The lack of clarity surrounding U.S. and worldwide economic growth certainly played a big role in the recent Wall Street sell off. In part, it was precipitated by the “debt ceiling” prank that was played upon the country and the world, especially after the market dissected the deal and found that, through the use of smoke and mirrors, economic growth (and therefore tax revenues) was assumed to be 4%, a growth rate that is hard to fathom, at least for the U.S. and Europe, given the financial landscapes in these two major consuming regions.
Housing & GDP
Housing is a case in point. The direct contribution of Residential Fixed Investment to GDP was 4.8% in 1990, 5.2% in 2000, and 6.1% during the housing boom of 2005. In this year’s first half, it registered 2.2%, the lowest level since records have been kept. This measure of housing’s impact on GDP significantly understates its importance. Ancillary to housing are such things as furniture and furnishings, appliances, demand for utilities, demand for other services such as landscape and repair, etc. Then there is the multiplier impact of the earnings of construction workers as they spend those incomes in the course of everyday living. It can be said with a high degree of certainty that U.S. economic growth will be weak until housing returns to some semblance of health. Historically, changes in housing construction have contributed significantly to the business cycle, both to pushing the economy into recession, and to lifting it out. In most post-WWII recessions, a housing turnaround usually starts before the recession ends. Given the state of housing today, is it any wonder why the U.S. economy is at stall speed?
The Swinging Pendulum
In 2005 and 2006, if you could breathe, you could get a mortgage loan with little or nothing down and just your word on whether or not you could afford the payments. But today, just when the economy needs a growing housing sector, the pendulum has swung to the other extreme. Not only have most mortgage companies disappeared, but the criteria to qualify for those that are still in business are the strictest they have ever been. In addition, Congress and the states have now placed many obstacles into the mortgage lenders’ paths including the promotion of legal actions against the largest mortgage lenders (or their successors) and the provision of legal aid, in the form of obstacles to the foreclosure process, to underwater homeowners who have quit making payments.
- Bank of America (BAC) has tried to extract themselves from the litigation cesspool resulting from their acquisition of Countrywide with an $8.5 billion global settlement, which still has to be approved by the court. (Just think – BAC purchased this garbage heap without any government assistance – does this say something about BAC management?) But, NY State’s Attorney General has decided that $8.5 billion is completely inadequate, indicating that the settlement should be in the $22 to $27.5 billion range. At the same time, AIG is planning to sue BAC for $10 billion on the grounds that the mortgages it purchased from Countrywide were misrepresented (whatever happened to due diligence or buyer beware, especially for “sophisticated” investors?).
- With all this going on, it isn’t any wonder that Jamie Dimon has decided to remove JPMorganChase (JPM) entirely from the mortgage business. Dimon has proven over the years that he is an industry leader, so, his withdrawal from the mortgage business may be an omen of things to come.
- Meanwhile, states are passing legislation aimed at “helping” consumers, but with vast unintended consequences for the mortgage markets. Don’t misunderstand – I am not arguing in favor of the mega banks and Wall Street who have significant responsibility for the current state of housing in the U.S. But, litigation and legislation could have the unintended consequence of further slowing and postponing any housing rebound:
- According to Mark Hanson of M Hanson Research, California recently passed legislation prohibiting second lien holders from filing deficiency judgments in short sales. Immediately JPM pulled all of their short sale second lien buyout acceptances, which forgive significant second lien deficiencies for a price of $3,000 to $5,000, and is now asking for 50% of the note amount. This will nullify the short sale and force the first lienholder to foreclose, now giving JPM the right to a deficiency judgment. Such legislation may have an adverse and unintended consequence of scuttling the short sale market in California, just when real progress was being made.
- Nevada leads the nation in underwater mortgages. Zillow reports those numbers are as high as 80% in Las Vegas and 70% in Reno. To deal with this, the last Nevada legislature passed legislation which prohibits a first lienholder from collecting a deficiency judgment on a primary residence short sale. This means that everyone underwater can walk away without significant consequences and presages even more short sales and foreclosures. In addition, another law prohibits note holders who purchased mortgage notes at a discount from collecting more than they paid for the note in a foreclosure process. The consequences of such interference can potentially be disastrous for the secondary mortgage market. Taken to its logical conclusion, no one would be willing to purchase troubled loans at a discount because the best return possible is just a return of capital.
