Are tighter lending standards holding back the recovery?

Is heavy financial regulation and tightening of loan and mortgage requirements slowing the housing recovery? Over the last six months, we have discussed the effects of Dodd Franks, Basel III, and QRM (qualified residential mortgages). There is tremendous concern over the tightening of lending standards.

How much do analysts think it is affecting markets? At what cost to prospective homeowners? Presently entry level buyers nationally are 7 to 8% of the buying market (historically, they have been somewhere between 18% to 25%). After real estate/financial ‘boom’ cycles we historically see a tightening of lending standards from banks, mortgage lending, and government regulators.

Underwriting standards as well as the regulatory standards have been put in place to prevent another financial meltdown. Most of us know the reason for the meltdown were lax underwriting standards that allowed no doc, low doc, and NINA loans that enabled people to borrow beyond their means.

Mark Zandi, chief economist for Moody Analytics, wrote in the Washington Post last week, “For the housing recovery to maintain its momentum, first time and trade up home buyers must pick up the slack.” I agree entirely. This analyst is concerned about the number of Millennials that have not been able to purchase a home, and reap the benefits of accruing equity. Many of the Baby Boomers’ largest source of wealth was from appreciation on their first home purchases. Yet these same buyers today face a significant barrier of qualifying for mortgages. The average score on loans to buy homes last year was above 750 FICO (on a scale of 300 to 850). This is some 50+ points higher than the average among those who received mortgages a decade ago, before the housing bubble. When most Baby Boomers bought their first house, late payments could be explained with a letter. No longer. The very ones that need more liberal underwriting seem to be paying the price of the previous decades loose standards.

It is harder to qualify. But there are loans buyers with low FICO can qualify for. You could have gotten a mortgage with a 620 Fico, 3.5% down payment, and debt to income ratios to 43%-50% for the last few years. Even today you can get an 80% loan with a FICO score of 620. Does it require more documentation? Probably. But for those that have been through the process, it would be a learning experience anyway.

The use of the average score of those who bought homes as proof that lending standards are too tight is somewhat of a flawed analysis. The FICO score reveals more about the buyers’ credit quality on average, but not that lending standards are tight. We must remember that there is no subprime lending in the mortgage business anymore, and that is a good thing.

Many critics point to the resurgence of the auto loan business and the strength of sales in the industry, which offers subprime lending and which is experiencing a boom, so that should be proof that housing should follow suit. However, the debt structure of car loans is much different from housing, and can’t fuel the fires of trouble that subprime loans in housing can (and once did). There is not the inherent ability to refinance a car loan like there is with real estate.

There are many factors keeping mortgage credit tight:
• Lenders are less willing to take on risk because they were burned in the housing collapse. The costs associated with riskier lending (legal, debt carry, maintenance, etc.) and the problems and additional infrastructure / manpower needed to service distressed borrowers and property (15+% annual cost) is also a factor.
• Bank and mortgage regulators have a mountain of regulations put in place by Dodd Franks, Basel III, and the CFPB. 95+% of new loans are subject to these tighter standards.
• Besides the debt-to-income ratio standard being moved down from 45% to 43%, a lot of the new QM (qualified mortgage) guidelines have already been accepted by the marketplace. Also, lenders will do non-QM loans and even interest only loans but only for the upper income home buyers in America. What I am trying to stress here is that the guidelines that we have seen in the last few years, and in place today, are not overly stringent. Lenders are all adjusting to the new guidelines that went into place January 10th. There was no practice run, so conservatism will reign initially. The QRM rule provides safe harbor from borrower suits under the Truth in Lending Act. Most lenders will in all probability not make loans that fall outside the safe harbor rule. And those that do stay within guidelines will have harsher lending parameters than they have had in the past.
• Lenders are qualifying consumers for loans to people with 620 FICO scores and 3.5% down. How much more risk do you want them to take? How much more risk would you take? Because ultimately it is all the taxpayers that bear the brunt of another financial meltdown.

Do we need to slacken lending standards? This analyst believes if a borrower does not have ‘skin the game’ without a stake or ramifications, that it is not lending, it is giving money away with longer term negative consequences. Most of the lending guidelines currently are reminiscent of the lending standards back in the early 90’s when rates were higher and the affordability was not as attractive as today. It did not slow down the market. People still want shelter, and if they want to buy they will find a way.

So what is slowing the economic recovery and how does current lending affect it?

