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Thoughts on Mortgage Risk, Housing Bubbles and Market Perceptions

Mortgage Risks

We spent a good part of the spring and summer of 2005 involved in various discussions with writers, homebuyers, homeowners and others regarding risks in today's mortgage and real estate markets. These range from those related to the size and composition of the portfolios held by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac; certain aspects of heavily-marketed mortgages; risks of localized house price "bubblettes"; investor appetites; and other forms of risks related to lending, loans and the assets which back them.

Two years have now passed, and those concerns remain a portion of the current mortgage and real estate discussion. Interest rate increases have continued, straining some borrowers; tighter credit conditions coupled with those higher interest rates have served to crimp affordability, which has translated into declining demand for homes; in turn, home price appreciation, has softened on a broad basis, with some markets cooling at a fairly quick pace.

The paragraphs which follow are a collection of thoughts revealed in the HSH Weekly Market Trends, themselves distilled from many hours trying to look at these issues from as many sides as can be found. We hope that you'll find them useful to your outlook and understanding.

Concerns about risk have been on the rise for the last couple of years, but a certain level of immediacy has more recently entered the picture. Adding to calls by Fed Chairman Greenspan for limits on the size of the GSE portfolios, a joint release in May by the Office of the Comptroller of the Currency, Federal Reserve, FDIC, OTS and NCUA was an 11-page reminder to lenders that they need to begin to be more prudent in making home equity loans and lines of credit. The release provided an outline of tools and methods banks are being urged to employ to measure -- and manage -- the risks of loans to homeowners.

In December 2005, the same group of regulators published for industry comment a series of proposed guidelines covering the riskiest sorts of first mortgage loans, urging lenders to look beyond credit scores as a means of qualification, be more explicit in revealing potential risks to borrowers and stress-testing the loan on their books, among other proposed regulations. Final adoption of at least some of the regulations is likely this summer, which will likely curtail the use and availability of certain kinds of mortgage credit.? Meanwhile, new loans have arrived on the scene, including those with 40- and even 50-year repayment schedules.

It's a fair assumption that when a group of disparate regulators agrees it's necessary to point out to banks the need to pay closer attention to their loanmaking procedures, it's a clear signal that credit terms and conditions are running wide open, perhaps fecklessly so. It's also meant as a caution that the favorable climate under which these loans have been made isn't likely to last indefinitely.

Has prudence in lending standards been left out of the process? Perhaps. The ability of a borrower (or lender) to manage the layering of risks of a high LTV loan, or a high degree of interest rate variability, or expanded debt-to-income ratios, or stated-but-undocumented income, or making minimum or interest-only payments -- or some, if not all, of those factors -- against a home whose value is seriously inflated is untested in rougher economic waters, good credit score or not.

We also find it rather ironic that investment firms specifically note that "past performance is no indicator of future returns," but that is precisely what a credit score would have investors believe: that a borrower who has performed well in the past will continue do so in the future. By the definition of the model, this may be mathematically true, but there seems to be perhaps a little more faith and a little less science than might be expected in extending this historical estimation to cover future behavior in yet-unseen circumstances.

Mortgage investment and mortgage lending have always been a risky business, and always will be. Real estate is subject to strong expansions and contraction in both local markets and larger regions, and as every homebuyer knows, interest rates wax and wane. We hope that the cross-currents of these risks don't suddenly intertwine, because the risks inherent in today's mortgages are accumulating... somewhere.

For loans already originated, mortgage bond rating agencies such as Moody's and Standard and Poor's have expressed concerns about risks associated with bonds backed by highly leveraged loans, including 'piggybacked' loans and loans featuring reduced documentation. In the background, certain pools of mortgage-backed securities will now require greater "credit enhancement", a means of decreasing the risk of the pool of securities. The higher costs of 'enhancing' will ultimately make their way into the prices of new loans, making them less attractive to borrowers.

Is one of those risks under-compensation (a low yield return) to investors? With inflation markedly above last year (but Treasury and mortgage yields well below them), the answer might be affirmative. It's safe to say that, at the moment, a crush of money both domestic and foreign continues to pour into Treasuries and mortgages (described in some circles as a kind of world "savings glut").

For foreign investors and foreign central banks, investing in US-based or -backed assets is a safe bet; even as yields seem puny to us, they represent good value when compared with other opportunities in their native lands. Corporations here, flush with cash after years of high profit levels, have little need to issue new bond debt to finance expansion or upgrades, so there's little new good quality debt available for investors to buy, as well. With too much money chasing too few acceptable bond assets -- specifically Treasury issues and mortgage-backed securities -- this has served to continue to press yields lower and perhaps concentrate money into narrow and frequently related avenues. Should a sudden or over not-so-sudden shift in investor appetite for low-yielding paper occur, mortgage rates would likely rise in a hurry.

