The Miraculous Continuous Workout Mortgage

Professor Robert Shiller

Nobel Prize winner Robert Shiller et al. have posted Continuous Workout Mortgages: Efficient Pricing and Systemic Implications to SSRN. The paper opens,

The ad hoc measures taken to resolve the subprime crisis involved expending financial resources to bail out banks without addressing the wave of foreclosures. These short-term amendments negate parts of mortgage contracts and question the disciplining mechanism of finance. Moreover, the increase in volatility of house prices in recent years exacerbated the crisis. In contrast to ad hoc approaches, we propose a mortgage contract, the Continuous Workout Mortgage (CWM), which is robust to downturns. We demonstrate how CWMs can be offered to homeowners as an ex ante solution to non-anticipated real estate price declines.

The Continuous Workout Mortgage (CWM, Shiller (2008b)) is a two-in-one product: a fixed rate home loan coupled with negative equity insurance. More importantly its payments are linked to home prices and adjusted downward when necessary to prevent negative equity. CWMs eliminate the expensive workout of defaulting on a plain vanilla mortgage. This subsequently reduces the risk exposure of financial institutions and thus the government to bailouts. CWMs share the price risk of a home with the lender and thus provide automatic adjustments for changes in home prices. This feature eliminates the rational incentive to exercise the costly option to default which is embedded in the loan contract. Despite sharing the underlying risk, the lender continues to receive an uninterrupted stream of monthly payments. Moreover, this can occur without multiple and costly negotiations. (1, references omitted)

If it is not obvious, this is a radical idea.  It was not even contemplated before the financial crisis. That being said, it is pretty brilliant financial innovation, one that should not just be discussed by academics. The paper provides a lot more detail about the proposal for those who are interested. And if you want to avoid taxpayer bailouts of the housing market in the future, you should be interested.

A Shortage of Short Sales

Calvin Zhang of the Federal Reserve Bank of Philadelphia has posted A Shortage of Short Sales: Explaining the Under-Utilization of a Foreclosure Alternative to SSRN. The abstract reads,

The Great Recession led to widespread mortgage defaults, with borrowers resorting to both foreclosures and short sales to resolve their defaults. I first quantify the economic impact of foreclosures relative to short sales by comparing the home price implications of both. After accounting for omitted variable bias, I find that homes selling as a short sale transact at 8.5% higher prices on average than those that sell after foreclosure. Short sales also exert smaller negative externalities than foreclosures, with one short sale decreasing nearby property values by one percentage point less than a foreclosure. So why weren’t short sales more prevalent? These home-price benefits did not increase the prevalence of short sales because free rents during foreclosures caused more borrowers to select foreclosures, even though higher advances led servicers to prefer more short sales. In states with longer foreclosure timelines, the benefits from foreclosures increased for borrowers, so short sales were less utilized. I find that one standard deviation increase in the average length of the foreclosure process decreased the short sale share by 0.35-0.45 standard deviation. My results suggest that policies that increase the relative attractiveness of short sales could help stabilize distressed housing markets.

The paper highlights the importance of aligning incentives in the mortgage market among lenders, investors, servicers and borrowers. Zhang makes this clear in his conclusion:

While these individual results seem small in magnitude, the total economic impact is big because of how large the real estate market is. A back-of-the-envelope calculation suggests that having 5% more short sales than foreclosures would have saved up to $5.8 billion in housing wealth between 2007 and 2011. Thus, there needs to be more incentives for short sales to be done. The government and GSEs already began encouraging short sales by offering programs like HAFA [Home Affordable Foreclosure Alternatives] starting in 2009 to increase the benefits of short sales for both the borrower and the servicer, but more could be done such as decreasing foreclosure timelines. If we can continue to increase the incentives to do short sales so that they become more popular than foreclosures, future housing downturns may not be as extreme or last as long. (29)

Housing Booms and Busts

photo by Alex Brogan

Patricia McCoy and Susan Wachter have posted Why Cyclicality Matter to Access to Mortgage Credit to SSRN. The paper is now particularly relevant because of President Trump’s plan to roll back Dodd-Frank’s regulation of the financial markets, including the mortgage market. While McCoy and Wachter do not claim that Dodd-Frank solves the problem of cyclicality in the mortgage market, they do highlight how it reduces some of the worst excesses in that market. They make a persuasive case that more work needs to be done to reduce mortgage market cyclicality.

