The interaction of immovable objects and inexorable forces is seldom pretty. One example is housing finance in the US. If no one blinks, an ugly situation could get even worse.
One the one hand, we have the complete lack of resolve on the part of the officialdom to fix the abuses in the private label securitization market, which prior to the crisis, accounted for 60% of mortgage financing. The weak risk retention rules in Dodd Frank don’t cut it, and the sell side (the major banks) have been completely unwilling to consider reforms, such as those proposed by the FDIC in early 2010, that would have addressed enough of the problems to entice investors back into the pool. (The FDIC’s plan include one year seasoning before a loan could be sold into a securitization, 5% risk retention, loan level disclosure, and no CDOs.)
Instead, we have wishful thinking from what Matt Stoller has called the hope and change school of “how we fix housing”. I got a call from a very earnest financial reporter a few weeks ago, and he seemed quite convinced that covered bonds, a conservative structure with a long history in Germany, would solve the problem. Given that securitization contracts proved to be meaningless – originators lied about what they were selling, trustees refused to intervene as required to do by contract in the light of clear problems with the loans (and are now trying to get their own get out of jail free cards per the example of Bank of New York in its settlement with Bank of America), and servicers scam borrower and investors – it is hard to fathom would anyone with an operating brain cell have anything to do with this market. I called an investor, who confirmed my dour views: “It isn’t the structure that the problem, it’s the people behind the structure.”
Private capital is on strike until better regulations are in place or memories fade, and the losses are so great that market participants say it will be a decade before there is another private securitization market in the US. This has more serious implications that you might think.
We now have a housing finance market that is almost totally on government life support. One private label was done last year. Administration officials complain that lending standards (which are a reflection of Fannie, Freddie and FHA standards) are too restrictive, as reflected in average FICO scores and down payment requirements (note I’m not entirely sympathetic, borrowers should have more in the way of down payments than was the norm in the housing bubble era. As Josh Rosner has said, a home with no equity is a rental with debt). Maybe they should have been a little more supportive of tougher requirements for mortgage securitizations when Dodd Frank was being crafted.
Banking expert Chris Whalen reports that even with the caviling by Obama loyalists that mortgage credit is being offered to too few, some banks are managing to make loans they will come to regret:
…banks such as Wells Fargo (“WFC”) are behaving irrationally in the conforming residential mortgage market, writing loans simply to buy market share and at least some earning assets. Other large banks are doing similar stupid things in the markets for 1-4 family housing and commercial real estate, using shoddy underwriting standards and non-existent credit analysis to simply put assets on the book. These particular chickens won’t come home to roost for about two years, notes one veteran banker.
Now consider how this looks in a few years. Whalen reports that is pretty much impossible to get a mortgage of $1 million , which is consistent with an absence of lending outside the “conforming” mortgage market (loans bigger than the GSE ceiling of $625,000 in certain high cost areas).
Now consider where this is all going. The latest FHFA inspector report said that Fannie and Freddie could not be privatized, despite conservative fantasies to the contrary. Under the conservatorship, they are required to shrink their balance sheets over time. The Administration released trial balloons of creating what amount to new GSEs that supposedly will work better (by virtue of having more of them and requiring each to be better capitalized). That plan encountered more vociferous pushback than the Administration expected and appears to be on hold. The FHA has been steeping into the breach as the Administration has increasingly relied on it to serve as a major source of mortgage funding.
Consider how this plays out: Republicans are hostile to “affordable housing.” Some of this is ideological (they hate lower income people) and some is political (the GSEs were a Democratic pork operation, and they assume, probably correctly, that any successors will boost Democratic party interests). There is some merit to this view, since using housing finance to implement housing policy simply makes residential real estate more, not less, costly over time. And it is inefficient: you can’t measure the impact of finance-related subsidies with great precision, and the benefits accrue to a significant degree to non-targeted groups (for instance, the Fed’s efforts to help the housing market via targeting QE at mortgage backed securities helped lower mortgage financing costs, which led to refis almost entirely by the sort of people who refi whenever mortgage rates drop, those with good balance sheets and incomes. That did nothing to help people in high interest rate loans who were at risk of default. In the overwhelming majority of cases, their credit wasn’t good enough for them to refi into a conforming mortgage).
The Democrats are much more eager to Do Something but Obama is keen to cut the deficit. That will play into the Republican’s hands, since they hate the GSEs and will likely start getting agitated about the FHA, since its capital reserve has fallen below the Congressionally stipulated minimum of 2%. And the Republican are completely unrealistic as to private market alternatives ex serious regulatory reform (not that the Democrats have any more appetite for sufficiently tough regulation, mind you).
So how may this turn out? It’s a no-brainer that we will continue to have a housing market dependent on the willingness of the Federal government to continue to guarantee pretty much all mortgages. The GSE wind-down is on auto pilot. It is not inconceivable that the Republicans will try to rein in FHA lending, either in terms of tightening quality standards or imposing limits on the total guaranteed per year, which will further limit overall mortgage credit, again relying on the mistaken belief that if the government “got out of the way,” private sector lending would resume. While there is a price at which private loans would get done ex better investor protections, it’s at a much bigger premium than borrowers can stomach (one investor said he’d lend at a 5% premium to Fannie and Freddie rates. He’s greedy, so let’s reduce that by 50%. That’s still a deal-killer for most prospective buyers).
In other words, mortgage financing is likely to become even more politicized, and the results have high odds of constraining government involvement in this sector, which would be a plus ex the failure to take reform of the private market seriously. So if you are of the school that mortgage finance it too restricted now, don’t bet on it getting better any time soon.