Hoping to spread those risks over a broader spectrum to mute the impact of such a shift may be the reason behind the Treasury's recent decision to begin offering 30-year Treasury Bonds again. The new offerings are a way to again peg long-termed instruments like mortgages, and may have helped to foster the introduction of those new 40-year (and longer) loans.

On Bubbles

Discussion about real estate market "bubbles" has become a popular pastime in recent months. However, prominent observers and market participants are always quick to point out that while there has been no national devaluation of property prices since the great depression, there have been periods where certain markets -- or kinds of properties -- have suffered adverse conditions.

Federal Reserve chairman Alan Greenspan is among those who avow that due to the nature of the market, national bubbles in real estate prices are unlikely to form. At one point in 2005, he noted that there is "at a minimum, a little froth in this market." At the time, Greenspan said that while the Fed doesn't "perceive there is a national bubble... it's hard not to see that there are a lot of local bubbles" in housing, and that current property price gains represent "an unsustainable underlying pattern".

Bubbles or not, worries about declining home prices are prevalent in 2006. Overvalued real estate markets are growing in number, and given high inventories of homes on the market for sale, declining prices are a realistic possibility as the year continues. According to the private-mortgage insurer PMI Group, 48 of the nation's 50 largest metropolitan areas were at risk of price declines as of their April outlook. To what degree softening prices will distort a market is a very localized issue, but it has been noted that power is shifting from seller to buyer in 2006, and that seems likely to continue for a while.

Another item which should be on the radar screens is the influence of real estate investors on prices in a given local market. Home purchases by investors traditionally make up about 5% of the market, but estimates for recent activity have run as high as perhaps 20% of the market in the past year, and higher in certain markets or for for certain kinds of properties, such as condominiums. Investors probably aren't as likely to hold onto their properties and are probably more likely to sell at fire-sale prices to avoid rising expenses, and any wide-scale 'dumping' of holdings into and already-glutted market would further depress prices.

It's still not clear which markets may be in 'bubble mode,' although following those with the strongest or longest price increases over the past several years should provide some indication. And if there are such bubbles, what do they look like? Are they the kind of sporadic and isolated bubbles which, like those from a child's wand, exist and explode individually? Or do those bubbles resemble those on a glass of soda, where the popping of one changes the tension and structure of another, causing them all to eventually burst? A lot of isolated bubbles might survive in adverse conditions, but a mass of interconnected bubbles might not.

In any discussion of housing bubbles, talk ultimately centers around risk. In particular, the question is whether lenders and borrowers are accepting too much risk in the kinds of loans they make available -- and which borrowers select -- weighed against the market climate which exists today. It should be noted that, if the market is functioning properly, a lender's role is to act largely as a kind of conduit between investor and borrower, with any risks theoretically passed along to the ultimate investor. That's not to say that a lender might not also be an investor in this case; however, many mortgages are packed up into securities and sold to others.

Why all the big push into ARMs in the last year or so? And who are these investors, anyway?

About six years ago, an unsustainable stock market imploded, taking with it a lot of money. Perhaps more significantly, it also wiped out the desire of many individual investors to invest in equities. A sizable number of them took at least a portion of their holdings out of stocks and instead put their funds into bonds, either directly, or via money managers seeking any form of positive returns in an adverse investment climate.

As a result, that money came to be invested in Treasuries and mortgage-backed securities, as well as real estate investment trusts, or REITs. Coupled with a difficult economic climate, falling inflation and a Fed slashing rates to boost growth, this helped produce some of the lowest interest rates in over 40 years, causing a historic tsunami of first mortgage refinances.

That wave had two effects: First, most of those refinances turned many outstanding loans into fairly low-yielding 30-year FRMs. Since most lenders don't want to hold long-term low-yielding paper, the vast majority of these were sold off to the secondary markets, bloating their mortgage holdings (a major contributor to Fannie Mae's woes). Worse, those refinances decimated portfolios made up largely of adjustable rate mortgages (ARMs), leaving investors with yawning holes in their portfolios but handfuls of cash to re-invest -- hopefully in ARMs.

Originating ARMs is always a challenge, as borrowers prefer FRMs in nearly all circumstances. Worse, investors needed to originate ARMs in an interest rate climate which, even now, still sports some of the lowest rates in at least a generation. How to attract borrowers to products whose interest rates are most certain to rise in coming years, bringing budgetary risk? You start adding and/or combining features rarely found on FRMs.

For starters, you can bait the hook with an interest-only payment feature. Then, reduce or eliminate down payment requirements; offer more-generous qualification ratios for good (or perhaps not-so-good) credit scores. Toss a "minimum payment" feature into the mix, but downplay the negative amortization component of such an arrangement. Then, promote the monthly "savings" of these products knowing that those savings are fleeting at best, and that ultimately, the bills will come due.