The abstract reads,

Virtually no attention has been paid to the problem of cyclicality in debates over access to mortgage credit, despite its importance as a driver of tight credit. Housing markets are prone to booms accompanied by bubbles in mortgage credit in which lenders cut underwriting standards, leading to elevated loan defaults. During downturns, these cycles artificially impede access to mortgage credit for underserved communities. During upswings, these cycles make homeownership unnecessarily precarious for many who attain it. This volatility exacerbates wealth and income disparities by ethnicity and race.

The boom-bust cycle must be addressed in order to assure healthy and sustainable access to credit for creditworthy borrowers. While the inherent cyclicality of the housing finance market cannot be fully eliminated, it can be mitigated to some extent. Mitigation is possible because housing market cycles are financed by and fueled by debt. Policymakers have begun to develop a suite of countercyclical tools to help iron out the peaks and troughs of the residential mortgage market. In this article, we discuss why access to credit is intrinsically linked to cyclicality and canvass possible techniques to modulate the extremes in those cycles.

McCoy and Wachter’s conclusions are worth heeding:

If homeownership is to attain solid footing, mitigating the cyclicality in the housing finance system will be imperative. That will require rooting out procyclical practices and requirements that fuel booms and busts. In their place, countercyclical measures must be instituted to modulate the highs and lows in the lending cycle. In the process, the goal is not to maximize homeownership per se; rather, it is to ensure that residential mortgages are made on safe and affordable terms.

*     *     *

Taming procyclicality in industry practices in housing finance is much farther behind and will require significantly more work. There is no easy fix for the procyclical effect of mortgage appraisals because appraisals are based on neighboring comparables. Similarly, procyclicality will require serious attention if the private-label securitization market returns. While the Dodd-Frank Act made modest reforms designed at curbing inflation of credit ratings, the issuer-pays system that drives grade inflation remains in place. Similarly, underpricing the risk of MBS and CDS will continue to be a problem in the absence of an effective short-selling mechanism and the effective identification of market-wide leverage. (34-35)

McCoy and Wachter offer a thoughtful overview of the risks that mortgage market cyclicality poses, but I am not optimistic that it will get a hearing in today’s Washington.  Maybe it will after the next bust.

The Rental Crisis and Household Formation

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The Mortgage Bankers Association has posted a Special Report: Diverted Homeowners, the Rental Crisis and Foregone Household Formation. The report’s bottom line is that people who should have been homeowners have displaced people who should have been renters. Those displaced people have been left in their original households, typically those headed by their parents.

The Report’s Executive Summary states that among the long term impacts of the Great Recession

have been the emergence of a rental housing shortage and an intensified affordability crisis in the rental market. In this report, we analyze various supply and demand factors that have led to this crisis.

In so doing, we provide detailed analysis of the shifts in homeowner and rental demand. As we note, these shifts cannot be analyzed without understanding the shifts in household formation that have occurred. We utilize data from the U.S. Census and focus the analysis on 3 distinct time periods (2000, 2006, 2012) to highlight housing epochs that are relatively normal, at the peak, and near the bottom of the market. Special attention is also placed on those younger than age 45 because they represent the households most commonly making first time decisions to form a household and to own a house.

Our primary findings:

• A sharp downturn in homeowner growth since 2006 suggests that 6.0 million would-be homeowners (the expected number compared to actual) have been shifted to renting or have left the housing market.

• These diverted homeowners triggered a cascade of adjustments throughout the rental housing sector that are measurable in different ways.

• A sizable portion (roughly a third) of the diverted homeowners likely have been absorbed into single-family rentals, especially among households aged 25 to 54.

• Although larger than expected, growth in the rental sector was too small to account for both the expected rental growth and also the large number of diverted homeowners. Before disruptions to the owner-occupied market, the rental sector had been expected to grow by 4.4 million occupied units after 2006, due to the arrival of the large Millennial generation. While diverted homeowners resulted in demand for nearly 6 million additional rental units, rental housing only grew by 5.2 million.

• New construction was crippled during the financial crisis and aftermath, slowing its response to the swelling rental demand, although multifamily construction volume nearly doubled in 2012 compared to 2010, and increased another third in 2014 compared to 2012.

