The (Slow) Housing Recovery: Tighter mortgage financing is to blame

I’ll never forget the time I was visiting a new home sales office near Los Angeles in the height of the boom years.  The agent was attempting to explain to the potential buyer how an Option ARM could help them qualify for a higher loan balance that could easily be refinanced into a standard 30-year fixed rate program down the road.  As the alarm bells started going off in my head, I decided to re-visit the first model rather than risk challenging the agent’s presumptuous thinking.  It was at that point that I was pretty sure our industry was firmly in bubble territory.

Fast forward to 2014, and we now have the opposite problem of not enough credit due to often overly stringent underwriters who prefer to approve only the best candidates with near-perfect credit scores and reliable W-2 income.  In fact, the problem has become acute enough that the Mortgage Bankers Association recently revised their 2014 forecast downwards due to “a combination of rising rates and regulatory implementation, specifically the new Qualified Mortgage Rule.”  The new forecast predicts annual refinancings this year to be down 60 percent from 2013 (largely due to higher interest rates) but purchase originations to still rise by 3.8 percent.  During the fourth quarter of 2013, the mortgage businesses for Wells Fargo and JPMorgan Chase were reportedly down by 60 and 55 percent from a year ago, respectively.

As noted in my column last month, the reasons for the tighter credit are two-fold:  an incomplete Dodd-Frank Act which means regulations are unclear, and new Qualified Mortgage Rules which went into effect on January 10^th.  Qualified mortgages are those which are no longer than 30 years, charge fees and points no more than three percent of the loan amount and don’t include any negative amortization or interest-only programs.  For adjustable rate loans, underwriters now must take into consideration the potential maximum rate and payment amount over the life of the loan instead of approving based on the teaser rate alone.  This would seem to disproportionately impact younger buyers who were previously willing to take a gamble that their paychecks would improve along with their careers, thus making higher monthly payments in the future feasible.

Also now largely shut out of the mortgage market are the newly self-employed, as evidenced by nationally syndicated housing columnist Lew Sichelman’s disappointing experience to refinance a rental property despite a credit score of 760 and an LTV of 70 percent.  With less than two years of history of 1099 income, Lew’s equity in several other properties simply wasn’t relevant under today’s underwriting criteria.

There may, however, be a signs of a thaw in this somewhat frozen market.  Many eyes are now on former congressman Melvin L. Watt as director of the Federal Housing Finance Agency, which oversees both Fannie Mae and Freddie Mac.  As opposed to Edward DeMarco, the agency’s acting director for the past four years, Mr. Watt has already indicated a clear shift in direction which includes delaying a series of higher loan fees announced in December and putting access to mortgage credit front and center ahead of other goals, especially that of scaling back the federal government’s role in propping up the residential mortgage market.

What this means in the short run is that those buyers without perfect credit and large down payments will not face higher upfront loan fees charged by Fannie and Freddie.  In the long run, there remains a larger policy disagreement on the role of private capital in our nation’s mortgage market, one that would be completely separate without any connection to government.  And yet in a lending environment of mortgage rates below five percent, private capital has stayed on the sidelines because there are too many other competing options which offer higher yields.  Add in the considerable interest rate risk that an investor takes with a traditional 30-year fixed-rate loan and it’s not surprising that lenders continue to be picky.  Eventually, however, lenders which rode the now-declining refinancing wave of 2013 will have to make up that lost business with new loan originations.

To spur lending, three things should happen.  Firstly, Fannie and Freddie will have to expand the range of mortgages they guarantee without lowering standards.  Secondly, the re-emergence of private capital should occur before government fees are raised.  And thirdly, Mr. Watt should ensure that the 30-year fixed-rate loan remains a bedrock of housing finance given its historic role as the best way for homeowners to slowly build wealth without worrying about future interest rate shocks.  

Where do they stand? Obama vs. Romney on housing policy

After several years of false starts, there finally appear to be more green shoots appearing in the nation’s housing market which indicate a slow yet actual rebound.  Sales of both new and existing homes are on the mend, affordability is at generational highs, and the dreaded tsunami of foreclosures expected to lower prices even further have largely been bought up by investors to re-purpose as rental properties.  Even better, according to Moody’s housing analyst Celia Chen, homeowners will begin to favor newly built homes versus distressed homes which are damaged.

Nonetheless, because the economy remains the top concern of most voters in the 2012 Presidential election, how President Barack Obama and the GOP’s presumptive nominee Mitt Romney influence housing policy is of critical importance to homebuilders and homeowners alike.  As a political Independent for well over a decade, I may have no abiding loyalty towards either major party, but I do certainly want what’s best for the industry and, by extension, the country.

