REQUIRED READING: The 17th century English poet John Donne famously wrote, ‘No man is an island, entire of itself; every man is a piece of the continent, a part of the main.’ The same observation can apply to today's housing market and the efforts of residential mortgage originators. A myriad of considerations from external social, political and economic conditions have both positive and negative impacts on the efforts of originators and the general health of the regions they serve.
In order to consider where our industry is headed, we need to understand the various factors that continue to have an impact on its progress.
Housing's health problems
In looking at today's housing market, there is good news and bad news. In both cases, the servicing aspect of mortgage banking is impacting the origination efforts.
First, the good news: In the states with the weakest housing markets – California, Nevada, Arizona and Florida – foreclosures have peaked and are trending downward. Concurrently, delinquencies fell during the fourth quarter of 2010 to the lowest level in two years, and 8.2% of households are currently behind by one payment or more. We know that fewer delinquencies mean fewer foreclosures, as well as less downward pressure on home prices.Â
However, we need to be skeptical about the delinquency numbers, especially with the increase in loan modifications that essentially take loans out of the delinquent column. Many of those loans will default again.Â
Now, the bad news: While foreclosures have peaked in some markets, they are still rising in others, and still rising overall. We are just perhaps only halfway through this foreclosure monster – and until that plays out, we cannot see a very positive outlook for the housing market.Â
The wobbly economy
On one hand, the U.S. economy is emerging from a deep recession with lackluster growth. However, the gross-domestic-product growth should be above 6%, not the paltry 2% to 3% growth we are experiencing. Without more vibrant growth, the economy will not be able to absorb the millions of unemployed people.Â
On the other hand, we have seen the unique combination of ultra-low rates, a very steep yield curve and record corporate profits. All of these factors bode well for financial assets, as we have seen the stock market double from its March 2009 bottom, and bond yields are at all-time lows. So while the general economy may be limping along, the equities and fixed-income markets seem to be doing quite well.Â
But there are some concerns, especially with prices. The producer price index (PPI) is rising much faster than consumer prices. In fact, over the last quarter, prices have risen 2.4%, annualized. There are jumps in the import prices index, which have risen by 5% over the last 12 months. The PPI was once referred to as the wholesale prices index – and since wholesale prices are rising, we can safely assume that consumer prices are not far behind. Until that happens, corporate profits will be reduced.Â
Nonetheless, large-scale economic growth cannot take root until the housing situation has returned to normal. Again, housing is not an island entire of itself.
Partisan politics
There has been a lot of negative press about the rancor between the political divisions in the federal power setup. Yet there are historical reasons to believe that divided government is good, and it appears that bipartisan cooperation may be at play in reforming the government-sponsored enterprises (GSEs).
The GSE reform proposals made by the Obama administration include returning to original conforming loan amounts, requiring a 10% down payment and returning the Federal Housing Administration (FHA) to its traditional role. The agencies would then slowly ‘wind down’ the GSEs by increasing pricing to the point that private capital replaces the Treasury-guaranteed GSEs. Then, they would restrict Fannie and Freddie from making new originations while winding down their investment portfolios.Â
The chairman of the House Financial Services Committee, Rep. Spencer Bachus, R-Ala., has responded positively to these proposals. Even Rep. Barney Frank, D-Mass., with his lifelong relationship with the agencies, understands that they had to be completely dismantled. One can assume that the private-market-friendly nature of the proposals would even satisfy the Tea Party, which has yet to admit to having any common ground with the White House.
However, in addition to the winding down of the GSEs, the proposal also recommends a whole host of new regulations that may cause partisan splits, including a call for the ‘better targeting of government's support for affordable housing.’ The proposal also calls for greater transparency in the securitization process and would require originators and aggregators to keep skin in the game. This idea sounds good on paper, but in reality, it will likely force some smaller mortgage bankers to become brokers in order to escape this requirement.Â
A missing private market
Once the GSEs leave the market, the new originations from the GSEs should dry up, and private capital will dominate. Securitization should follow, allowing a wider number of participants to manage the risk and subsequent returns that they fetch.Â
I say should, because if Congress enacts a law that requires the originator to hold a residual of that mortgage, that market may not come back as more banks choose to hold assets rather than seek a securitization exit. Other markets, such as collateralized debt obligations, will probably not ever be resurrected on a large scale. The idea of a covered-bond market has been proposed for a number of years, but it has yet to gain any traction.
