In past recessions, the housing and mortgage sector, stimulated by the lower interest rates generated by an easier monetary policy, was a source of strength that led the economy out of the recession. Not this time.

Despite the fact that the easing of monetary policy has been more aggressive than in any prior recession, and included unprecedented purchases of mortgage-backed securities by the Federal Reserve, the spark has fallen on wet grass.

Sales of new and existing homes are lower today than at any time in the last decade. House prices have not rebounded as expected. The volume of mortgage refinances has fallen far short of predictions based on past relationships.

Why has monetary easing failed to do the job this time? In a recent article, I pointed out that the interest rates that mortgage borrowers actually pay have not declined as much as published rate series suggest because so few borrowers qualify for the lowest rates. Published rate series have a downward bias because they don’t cover potential borrowers who are priced out of the market.

While interest rates on prime loans have declined, the rate penalties for less-than-prime conventional loans (those not FHA or VA) have increased.

One illustration: Before the crisis, the FICO score of borrowers taking loans with 70 percent loan-to-value ratios could be very low without affecting the rate. Today, a borrower taking a 70 percent loan needs a FICO score of 740 to get the lowest rate, with a score of 640 the rate will be 0.5 percent to 0.625 percent higher, and with a score of 600 conventional loans are not available at any price.

This can be largely attributable to the post-crisis policies of Fannie Mae and Freddie Mac, as noted below.

In addition, underwriting requirements have become extremely tight. Minimum credit scores have been raised, maximum ratios of loan amount to property value (LTV) have been reduced, and documentation rules have become much stricter. Full documentation has become the rule for every borrower, and underwriters no longer have discretion to use their judgment in difficult cases.

The impact of these changes has been reinforced by a pervasive downward bias in appraisals, a complete turnaround from the upward bias that prevailed before the financial crisis. Where a reported 90 percent LTV before the crisis was probably closer to 95 percent, today it is closer to 85 percent.

The turnaround in appraisal bias is a key to much of what has happened. Expectations of lenders and investors have done a 180-degree turn, from unbridled optimism that home prices will keep rising, thereby validating liberal lending terms, to hesitancy and caution lest the period of home-price declines not be over. Much of the tightening in lending terms reflects this major swing in expectations.

The same thing happened in the early 1930s, except in that period mortgage lending came to a complete halt because there were no federal agencies supporting the market — they had yet to be created.

The recent financial crisis, furthermore, transformed the housing finance system in some fundamental ways that have made the system less responsive to monetary easing by the Federal Reserve.

First, the private mortgage-backed securities (MBS) market imploded, leaving only markets in securities guaranteed by the federal government. Conventional mortgage lenders are now almost completely dependent on guarantees from Fannie Mae and Freddie Mac to be able to sell their mortgages.

Second, those agencies have made extensive use of the representations and warranties provided by lenders doing business with them to require the repurchase of loans made in pre-crisis years that have gone bad.

As a result, in order to avoid possible violations that could trigger buybacks in the future, lenders today impose more restrictive underwriting rules than those of the agencies.

Third, the crisis eliminated some large mortgage lenders, including Countrywide, Washington Mutual, Indy Mac and Wachovia. These firms were heavily into third-party originations — acquiring mortgages through brokers and small lenders, and selling them into secondary markets. This has left significant market power in the hands of the three remaining behemoths serving this market: Wells Fargo, Chase and Bank of America.

Insiders tell me that the market power of these firms is enhanced by the lower guaranty fees they pay to Fannie and Freddie relative to the fees paid by smaller firms. I am also told that the behemoths are enjoying profit margins many times larger than those that were common in third-party originations before the crisis. Larger margins are embedded in the rates paid by borrowers.

Finally, the crisis wiped out the capital of Fannie Mae and Freddie Mac, which on Sept. 6, 2008, were placed into conservatorships. The Federal Housing Finance Agency (FHFA), which had been their regulator, was appointed the conservator. Its charge was to "preserve and conserve the company’s assets and property and to put the company in a sound and solvent condition."

The agencies have followed this charge exactly, posting prices and underwriting rules designed to maximize their net revenue. If their income statements separated out operations since conservatorship, the agencies would be extremely profitable.

This fact is obscured in the actual statements, however, because large profits on current operations are swamped by losses on loans purchased before the crisis.

A major consequence of revenue maximization by the agencies is that there is a very sizable group of borrowers who are current on their existing loans and should be able to refinance or buy homes but can’t. Either they can’t meet draconian underwriting rules, or they are priced out of the market by the heavy penalties imposed on less-than-pristine mortgages.

Two strategically important groups have been particularly hard hit. One is the self-employed, who are predominantly the small-business owners who are a major potential source of employment growth. The other group comprises investors who buy homes to resell at a profit, and who are desperately needed right now to buy foreclosed homes sold by lenders.

Thanks to Alan Boyce. A future article will discuss how to remake the agencies into team players.

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