Editor’s note: How bad will the real estate market get before it gets better? Inman News compiles the facts and analysis in this five-part series. (Read Part 1, “The housing market: How bad will it get?“ Part 2, “Vendors cope with real estate downturn“; Part 4, “Investor worries rise“; and Part 5, “Diminished role for GSEs, FHA.”)
The fate of housing markets where loose lending practices helped inflate housing prices may depend on how tight-fisted mortgage lenders become now that many of those loans are going bad, economists say.
In a recent study on the use of adjustable-rate mortgage loans in 22 Los Angeles neighborhoods where prices plummeted between 1990 and 1995, academics Andrey Pavlov and Susan Wachter determined that cutting off access to such loans worsened the downturn.
It was the fluctuation in the use of the risky loans, not their higher default rates, that most exacerbated the declines, they said (see Inman News story).
Predicting how tight credit will get in the current downturn is tough, because what happens depends largely on the whims of two fickle groups — Wall Street investors who have funded the bulk of subprime loans, and policy makers who make the rules for mortgage lenders.
If housing markets are at the mercy of lenders, then lenders themselves are also at the mercy of market forces and regulators.
So far, while delinquencies and foreclosures are on the rise, lawmakers and regulators in Washington, D.C., have resisted calls by consumer groups for outright bans on certain types of loans perceived as the most risky.
Although federal regulators have instituted new guidance for lenders making subprime and “exotic” interest-only and pay-option loans, that advice doesn’t automatically apply to lenders regulated by the states.
So far, more than 30 states have adopted the federal guidance for nontraditional loans. Others, including Maine and Colorado, have gone further, passing laws intended to curb predatory lending. Some in the lending industry say such laws, while well intentioned, will make it harder to sell loans originated in those states in the secondary market — restricting the flow of funds into mortgage lending.
The industry, along with many economists and academics, has argued against most proposed restrictions on lending practices, saying market forces have already forced originators to tighten up their underwriting standards.
Ban one loan, and lenders will dream up others, said Joseph R. Mason, associate professor of finance at Drexel University’s LeBow School of Business.
“Product regulation in this sector is inherently doomed, because it was founded on very creative financial engineering,” Mason said.
In Mason’s view, tax incentives that allow homeowners to write off the interest payments on their mortgages have encouraged some to live beyond their means. Mortgage lenders have facilitated the process by allowing them to borrow against their homes to pay off credit card debts or buy cars they can’t afford, Mason said.
“If you think about it, it’s exactly the opposite of the behavior you want to incentivize — for people to own their own homes, and have equity they can tap into in retirement,” Mason said.
For now, regulators and lawmakers seem largely content to sit on the sidelines. It’s market forces that are shaping up to be the biggest threat to continued access to credit for home buyers — especially those with marginal credit. Interest rates on mortgage loans, even for borrowers with good credit, are up significantly from last year.
According to government-sponsored mortgage repurchaser Freddie Mac, 30-year fixed mortgage rates shot up 50 basis points during the second quarter, ending at 6.7 percent. That compares with an average of 6.42 percent in 2006 and 5.87 percent in 2005. Adjustable-rate mortgages indexed to one-year Treasuries gained 25 basis points to 5.7 percent in the latest quarter, after averaging 5.54 percent in 2006.
The good news for potential home buyers is that Freddie Mac economists, in their most recent forecast, said they expect fixed and adjustable mortgage rates to remain near current levels for the rest of the year.
Still, Freddie expects mortgage originations in 2007 to total $2.75 trillion — an 8.5 percent decline from the year before. Refinance loans are expected to make up 42 percent of that business, the lowest level in seven years.
Since delinquencies and defaults in subprime loans began a steady rise last year, there have been dozens of headlines about mortgage loan originators closing their doors, declaring bankruptcy or being acquired by their creditors. According to Bloomberg News, at least 60 mortgage companies have been forced to take such actions since the beginning of 2006.
But some observers attribute at least some of the attrition to a continuing trend of consolidation in the industry. According to a report by the federal agency that oversees Freddie Mac, the top 25 lenders originated 87 percent of single-family mortgages in 2006, compared with a one-third market share in 1994.
For mortgage lenders that remain in the game, there are opportunities to make more loans in a less competitive environment on more profitable terms. Countrywide Financial Corp. in May announced it would hire 2,000 salespeople in order to grab a bigger market share from struggling competitors.
