There is No Free-Lunch Mortgage

Ed Pinto is pushing something he calls a “wealth builder home loan.” Here is his thought process:

1. With a 15-year mortgage, the borrower accumulates equity faster than with a 30-year mortgage. However, by the same token, the monthly payment is higher, which creates a hurdle for low-income home buyers.

2. With an up-front payment, you can buy down the interest rate on a 15-year mortgage, making the monthly payments more affordable.

3. Therefore, a 15-year mortgage with an interest-rate buydown is a way to help low-income borrowers afford mortgage payments and build up equity rapidly.

(1) and (2) are true. However (3) is false. The problem is that the interest-rate buydown undermines the borrower’s equity. Consider two cases.

Case 1: the borrower pays for the buydown. As this article describes it,

let customers of modest means use a down payment of up to 5 percent to “buy” a lower interest rate

So, if you buy a $200,000 house and you have $10,000, you use that $10,000 to buy down the rate. But you could have used that $10,000 as a down payment on the house! That would have given you 5 percent equity to start with, instead of starting with zero.

Case 2: the seller pays for the buydown. If the seller pays $10,000, then the transaction price will be $10,000 above what the house would sell for without a seller concession. So if the borrower makes no down payment, the borrower starts out with $10,000 in negative equity.

There is no free lunch in mortgage lending. People with low incomes and little money to put down on a home are home speculators. There is no reason to encourage them to become home speculators.

Help people save for the down payment. That is the only “affordable housing” approach that does not foster speculation.

Mortgage Equity Withdrawal

Bill McBride tracks data on mortgage equity withdrawal as a percentage of disposable income. You withdraw mortgage equity when you take out a second mortgage or refinance your existing mortgage with a larger loan (“cash-out refi,” as we call it). The graph at the link shows how from 2002-2007, the withdrawal rate was between 4 and 9 percent each quarter. Ordinarily, the number should be slightly negative, as people pay down the principal in their mortgages. We had big negative numbers in 2009-2011, “mostly because of debt cancellation per foreclosures and short sales, and some from modifications.”

Thanks to a commenter for the pointer. Some further comments:

1. From an AS-AD perspective, you can say that mortgage equity withdrawal boosted AD from 2002-2007, and then it went into reverse when the subprime crisis hit. This might be the best story for the drop in AD.

2. From a PSST perspective, you can say that a lot of consumption patterns were unsustainable, based on people spending capital gains on housing. When the capital gains leveled off and then turned into capital losses, the economy needed to find new patterns of trade, and it still has not done so.

3. Apropos of nothing, I once cursed out the guy who developed the measure of mortgage equity withdrawal. In about 1982 or so, Jim Kennedy was the forecaster for Industrial Production, and I was the forecast co-ordinator (we were both economists at the Fed). The forecast process, which was pretty much all clerical, was time-consuming and grueling. I had finally put a forecast to bed when Jim came in and said that the forecast for Industrial Production was out of synch and needed an update. He was very concerned about who might be blamed for the glitch. I shouted, “I don’t care whose bleeping fault it is!” I really lost my temper. It was just a case of my being tired, still at work long after I usually went home, and caught off balance by having my relief at being finished turned to anguish at finding that there was more work I had to do.

On Housing Finance Reform

I write,

The dysfunctional and regressive nature of policy in housing reflects the political configuration in Washington. For several decades, policies combined the efforts of social engineers clumsily seeking to expand home ownership with well-heeled interest groups skillfully lobbying for profits. The social engineers put taxpayer subsidies up for grabs, and the interest groups do the grabbing.

Paul Willen on Risk Retention

He notes that the new risk-retention rules in mortgage securities mandate a lower rate of losses than the securitizers actually took in the subprime crisis. In other words, Congress claims to have improved the safety of securitization by mandating “skin in the game” that amounts to less than what the securitizers actually had.

Tim Geithner on Freddie and Fannie

Nick Timiraos extracts from the new Geithner book.

But the erosion in underwriting standards, the rush to provide credit to Americans who couldn’t have gotten it in the past, was led by consumer finance companies and other nonbank lenders that did not have to comply with the Community Reinvestment Act—which, after all, discouraged redlining for nearly three decades before the crisis. These firms took credit risks because they wanted to, not because they had to; they believed rising home prices would protect them from losses, and their investors were eager to finance their risk-taking. Fannie and Freddie lost a lot of market share to these exuberant private lenders, and while they did belatedly join the party, the overall quality of mortgages they bought and guaranteed was significantly stronger than the industry average.

That strikes me as beside the point. The comparison to make is not between risk of the mortgages Freddie and Fannie bought with some industry average. The comparison that matters is between the mortgages that they bought and their capital and loss reserves. With enough capital, they could have taken on the worst of the subprime mortgages and survived. Conversely, even relatively safe mortgages can take you under if you do not maintain the loss reserves and capital that are needed in an adverse house price scenario.

This defense of Freddie and Fannie comes across to me as purely rhetorical. I hope he is too smart to really believe it. Otherwise, I would say that if this is the way that high government officials think about finance, then anyone who thinks that such people can prevent crises is making a really unsound wager.

