Higher mortgage rates will loosen credit standards
Higher mortgage rates compensate investors for greater risks, leading to looser lending standards.
For the last several years, the refrain from housing insiders has been that credit standards are too tight and should be loosened. Real estate industry lobbyists appeal to lawmakers for policies the real estate industry believes will promote more transactions at higher prices. Most often this myopic lobbying causes unintended long-term detrimental impacts on the housing market.
In 2004 every realtor wish was granted: lending standards were loosened to the point of complete abandonment, and restrictions on the amount prospective buyers could borrow were also removed through teaser rates, liar loans, and negative amortization. In the short term, realtors reaped the benefits as transaction volumes escalated even as prices rose higher and higher.
Rather than being the culmination of all their dreams, the direct result of loosening lending standards was a massive housing bubble and painful, equity-crushing housing bust that lowered home ownership rates to 20-year lows, and caused an 80% reduction in new home construction — a condition the industry has not recovered from.
Despite industry spin, mortgage lending standards are not tight, and the constant repetition of this lie prompted me to label tight lending standards as the biggest lie in housing in 2015. In my opinion mortgage lending standards should not be relaxed further. However, the competition for business among lenders will force a gradual loosening of credit standards over time. I believe higher mortgage rates will accelerate this process.
Higher rates attract more capital
The secondary market for mortgages that aren’t insured by the GSEs is dead. To lure private capital to the mortgage market, interest rates must rise. Everyone says they want private capital to form the basis of housing finance, but nobody is willing to accept the consequences of attracting this money: higher interest rates. The FHA and GSEs package mortgage-backed security pools, guarantee them, and sell them to investors. Without this government backing, investors would demand better returns, and the only way returns improve is if mortgage interest rates rise.
As mortgage rates rise, investor demand for non-qualified mortgage debt will increase as well because the investors are compensated for the additional risk. This in turn will prompt loan originatiors to fill this demand with borrowers on the fringes of qualification. Over time this qualifying fringe will get pushed farther and farther out, loosening credit standards.
Though this has the potential to repeat the same disastrous pattern that lead to the housing bubble, with the proper pricing of risk (i.e. higher mortgage rates), the borrowers who use these loans won’t have the buying power to push house prices into true bubble territory. To see evidence of this, we need to revisit a story from a year ago.
Last December I wrote that the 3% down mortgage announcement was more sizzle than meat. I stated that while this new program will be available, very few people will qualify, and it will not be any less expensive or more available than the 3.5% down programs already run by the FHA. In other words, risk will be properly priced, so the program won’t have an impact. How did my prediction turn out?
For all the uproar that surrounded Fannie Mae and Freddie Mac introducing loan programs that allowed buyers to put down as little as 3% around this time last year, not many buyers are actually taking advantage of the low down payment loans, according to a new report from Black Knight Financial Services.
In Dec. 2014, Fannie and Freddie officially rolled out 97% loan-to-value products. At the time, officials from the Federal Housing Finance Agency said that they expected the low down payment loans to represent a small portion of the government-sponsored enterprises’ business moving forward.
Black Knight’s latest Mortgage Monitor report, released Monday, shows just how small that portion actually is.
According to Black Knight’s report, high-LTV loans (loans with LTV’s above 95%) from the GSEs have accounted for less than 3% of the total number of high-LTV loans originated in 2015.
Since the GSEs and mortgage insurers are properly pricing the risk, these loans are so expensive that nobody uses them. Plus, when the FHA lowered it’s insurance premium (and underpriced the risk), nobody wanted the GSE loans.
The 3% down mortgage program was more sizzle than meat.
Why standards aren’t looser
The lending standards of the 1990s were normal and prudent. Lenders properly evaluated their customers ability to repay, and they priced the loan products according, denying credit to many on the fringe. This is how lending is supposed to work.
Lenders aren’t eager to lower lending standards and underwrite loans they know will go bad, particularly given the huge losses they just endured for doing so 10 years ago. The fear of buy-backs prevents lenders from making bad loans and passing the losses on to others, so they are unwilling to make bad loans, which is a good thing.
Further, even if mortgage standards were to loosen significantly and lenders were to push more people on the fringes into the available loan programs, it won’t create a housing bubble as long as loans were based on verifiable income and reasonable debt-to-income ratios on conventionally amortizing mortgages, which they would be to conform to the new mortgage rules. Even the non-QM lending will fear the bite of the ability-to-repay rules.
What the market really needs is continued improvement in job and wage growth, and so far most analysts believe 2016 will finally be the year we see a true recovery from the Great Recession. I believe they are right, and 2016 will be a good year for the economy, irrespective of how the rising interest rates will kill home sales.