Another drag on the mortgage market, and, in fact on the market for all non-government guaranteed private sector loans, is the push on the part of regulators to drive bank capital levels higher. Too much leverage along with the repeal of Glass-Steagall certainly played a large role in the global financial crisis, whose second act is currently on stage in Europe. Bank capital and liquidity ratios are now under close scrutiny, and the Basle III accords will require banks to hold significantly more capital and in purer form. To “preserve” their capital and meet the stricter requirements, banks will prefer to invest in items exempt from the capital requirements (like government guaranteed paper) rather than placing assets in areas requiring high capital retention. (The spenders in Washington appear to be quite comfortable with this!) The unintended consequence here will be fewer “risky” loans, and those that are made will be at much higher interest rates to compensate for the additional capital required.
Qualified Residential Mortgage (QRM) and Qualified Mortgage (QM)
The Dodd-Frank legislation is also in the process of imposing significant restrictions on mortgage lenders. One Washington lawyer, Laurence Platt, recently remarked that “the natural consequence of QM and QRM is that only the most privileged borrowers in our country will be able to get mortgage loans…”
QRM requires lenders to meet strict underwriting standards, which will be written into Fannie Mae and Freddie Mac guidelines. Failing that, the lender must retain 5% of the credit risk if the loan is sold or securitized. QRM requires a minimum 20% down payment and very low debt to income ratios. The FDIC has indicated that approximately $8.5 trillion of currently outstanding mortgage loans would not have qualified under these guidelines. Lenders have testified that any non-QRM loan would be very expensive for consumers.
More scary is the QM standard which prohibits such things as negative amortization loans, loans with balloon payments, or loans with terms exceeding 30 years. But the kicker to QM, as proposed, is that there are severe legal and monetary penalties to lenders if it is determined that the borrower did not have the “ability to repay” at the time the loan was originated. Even “unintentional” violations can be fined at $5,000/day. Imagine what the legal profession is going to do to this “ability to pay” standard. I suspect that the fact that the home went into foreclosure will be a strike against the lender under QM.
Clearly, both the QM and QRM compliance nightmares discourage the reappearance of the small mortgage companies that dotted our landscape just a short 5 years ago. Only the large institutions can afford the compliance here, and, as discussed above, they have other significant impediments to being in the mortgage business.
Fannie and Freddie Cutbacks
The bankrupt Fannie Mae and Freddie Mac, which currently purchase more than 90% of mortgages made today, are significantly reducing their loan maximums effective October 1. This can’t be anything but negative for the mortgage markets. As these two behemoths continue to cost taxpayers billions of dollars every month, sooner or later (certainly not until after the 2012 elections) their losses will have to be addressed. Fannie and Freddie alone, in the current environment, cannot support a growing mortgage market with reasonably priced mortgages, a requirement for the U.S. economy to prosper.
Where are the Cash Down Payments?
According to Zillow, 26% of mortgages in the U.S. are underwater with some markets significantly higher. Mark Hanson has made the point several times that when short sales or foreclosures occur, the former homeowner generally has no cash or resources to use as a down payment on another home. (No wonder apartment REITs are booming!) This alone culls the pool of potential home buyers.
In the end, the impediments to the mortgage market appear significant: litigation, new consumer “friendly” legislation, higher bank capital requirements, QM and QRM compliance issues, and lower maximum loan amounts from the bankrupt Fannie Mae and Freddie Mac entities are all coming together at once. The reduction of the availability of mortgage money is a certainty. In addition, a large swath of consumers with underwater mortgages and those with excessive credit debt burdens simply have no funds for the down payments that will now be required under the Dodd-Frank legislation. Under such conditions, it is likely that home prices will continue their downward spiral and new home construction will continue at record low levels.
As stated at the beginning of this piece, housing has historically led the economy out of recessions. Not this time! Without a healthy housing sector, economic growth is significantly constrained. Under these circumstances, the idea of 4%, or even 3%, economic growth reappearing in the U.S. anytime soon is a dream only Washington politicians can harbor. The reality is that without a healthy housing sector, even 2% long term growth seems like a stretch, and the economy will remain vulnerable to outside shocks.
Robert Barone, Ph.D.
August 15, 2011
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