Credit expansion is the problem in housing, not the solution

Expanding credit makes lenders and realtors more money in the short term, but it invariably leads to inflated house prices and a market collapse.

planet_banksThe real estate cycle that culminated in the parabolic rise in prices during the Great Housing Bubble was the result of a series of solutions to short-term problems that led to a major catastrophe.

Imagine a housing market where prices are affordable and everyone owns a house that wants to. This would be a stable baseline condition similar to what existed from the 1950s to the 1970s. Under these conditions, when an improving economy created more jobs or higher wages, homebuilders responded by providing more supply, and house prices maintain a stable balance between income, rent, and the cost of ownership.

In the stable housing market environment described above, increasing credit availability is unnecessary because it would merely make homeowners out of people unable to sustain home ownership due to a lack of financial management skills. Unfortunately, the political left doesn’t accept this reality, so they push for subsidies and increased credit availability even if the beneficiaries of that largess can’t sustain home ownership.

As new demand enters the market and prices rise, the demand temporarily outstrips the supply, and the resulting shortages cause prices to rise further, pricing marginal buyers out of the market. Lenders typically responded to these conditions by offering toxic loan terms that allowed borrowers to stretch their incomes into larger loans: this is where the short-term solutions of lenders invariably lead to a disaster.

When lenders take that approach to every buyer and every deal in the marketplace, and very soon, affordability products proliferate, prices inflate, and the entire market becomes unstable. Over the period of a few years, the lending market becomes saturated with amortizing ARMs, then interest-only ARMs, and finally Option ARMs.


Once financing crosses the Ponzi threshold of interest-only loans, the market destabilizes, mortgage defaults accelerate, and a credit crunch becomes imminent; it’s only a matter of time before lenders realize their folly and abruptly stop making bad loans. Once that happens, credit tightens, and lenders retreat to the stability of 30-year fixed-rate mortgages. Rather than repeat this cycle and endure another painful housing bubble, legislators passed the Dodd-Frank law and put in place new qualified mortgage rules and ability to repay rules (See: Will the “Ability to Repay” rules prevent reckless lending?).

The new mortgage regulations will prevent future housing bubbles because they banned the toxic loan terms that inflated house prices last time. These new mortgage rules fundamentally change how housing markets work.

Unfortunately, this leaves lenders with a problem: How should they respond when prices become elevated and marginal buyers are priced out? IMO, and in the opinion of the framers of the Dodd-Frank law, lenders and buyers just have to accept it. The cycle of expanding credit must end because we know where that road leads us. However, it shouldn’t be a surprise that with the US taxpayer assuming the risk, lenders lobby for their old solutions — solutions proven disastrous in the long-term — because those solutions make them money in the short term.

The New Housing Crisis?

David H. Stevens, President and CEO at Mortgage Bankers Association, Jun 19, 2015

We are currently in the middle of a housing crisis.  That’s right…I said it.  Industry experts, economists and even consumer groups have predicted one would emerge, albeit this is not what they expected and it is certainly sooner than anticipated.

He is right about an upcoming crisis (See: Mortgage and Foreclosure Crisis 2.0)mortgage-foreclosure-crisis-2.0

Yes, the word crisis is harsh and alarmist, but it accurately reflects the complete void of focus on housing as an opportunity by Washington policy makers, including the actions of the regulators and enforcement officials that are narrowing the credit box.  Fact – there is a shortage of affordable housing (both rental and owned) and the homeownership rate today is at its lowest point in over two decades.  Today’s environment is not encouraging credit expansion. It’s forcing lenders to be overly conservative – ultimately failing entry-level homeowners on every front.

This is where he completely jumps the shark. The problem caused by high prices is not solved by expanding credit for reasons I outlined above. The problem is solved by lower prices and more supply.

What’s the number one issue choking off access to affordable credit? Regulating through enforcement and it’s happening on a case-by-case basis.  The guessing game for businesses to know if and when they may be penalized has produced the most defensive lending posture in years. This atmosphere of the unknown; this environment of fear and trepidation rather than an environment of constructive engagement and compliance have a steep cost. And we’re not just talking costs for compliance or production.  We’re talking costs for any mistake, even a minor one that may have no bearing on the efficacy of the loan, making lenders even more conservative in lending.  It’s impacting the willingness of lenders to take the risk even to some who would otherwise qualify for their dream to obtain a home.

Spare me the American Dream bullshit. Regulation preserves the stability of the market by banning the terrible practices undertaken in the guise of expanding credit, regulations that became necessary due to a complete abdication of responsibility demonstrated by lenders during the housing boom. The American Dream he advocates makes millions for realtors and lenders and leaves marginal borrowers who couldn’t sustain ownership penniless.


The mortgage lending industry has acknowledged and taken accountability for the role we played in actions that led to the meltdown.  Lenders have paid hundreds of billions in settlements.

Almost nobody in the lending or real estate industries acknowledged any responsibility for the housing bubble, and the settlements were only paid grudgingly after threat of more damaging legal battles caused lenders to cut their losses. These settlements were conspicuous by their lack of an accompanying statement of wrongdoing.

We’ve also made tremendous change in controls, compliance, and to improve the consumer experience.  Now it’s time policymakers – the vast network at the federal and state level – account for their role in the recovery.  It’s time to acknowledge the flaws in policy, corrections needed to the rules, and the impacts of going too far.

linked_to_performanceForcing prudent lending standards on an out-of-control industry has been painful for the industry, but it’s putting the housing market on stable footing. If rising mortgage rates do put pressure on prices, it won’t put pressure on the legions of borrowers who have fixed-rate mortgages with affordable payments. The market is much better off for the changes imposed by Dodd-Frank.

Unless we call this what it is – a crisis – and focus on the critical role that our national leaders can play, there is no hope of traction.

It is my sincere hope that despite his hyperbole that there is no hope of traction on rolling back the protections provided by Dodd-Frank.

Let’s fix what needs to be fixed. Let’s change the dialogue of distrust to a dialogue of confidence.

If he wants to change the dialogue, he needs to drop the alarmist hyperbole. Further, he needs to come up with new ideas rather than retreating to the policy options of yesterday that were specifically banned because the role they played in the housing bubble and bust.need_bonus

Let’s fix the rules to allow for innovative, sustainable, safe lending.

We have. Dodd-Frank allows for sustainable, safe lending. Since promoting financial innovation results in future housing bubbles, that part of his request is by necessity falling on deaf ears.

Let’s end the relentless enforcement regimes.

Let’s not.

Give us the confidence to provide access to credit to more qualified borrowers at the lower and middle income levels. Reignite the economic engine of the real estate market.

Lenders have the confidence to provide loans to any qualified borrowers, and they have fear about loaning money to deadbeats — as they should. The only reason lenders want to change that is so they can make more money in origination fees and pass the risk on to taxpayers; I’m not in favor of that.

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