• The clear inference is that slightly more than 5 million otherwise-expected renters left or never entered the housing market, their growth displaced by the diverted homeowners, and diminishing overall household growth far below expectations. (1)

• A further consequence of the resulting increase in demand and shortfall in supply in the rental market was an increase in rents, with rental affordability problems surging to record heights in 2010 and 2012. This dynamic created an increased incidence of high rental cost burdens that was remarkable for its relative uniformity across the nation.

There has been a fair amount written recently about household formation (here and here, for instance), but this Report is notable for its description of the cascading effect that the financial crisis has had on today’s housing market. We are around the fifty-year low for the homeownership rate.  If that rate has hit bottom, perhaps the trends identified in the MBA report are about to reverse course.

Did Dodd-Frank Make Getting a Mortgage Harder?

Christopher Dodd

Christopher Dodd

Barney Frank

 

 

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The short answer is — No. The longer answer is — No, but . . .

Bing Bai, Laurie Goodman and Ellen Seidman of the Urban Institute’s Housing Finance Policy Center have posted Has the QM Rule Made it Harder to Get a Mortgage? The QM rule was originally authorized by Dodd-Frank and was implemented in January of 2014, more than two years ago. The paper opens,

the qualified mortgage (QM) rule was designed to prevent borrowers from acquiring loans they cannot afford and to protect lenders from potential borrower litigation. Many worry that the rule has contributed to the well-documented reduction in mortgage credit availability, which has hit low-income and minority borrowers the hardest. To explore this concern, we recently updated our August 2014 analysis of the impact of the QM rule. Our analysis of the rule at the two-year mark again finds it has had little impact on the availability of mortgage credit. Though the share of mortgages under $100,000 has decreased, this change can be largely attributed to the sharp rise in home prices. (1, footnotes omitted)

The paper looks at “four potential indicators of the QM rule’s impact:”

  1.  Fewer interest-only and prepayment penalty loans: The QM rule disqualifies loans that are interest-only (IO) or have a prepayment penalty (PP), so a reduction in these loans might show QM impact.
  2. Fewer loans with debt-to-income ratios above 43 percent: The QM rule disqualifies loans with a debt-to-income (DTI) ratio above 43 percent, so a reduction in loans with DTIs above 43 percent might show QM impact.
  3. Reduced adjustable-rate mortgage share: The QM rule requires that an adjustable-rate mortgage (ARM) be underwritten to the maximum interest rate that could be charged during the loan’s first five years. Generally, this restriction should deter lenders, so a reduction in the ARM share might show QM impact.
  4. Fewer small loans: The QM rule’s 3 percent limit on points and fees could discourage lenders from making smaller loans, so a reduction in smaller loans might show QM impact. (1-2)

The authors find no impact on on interest only loans or prepayment penalty loans; loans with debt-to-income ratios greater than 43 percent; or adjustable rate mortgages.

While these findings seem to make sense, it is important to note that the report uses 2013 as its baseline for mortgage market conditions. The report does acknowledge that credit availability was tight in 2013, but it implies that 2013 is the appropriate baseline from which to evaluate the QM rule. I am not so sure that this right — I would love to see some modeling that shows the impact of the QM rule under various credit availability scenarios, not just the particularly tight credit box of 2013.

To be clear, I agree with the paper’s policy takeaway — the QM rule can help prevent “risky lending practices that could cause another downturn.” (8) But we should be making these policy decisions with the best possible information.

Fannie, Freddie & The Affordable Housing Feint

ShapiroPhoto

Robert J. Shapiro

kamarck_mm_duo

Elaine C. Kamarck

 

 

 

 

 

Robert J. Shapiro and Elaine C. Kamarck have posted A Strategy to Promote Affordable Housing for All Americans By Recapitalizing Fannie Mae and Freddie Mac. While it presents as a plan to fund affordable housing, the biggest winners would be speculators who bought up shares of Fannie and Freddie stock and who may end up with nothing if a plan like this is not adopted.  The Executive Summary states that

This study presents a strategy for ending the current conservatorship and majority government ownership of Fannie and Freddie in a way that will enable them, once again, to effectively promote greater homeownership by average Americans and greater access to affordable housing by low-income households. This strategy includes regulation of both enterprises to prevent a recurrence of their effective insolvency in 2008 and the associated bailouts, including 4.0% capital reserves, regular financial monitoring, examinations and risk assessments by the Federal Housing Finance Agency (FHFA), as dictated by HERA. Notably, an internal Treasury analysis in 2011 recommended capital requirements, consistent with the Basel III accords, of 3.0% to 4.0%. In addition, the President should name a substantial share of the boards of both enterprises, to act as public interest directors. The strategy has four basic elements to ensure that Fannie and Freddie can rebuild the capital required to responsibly carry out their basic missions, absorb losses from future housing downturns, and expand their efforts to support access to affordable housing for all households:

