What could hold back the start of a recovery in housing this year?
This post is adapted from the author’s testimony at a recent hearing before the U.S. Senate Banking, Housing, and Urban Affairs Committee.
Many of the major negative housing trends that dominated the headlines since the crisis are now well off their post-crisis peaks. While prices are only flat to slightly down year-over-year, there is finally some optimism for probably the first time in more than three years. But before we get ahead of ourselves, let’s examine some of the economic fundamentals and also assess the policy and regulatory headwinds that are still blowing from Washington.
New delinquencies are trending lower on a percentage basis. The decline in home prices also appears to be leveling off or approaching a bottom on a national basis. Data from CoreLogic suggests that house prices have increased, on average, across the country over the first three months of 2012 when excluding distressed sales. Even the numbers from the Case-Shiller Index out this week suggest that a floor in home prices has been reached.
There is also a relative decline in the supply of homes for sale. The chart below shows how the existing stock of homes for sale is now approaching a level equal to five to six months of sales. This is a very promising development. According to the Commerce Department, the housing inventory fell to just over five months of sales in the first quarter, the lowest level since the end of 2005.
In short, the level of housing supply today suggests that the market is close to equilibrium, which implies house prices should rise at a rate consistent with rents. Market analysts often look at a level above or below six months of sales as either favoring buyers or sellers, respectively. It’s not surprising then that the recent stabilization of home prices nationally has occurred as the existing inventory, or supply level, has declined.
A couple of important caveats should be kept in mind, however. First, almost any discussion of national inventory trends can gloss over regional problems, or acute supply challenges in individual state markets. Second, the transaction data around home sales suggests that any near-term demand-supply equilibrium is occurring off of an extremely low transaction volume. In essence, weak demand for single-family homes appears to have eclipsed the supply challenge moving forward for the housing market.
Consider that homes are more affordable than they have been in decades.
The National Association of Realtors Home Affordability Index measures the “affordability” of a median-income family purchasing a median-priced home (using a 20 percent downpayment for a 30-year fixed rate mortgage). All of which is to say that house prices look low on a historical, user-cost basis.
So, this begs the question: Why are home sales still so depressed?
One major reason: tight lending and underwriting standards. Earlier this month, Federal Reserve Chairman Ben Bernanke commented on this trend by reviewing information from the latest Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS).
Most banks indicated that their reluctance to accept mortgage applications from borrowers with less-than-perfect records is related to “putback risk”– the risk that a bank might be forced to buy back a defaulted loan if the underwriting or documentation was judged deficient in some way.
Federal Reserve Governor Elizabeth Duke also gave a speech earlier this month on this theme, providing yet even more detail on the conclusions from the April SLOOS:
- Compared with 2006, lenders are less likely to originate Government Sponsored Enterprise-backed loans when credit scores are below 620 regardless of whether the downpayment was 20 percent or not.
- Lenders reported a decline in credit availability for all risk-profile buckets except those with FICO scores over 720 and high downpayments.
When the lenders were asked why they were now less likely to offer these loans:
- More than 84 percent of respondents who said they would be less likely to originate a GSE-eligible mortgage cited the difficulty obtaining mortgage insurance as factor.
- More than 60 percent of lenders pointed to the risks of higher servicing costs associated with delinquent loans or that the GSEs might require them to repurchase loans (i.e., putback risk).
Another important market development to acknowledge is that lenders can’t keep up with demand, particularly with regard to mortgage refinancings. Anecdotal evidence suggests that some lenders are simply struggling to process all the loan applications coming their way. Part of the problem appears to be the structural shift in the market toward full and verified documentation of income and assets, which has lengthened the processing time for mortgage applications.
But if lenders and servicers don’t have enough capacity, why are they not just hiring more staff or upgrading their infrastructure so they can handle more loans or business? This seemingly innocent question is really important. Don’t market participants still perceive this business as profitable long term with a comparatively good return on investment when viewed against other business lines?
Governor Duke’s conclusion is spot-on. Lenders or servicers are hesitating in the near term because they just don’t have a good sense of how profitable the housing finance-and-servicing business will be over the medium-to-long term.
And that’s because of the policy questions that haunt the housing sector. There is perhaps no other major industry that faces more micro-policy uncertainty than housing today. Putting aside broader GSE reform, these uncertainties can be grouped into two buckets: servicing and underwriting.
On the servicing side, federal regulators are in the process of establishing new industrywide rules governing their behavior, changing how servicers get compensated and altering the way the business itself can be valued if it’s part of a broader bank balance sheet.
On the underwriting side, the Dodd-Frank law pushed regulators to try to finalize very complicated rules governing who should be able to qualify for certain types of mortgages (i.e., ability to pay standards), including those that are bundled into mortgage-backed securities.
All of these actions will affect the future of house prices, as credit terms and mortgage availability are intimately linked to the user-cost of housing generally.
The urgency to resolve all of this uncertainty is all the more important because while there are clear short-term impacts on the market, there are also potential long-term consequences. For example, if lenders decide to hold off on making new near-term investments in their mortgage business, the long-term potential of a full rebound in housing may be diminished as the existing or legacy infrastructure and skills can be expected to atrophy further.
Mortgage servicers are not in business to lose money. Moreover, the total volume of resources devoted to performing this function – employees, investment in computers and telecommunications infrastructure, legal compliance officers, sales staff – is not static. It adjusts upward and downward based on perceived opportunities, expected future revenues and government involvement.
Some big investments are not being made because of concerns that regulations will impose costs on the industry that cannot be recovered through servicing fees or other revenue streams. Here there have been a few positive developments recently, suggesting that at least some investors are willing or able to take on the aforementioned headwinds.
Non-bank and specialty mortgage servicers like Nationstar and Ocwen are buying up MSRs from the large banks. Home prices also appear to have reached the point where investors could buy properties and rehabilitate them for less than it would cost to construct them brand-new. This trend helped spark some fresh investments in late 2011, which has generated some modest momentum for 2012. In the first quarter this year, GDP was 2.2 percent and residential investment provided a 0.4 percent contribution or share of that figure.
But so much policy uncertainty still looms.
No one really knows who the ultimate purchasers of mortgages are likely to be five years from now. Since the ultimate holders of mortgages – currently Fannie Mae and Freddie Mac, on behalf of the government – are the servicers’ client base, the current lack of clarity on who or what is likely to fund mortgages in the future has obvious ripple effects on servicers and all other professions exposed to mortgage finance.
A similar phenomenon is casting a shadow over the mortgage insurance industry. The difficulties in obtaining mortgage insurance are constraining lenders from selling to Fannie and Freddie, even if they have found buyers and are willing to originate the loans. Several mortgage insurance companies have failed in recent years, others are no longer offering insurance on a forward-looking basis and are just managing their existing exposures.
Resolving even some of the uncertainty holds by far the greatest potential for responsibly helping the housing market moving forward. It’s just too bad that there is an election in November, since it means policymakers and regulators can be expected to dither out of fear of upsetting a particular interest group before votes are cast.