Concerns for lending in 2014

All in all, the economic and real estate news for 2013 was positive. Home prices are up nationally, unemployment is creeping down steadily, and Texas continues to outperform the rest of the country. We are generally optimistic for 2014 and the future. However, there are still some lingering concerns for 2014 and beyond that are worth reviewing.

This time last year, we raised concerns about the budget cliff and sequester. This budget brinkmanship had an effect on the national and regional economies, Texas included. Texas received about $55.1 billion during the 2010-11 biennium from the federal government, and $65.5 billion in 2011-12, or about 36% of all Texas budget funds. More than half of federal funds (52%) are allocated to Health and Human Services. This year federal funding increased 4% because of the $12 billion that Texas received in the form of American Recovery and Reinvestment (ARRA) funds.

The sequester was mandated by the Budget Control Act of 2011, better known as the debt ceiling compromise. This instituted a 2 percent cut in physician and other providers’ Medicare payments, and a 7.6 to 9.6 percent across the board cut in all discretionary spending, except programs for low-income Americans. The cuts are evenly divided between defense and nondefense programs, with most analysts predicting a crippling effect on all affected departments, agencies, and industries. In addition, the BCA set a firm limit on discretionary spending. They are set to reduce spending by $78 billion this year.

A study at the start of the 2012 out of George Mason University predicted the cuts would affect 2.14 million jobs in the federal and private sectors nationally. Department of Defense cuts would cost 326,000 jobs, including the more than 48,000 civilians who work for the Defense Department. That study showed hardest hit states would be California, Virginia, and Texas.

San Antonio, Austin, El Paso and Killeen were greatly affected because of the number of military bases located there. In addition, defense contractors such as Bell Helicopter and Pantex in Amarillo were affected by the cuts. Federal funds are a vital part of any state budget, and they are particularly important in the Texas state budget due to the amount of federal bases. Texas ranked 11th highest in federal funds as a share of state government spending (35%) in 2011. If the Army furloughs 39,999 civilian employees over the next three years, it could hurt operations at Fort Hood in Killeen and Fort Bliss in El Paso, not to mention other military bases across the state. The number of civilian jobs created at those bases would also be affected. Values have plateaued in some metros, and sales have slowed. Regionally, Killeen, El Paso, and San Antonio have felt the affect as over 90,000 defense jobs have been cut in Texas this year. Fortunately, the energy sector has continued to create jobs in those same areas. Even with the loss of defense jobs, San Antonio has seen a net creation of 8,000 jobs this year.

The sequester and budget cuts obviously had an effect on those Texas metros and cities that are heavily reliant on federal and defense spending. But again, the Texas economy and job creation have more than kept pace with these budget cuts and layoffs. The affect on real estate and lending were minimal. As most know Texas continues to be a ‘seller’s market’.

Basel III
In 2012 and again at the first of this year we raised concerns about a new round of banking regulations, known as Basel III, that was put in place for banks at the start of 2013. Banks will be required to carry more capital and have stricter terms for real estate loans.

For those unconcerned and uninitiated about Basel III, you should know that it has the potential to slow real estate and small business lending from banks. Basel III’s purpose was to set precautionary measures on banks to protect the economy from financial crises similar to that of our last recession. There was a real danger of the international banking system collapsing in 2008. The Federal Reserve and other countries’ central banks stepped in to bail out the affected institutions, in some cases even taking over investment banks to ensure their continued operation. The prevailing thought was to keep the banks and those industries open to prevent a total international financial meltdown. Basel III was intended to ensure banks accept a level of responsibility for the financial economy they operate within, and to act as a safeguard against further collapse.

The Basel III reforms arose from the concern of the world’s leading countries, politicians, central bankers, business leaders, and economists that entire national economies and to a great extent the material well-being of all their citizens had been put at risk by the high-risk behavior of a handful of major banking institutions in the USA, Switzerland, England, and other industrial powers. They had grown so big, particularly when you looked at the size of their assets and risks compared to their national economies, that they had become “too big to fail”. If they were not rescued, their collapse would cause even more severe national and international economic damage through job losses, housing repossessions, reduced GDP, and lending of credit. In addition, the burden of saving these giant institutions would cost ordinary taxpayers heavily.

Although Basel III was initiated and championed by the finance industry, the industry has since lobbied aggressively against certain aspects of the Basel III reforms. Lately there seems to be mounting evidence that the industry sees and agrees with the requirements as beneficial in the long term. That’s good, since the industry needs help in improving and rehabilitating the industry’s reputation among the investment community, depositors, law-makers, and consumers.
The good news this year is that a global, voluntary regulatory standard on bank capital adequacy, stress testing, and market liquidity risk was to be started this year. It was agreed upon by the members of the Basel Committee on Banking Supervision changes from April 1, 2013 extended implementation until March 31, 2018, a welcome delay as the economy continues to recover.