Such a lender might also consider expanding the definition of who might be able to get a loan with low- or no-documentation, or otherwise fit more people under the umbrella (known as 'Alt-A') who couldn't otherwise obtain credit at such favorable terms. You help people "stretch" into homes fetching increasingly outrageous prices at a time of perhaps record valuations, and you do it while the economy is in pretty fair shape. Demographics aside, you've helped fuel what could be considered excess activity -- in a market which should need no help -- by 'artificially' stimulating demand through the use of cheap and easy credit. You've enhanced demand by expanding the definition of who can expect to buy a home.

Aside from the regulatory push noted above, two of the largest proponents of Option-style ARMs -- World Savings and Washington Mutual -- quietly tightened their underwriting standards late last year, raising minimum monthly payments and increasing the interest rates which define the initial period of the loan. While the market for such loans if still strong, it appears that portfolio appetites for some of the "riskiest" loans -- at least those with rock-bottom interest rates and liberal underwriting conditions -- are becoming sated.

Of course, this is a simplified explanation of how we got to where we are at the moment: talking about risk. There are a number of other factors promoting today's market, but the concentration of investment assets into narrowly defined (and perhaps related) investments -- Treasuries and mortgages -- is where at least some of the fuel is coming from.

However, as long as investors keep pouring money into these kinds of mortgages, or until those formerly-decimated portfolios are re-filled -- or until losses in these products begin to show (probably not this year, at least) -- this housing boom will continue to press onward, even if the underlying mortgages are "risky".

Perception Risk

One of the other areas of concern could be called "perception risk," referring to the way a given borrower might regard future market conditions. Many borrowers go by the credo "if this loan doesn't work out, or if my situation changes, I'll just refinance."

Consumers are vaguely aware that mortgage market conditions, at this writing, are probably as liquid as they have ever been. Right now, almost anyone who wants a loan can get one, regardless of circumstance. Down the road from here, however, we wouldn't bet that investors will still be as interested in lending their money to a borrower with no equity, a sizable debt load, imperfect credit, or other imperfection. Perhaps more importantly, even if loans are available, they may not be at terms favorable to the borrower's immediate needs; they may not allow for a high loan-to-value ratio, high "back-end" debt load, or interest-only payments, for example.

That's even leaving interest rates out of the consideration. We sometimes forget that despite the recent rises, most interest rates remain very favorable by historical standards. At some point, rates may get back to would be considered "normal" or "typical." In other words, it's likely that interest rates will be broadly (even if not significantly) higher than today at some point in the reasonably near future. If so, borrowers who need to refinance may find rates ranging from somewhat to considerably higher than those the borrower enjoys today.

In short: betting the house that today's extraordinarily low-rate, liquid and favorable mortgage market conditions will stick around is not a safe bet at all.

Some homeowners think there's a safety net despite this. They believe that, if the need arises, they can just sell their home as a way to get rid of a once-advantageous mortgage product that's now costing them way too much. But unless you're really up on the state of your local real estate market, this is not a particularly safe bet either. For one thing, how many other sellers could find themselves in the same boat, with a need to sell at nearly the same time? How many investors hold properties in your market? How many jobs in your market depend on a single company or industry, and what would happen if it suddenly announced mass layoffs?

These, and many other possible situations, could produce a glut of properties coming on the market, and this could serve to level or even depress prices, even if there is no "bubble" pop. That could leave a borrower exposed, since sizable disposition costs could erode or eliminate any equity in the home, or could even leave a borrower "underwater" (owing more on the sale than he realized in profit) after the existing mortgage and sales charges are paid.

It wouldn't take a 100% LTV mortgage or an interest-only or minimum (negative amortization) position on the borrower's loan to put him into financial trouble.

Betting that today's robust real estate market will still be in place when or if a borrower should need to sell is not a safe bet, especially if liquid mortgage markets become less liquid -- or if they become the catalyst for a decline in buyer demand.

How will it all end? At the moment, the answer is "so far, so good". We seem to be enjoying an orderly retreat from a market overheated in many areas. Credit conditions have tightened mildly, and interest rates, although considered "high" by some, remain historically favorable. Home price increases are showing signs of deceleration, but to date, no regional or even market-wide declines have been noted, but a period of softer activity seems to still be ahead.

Certainly, a combination of events -- spiking interest rates, a sharply slowing economy, falling home prices, etc -- could presage a bad ending to the real estate boom. It is becoming more likely, though, that some homebuyers are or will be pinched by their choice of loan, weighed against the new realities of their local market in a time of rising interest rates. Overall, however, we're actually not quite that pessimistic about the prospects for today's mortgage and real estate markets; we're just pointing out what could happen. Most borrowers will do fine with their choices of product and their ability to manage accepted risks and market conditions. We'll just caution that since it's unlikely that Murphy's Law has been repealed, borrowers need to be aware of these risks if they should hope to manage or ameliorate them and know that some of them are well beyond their control or influence.

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