Promoting financial innovation will result in future housing bubbles
With house prices bottoming, lenders are less risk adverse because they know rising prices reduces losses when loans go bad. As a result, lending standards will soon begin to loosen up on the fringes as lenders will take on marginal borrowers in an attempt to underwrite more loans. This is a natural part of the credit cycle, and fortunately with new regulations in place governing qualified mortgages, the cycle of loosening standards should not go so far as to inflate another disatrous housing bubble. But that doesn’t stop lenders from trying.
Many in the lending industry think their work is like science that continually advances. It is not. It is far more akin to assembly line work where the same widgets are pumped out year after year. When lenders start to innovate, trouble is brewing. The last significant advancement in lending was the widespread use of 30-year amortizing loans that came into favor after World War II. Prior to that time, home loans were interest-only, short-term loans with very high equity requirements (50% was most common.) This proved problematic in the Great Depression as many out-of-work owners defaulted on their loans. A mechanism had to be found to get new buyers into the markets and allow them to pay off the loan. The answer was the 30-year, fixed-rate amortizing loan. To say this was an innovation is a stretch as this loan has been around as long as banking has existed, but it did not become widely used until equity requirements were lowered. The lenders were willing to lower the equity requirements as long as the loan was amortizing because their risk would decline as time went by and the loan balance was paid off.
Over the last 60 years since World War II ended, a number of experimental loan programs have been attempted. These include, interest-only loans, adjustable rate loans, and negative amortization loans among others. It is this group of loans that has consistently failed in the past for one simple reason: if payments can adjust higher, people will default. It is really that simple. The Option ARM is certainly the most sophisticated loan ever invented. It is a dismal failure, not because it isn’t sophisticated, but because it has embedded within it the possibility (probability, no — near certainty) of an increasing payment. Any loan program that has the possibility of a higher future payment will fail because there will be a certain number of people who cannot afford the higher payment. Fortunately, these unstable loan programs were recently banned.
The financial innovation meme must die
The lending industry touted its “innovation” with exotic loan products. They sold these toxins far and wide. Now that these loans are achieving the highest default rates ever recorded, it is safe to say the “innovations” over the last 5 years were not entirely successful. It is amazing that a group of intelligent bankers came up with this loan and expected a positive outcome. When you really look at the whole “innovation” meme, you see that it is nothing more than a public relations effort to convince brokers the products were safe to sell and borrowers the products were safe to use. It is hard to fathom the widespread acceptance of this nonsense, but that is the nature of the pathological beliefs of a financial mania.
Here is where the lenders lie to themselves and to the general public after a financial debacle like the Savings and Loan problems of the 1980s or our current housing bubble: they blame the collapse and the high default rates on some outside factor rather than the terms and conditions the lenders created all by themselves. There are still many out there who believe the high default rates and problems in the housing market in the 90s were caused by a weak economy. This is rubbish. House prices declined for 6 years. The decline started before the economy went soft, and it continued well after it had recovered. People defaulted because they overextended themselves on loans to buy overpriced housing, and toward the end of the mania, many were using interest-only loans. Whenever lenders start loaning people money with total debt-to-income ratios over 36% people start to default. Whenever lenders start loaning more than 80% of the purchase price, people get underwater and start to default. These phenomenons, which I document daily on this blog, are not new. It happened in the early 90s, and it happened in the 00s for the same reasons: lax lending standards.
By Jason Gold — March 11, 2013
The housing bubble and ensuing financial crisis not only wreaked havoc on the U.S. economy, but it also shook public confidence in financial markets and robbed Americans of their faith in homeownership as a stable iconic pillar of middle class security.
Much of the fallout can be blamed on the exotic financial “innovations” hawked by Wall Street in the run-up to the financial bust: “liar loans,” where no verification of income was required; synthetic derivatives, whose highly speculative design put the entire financial system at risk; and home equity lines of credit that exceeded the value of homes by up to 125 percent.
Today, housing prices are finally rising and the stock market is going gangbusters. But the idea of “financial innovation” retains its negative aura.
That’s a problem, because just as there are good and bad witches in Oz, there’s good and bad innovation on Wall Street.
When it comes to residential home mortgages, there is no good innovation on Wall Street.
Good financial innovation is transparent, easy to understand, reduces risks, and benefits all market participants—not just savvy insiders.
Like a 30-year fixed-rate mortgage.
Bad financial innovation is opaque to small investors, emphasizes debt over equity and risk, and mainly benefits the financial services industry.
Take adjustable rate mortgages that reset after two years but include a five-year prepayment penalty. These loans guaranteed the borrower much higher payments after the reset, something many that borrowers were unprepared for, or a substantial penalty that sent the original loan amount soaring.
Still, we shouldn’t overreact when it comes to new financial products or create a regulatory environment that stifles the right kind of creativity.
We shouldn’t overreact, but we should react appropriately by banning most forms of financial innovation proven to be dismal failures in the past. Without regulation of these financial products, the incentives of Wall Street will be to inflate another housing bubble, extract huge fees on toxic loan products, and leave the mess to the US taxpayer to clean up. Since it’s plainly obvious to everyone that the US taxpayer will bail out this kind of misconduct in the future, regulations must be in place to protect taxpayers from it.