A shadowy inventory
Recent data released by Standard & Poor's (S&P) has found the shadow inventory is dropping, albeit slowly. However, there are two reasons why this falling number should not be celebrated.Â
First, as banks do more and more loan modifications, fewer homes make it all the way to foreclosure. Banks modify the loans so that they become ‘cured’ and can pass into the current column. This action removes them from the shadow inventory.Â
But as we know, S&P's recent report on the shadow inventory shows that many – if not most – of these distressed properties run into new problems and redefault. Second, S&P's data only includes loans that were packaged and sold as securities by Wall Street; it does not include loans that banks kept on the books or the loans bought by the GSEs. The exclusion of these loans, which could make up over half of the cohort and could perform very differently, makes extrapolations into the broader mortgage market incomplete.Â
Slumping property values
Housing values have depreciated significantly since the September 2008 crash. This has wreaked havoc in many areas, especially the reverse mortgage sector, which relies on property values for the basis of its origination.
As a result, we probably will see a real shrinking of the reverse mortgage market. The FHA currently guarantees about 99% of reverse mortgages. It even funds jumbo reverse mortgages. But the FHA has announced that it wants to shrink its role to that of affordable housing. If this were to happen, it would require private lenders to take its place.
If Congress follows the request of the FHA to let the higher loan limits expire on Oct. 1, it could help bring proprietary products back and slowly start to lower the FHA's reverse mortgage market share. But it would likely shrink the market in the process.Â
Too-high unemployment
The two factors driving up foreclosures are unemployment and home-price decreases. That is why we see twin bands of foreclosures.
The economic problems in the Southwest (Arizona, California, Nevada and Utah) and Southeast (Florida and Georgia) are mostly due to home-price depreciation, while those in the Rust Belt are driven more by the unemployment situation. California and Nevada both have high unemployment and depreciating home values.Â
In February, jobless claims came in significantly lower than expected. If this continues, we may see a lowering of shadow inventory. Ohio, Pennsylvania, Michigan, Indiana and Illinois are some of the states that show the biggest reductions in unemployment claims. That should reduce foreclosures in the Rust Belt, but it will not help the situation in the Southeast or Southwest.
Consumer debt levels
If you look at consumer debt as a compilation of mortgage, installment and credit card debt, the figures show that the country is actually deleveraging and is doing its best to pay off its debt. Having said that, we are still at very high levels that are above where we were in 2006, which most everyone believes was bubble territory.Â
Consumer debt is falling and is 6% lower than its September 2008 high-water mark. Credit card debt is falling even faster and is down over 16% off its recent highs. All of these actions are credit-positive, so the effect of tighter requirements – most notably, debt-to-income levels – will reduce the pool of potential homeowners, but not as much as it otherwise would due to falling debt levels (especially credit card debt).
Inflation's impact
It is important to first distinguish between real home prices and nominal home prices. Your home may hold its price for 20 years, but after factoring inflation into this equation, you have actually lost purchasing power – so in real terms, your home price decreased.
Most people have to finance their homes. As such, they make housing decisions based upon what they can afford. But we all know that prices do not show perfect correlation and that there might be some lag. I recently ran a regression analysis on the change in the interest rate against the change in real home prices and found some interesting results.Â
First, home-price changes lagged behind changes in the mortgage rate. The real housing price changes were significant at the 95% level for up to three years. So if the mortgage rates were to drop, we could expect to find some price increases – but they would be spread over the next three years. Likewise, when the mortgage rates increase, home prices drop in real terms.Â
It is also important to distinguish between rising inflation and higher but stable inflation. With higher but stable inflation, we can expect to see nominal price increases, while real home values show modest increases.
Taylor Cottam is an independent risk consultant and editor of EconomyPolitics.com. He can be reached at tcottam@yahoo.com.