According to the NAHB, the housing sector normally accounts for 15% of the nation’s GDP, and is one of the few sectors which cannot be out-sourced to other countries across the globe.  Based on population growth and demographics, the nation will have to build 17 million new residences just to keep up with demand over the next decade, and yet for now the industry remains largely hamstrung by deferred household formations, limited construction financing, and a flawed appraisal system in which new homes erroneously get compared against deeply discounted distressed and foreclosed units.

So can market forces alone help guide this all-important sector of the U.S. economy to health, or will it continue to need more help?  The answer to that question depends on whom you ask.

For Mitt Romney, while there is nothing on his campaign Web site which specifically addresses housing, he seems to rely more on the private market to sort things out.  According to Glenn Hubbard, an economic adviser to Romney, the domination of housing finance by government entities such as the FHA, Freddie Mac and Fannie Mae is simply not sustainable and must be phased out in favor of private lenders.

At a recent campaign event in Florida, Romney also reportedly mused about getting rid of agencies such as the Department of Housing and Urban Development (HUD) as part of his plans to simplify the federal government.  As for foreclosures, he prefers to let the free market let prices hit ‘rock bottom’ as opposed to government policies which would seek to make such declines more orderly.

President Obama, on the other hand, seems to believe that continued intervention by the federal government – at least in the short to medium run -- is essential to providing adequate mortgage capital and even to help underwater borrowers refinance, with restrictions, to today’s historically low rates.  He probably doesn’t have much choice:  given that his previous attempts to bolster the housing market haven’t worked at even close to the scale that is necessary – with less than 20% of homeowners eligible for loan modifications -- if government intervention is to work at all, the policies must be more aggressive.

More recently, Obama seems to have absorbed this criticism, unveiling more than a half dozen plans to encourage refinancing, to reduce the overhang of debts owed by underwater homeowners, and to expand existing aid programs even to borrowers who were speculators or simply took on too much debt.  These latest moves seem as much practical as they are political, since the previous obsession with refusing to help those who made financial mistakes has really acted as a structural brake on the economic rebound.  Schadenfreude may feel good to the individual, but it does nothing to fix the housing market.

Since the Obama Administration has put the housing market back on its front burner, I’d expect the Romney campaign to do the same.  But given that the federal government continues to guarantee or insure more than 90% of all home mortgage activity through FHA, Fannie Mae and Freddie Mac, candidate Romney will have to offer specifics on just what, when and how the private sector will successfully step up to the plate.

Did the Bush Administration stoke the housing bubble?

There's a detailed story in today's New York Times (hat tip: L.A. Land blog) detailing how policies of the Bush Administration and ignoring important warning signs (such as prices rising much faster than associated rents) served to stoke the housing bubble. From the story:

Eight years after arriving in Washington vowing to spread the dream of homeownership, Mr. Bush is leaving office, as he himself said recently, “faced with the prospect of a global meltdown” with roots in the housing sector he so ardently championed.

There are plenty of culprits, like lenders who peddled easy credit, consumers who took on mortgages they could not afford and Wall Street chieftains who loaded up on mortgage-backed securities without regard to the risk.

But the story of how we got here is partly one of Mr. Bush’s own making, according to a review of his tenure that included interviews with dozens of current and former administration officials.

From his earliest days in office, Mr. Bush paired his belief that Americans do best when they own their own home with his conviction that markets do best when let alone.

He pushed hard to expand homeownership, especially among minorities, an initiative that dovetailed with his ambition to expand the Republican tent — and with the business interests of some of his biggest donors. But his housing policies and hands-off approach to regulation encouraged lax lending standards.

Mr. Bush did foresee the danger posed by Fannie Mae and Freddie Mac, the government-sponsored mortgage finance giants. The president spent years pushing a recalcitrant Congress to toughen regulation of the companies, but was unwilling to compromise when his former Treasury secretary wanted to cut a deal. And the regulator Mr. Bush chose to oversee them — an old prep school buddy — pronounced the companies sound even as they headed toward insolvency.

As early as 2006, top advisers to Mr. Bush dismissed warnings from people inside and outside the White House that housing prices were inflated and that a foreclosure crisis was looming. And when the economy deteriorated, Mr. Bush and his team misdiagnosed the reasons and scope of the downturn; as recently as February, for example, Mr. Bush was still calling it a “rough patch.”

The result was a series of piecemeal policy prescriptions that lagged behind the escalating crisis.
Click here for full article.

Did the 1997 change in the tax law for home sales launch the bubble?

Remember back in 1997 when the tax law was changed so people selling their principal residences would never have to pay capital gains taxes on certain amounts ($250,000 for singles, $500,000 for couples?). That was also about the same time that the housing bust here in Southern California of the early 1990s finally began to show some real bounce. A story in the New York Times investigates:

By itself, the change in the tax law did not cause the housing bubble, economists say. Several other factors — a relaxation of lending standards, a failure by regulators to intervene, a sharp decline in interest rates and a collective belief that house prices could never fall — probably played larger roles.