  • In recognition of Fannie and Freddie’s repayments to the Treasury of $239 billion, some $50 billion more than they received in bailout payments, the Treasury would write off any remaining balance owed by the enterprises under the “Preferred Stock Purchase Agreements” (PSPAs).
  • The Treasury also would end its quarterly claim or “sweep” of the profits earned by Fannie and Freddie, so their future retained earnings can be used to build their capital reserves.
  • Fannie and Freddie also should raise roughly $100 billion in additional capital through several rounds of new common stock sales into the market.
  • The Treasury should transfer its warrants for 79.9% of Fannie and Freddie’s current common shares to the HTF [Housing Trust Fund] and the CMF [Capital Magnet Fund], which could sell the shares in a series of secondary stock offerings and use the proceeds, estimated at $100 billion, to endow their efforts to expand access to affordable housing for even very low-income households.

Under this strategy, Fannie and Freddie could once again ensure the liquidity and stability of U.S. housing markets, under prudent financial constraints and less exposure to the risks of mortgage defaults. The strategy would dilute the common shares holdings of current private investors from 20% to 10%, while increasing their value as Fannie and Freddie restore and claim their profitability. Finally, the strategy would establish very substantial support through the HTF and CPM for state programs that increase access to affordable rental housing by very low-income American and affordable home ownership by low-to-moderate income households.

Wow — there is a lot that is very bad about this plan.  Where to begin? First, we would return to the same public/private hybrid model for Fannie and Freddie that got us into so much trouble to begin with.

Second, it would it would reward speculators in Fannie and Freddie stock. That is not terrible in itself, but the question would be — why would you want to? The reason given here would be to put a massive amount of money into affordable housing. That seems like a good rationale, until you realize that that money would just be an accounting move from one federal government account to another. It does not expand the pie, it just makes one slice bigger and one slice smaller. This is a good way to get buy-in from some constituencies in the housing industry, but from a broader public policy perspective, it is just a shuffling around of resources.

There’s more to say, but this blog post has gone on long enough. Fannie and Freddie need to be reformed, but this is not the way to do it.

 

Credit Risk Transfer Deals

A Syn

The Federal Housing Finance Agency released an Overview of Fannie Mae and Freddie Mac Credit Risk Transfer Transactions. It opens,

In 2012, the Federal Housing Finance Agency (FHFA) initiated a strategic plan to develop a program of credit risk transfer intended to reduce Fannie Mae’s and Freddie Mac’s (the Enterprises’) overall risk and, therefore, the risk they pose to taxpayers. In just three years, the Enterprises have made significant progress in developing a market for credit risk transfer securities, evidenced by the fact that they have already transferred significant credit risk on loans with over $667 billion of unpaid principal balance (UPB).

Credit risk transfer is now a regular part of the Enterprises’ business. The Enterprises are currently transferring a significant amount of the credit risk on almost 90% of the loans that account for the vast majority of their underlying credit risk. These loans constitute about half of all Enterprise loan acquisitions. Going forward, FHFA will continue to encourage the Enterprises to engage in large volumes of meaningful credit risk transfer through specific goals in the annual conservatorship scorecard and by working closely with Enterprise staff to develop and evaluate credit risk transfer structures. (2)

This is indeed good news for taxpayers and should reduce their exposure to future losses at Fannie and Freddie. There is still a lot of work to do, though, to get that risk level as low as possible. The report notes that these transactions have not yet been done for adjustable-rate mortgages or 15 year mortgages. Most importantly, the report cautions that

Because the programs have not been implemented through an entire housing price cycle, it is too soon to say whether the credit risk transfer transactions currently ongoing will make economic sense in all stages of the cycle. Specifically, we cannot know the extent to which investors will continue to participate through a housing downturn. Additionally, the investor base and pricing for these transactions could be affected by a higher interest rate environment in which other fixed-income securities may be more attractive alternatives. (22)

Taxpayers are exposed to many heightened risks during Fannie and Freddie’s conservatorship, such as operational risk. These risk transfer transactions are thus particularly important while the two companies linger on in that state.