Tag Archives: loan-to-value

Mortgage Leverage and Bubbles

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Albert Alex Zevelev has posted Regulating Mortgage Leverage: Fire Sales, Foreclosure Spirals and Pecuniary Externalities to SSRN. The abstract reads,

The US housing boom was accompanied by a rise in mortgage leverage. The subsequent bust was accompanied by a rise in foreclosure. This paper introduces a dynamic general equilibrium model to study how leverage and foreclosure affect house prices. The model shows how foreclosure sales, through their effect on housing supply, amplify and propagate house price drops. A calibration to match the bust shows consumption and housing need to be sufficiently complementary to fit the data. Since leverage plays a key role in foreclosure, a regulator can reduce systemic risk by placing a cap on leverage. Counterfactual experiments show that in a world with less leverage, the same economic shock leads to less foreclosure and less severe, shorter busts in house prices. A 90% cap on loan-to-value ratios in 2006 predicts house prices would have fallen 12% rather than 18% as in the data. The regulator faces a trade-off in that less leverage means less housing for constrained households, but also fewer foreclosures and less severe busts in house prices. A regulator with reasonable preference parameters would choose a cap of 95%.

This is pretty important stuff as it attempts to model the impact of different LTV ratios on prices and foreclosure rates. Now Zevelev is not the first to see these interactions, but it is important to  model how consumer finance regulation (for instance, loan to value ratios) can impact systemic risk. This is particularly important because many commentators downplay that relationship.

I am not in a position to evaluate the model in this paper, but its conclusion is certainly right: “Leverage makes our economy fragile by increasing the risk of default. It is clear that
foreclosure has many externalities and they are quantitatively significant. Since borrowers
and lenders do not fully internalize these externalities, there is a case for regulating mortgage leverage.” (31)

Housing Finance Reform at a Glance

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The Urban Institute has posted its November Housing Finance At A Glance.  This is a really valuable resource. The introduction provides a nice overview of recent developments in the area:

With a sweeping midterm election victory for the GOP, the path to legislative GSE reform got considerably narrower. Thus, the focus for reform turns to the FHFA and FHA, where we expect significant movement in the coming months. Over the past six months, the FHFA has asked for input on a variety of issues, and we have commented on them all: guarantee fees and loan level pricing adjustments, Private Mortgage Insurance Eligibility requirements (PMIERs), the single security, and affordable housing goals.
The FHFA has made a concerted effort to open the credit box, strengthening the provision by which lenders are relieved from much of their put-back risk and raising the maximum loan-to-value ratio for some GSE loans from 95 to 97. Both will help expand access without unduly increasing GSE risk. FHFA Director Mel Watt has indicated in recent speeches that work is underway to further clarify reps and warrants, with more guidance on the sunset provision, an independent resolution process for put-back disputes, and remedies short of a put-back for lesser mistakes.
As our new credit availability index indicates, these actions to open the credit box are very important. Our index shows that post-crisis loans have half the credit risk of loans made in the 2000-2003 period. The GSE channel is particularly tight, with about a third of the risk of the 2000-2003 period. This is corroborated by the data in our special feature, which shows that only 8.3 percent of recent Fannie loans (page 34) and 7.4 percent of recent Freddie loans (page 36) have FICOs under 700, compared to 35-37 percent in 1999-2004.
On the FHA side, there have also been initiatives to open the credit box, as outlined in the Blueprint for Access program. Since then, the FHA has released the initial critical draft chapters of their guidebook and a draft of the taxonomy of defects. Many hope to see lower mortgage insurance premiums to broaden access and lessen the risk of adverse selection as better credit flees to the less costly GSEs. Given that their actuary now projects that the FHA’s Mutual Mortgage Insurance Fund will not reach the statutory reserve requirements until 2016, however, such a move is far from certain.
Risk Sharing Developments
The GSEs continue to broaden their risk sharing activities, now turning to front-end risk sharing deals. Prior to this month, they had focused exclusively, and with much success, on laying off risk already on their books, known as back-end risk sharing. Fannie has laid off risk on 7.5 percent of their book of business and Freddie on 11.9 percent of theirs (page 21), both far exceeding the requirements of the Conservatorship Scorecard. The GSEs started including mortgages over 80 LTV in these transactions in May.
This month saw a very meaningful step in bringing private capital back into the mortgage market: the first front-end risk sharing deal, JPMorgan’s Madison Avenue Securities 2014-1 (page 21). JP Morgan warehoused loans made by JP Morgan Chase bank, then sold them in bulk into a newly issued Fannie Mae MBS, presumably for a very meaningful reduction in guarantee fees. JP Morgan retained the first 4.75 percent subordinated interest, and a 26.88 bps servicing strip that absorbs losses before the subordinated interest. The risk on the 4.75 percent subordinated interest was sold in the capital markets in the form of credit linked notes. Redwood Trust is also reported to be contemplating a front-end risk sharing transaction.
Front-end risk sharing bears important similarities to the private capital/catastrophic insurance structure contemplated by many GSE reform proposals. It is thus an administrative opportunity to experiment deliberately with a truly reduced government footprint in the conventional mortgage market. (3)
I am very excited by the possibility of putting private capital in a first loss position for residential mortgages and agree with UI that the stars are aligning, at least a little bit, for this to become a reality. Many interests will need to be balanced for this to move forward, but politicians of all stripes should be worried about leaving Fannie and Freddie in limbo for much longer.