But many economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law.

Vernon L. Smith, a Nobel laureate and economics professor at George Mason University, has said the tax law change was responsible for “fueling the mother of all housing bubbles.”

By favoring real estate, the tax code pushed many Americans to begin thinking of their houses more as an investment than as a place to live. It helped change the national conversation about housing. Not only did real estate look like a can’t-miss investment for much of the last decade, it was also a tax-free one.

Together with the other housing subsidies that had already been in the tax code — the mortgage-interest deduction chief among them — the law gave people a motive to buy more and more real estate. Lax lending standards and low interest rates then gave people the means to do so...

The provision — part of a sprawling bill called the Taxpayer Relief Act of 1997 — exempted most home sales from capital-gains taxes. The first $500,000 in gains from any home sale was exempt from taxes for a married couple, as long as they had lived in the home for at least two of the previous five years. (For singles, the first $250,000 was exempt.)...

The change in the tax law had its roots in a Chicago speech that Senator Bob Dole, Mr. Clinton’s Republican opponent in the 1996 presidential election, gave on Aug. 5 of that year. Trailing Mr. Clinton in the polls, Mr. Dole came out for an enormous tax cut, including an across-the-board reduction in the capital-gains tax...

The law’s defenders say that it also removed at least one tax incentive that had pushed homeowners to trade up. Before 1997, people had to buy a house that was at least as valuable as their previous one to avoid the tax, or else take the one-time exemption. Now they could buy a smaller property or move into a rental.

But many economists say the net effect of the law was clearly to inflate the real estate market. Dean Baker, co-director of the Center for Economic and Policy Research, a liberal policy group in Washington, criticized the exemption as “a backward policy” that “helped push more money into housing.”...

Perhaps the most detailed analysis of the provision has been the study by a Federal Reserve economist, Hui Shan, who did the analysis while at M.I.T. Ms. Shan looked at homeowners with significant equity gains, before and after 1997, and compared the likelihood of their selling their house. Her study covered 16 towns around Boston and took into account a host of other factors, like the general rise in home prices at the time.

Among homes that had appreciated less than $500,000, she concluded that the change caused a 17 percent increase in sales in the decade after 1997. Before the law changed, many people apparently avoided paying the tax by simply staying in their homes...

Click here for full story.

The pain in Spain

A couple of days ago, Pigginton's San Diego Housing Blog (one of the best and funniest, btw), compared Spain's housing market to Temecula. I think that does a disservice to Temecula. Granted, Temecula has been hurting for a while, but it adjusted far more quickly than anyone expected, and realistic pricing is one of the key factors that will bring a housing market back to life. There are some smoking deals in Temecula right now if you are willing to navigate the short sale swamp.

The same cannot be said for Spain's housing market, which appears to be toastito, according to UK's Guardian:

Spain had been among the euro zone's hottest real estate markets but house prices fell for the first time in a decade between April and June as chronic overbuilding and 8-year-high mortgage rates added to the impact of the U.S. credit crunch.
"House sales have fallen on a month-on-month basis since the beginning of last year, when the indicator began, and this is just the start," said Merrill Lynch economist Daniel Antonucci.
"We expect data to continue to worsen well in to next year."
Mortgage lending also plummeted 40.6 percent in June after a 40.4 percent drop in May, as the credit crunch squeezed Spanish banks.
Strong economic growth in Spain over the last decade had been supported by surging property and construction markets, though many analysts expect the country to go into recession in the second half of the year as housing demand collapses.
"It's awful, as usual," said Stephane Deo, chief economist at UBS. "The housing market is in freefall and this is just another confirmation that this sector is in deep, deep trouble."

Does this sound familiar?

As Patrick wends his way through Europe, I thought it would be fun to take a look over the next couple of days at a few of the markets he is either visiting or flying over...What is striking is how the bubble economy took hold in so many parts of the world, and with such similar (…even predictable? Nah!) results. This article in the Irish Times provides a succinct overview of how it all happened, and a surprisingly (to me at least) tough stance, Government must let Property Bubble burst:

Ireland's economy has grown in two broad stages in the last 20 years. The first one was a coupling of the country to the very powerful forces of globalisation (eg US multinationals), while the second saw the flourishing of the domestic economy with the tailwind of low interest rates.

Where the first phase saw Ireland grow in confidence, the second, arguably, saw it become complacent, uncompetitive and dazzled by its own unexpected success. This is standard behaviour in economies in the full throes of an economic bubble.

And:

The biggest mistake policymakers and politicians could make at this stage is to try to prop up the asset bubble in the property market.

However, the apparent bewilderment of some politicians in the face of the downturn, and the desire of many of our oligarchs (as expressed in these pages) to see their industries supported by the State, suggests that the short-term crisis and not the long-term future dominates attention spans.