Dodd-Frank prevents lenders from inflating another bubble
If lender lobbyists don’t roll back Dodd-Frank, the new mortgage rules will prevent future housing bubbles.
Everyone wants to buy a home and see it go up in value. Most people assume the greater the increase the better because they don’t want to believe there is a natural limit to home price appreciation determined by income growth. During boom times, people blithely assume the magic appreciation fairy doles out free money with no end in sight; however, that free money was created by the last buyer in the neighborhood establishing a new comparable sales value for everyone. Everyone cheers the new comparable sale while the last borrowers who set that value struggle with payments on a huge mortgage, sometimes not making it.
Last year in the post Large real estate investor purchases steeply decline in California, I described how rising real estate prices doesn’t trigger the same market reaction as in year’s past:
In the past, whenever affordability became a problem, lenders would come up with some
innovativetoxic loan product, allowing people to buy homes they really couldn’t afford; thus the cycle of Ponzi lending and borrowing would begin. During the bubble from the late 80s, toxic products such as adjustable-rate interest-only loans became common, and prices were pushed up to the limit of fake affordability these products created. During the most recent housing bubble, we hit what should have been a peak in late 2003, but lenders “innovated” again and began originating and securitizing option ARMs that pushed prices up to ridiculous levels.
To prevent the deflation of that housing bubble, the federal reserve engineered low mortgage rates by first lowering the federal funds rate to zero then printing money to buy mortgage-backed securities to push mortgage rates down from 6.5% to 3.5%. In the process they made stupid bubble-era prices affordable — which is where we stand today.
The difference today is that lenders must now deal with the Dodd-Frank restrictions of qualified mortgage rules and the ability-to-repay rules. These two rules effectively ban the toxic mortgage products used in the past to make unaffordable house prices temporarily affordable. So what happens when prices get too high and toxic mortgage products are unavailable? Home sales volumes crumble. Combine that with a pullback of institutional buying, and you end up with sales volumes well below last year’s below-average levels.
As I thought about this outcome, I began to question whether or not the legislators who passed the Dodd-Frank financial reform would succeed in preventing future housing bubbles. Back in January of 2013 I wrote that the new mortgage regulations will prevent future housing bubbles, and later I wrote that new mortgage regulations change how real estate markets work. Based on the evidence — declining sales caused by higher prices — I am becoming more hopeful that we really and truly are witnessing the end to the cycles of boom and bust in California real estate.
The last piece of the puzzle is whether or not people’s attitudes change. Real estate is religion in California, and the resurgence of kool-aid intoxication is an ever-present threat, but if people start to accept that house prices only rise with inflation and that excessive mortgage debt is a real burden, then the market lacks a key ingredient necessary to create a full-blown financial mania. Perhaps I succumb to my own optimism bias, but I want to believe people finally want to stop the madness.
With any regulation, there is fear that it will either be changed or enforcement will be lax. While it’s still possible future generations may forget the folly of the last decade, it’s unlikely our generation will: these new regulations are here to stay. A far larger concern is the lack of enforcement and oversight, and if the issue were left up to the agencies or the federal reserve, that would still be a big concern, but that’s not where enforcement will come from. Civil lawsuits from future loanowners decrying their inability to repay the loans is what will keep lenders in line.
What would inflate another bubble?
Housing bubbles inflate for one of a few reasons:
- Unstable loan products with rising payments allow borrowers to increase their loan balances beyond what their incomes can support. This usually happens in response to rising prices when borrowers want to raise their bids to obtain a better property but they can’t qualify using an amortizing loan. Interest-only and Option ARMs are Ponzi loans doomed to fail at some point in the future.
- Debt-to-income ratios get out of line. During the 1970s, lenders allowed very high debt-to-income ratios because both they and their borrowers assumed the borrower would obtain 10% or better raises every year due to inflation. A 60% debt-to-income ratio becomes affordable after three or four years of 10% yearly raises. In the 1990s, lenders allowed borrowers to stretch again, and they underwrote many interest-only loans which took the debt-to-income ratio to unsustainable heights.
