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.