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One of the big differences between the current housing boom and the epic home price surge and subsequent crash that ultimately led to the “Great Recession” is the quality of the buyers, or more precisely, the underwriting standards lenders use when making mortgage loans, and the soundness of the loan products and features lenders offer.
Without a doubt, by 2005, 2006 and 2007 lending standards were completely out of touch with reality and the various tools used by the mortgage system to keep the party going – 100% loan-to-value, zero interest, reverse amortization, no income verification, subprime etc – were used to keep the mortgage system going even after house prices had risen and put them out of reach for many would-be home buyers.
In the aftermath of the great financial crisis, federal regulators made notable efforts to understand what went wrong and then put measures in place to prevent such egregious behavior in the future.
The Dodd-Frank Wall Street Reform and Consumer Protection Act included a provision called the Mortgage Reform and Predatory Lending Prevention Act that sought to tighten the mortgage origination process by:
The purpose of this section and section 129C is to ensure that consumers are offered and receive mortgage loans on terms that reasonably reflect their ability to repay the mortgage, are understandable, and are not unfair, deceptive, or unreasonable.
To that end, there are two key subsections: (Note: Dodd-Frank is a massive piece of legislation with many provisions. These are just two small samples of items that focus specifically on mortgage origination standards):
Subtitle B: Minimum Mortgage Standards
General.— Pursuant to rules established by the Commission, to make a mortgage loan, a creditor must make a reasonable, good faith determination, based on verified and documented information, that at the time of closing, the consumer has a reasonable ability to repay the loan in accordance with the terms of the loan and all applicable taxes, insurance (including mortgage guaranty insurance), and assessments.
This section details the tightening of regulations, multiple loans (borrowers having subordinate loans on the same property), income certification, no interest options, negative amortization options, and other lending phenomenon that contributed to the mortgage frenzy of the time.
Subtitle F: Evaluation Activities
Generally, a creditor may not extend credit to a consumer in the form of a subprime mortgage without first obtaining a written appraisal of the real property that is the subject of the mortgage prepared in accordance with the requirements of this section.
This section details stricter rules to regulate the appraisal process for properties financed using “high-risk” subprime mortgages.
Taken together, these two subsections point out a major flaw in the legislative process for financial regulation, which has a constant tendency to look backwards, particularly in addressing past practices that led to financial crises.
Whether it makes sense to try to regulate future financial activity is not the subject of this post, but suffice it to say that the mortgage origination-related provisions of the Dodd-Frank Act focused on the activities that led to the Great Recession and did not attempt to regulate other new methods that might be employed in future speculative events.
One of the areas I'm interested in is the non-conforming “jumbo” loan market, and particularly in my own market, Boston, we've seen some really reckless behavior from borrowers and lenders throughout 2020, 2021 and into 2022.
Following on from my last post on the subject, I have dug a little deeper into the homes I have previously featured to gain a better understanding of the nature of the debt that funded these reckless purchases.
From a traditional mortgage lending perspective, these purchases seem very sound, given that the average loan-to-value ratio (LTV) is around 70% (i.e. 70% loan, 30% down payment), all mortgages are simple 30-year fixed rate loans (no risky options or even a single ARM), and all are income verified.
But when you consider that each of these buyers is bidding a whopping 30% above the listing price on average, a different conclusion may be drawn.
First, below is a simple averaging model for pricing the Boston housing market that I developed using the S&P CoreLogic Case-Shiller Home Price Index (CSI) for Boston: Overlaid on Zillow's price history, the model uses the CSI to calculate price trend lines based on actual annual price changes for 2016-2019, and the average annual price changes over the past eight years for 2020-2022.
My broad premise in this model is that 2020-2022 was an incredibly unusual period in which lending rates were abnormally low and buyers (as a result of COVID-19 hysteria) were simply not acting cautiously.
As the model shows, there is a significant risk of “mean reversion” in the country’s overheated housing market as interest rates rise and prices fall to a more fundamental balance, which, if realized, would call into question the financial soundness of the loans backing these properties.
Given the macro-economic situation, and particularly the new headwinds for the housing industry, if Boston home prices were to fall by 25% (not inconceivable given the intensity of price increases over the past two years and the magnitude of previous declines of roughly 16% after the S&L crisis in the late '80s and 18% after the Great Recession), the average LTV for all of these homes would be around 92%, putting buyers and lenders on a much less healthy financial footing.
Furthermore, given that buyers have pushed through with frenzied bidding, resulting in prices that are well outside the simple average price trend (model), the prices of many homes may fall even more rapidly.
Below are three homes selected from my first post, annotated with a simple average price model and mortgage details to illustrate the point.
Note that we calculated not only the LTV on the settlement date, but also the LTV after a 25% drop in price and a simple average price model forecast of value based on more fundamentals.
The loophole in lending standards this cycle appears to be that home appraisals either failed to accurately reflect the extraordinary price appreciation occurring in the market or the fact that borrowers had prepared 20% to 30% down payments and good credit histories was simply ignored altogether.
A smart lender would evaluate the appraisal to determine a more fundamental valuation and then either require more down payment from a borrower who is willing to bid given the additional risk, or reject the deal altogether.
For example, in the first listing mentioned above, the base value of the home at the time of purchase was probably closer to about $1.3 million, but the bid came in at $1.72 million, or about $420,000 above the base price.
If the lender had been more cautious, it would have walked away from the deal or required the borrower to come up with a down payment of about $800,000, instead of the mere $400,000 that he actually paid.
This resulted in a loan of approximately $920,000 against an $800,000 down payment, with a very healthy LTV of 53%, which should be well fortified against any future declines in home prices due to the economic downturn.
Apparently the lender did not perform this level of due diligence because the borrower could not afford the additional deposit and all parties involved (lender, broker, lawyer, buyer and seller) simply wanted to complete another transaction.
I think my small sample size clearly indicates something important about how the housing market is performing this cycle: there is real, yet not yet fully realized, systemic risk emerging from the prime lending market, particularly with regard to privately funded “jumbo” loan activity.