Here are four ways “good” financial innovations can help—not hinder—homeownership:
1. “Underwater insurance”: If the crisis taught us anything, it’s that home values can plunge as well as rise and that when they do, underwater homeowners can’t move if a better job opportunity appears elsewhere. But what if people who can’t afford large down payments, but are perfectly responsible candidates for homeownership, could buy a modestly priced insurance policy (at its most basic, a derivative is a simple insurance contract) to protect against a downturn in home values? That policy could mean the difference between a better job and greater opportunity at wealth and mobility.
The best underwater insurance is a large down payment. The whole point of a down payment is to give the borrower an interest in the property (most won’t walk away from a substantial down payment even though it’s a sunk cost), and to provide a cushion for lenders in the event prices decline. Underwater insurance is unnecessary if down payment requirements are high. Further, if such an insurance policy were issued on low-down payment loans, it would have an extraordinarily high cost if risk is priced properly. This is an idea that sounds good until one looks at the problems with actually implementing it.
2. HomeK: a down payment savings account: One of the biggest hurdles to homeownership is the down payment, especially with the stricter mortgage underwriting standards adopted in the wake of the housing bust. To overcome that obstacle, 401(k) plans could be expanded to facilitate savings for down payments. Potential first-time homebuyers can set aside up to half of their future contributions to retirement accounts into a tax-preferred subaccount designated for down payments. And boosting overall savings would buffer homeowners against the risk of falling home values as well as the likelihood that entitlement reform will trim Social Security benefits.
People are already allowed to borrow from their 401Ks for a house down payment. Creating a special account is unnecessary, and it creates costly paperwork and compliance issues.
3. REO to rental: REO (real-estate owned) refers to homes that a bank takes back from a borrower after a foreclosure. Despite improvement in the housing market, many REOs still exist, which has given cash-rich investors a chance to capitalize on rising rents and low interest rates. Recently even mammoth hedge funds and private equity investors have entered the fray, snapping up bargain-basement-priced homes by the thousands and helping fuel the housing comeback.
This is hardly a financial innovation. Large hedge funds moving in to buy up distressed properties for positive cashflow is the proper working of the financial market. In my earliest posts I talked about how the housing market would bottom when investors bought up distressed properties. I didn’t anticipate the problem becoming so large as to entice large private equity funds, but the concept is the same. If prices fall low enough, any cashflowing asset becomes desirable to investors.
There was room for innovation in the REO-to-rental space, but alas, it was not to be.
4. Assumable mortgage: An assumable mortgage allows a new borrower who qualifies for the terms of an existing mortgage to transfer the note upon purchase of the home. This idea seeks to minimize two of the biggest risks investors and lenders face in mortgage lending: early pre-payment and default risk. The Federal Housing Administration currently has mortgages that are assumable in certain cases and it’s astounding they are hardly ever mentioned as more significant assets. With interest rates at historic lows—and conventional wisdom pointing to increases starting next year—an assumable mortgage with a fixed rate of 4 percent or less should add quite a premium to the price of a home. It’s also something investors should embrace as well.
FHA mortgages are already assumable. They have been since the program was started in the 1930s. Again, this is hardly a financial innovation. And investors don’t embrace assumable loans because they end up getting stuck with a low interest rate loans in a high interest rate environment. This creates an asset-liability mismatch that costs them dearly.
Financial innovation with residential mortgages is impossible
Unless you change human nature, there are always going to be people who are too irresponsible to make consistent payments. This is the key to any loan program. Either people do or do not make their payments. You can reinvent new terms and schedules as often as you like, and it will always boil down to people making payments. When these fancy loan programs contain provisions that make it difficult for people to make payments — like increasing payment amounts — they will default, and the loan program will fail. This is certain.
When lenders create new, “sophisticated” loan programs that require advanced financial management on the part of the borrower, both the lenders and the borrowers fall victim to the Lake Wobegon effect. Everyone thinks they have above average abilities when it comes to managing their finances. In reality, perhaps 2% of borrowers have the financial discipline to handle an Option ARM loan. Unfortunately, 80% of borrowers think they are in this 2%. The reason for this comes from the inherent conflict between emotions and intellect. 80% of borrowers may understand the Option ARM loan, but when the pressures of daily life create emotional demands for spending money on one’s lifestyle, the intellectual knowledge that this money should go toward a housing payment is conveniently set aside. It is this 2% of the most disciplined borrowers who will cut back on discretionary spending to make their full housing payment. Everyone else will make the minimum payment, fall behind on their mortgage, and end up in foreclosure.
It seems lenders forget basic facts about lending every so often and create a new financial bubble. Perhaps they succumb to the pressure of the investment community or their own shareholders, or perhaps they just start believing their own “innovation” bullshit and forget the basics of sound lending practices. This is why we need recessions. These pathologic lending practices must be purged from the system or else they will survive to build an even bigger and costlier bubble — although it is difficult to imagine a bubble bigger than this one, it is still possible.
In the aftermath of a financial fiasco, lenders returned to the practices that did not fail them in the past — as evidenced by all the whining from realtors and homebuilders about tight lending standards. Some will consider this rollback of standards taking lending standards back 50 years. They would be right. The only program lenders know is stable is a 30-year, fixed-rate, conventionally amortizing loan based on 80% of appraised value taking no more than 28% of a borrowers gross income (36% maximum total debt.) This is why lending standards are so tight today, and it’s also why similar standards became part of the qualified mortgage rules designed to prevent future housing bubbles.