The big question for lenders like Countrywide is whether they will have to pay more for the money they borrow to make loans, and whether investors who buy securities backed by those loans will demand greater returns for the risk those loans entail.
Many experts say subprime borrowers can bank on the interest rates associated with those loans to continue to head up — if they’re able to get loans approved at all.
To provide more borrowers with an alternative to private subprime mortgage lenders, some policy makers advocate a greater role for government-backed mortgage repurchase and guarantee programs.
If lawmakers can help mortgage repurchasers Freddie Mac and Fannie Mae put their accounting and management scandals behind them — and push through legislation modernizing the Federal Housing Administration’s loan guarantee programs — subprime borrowers won’t be left out in the cold, advocates for quick government action say.
But Congress has been moving slowly on legislation that would reform oversight of Fannie and Freddie, and there’s considerable controversy over plans to modernize FHA by allowing risk-based pricing and zero-down loans.
In the meantime, cracks have appeared in the foundations of some of the investments that fund private-label mortgage lenders. Those cracks include a crisis at two Bear Stearns hedge funds that invested heavily in securities backed by subprime mortgage loans, and moves by ratings agencies to downgrade similar mortgage-backed securities.
If the investors who bankrolled the housing boom lose confidence in such securities, that could drive up the cost of borrowing and reduce consumers’ home-buying power, further depressing home prices.
Even in the absence of a credit crunch, home prices are expected to come down — or at least sit still for some time — in areas where they’ve outstripped wages.
When mortgage rates were at historic lows in 2001 and 2002, “People could afford to buy a lot of house,” said Standard & Poor’s Chief Economist David Wyss. “With a 5 percent mortgage rate, you can afford the monthly payment on a very expensive house. Being good Americans, we all promptly ran out and bought very expensive houses.”
The result, Wyss said, was that home prices hit record levels — not only in absolute terms but relative to income. The average home price in 2006 was 3.4 times the average household income, compared with the historical norm of 2.6.
That implies a continued drop in home prices, Wyss said. Assuming average incomes continue to rise, “that should get us back to a reasonably normal ratio over the course of the next two years.”
Wyss expects home prices to decline 8 percent on average nationwide between 2006 and 2008, bottoming out in the first quarter of 2008.
“So far we’ve only seen about a 2.1 percent drop in home prices,” Wyss said in a July 10 conference call with securities investors and reporters. “We still believe we have another 6 percent to go, and that we should bottom out early next year.”
For borrowers who hope to take advantage of the lower rates available with loans guaranteed by Fannie, Freddie or the Federal Housing Agency, the good news is that regulators say they intend to keep the conforming loan limit at $417,000 in 2008, no matter how drastically home prices fall this year.
During the downturn, Wyss expects to see two distinct troughs, and one peak. First, sales activity will hit bottom, then home prices, and finally losses to investors in mortgage-backed securities will peak.
“Notice that not everything hits bottom at the same time,” Wyss said. “We expect (sales) activity to bottom out this fall. Prices probably won’t bottom out until early next year because you’re going to have to get rid of that inventory of unsold homes. And (MBS investor) losses will probably not peak until late 2008, and possibly even early 2009.”
Wyss and other economists believe declining home prices will only make it more difficult for troubled borrowers to refinance or sell their homes. Borrowers with rising loan-to-value ratios may not be able to refinance because of tightened underwriting guidelines, which could fuel more foreclosures.
Falling home prices, rising interest rates and mortgage fraud are all contributing factors to the poor performance of subprime loans originated and securitized in 2005 and 2006, Standard & Poor’s says. Losses on all subprime MBS issued since the fourth quarter of 2005 totaled 29 basis points, compared with 7 basis points for 2000 — which until now, according Standard & Poor’s, had been the worst-performing year of the decade.
Those losses — and expenses lenders incur when they agree to do workouts or modify the loan terms of troubled borrowers — not only hurt their bottom lines, but reduce the amount of capital they have available to make more loans, said Joseph R. Mason, associate professor of finance at Drexel University’s LeBow School of Business.
“The big question is how much” losses will amount to, Mason said. “Whether you want to measure it through a decrease in market capitalization, the cost of charge-offs, loan modifications, bailouts … I can’t tell you the dollar amount, but I can tell you the amount is big, and that’s the amount of foregone lending.”
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