Qualified residential mortgages
Qualified residential mortgages should make home buying more costly in 2014. On January 1, 2014, a new provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act goes into effect. The “qualified residential mortgage,” or QRM, may have far-reaching effects that will lessen the number of people who can obtain home loans. In my eyes it particularly affects ‘entry level ‘ buyers. Most of us started as ‘entry level‘ buyers, which forced us to save a bit more and allowed us to build equity for our next house. Not having more lenient financing for these type of buyers will have a definitive long term effect on housing. ‘Entry level’ buyers will be forced to pay more and more of their income to continually escalating rents. The inability to have tax advantages and the ability to share in one of the best leveraged ‘hard assets’ in the nation will have long range affects on the Millennials and others that also are not seeing the positive effects of inflation on other assets that the Baby Boomers saw.

QRM was designed to set the bar for residential mortgages and to minimize the risk that borrowers may default. It requires that debt ratios be limited to 43 percent and loan fees limited to 3 percent, and interest-only loans and negative amortization are not allowed in most cases. The Dodd-Frank bill also requires the lender to retain 5% of any mortgages they make. Most lenders do not have the ability to retain 5% since they are making less than 2% on most loans. This opens the door for mortgage lending to the large banks, who have deposits and other capital they can pledge as that 5%. In other words, if they make a $100,000 loan they must retain $5,000 to secure the loan. QRM loans are exempt from the risk retention rules. This means that the lender can sell the loan on the secondary market without having to retain the 5 percent. The effect of these provisions is already being felt in the lending industry. Citibank has restricted its lending to those areas where it has a banking presence. Compliance departments have tripled in size at many large lenders. Community banks and credit unions are being choked by the regulations and often lack the resources to meet the new compliance requirements.

Community banks and credit unions have historically had a much lower default rate compared to other lenders. The reason is that they know their customers. Community bank loans have often been based on a handshake, a borrowers character, and knowing the customer over a longer term. In terms of credit union loans, people feel they are hurting themselves and other members if they default.

That is what makes the new provisions so difficult for lenders. In the past, loans have been turned down primarily due to credit issues. For the first time in history, lending decisions may be made based upon compliance issues rather than just credit issues. Imagine that you made a mistake on a purchase agreement contract. The buyer and seller want to change the agreement to correct the mistake, except the law prohibits you from doing so. If a lender makes a mistake with any part of the compliance, the lender now has to pay all of the borrower’s closing costs. Even if the mortgage agent made the mistake, the mortgage agent must still be paid. The lender cannot deduct any costs or losses resulting from the mistake. The lender still has to close the loan. These provisions will be particularly difficult for online mortgage sites.

In addition to the issues above, jumbo loans currently fall outside the QRM provisions. A jumbo mortgage is a mortgage loan that may have high credit quality, but is an amount above conventional conforming loan limits – $625,000 in Texas. This creates tremendous uncertainty as to what will be required of lenders who want to sell jumbo loans on the secondary market. The result will most likely be that be even fewer jumbo loans will be available.

There will be fewer loan choices as community banks and credit unions are squeezed out of the market, making it even harder for many borrowers to qualify. The loan process will also probably take longer due to the increased compliance measures. Lenders generally want to issue loans that meet QRM criteria. It gives them an exception to a rule they find troubling. It allows them to sell a higher percentage of their mortgages into the secondary market, thereby reducing their long-term risks. As a result, the majority of lenders will impose these guidelines upon their customers. These rules will essentially set the bar for mortgage lending standards in the U.S. Those borrowers who fail to meet these criteria will have a harder time finding a loan compared to borrowers who do meet the criteria.

Remember in 2005, the median home value in Austin was around $171,000, and today it is around $220,000. But with wages staying flat during this same time in Austin as well as the rest of the country, it makes affordability and qualifying farther out of reach. With a healthier economy, they might end up paying a higher interest rate as well. Lenders claim that risk retention increases their operating costs, so they will likely charge more for loans that are subject to risk retention.

So here’s the bottom line: why wait to buy? Values, rates, lending all are increasingly making it harder to buy. Encourage anyone who is on the fence about selling or buying to do so before the end of the year. Otherwise, they may be caught up in maelstrom of new regulations that can sink their sale and that might also hamper the real estate recovery.