- Another way housing bubbles can get inflated is to abandon underwriting standards altogether. Obviously, in the Great Housing Bubble lenders did everything they did wrong from the first two bubbles and added negative amortization, teaser rates, and liar loans to boot.
It all comes down to borrower leverage. If borrowers are not allowed to take on debts they cannot successfully service and repay, housing bubbles won’t happen — which is one of the main arguments against a bubble today. Wall Street might believe residential mortgages are the best investment available again, but without interest-only mortgages, Option ARMs, seconds, and HELOCs to pump money into those mortgages in an unstable way, housing bubbles won’t inflate.
How do we prevent another housing bubble?
Let’s review my recommendations for preventing future housing bubbles from The Great Housing Bubble:
Loans for the purchase or refinance of residential real estate secured by a mortgage and recorded in the public record are limited by the following parameters based on the borrower’s documented income and general indebtedness and the appraised value of the property at the time of sale or refinance:
- 1. All payments must be calculated based on a 30-year fixed-rate conventionally-amortizing mortgage regardless of the loan program used. Negative amortization is not permitted.
- 2. The total debt-to-income ratio for the mortgage loan payment, taxes and insurance cannot exceed 28% of a borrower’s gross income.
- 3. The total debt-to-income of all debt obligations cannot exceed 36% of a borrower’s gross income.
- 4. The combined-loan-to-value of mortgage indebtedness cannot exceed 90% of the appraised value of the property or the purchase price, whichever value is smaller except in specially sanctioned government programs.
The new regulations specifically ban interest-only and negative amortization loans, so #1 happened.
The debt-to-income ratio limits are not as low as I proposed, all loans, including jumbos, now have a maximum allowable debt-to-income ratio of 43%. The standard today set by the GSEs is 31% of gross income, and since all attempts at higher limits failed, it’s unlikely this will go up. So provisions two and three happened.
There is the risk that second mortgages and HELOCs may rise back to 100% of value or higher, but given the magnitude of the losses on these loans from the bubble, it will be a while before lenders start making those stupid loans again. Plus, with rising future interest rates, demand for HELOCs and seconds will not be what it was during the bubble when lower rates allowed borrowers to refinance larger sums with the same payments.
Any sums loaned in excess of these parameters do not need to be repaid by the borrower and no contractual provision is permitted that can be interpreted as limiting the borrower’s right to exercise this right, make the loan callable or otherwise abridge the mortgage agreement.
This last statement is the most critical. This is how the enforcement problem can be overcome. Regulators are pressured not to enforce laws when times are good, and decried for their lack of oversight when times are bad. If the oversight function becomes a potential civil matter policed by the borrowers themselves, the lenders know exactly what their risks and potential damages are. Any lender foolish enough to make a loan outside of the parameters would not need to fear the wrath of regulators, they would need to fear the civil lawsuits brought by borrowers eager to get out of their contractual obligations.
Given the legal environment favoring loanowners in response to the collapse of the bubble (loan modification entitlements, Loanoweners Bill of Rights, and so on), lenders will not be eager to stick their necks out and make loans outside the parameters of a qualified mortgage.
Imagine what will happen if they do. Let’s say a lender makes a loan with a debt-to-income ratio that makes the loan unaffordable to the borrower. At the first sign of trouble, the borrower will petition for a loan modification. If they are denied, they will find an attorney to bring suit to force the lender to favorably modify the mortgage, and they will win because the loan is outside the “safe harbor” of a qualified mortgage.
The threat of future lawsuits from borrowers — lawsuits the lenders know they will likely lose — will prevent them from loaning outside the parameters of a qualified mortgage. If lenders don’t loan outside those parameters, borrowers will be able to afford their mortgages, and a housing bubble and associated collapse will not occur.