State of the Nation’s Housing Finance

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The Joint Center for Housing Studies of Harvard University has released the 2014 edition of The State of the Nation’s Housing. As to the nation’s housing finance system, the report finds that

The government still had an outsized footprint in the mortgage market in 2013, purchasing or guaranteeing 80.3 percent of all mortgages originated. The FHA/VA share of first liens, at 19.7 percent, was well above the average 6.1 percent share in 2002–03, let alone the 3.2 percent share at the market peak in 2005–06. Origination shares of Fannie Mae and Freddie Mac were also higher than before the mortgage market crisis, but less so than that of FHA. According to the Urban Institute’s Housing Finance Policy Center, the GSEs purchased or guaranteed 61 percent of originations in 2012 and 2013, up from 49 percent in 2002 and 2003.

Portfolio lending, however, has begun to bounce back, rising 8 percentage points from post-crisis lows and accounting for 19 percent of originations last year. While improving, this share is far from the nearly 30 percent a decade earlier. In contrast, private-label securitizations have been stuck below 1 percent of originations since 2008. Continued healing in the housing market and further clarity in the regulatory environment should set the stage for further increases in private market activity. (11)

As usual, this report is chock full of good information about the single-family and multi-family sectors. I did find that some of its characterizations of the housing market were lacking. For instance, the report states

Many factors have played a role in the sluggish recovery of the home purchase loan market in recent years, including falling household incomes and uncertainty about the direction of the economy and home prices. But the limited availability of mortgage credit for borrowers with less than stellar credit has also contributed. According to information from CoreLogic, home purchase lending to borrowers with credit scores below 620 all but ended after 2009. Since then, access to credit among borrowers with scores in the 620–659 range has become increasingly constrained, with their share of loans falling by 6 percentage points. At the same time, the share of home purchase loans to borrowers with scores above 740 rose by 8 percentage points.

Meanwhile, the government sponsored enterprises (GSEs) have also concentrated both their purchase and refinancing activity on applicants with higher credit scores. At Fannie Mae, only 15 percent of loans acquired in 2013 were to borrowers with credit scores below 700—a dramatic drop from the 35 percent share averaged in 2001–04. Moreover, just 2 percent of originations were to borrowers with credit scores below 620. The percentage of Freddie Mac lending to this group has remained negligible.

