May302012

Top ten ways to protect taxpayers against Ponzi mortgage theft

How do we taxpayers protect ourselves against Ponzi mortgage theft?

Prior to the collapse of the housing bubble, when lenders gave free money to loan owners, it was theirs to give — and to lose. But when the losses overwhelmed our banking system, the government took conservatorship of the GSEs, and they backstopped the largest banks with our too-big-to-fail guarantees. With those two steps and the dramatically increased market share of the FHA, the government now assumes nearly all risk of loss in the US mortgage market.

With taxpayers absorbing future losses through explicit and implicit guarantees, lenders have every reason to inflate another housing bubble. Another bubble would generate enormous fee income at origination and interest income through ever-increasing loan balances. When it all blows up, the government pays the tab and lenders get big bonuses for their financial prowess. None of the reforms enacted since the collapse of the housing bubble would prevent another housing bubble. In fact, the current system of incentives actually serves to promote one.

So how can taxpayers be protected?

The ten measures presented can be broadly categorized in two guiding principals:

  1. first, we must scale back or eliminate loan guarantees, and
  2. second, we must limit the growth of loan balances.

Scaling back loan guarantees is accomplished with five specific policies:

  1. break up the too-big-to-fail banks,
  2. dissolve the GSEs,
  3. Tighten FHA guidelines further,
  4. raise FHA down payment requirements,
  5. restore mark-to-market accounting and require timely liquidation of REO.

Limit the growth of mortgage balances is also accomplished with five specific policies:

  1. cap secured borrowing at 80% LTV,
  2. limit appraised values by rental cashflow,
  3. permanently ban interest-only and negative amortization loans,
  4. base payment qualification standards on maximum allowable interest rate,
  5. limit debt-to-income ratios to 31%.

Let’s examine each of these in more detail.

Scale back or eliminate government loan guarantees

The surest way to protect taxpayers to get them out of the loan guarantee business. Taxpayers currently insure over 95% of the mortgage market. In 2006, the US taxpayer was ostensibly covering about 2% of the mortgage market through the FHA, VA, and other government programs. We need to return to the days of near zero government guarantees, and we need to prevent the conditions where implied guarantees may become explicit as happened in 2008.

1. Break up the too-big-to-fail banks

Too-big-too-fail is too-big-to-exist. When banks no longer fear going bankrupt and losing money for their investors or depositors, they are likely to take unnecessary risks. This is an unconscionable risk for the US taxpayer to bear. Quite frankly, I can’t understand why there is even debate on this subject. The too-big-to-fail banks should be broken up at the earliest possible opportunity — like today.

2. Dissolve the GSEs

As long as the GSEs exist in any form, they will have the implied guarantee of their entire portfolios. Politicians will try to suggest otherwise, as they did for nearly half a century prior to taking them into conservancy in 2008. Politicians proved without any doubt that no matter what promises they make, no matter what assurances they give, if the GSEs get in trouble, they will get bailed out. As long as these entities exist, the US taxpayer will have an implied guarantee on every loan they own or insure.

3. Tighten FHA guidelines further

In lending, defaults occur at the fringes of qualification. Borrowers with 800 FICO scores default much less frequently than borrowers with 500 FICO scores. Borrowers with 20% debt-to-income ratios default much less frequently than borrowers with 40% debt-to-income ratios. Whenever lenders draw lines in the shades of gray, the largest number of defaults will come from those people near the lines. For taxpayer-backed loans, these lines should be as narrowly construed as possible. The FHA should be the safest loan in the industry, not the substitute for subprime.

Currently, FHA will allow FICO scores down to 620. Default rates on FHA loans with FICO scores from 620-650 is 15%. That is far too high. Each standard for an FHA loan should be carefully examined, and qualification standards should be tightened to nearly eliminate risk on FHA loans. The effect should be to greatly reduce FHAs market share as private lenders willing to take more risk will provide competing loans. This has historically been the FHAs function. They are supposed to be the lender of last resort. We need to relegate them to that role again.

4. Raise FHA down payment requirements

The FHA guideline which exposes taxpayers to the most risk is the low down payment. Since it costs a buyer at least 6% (probably closer to 9%) to liquidate a property when factoring in discounts, commissions, and closing costs, any down payment of less than 10% is exposing taxpayers to risk of loss. The risk of loss goes up exponentially as down payment requirements drop. This exponential increase in loss severity is due partly to liquidation costs as described above, and partly due to the fact that default rates go up significantly as down payments decrease.

5. Restore mark-to-market accounting and require timely disposition of REO

Once the loan guarantees are scaled back or eliminated, lenders must be forced to endure the full brunt of the losses for their foolishness.

One of the main reasons the economy has suffered since house prices collapsed is because so much capital is tied up in unproductive uses. Part of the economic cycle is to purge bad business models and Ponzi debt and reallocate capital to more productive uses. That’s what recessions are for. We have not gone through the necessary purging in this recession, so rather than endure a short deep recession, we have endured a somewhat less deep but much longer one. To restore the engine of economic growth, we need to return to mark-to-market accounting, and force lenders to take their write downs and dispose of their REO. That frees up capital for better uses. Over the last six years, money tied up in residential housing has been dead money contributing nothing to economic growth.