Unemployment

As a country we have not caught up to pre-recession numbers. The number of underemployed from the Bureau of Labor Statistics is closer to 13% than the headline rate of 6.7%. The country needs to find employment for the unusually high number of long term unemployed. Only 7 states are at pre-recession employment numbers. For those states that are not there, what industries need to be incentivized? Nationally and locally we have a roadway and utility maintenance issue. We can fix our infrastructure and get the unemployed working again at the same time.

Income

Incomes are weak. Years of soft income growth has caught up to an economy that is based on debt consumption. One of the key reasons for the mediocre economic growth in the US has been the ongoing weakness in household wages. As the chart below shows, US median inflation-adjusted household income (red line) remains well below pre-recession levels (the chart also appropriately shows U6 unemployment).

voice graph 1-31 3

Debt to income

Debt to income ratios probably need to re-evaluated. Is the current household debt to income ratio when purchasing a home too high, even after all the deleveraging that has gone on? There are many monthly expenses Americans pay for with credit that don’t properly show up on debt to income ratios. Many Americans add these monthly expenses, such as cable bill, insurance bill and others, to credit cards because monthly cash flow doesn’t cover it.

Currently the American jobs being created do not, on average, pay enough to support and sustain an increase in mortgage applications and approvals. Since the majority of the jobs nationally recovered have been in the low wage service sector and going to people 50 and over, the improving employment picture has not done much to help housing. Many Americans are making less than what they made during the housing bubble, so the debt to income and liability to income ratios aren’t as strong as most think. The after tax expense incomes for Americans is not rosy. Texas is in a better place. When comparing straight income, Texas might look worse off; however, considering the low cost of housing and general living expenses, Texans have more money to spend. Housing and job creation in Texas remains strong. The first chart show jobs created on a national level:

voice graph 1-31 2

Compare that to the Austin breakdown of job creation/loss:

voice graph 1-31 1

Student loan debt

Student loans today are one of the only deteriorating pockets of consumer credit, with balances and delinquency rates rising to record highs even as a strengthening economy allows Americans to reduce total borrowing. Outstanding student debt topped $1 trillion in the third quarter of 2013, and the share of loans delinquent 90 days or more rose to 11.8 percent, according to the Federal Reserve Bank of New York. By contrast, delinquencies for mortgage, credit card, and auto debt all have declined from their peaks.

I have not seen a good chart comparing debt from four-year universities vs. for profit school (University of Phoenix, etc). The understanding we have is that student debt from four-year schools may not be as burdensome as thought. However the structure of that debt needs to be rethought. This debt stands at 1 trillion dollars and is growing. Unlike other household debt that can be written off in a bankruptcy filing or through foreclosure or a short sale, student loan debt just grows and grows and grows. This is the one household debt that has been rising throughout this cycle.

Aversion to borrowing

According to Federal Reserve and other financial analysts, credit debt has been paid down dramatically since the boom. For most Americans, what matters is how much they must spend, line by line, to pay their regular monthly bills. It is clear that even when a person has little debt, if their monthly expenses plus a new house payment will exceed their ability to pay, the mortgage will fall into trouble. As stated the good news is at the start of this cycle most Americans aren’t as willing or likely to borrow as much money as they have in the past. They have budgets and know how much their total mortgage payment which includes principal, interest, taxes and insurances is. This is a plus for America because this means consumers have more money in their pockets at the end of the month.
Consumers and their families should look at housing as the cost of shelter, and take on only the debt they can afford to pay. This is and should be a different perspective than looking at investments or hard assets in the way Wall Street firms or foreign cash buyers who are looking for yield investments or wanting a place to park cash. The theory that buying a home will allow the homeowner to both live in it, and watch the investment grow is still accepted by many Americans. Now, they are more likely to believe it is the payment they are buying. They want to buy within their means.
Economic cycles seek equilibrium. They also seem to come full circle historically. Since the late 50’s we have been in a very long economic cycle driven by corporate globalization, technology, debt, and demographics. In this phase capital gets better treatment than labor, meaning that corporate profit is paramount to higher wages. If incomes don’t grow in an economy based on debt, and that economy has no financial bubble to create fake demand to create fake well-paying jobs, then you get this type of cycle we are seeing right now.

Conclusions

It’s not lending standards that are too tight, it’s the economy. We need more people employed full time, and long term unemployment needs to be addressed.
In conclusion, the good news is the housing market is getting better. Not just in Texas, but across the nation. The problem we have with this housing cycle is that home price increase appreciation, caused by a shortage of inventory following the bubble, is pricing Main Street America out of the market. Employment and incomes need to rise before we can say the recovery is complete.

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