Wednesday, August 10, 2011

It's the End of the World as We Know It

I chose the title of the REM 80's song "It's the end of the world as we know it," because this past weekend as I was watching all of the fallout from our first-ever credit downgrade, the chorus to this ridiculous song kept running through my head.  But if the title sounds flippant, the reality of our situation is more serious.  For the housing industry, this really is the end of the world as we have known it.

Not only did Standard and Poors downgrade the US credit rating from Triple AAA to AA+, they also downgraded the rating of Fannie Mae and Freddie Mac.  The downgrade sends a powerful message reiterating what we have known for some time--Fannie Mae and Freddie Mac are probably not much longer for this world.  And although Fannie and Freddie are about to go away, at this point we still don't know whether their replacements will be completely private, as conservatives want, or completely public, as Barney Frank has indicated that he wants.  All we know is that government conservatorship of two giant agencies which have gobbled up hundreds of billions of tax dollars in just under three years is going to have to end.

The downgrade was not all that happened last week. The comment period for the FDIC's qualified residential mortgage proposal ended August 1.  A similar proposal by the Federal Reserve ended its comment period a few weeks ago, so now the future of housing is back in the hands of government employees who appear to be determined to drive the final nails into the housing market's coffin.  The new proposed guidelines require a 20% down payment for a purchase, 25% equity for a refinance and 30% equity for a cash-out refinance. The borrower's debt to income ratio cannot exceed 28% for his housing ratio to his income and 36% for his total debts to his gross income. These ratios do not have compensating factors--allowing, for example, high cash reserves to be used to offset a higher ratio. As an additional blow, any borrower with a 60 day delinquency on his credit report will not qualify for a QRM.

Using these guidelines, only 20% of the loans sold to Fannie and Freddie over the last 10 years would have met the criteria of a QRM. The Federal Housing Finance Authority found that less than one-third of loans sold to Fannie and Freddie in 2009 would have met the QRM guidelines, and 2009 was one of the strictest underwriting years on record.

Any loan not meeting the QRM guidelines will be subject to 5% risk retention by the originator. That means that to originate at $200,000 loan, the originator would have to be able to retain $10,000 of that loan for the life the loan. (Risk retention guidelines implemented by Dodd Frank state clearly that the retained portion cannot be sold off separately.) Those dollar amounts will add up fast, so the risk retention guidelines will ultimately exclude a lot of smaller originators from originating anything except a QRM.  And since the FDIC has stated plainly that QRMs are meant to be only a very small slice of the housing market, this means that most residential mortgage lending will by necessity be done by the major banking giants--Wells Fargo, BofA, Chase, and Citi.

The qualified residential mortgages are mandated by the Dodd Frank bill, but the requirement for homebuyers to have 20% equity in their homes is based on a misguided notion by many in government, including former FDIC chair Sheila Bair, that at one time all Americans had to put down a 20% down payment to buy a home.  In interviews that she gave to Fox Business on this issue, Bair said smugly that 20% down payments had worked for this country in the past, and she believed that this was a good model going forward.  What Bair does not say is that the default rate for 30 year fixed rate mortgages has been less than 1% regardless of the size of the downpayment.  Careful underwriting and fixed rate mortgage notes are much better indicators of whether a mortgage will perform than whether the homebuyer puts down a substantial amount of money at closing.

The truth is that our housing market has never relied on 20% down payments as the standard.  For some research supporting this, see the post that I wrote a few months ago entitled, "The Myth of the 20% Down Payment."  Our housing market has been built and has thrived on a variety of credit products that allowed borrowers to make substantially smaller down payments to qualify for home ownership.  So if we want to look at how the 20% down payment model works, we cannot look at our own, pre-1990s past.

However, we can look at the experiences of Hong Kong.  An AOL real estate story by Ann Brenoff posted June 14, 2011, states that when Hong Kong recently implemented a 20% down payment requirement for foreign buyers, sales at 10 of the nation's largest residential developments fell 60% the following week.  In Hong Kong, the government implemented the measure specifically to slow home purchases and stop inflation of home values.  In our country, rising home values is hardly a problem--2011 is seeing property values fall again all over the country as potential buyers either do not qualify or choose to purchase lower-priced foreclosures and short sales.  And as more and more Americans choose strategic default and walk away from homes that they could actually afford, we will have an increasing number of foreclosures which will continue to force home prices down.  No, what we need is certainly not a slower housing market.

When I tell people that at the end of the year when the QRM guidelines go into effect, potential homeowners who want the best rate will have to put 20% down, have no more than a 36% debt to income ratio and be current within 30 days on their obligations, they are shocked. After all, a $200,000 home would require $40,000 down payment plus closing costs, putting it well out of the range of many young American families. When I tell them that those who cannot qualify will go into a loan where the lender maintains 5% of the risk--which will probably be mainly one of the major banking entities--Wells Fargo, Chase or BofA--and that these loans are expected to cost 3 times as much as a "qualified residential mortgage" they are even more shocked. FHA has always been a popular product for young families nationwide, and especially in lower income communities such as El Paso, even though our community FHA loan limit is capped at around $275,000. But now that FHA has a mandate to reduce its lending presence to between 10 -15% of mortgage loans, most Americans are going to be left out of homeownership permanently.

In response to the stock market problems and Bernanke's promise to keep interest rates low for the next two years, mortgage rates right now are at record lows.  I feel very confident in predicting that this window of opportunity to refinance or purchase at low interest rates is the last one that we will see in a very long time.  If you are thinking about buying a house or refinancing your house, now is the time if you qualify.  After the qualified residential mortgages become the new standard for residential lending in a few months, the real estate market as it has traditionally existed in the US really will have come to an end.

For books by Alexandra Swann visit her website at

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