Yet another drag on the mortgage market recovery is the high cost of credit. For borrowers who are able to access credit, loan costs have increased steadily. To start, interest rates climbed from 3.35 percent at the end of 2012 to 4.46 percent at the end of 2013. This increase was tempered somewhat by a slight retreat in early 2014. In addition, the GSEs and FHA raised the fees required to insure their loans after the mortgage market meltdown, and many of these charges remain in place or have risen. The average guarantee fee charged by Fannie Mae and Freddie Mac jumped from 22 basis points in 2009 to 38 basis points in 2012. In 2008, the GSEs also introduced loan level price adjustments (LLPAs) or additional upfront fees paid by lenders based on loan-to-value (LTV) ratios, credit scores, and other risk factors. LLPAs total up to 3.25 percent of the loan value for riskier borrowers and are paid for through higher interest rates on their loans. (20)

Implicit in this analysis is the view that lending should return in some way to its pre-bust levels. But, in fact, much of the boom lending was unsustainable for many borrowers. The analysis fails to identify the importance of promoting sustainable homeownership and instead relies on one dimensional metrics like credit denials for those with low credit scores. Until we are confident that borrowers with those scores can sustain homeownership in large numbers, we should not be so quick to bemoan credit constraints for people with a history of losing their homes to foreclosure.

The Center’s analysis also takes a simplistic view about guarantee fees.  The relevant metric is not the absolute size of the g-fee. Rather, the issue should be whether the g-fee level achieves its goals. At a minimum, those goals include appropriately measuring the risk of having to make good on the guarantee.

Finally, the Center demonstrates symptoms of historical amnesia when it characterizes an interest rate of 4.46% as “high.” This is an incredibly low rate of interest and one would expect that rates would rise as we exit from the bust years.

I have made the point before that the Center’s work seems to reflect the views of its funders. The funders of this report (not identified in the report by the way) include the National Association of Home Builders; National Association of Realtors; National Housing Conference; National Multifamily Housing Council; and a whole host of lenders, builders and companies in related fields that make up the Center’s Policy Advisory Board. These organizations benefit from a growing housing sector. This report seems to reflect an unthinking pro-growth perspective. It would have benefited from a parallel focus on sustainable homeownership.

Battle of the Mortgage Experts

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Judge Saris of the United States District Court (D. Mass.) issued a Memorandum and Order in Massachusetts Mutual Life Insurance Company v. Residential Funding Company, et al., No. 11-30035-PBS (Dec. 9, 2013). The opinion addresses a battle of statistical experts over the proper way to sample some of the hundreds of thousands of mortgages at issue in this litigation.

Mass Mutual, the plaintiff, alleges that the defendants misrepresented material aspects of many of those mortgages. To prove this, Mass Mutual intends to “reunderwrite” about 3.5% of loans by reviewing the “original loan file to determine whether  it was originated in accordance with applicable standards.” (3) . More particularly, Mass Mutual alleged that

the defendants marketed the [RMBS] certificates with representations that the loans backing the securities were underwritten in accordance with prudent underwriting standards and the underlying properties were appraised in accordance with sound appraisal standards, in order to ensure that the borrower could repay the loan and to decrease the risk of default. Plaintiff asserts that the loans underlying each [loan pool] were, in reality, far riskier than represented. Plaintiff also alleges that the defendants knowingly reported false loan-to-value (“LTV”) ratios, and in the case of defendant HSBC, inaccurate owner-occupancy rates for underlying properties. The defendants deny that they made any material misrepresentations in the marketing and sale of the certificates. (4)

The Court stated that while the defendants had identified various methodological errors that would render the report of Mass Mutual’s expert unreliable, similar challenges had failed in four other RMBS litigations. The Court ultimately denied the defendants’ motion to exclude the opinions of the plaintiff’s expert.

A body of law about expert evaluation of misrepresentations in securitization is slowly developing as cases are moving from the motion to dismiss stage to the pretrial discovery phase. This will have broader significance than just securitization litigation, but I find it particularly interesting to watch experts attempt to reduce “questions of misrepresentation” regarding RMBS to yes/no answers. (15) Such attempts to quantify misrepresentation will be useful to resolve cases such as this but also to regulators and researchers down the line.