerous loan products. I expressed my belief that the new mortgage regulations will prevent future housing bubbles because the “Ability to Repay” rules will prevent reckless lending, but I could be wrong. These toxic loan products don’t conform to the new mortgage regulations, so right now they are very expensive and uncommon. If Wall Street misprices risk yet again, they could fund these non-conforming loans and inflate another housing bubble. We must pin our hopes on changes at the ratings agencies, new regulations, and institutional memory on Wall Street, so we all have reason to worry.

Concerns about riskier mortgages are sprouting

Paul Davidson, Sunday, 12 Mar 2017

Riskier borrowers are making up a growing share of new mortgages, pushing up delinquencies modestly and raising concerns about an eventual spike in defaults that could slow or derail the housing recovery.

The trend is centered around home loans guaranteed by the Federal Housing Administration that typically require down payments of just 3% to 5% and are often snapped up by first-time buyers. The FHA-backed loans are increasingly being offered by non-bank lenders with more lenient credit standards than banks.

I am not concerned about this for two reasons: (1) FHA loans require verified income, a reasonable debt-to-income ratio, and a conventionally amortizing mortgage, and (2) the profits and losses are concentrated in one agency and one insurance fund, so actuarial analysis works reasonably well to price risk and sustain the fund.

The landscape is nothing like it was in the mid-2000s when subprime mortgages were approved without verification of buyers’ income or assets, setting off a housing bubble and then a crash. …

“We have a situation where home prices are high relative to average hourly earnings and we’re pushing 5%-down mortgages, and that’s a bad idea,” says Hans Nordby, chief economist of real estate research firm CoStar.

So what? The reason house prices are high relative to income is because mortgage interest rates are very low. The mortgage terms are safe and stable, so these mortgages will not go bad in large numbers and destabilize the system.

The share of FHA mortgage payments that were 30 to 59 days past due averaged 2.19% in the fourth quarter, up from about 2.07% the previous quarter and 2.13% a year earlier, according to research firm CoreLogic and FHA. That’s still down from 3.77% in early 2009 but it represents a noticeable uptick.

While that could simply represent monthly volatility, “the risk is that the performance will continue to deteriorate and then you get foreclosures that put downward pressure on home prices,” says Sam Khater, CoreLogic’s deputy chief economist. Such a scenario likely would take a few years to play out. …

These loans will get modified, and any problems would be can-kicked for eternity if necessary to bail out the fund.

Here’s the worry: If home prices peak and then dip, homeowners who put down just 5% and are less creditworthy than their predecessors will owe more on their mortgages than their homes are worth. That would increase their incentive to default, especially if they have to move for a job or face an extraordinary medical or other expense, Khater says. Foreclosures would trigger price declines that ignite more defaults in a downward spiral.

In turn, funding for the non-bank lenders from banks and hedge funds likely would dry up, and FHA loans would be harder to get, dampening the housing market and the broader economy, Mish says. …

I think they underestimate the efficacy of can-kicking. There will be no downward spiral of foreclosures if the bad loans are can-kicked just like they have over the last 10 years.

The recipe for a housing bubble takes many ingredients, and loose lending standards are one of them; however, it requires a gross mispricing of risk and enormous capital flows into unstable loans before prices get pushed up into bubble territory.

Looser lending standards are part of the complex puzzle that inflates dangerous housing bubbles, but it’s also a natural part of the credit cycle, and not necessarily destabilizing to the housing market or the broader economy. If we start to see a proliferation of non-conforming loans funded by Wall Street, then we need to be very vigilant because that sets up the market for a structural failure.