It has been 10 years since Lehman Brothers collapsed and the mortgage market tanked with Fannie and Freddie taken over by the US government. Have we learned any lessons from the last collapse? Is the mortgage market substantially safer than before? Who will take it in the pants when the market cycles again? Will it be the same “bad actors” as before, new players, or you, the taxpayer?
Short sighted policies
The stated goal of the Government Sponsored Entities is to increase homeownership rates. This has been the goal under both Republican and Democratic administrations. This is a noble goal as there are many positive impacts to society from increased homeownership rates. But there is a catch.
How to increase homeownership?
In today’s environment wage growth has been basically stagnant while home prices have continued to increase. At the same time treasury yields have increased driving mortgage rates higher. People are making the same amount they did 10 years ago while housing prices have outpaced both inflation and any wage gains.
With wages stagnant and mortgage rates increasing how can anyone possibly increase homeownership. Leave it to our wonderful government to solve this conundrum.
Change the standards
Just as in the last crisis, loose underwriting standards took down many banks, brokerages, homeowners, and investors. Are we going to make the same mistake again? Absolutely! To increase the homeownership rate, Fannie/Freddie (now effectively owned by the US government) have been loosening lending standards in order to help more borrowers qualify for mortgages.
How do we know standards are loosening?
40% of all purchases over the last 12 months were low down payment loans, this encompasses over 1.5 million borrowers. Borrowers putting between 5 to 9 percent down grew at double the market average (source: Black Knight Analytics). Furthermore, over 35% of all lending by the government sponsored entities, Fannie/Freddie which are backed up by US taxpayers, was subprime (less than 10% down); this is up from 5% in 2010 (Bloomberg)
What is Subprime lending and why is this important?
Subprime lending (or non-prime) is basically any loan where the borrower puts less than 20% down and/or don’t meet traditional credit/income guidelines. Regardless of credit or other rations, in the last crisis, we saw that Loan to value was the number one indicator of a loss which should not be surprising to anyone.
Why is 20% the magic number?
Let’s look at what happened during the last recession. Remember prices can go decrease and decrease substantially. The last recession showed that borrowers with less than 20% down were substantially more likely to default on their loans. Why? In a recession with values dropping if you put only 5% down, the borrower is underwater almost immediately. In other words, the house is worth less that is owed. It doesn’t take a deep recession to see a 5-10% drop in values. A little hiccup in the economy could knock prices down 5-10% especially in higher cost areas like the Colorado front range where borrowers are spending larger portions of their income on housing.
Wait, everything is different now in the mortgage market! We cannot have the same issues again with Dodd Frank, etc…!
I hear the arguments now, default rates are at the lowest since the recession, underwriting is tougher, credit scores are higher and the list goes on. Unfortunately, none of these arguments hold water, subprime is back and the new lender in town is you and I the taxpayer through our ownership in Fannie/Fredie.
LTV number one indicator of loss
Being a private lender and riding through the last mortgage crisis with no bailout from the government, we learned real quick what happens in a market downturn. The number one factor on whether a lender will take a loss is Loan to Value. As a private lender in the last crisis we had a unique perspective to see how our lending practices performed under stress. We lend our own funds, look at every property, and service our loans. We get to see the whole loan cycle as opposed to many banks that pool their loans and securitize them offloading the risk to other parties. As the crisis unfolded we spread out the portfolio based on credit, income, loan to value, etc… the primary indicator of whether we would take a loss or not was the amount of leverage the borrower utilized. The lower the loan to value, the higher probability of a positive resolution.
What happens in a downturn?
A cascading effect occurs; the market falls, dampens consumer confidence, decreases consumer spending and businesses in turn cut back to accommodate the lower spending level (layoffs, fewer purchases, etc…). Borrowers that have equity in their commercial or residential property are considerably more likely to make a payment. In the last crisis, there were a considerable number of “strategic defaults” where the borrower could make a payment but chose not to since the house was underwater. The theory goes “why throw good money away when I can go rent or buy another house for less than what I currently owe?”. This is a simplistic explanation of what happened in the last crisis and what will happen again. The depth of how this plays out in the next crisis is the question.
What does this have to do with Fannie/Freddie the largest purchasers of residential mortgages? With 35% of mortgages originated having less than 10% down, the probability of major defaults has been amplified. It is highly likely that there will need to be a huge bailout by U.S. taxpayers to the tune of 100 billion dollars (Bloomberg) or more (this doesn’t include bailouts of FHA or VA which also makes subprime loans with down payments less than 5%!).
We haven’t learned our lesson!
The Federal Housing Finance Agency released its annual progress report summarizing the activities of the GSEs in 2017. One of the items highlighted was (Housing wire):
High LTV refinances: The GSEs announced in August a new refinancing program aimed at borrowers with high-LTV loans. The new offering will give borrowers with high-LTV loans who are current on their mortgage an opportunity to refinance. The GSEs explained that these borrowers are typically unable to refinance when their LTV ratio is higher than the limits on other existing refinance products.
They surmised: “giving underwater and highly leveraged borrowers the opportunity to refinance, not only will it benefit the borrower, but also lowers the default risk” How is this possible? The GSEs are not only making subprime loans that have a substantially higher likelihood of default, but they are also refinancing subprime loans giving the borrowers cash out further increasing the LTV and future losses from defaults. It is mind boggling!
It is perplexing that we are repeating the same mistakes that led to the collapse of various banks a decade ago. GSEs, which we as the taxpayer are funding/guaranteeing, are the new risk in town. They have increased their subprime lending from 5% in 2010 to 35% in 2018. At the end of the day there is a price to pay for the loosening of standards. The federal housing authority pegs this number at close to 100 billion dollars (Bloomberg). Get your checkbook ready because all of us will be on the hook for the bill.
Resources/Additional reading
- https://www.housingwire.com/articles/42974-fhfa-here-are-10-things-the-gses-did-to-improve-access-to-credit-in-2017
- https://www.bloomberg.com/news/articles/2017-08-07/fannie-freddie-might-need-100-billion-in-new-crisis-fhfa-says
- https://c.ymcdn.com/sites/www.coloradobankers.org/resource/resmgr/imported/Fact%20Sheet.pdf
- https://www.bloomberg.com/news/articles/2018-09-13/mortgage-market-revival-creates-new-risks-a-decade-after-lehman
- https://www.housingwire.com/articles/42974-fhfa-here-are-10-things-the-gses-did-to-improve-access-to-credit-in-2017
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all they need is their simple one page application (no upfront fees or other games).