Limit the growth of mortgage balances

The other necessary component to taxpayer protection from Ponzi mortgage theft is to limit the growth of mortgage balances. This concept is sacrilege to the lending industry which wants to divert every penny of borrower income to debt service payments. Without limits to mortgage loan balances, we are certain to have Ponzi borrowers who game the system to get free money they never intend to repay.

6. Cap secured borrowing at 80% LTV

Many people don’t understand what caused the housing bubble. There is much misinformation in the mainstream media, and some politically motivated books on the subject have clouded the issue even further. The reality is quite simple: Desire for mortgage equity withdrawal inflated the housing bubble.

The real culprit in a housing bubble is expanding home mortgage balances — people take on more debt and bid up prices. The real question is, “why do people do it?” The short answer is to capture appreciation: kool aid intoxication. But the truth is more nuanced.

In order for home price appreciation to motivate people to pay stupid prices and inflate housing bubbles, they need a way to access this appreciation. The more immediate and plentiful this access to money, the more motivated buyers are to borrow and cash out. Mortgage equity withdrawal is the doorway to appreciation; it makes houses very desirable and very valuable.

Texas was one of the few states which did not participate in the housing bubble. This was surprising because Texas was a major participant in the commercial bubble of the late 80s and early 90s. The reason Texas didn’t participate in the residential housing bubble is because they have laws prohibiting mortgage equity withdrawal beyond an 80% LTV. Since Texans didn’t have unlimited access to the housing ATM, they didn’t bother bidding up home prices. What would have been the point? Wealth you can’t spend doesn’t feel real.

The Texas experience clearly showed the individual incentives matter a great deal. California inflated a massive housing bubble because we permitted unfettered access to HELOC booty, and as property values went up, property taxes didn’t, thanks to Proposition 13. In addition to limiting mortgage equity withdrawal, California should consider changing Proposition 13 to trigger a reassessment with every refinancing of a residential property. A borrower would be hard pressed to argue the property isn’t more valuable considering they are borrowing against that increased value they just had appraised. If HELOC money cost the borrower more in property taxes, the State would benefit, and borrowers would have less incentive to hit the housing ATM.

7. Limit appraised values by rental cashflow

In a recent post, I noted that rental parity analysis in appraisals would prevent another housing bubble. Prices collapsed during the housing bubble because prices became greatly detached from their fundamental valuation of income and rent. This occurred because the comparative-sales approach enables prices to rise based on the irrational exuberance of buyers. If lenders would have limited their lending based on the income approach, and if they would not have loaned money beyond what the rental cashflow from the property could have produced, any price bubble would have to have been built with buyer equity, and lender and investor funds would not have been put at risk. Since lender and investor risk is now taxpayer risk, every effort should be made to establish the rental cashflow value of real estate and limit loan balances accordingly.

8. Permanently ban interest-only and negative amortization loans

When the credit crunch hit as house prices collapsed, negative amortization loans were discontinued almost immediately. It took a little longer for the market to turn against interest-only loans, but those ultimately went away as well. However, there are no regulations in place that would prevent these unstable loan programs from resurfacing. In fact, in the recent fed whitewash paper on housing, they actually defend the use of these loan programs — or at least their failure to regulate them. At this point, we can only hope lenders don’t lose their minds again and bring back these Ponzi loans. We need stiff regulations against such loans to prevent these Ponzi scheme loans from inflating future housing bubbles and putting taxpayer funds at risk.

9. Base payment qualification standards on maximum allowable interest rate

When qualifying people for loans, lenders are supposed to ensure they can afford to make the payments. In the promissory note, if the rate is adjustable, there is a cap on the maximum interest rate the borrower can be charged. This maximum theoretical payment is what lenders should be required to use when qualifying a borrower. As it stands, borrowers turn to adjustable-rate mortgages as affordability products without understanding their risks. When interest rates go up, payments can become unaffordable and the borrower may default. Right now that risk is ostensibly on the borrower, but since we know they can walk without recourse, that puts the risk back on the lender who in turn will transfer the loss to the US taxpayer.

10. Limit debt-to-income ratios to 31%

During the housing bubble, lenders allowed borrowers to pledge completely unrealistic portions of their income toward housing payments. Many borrowers in the early loan modification programs had debt-to-income ratios over 70%! After taxes, that leaves nothing at all. Only continued Ponzi borrowing sustains such high debt-to-income ratios.

The first round of loan modifications reduced borrowers DTIs to 38%, which was a significant improvement for many, but since the Ponzi loans were not forthcoming, even a 38% DTI proved too much. Nearly all of the early loan mods failed.

Finally, the government set loan modification targets and GSE loan qualification guidelines at 31%. This is still above the previous standard of 28%, but it is at least manageable without Ponzi borrowing, albeit with very little disposable income left over.

Right now, 31% DTIs are the standard because the government is the only game in town. However, there is nothing to prevent lenders from approving higher DTIs in the future. Since this will inflate prices, it will enable Ponzi borrowing, and the entire mortgage Ponzi scheme could inflate all over again. We need strict regulations limiting debt-to-income ratios on all residential home loans.

Would implementing these ten policies prevent future housing bubbles?

These policies wouldn’t necessary prevent future housing bubbles, but they will do one very important thing: these policies will prevent the US taxpayer from picking up the tab for the next one. That alone makes these policies necessary for implementation.

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