Having said that, much of the rest of the article makes Geithner sound a lot more sensible than the typical progressive housing policy type. He recognizes that the key to housing finance reform is bringing back a reasonable down payment. He also seems to be one of the few people who gets it that the attempts to bail out homebuyers were based on unrealistic expectations of the mortgage servicing industry.

Which Errors Would You Prefer?

Nick Timiraos reports,

some economists, together with policymakers at the White House and Federal Reserve, are warning that mortgage-lending standards have become too restrictive, years after carelessness by lenders inflating the housing bubble.

… the Urban Institute, a think tank in Washington, estimated that around 200,000 fewer mortgages were made in 2012 due to credit standards that were more stringent than they were before the housing bubble.

Don’t say that like it’s a bad thing!

In mortgage lending, a type I error is making a loan that defaults. A type II error is turning down a loan that would have been repaid. Some remarks.

1. When home prices rise, it very hard to make a type I error and very easy to make a type II error. If the house price has gone up, the borrower’s equity is presumably positive, and borrowers who get in trouble will sell their homes and pay off their loans.

2. During the bubble, Congress and HUD officials were convinced that lenders were making type II errors due to racial bias and anachronistic conservative lending standards.

3. After the crash, Congress and government officials were convinced that lenders had been making type I errors due to greed, predatory lending, and lack of regulatory oversight.

My own view is that lenders make type I errors and type II errors all the time. Still, I would rather have errors made by people for whom credit risk assessment is a profession, without the amateur meddling that comes from the political sector.

I’d Connect These Data Points

1. From Atif Mian and Amir Sufi.

We are now five full years from the end of the recession (if you buy NBER dating). And housing starts are still below any level we’ve seen since the early 1990s!

Pointer from Mark Thoma.

2. Shaila Dawan writes,

Nationally, half of all renters are now spending more than 30 percent of their income on housing, according to a comprehensive Harvard study, up from 38 percent of renters in 2000. In December, Housing Secretary Shaun Donovan declared “the worst rental affordability crisis that this country has ever known.”

Pointer from Tyler Cowen.

By the way, I saw this coming, and so I made a big investment last year in several companies that own and manage apartments. The performance of these investments was terrible, particularly when compared with the overall market. Go figure.


Nick Timiraos writes,

Mortgage rates could rise by as much as 1.5 percentage points for homeowners with weaker credit or smaller down payments under various legislative proposals to overhaul Fannie and Freddie Mac, according to a study prepared for an industry group.

The study purports to estimate what is seen. How about what is unseen? That is, suppose we reduce the distortions in capital markets that funnel money into high-risk mortgages. That means that the interest rate on high-risk mortgages goes up. And…? Some other interest rate goes down. It might even be the interest rate paid by firms undertaking productive investment.

Shame on the Consensus

Nick Timiraos reports,

A consensus has emerged over the last few years among economists, academics, and industry officials that says any new system should do the following:

  • Make the “implied” guarantee explicit and require any successors to Fannie and Freddie to pay a fee for that guarantee, as the chart up top illustrates. Successors would compete for business, selling securities and taking initial losses before any guarantee would be triggered.
  • Get rid of those investment portfolios, or shrink them to the point where they don’t create systemic risks. This way, the firms wouldn’t be guaranteed by the government—only their securities.
  • Require more capital and tighter regulation, since too little of both is what got Fannie and Freddie into trouble. Just how much capital will be required will be a major point of contention, because having more will protect taxpayers but would also raise borrowing costs.

As I have said before, what this “consensus” would accomplish is to complete the Wall Street takeover of the mortgage industry. The history is roughly as follows:

1. In the 1970s, Wall Street saw an opportunity to “disintermediate” the savings and loan industry, which formerly supplied mortgage loans. In a high-inflation economy, money market funds had a regulatory advantage for attracting funds (banks and S&Ls were constrained by regulatory limits on the interest that they were allowed to pay on deposits ceilings).

2. In the 1990s, with the savings and loan industry dead, Wall Street along with Freddie and Fannie took over the mortgage finance system. But Wall Street always resented having to work with Freddie and Fannie. See All the Devils are Here, by McLean and Nocera.

3. In the 2000s, Wall Street thought it had figured out a way to get around having to work with Freddie and Fannie. Investment bankers would issue “private label” mortgage securities, use the CDO structure to get most of these securities a AAA rating, and use those high ratings to substitute for the Freddie-Fannie guarantee. Wall Street firms managed to pull off this trick with a lot of subprime mortgages.

4. Then came the bust, which discredited the Wall Street model of securitization.

5. Now, what Wall Street wants is to re-start securitization. They realize that nobody will fall for the AAA-rating scam any more. They need a government guarantee. But they don’t want the government-guaranteed enterprise to take profits away from them the way that Freddie and Fannie did. Hence, the three items listed by Timiraos, particularly “get rid of the investment portfolios.”

Assuming that the “consensus” eventually becomes policy, the decks will have been completely cleared for mortgage finance in the United States to be a 100 percent shadow-banking enterprise, exactly what Wall Street wanted.

For me, this is painful to watch, even though for a long time I have realized that is the most likely scenario. It is like watching a young brat who wrecked the five-year old family sedan have his parents console him by buying him a brand-new sports car.

My suggested alternative to housing finance reform can be found here.