In U.S. Mortgages, Government Inc. Calls the Shots

The mortgage market has been chugging along without many hiccups since the 2008–’09 global financial crisis. And for good reason: Rates are at record lows, and underwriting has been standardized.

“Things are kind of in balance in the mortgage market,” says Andrew McCormick, head of the U.S. taxable bond team at T. Rowe Price in Baltimore. “In an environment where global markets are jittery, the U.S. mortgage still offers great liquidity.”

Pent-up demand from more young adults living with parents, modest housing price appreciation and more active new construction have fueled the housing recovery. Yet risks do exist under the surface.

For one, the government now has a larger role within the housing market. Whereas government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac have put controls in place for mortgage underwriting and home appraisals with an aim toward avoiding some issues that caused the crisis, they are the sole exit strategy for many mortgage originators. Unlike the secondary market before the crisis, today’s secondary market consists primarily of high-quality agency paper with little credit risk, but there’s a lack of reform, regulation and performance history, which could create significant problems.

“We have further entrenched the government in the mortgage market, which is a very unhealthy environment,” says Stijn Van Nieuwerburgh, professor of finance at New York University’s Stern School of Business and director of Stern’s Center for Real Estate Finance Research.

Despite the 2016 elections, in which either the Democrats or Republicans could eventually control both the presidency and Congress, Mark Zandi, chief economist at Moody’s Analytics in West Chester, Pennsylvania, expects changes to occur through the regulatory process, rather than legislation. “The fundamental issue is that, no matter how you reform them, mortgage rates will be higher postreform, and that’s difficult to sell politically,” says Zandi.

As rates have been scraping zero for some time, mortgages have been more of a buyer’s market, with about 57 percent of the $395 billion in mortgage originations used to purchase one- to four-family homes in the second quarter of 2015, compared with 24 percent of the $577 billion in originations in the fourth quarter of 2012, according to industry group Mortgage Bankers Association. “In terms of a shift in the market away from refinancing, that’s been going on, but it’s also been much less of a refinance market for quite some time now,” says Bryan Davis, portfolio manager of global fixed income at Principal Financial Group in Des Moines, Iowa.

Nonbank originators have one line of business; they originate mortgages that are eventually sold to an investor. By focusing on their technology, some of these originators are able to process loans faster so that when interest rates drop, they’re able to quickly refinance loans for borrowers. Compared with banks, nonbanks aren’t regulated and don’t take deposits, nor are they required to hold any capital or loans on their balance sheets. Instead, they rely on warehouse lines of credit to originate loans that are eventually sold to the GSEs. “Regulators should be focused on the funding sources for these nonbank lenders,” says Zandi. “Many get their funding from the big banks,” he continues. “If things go south and the big lenders decide they’ll get more cautious in extending lines of credit to small lenders, that might be a problem.”

Investors and the GSEs are somewhat protected from credit risk by the representations and warrants requiring originators to repurchase delinquent loans that weren’t originated properly. Nonbanks don’t have to comply with the same capital requirements as banks, though; thus they might not have the balance sheets to repurchase loans if a significant amount default. “If the nonbank originators had to hold some of the loans and adhere to capital standards, they’d be safer,” says Van Nieuwerburgh.

What’s helped normalize underwriting guidelines is that banks and nonbanks tend to originate different credits. As a result of the housing crisis, “the large banks began to withdraw to anything but a pristine credit borrower, and that void was filled by nonbank entities — which tend to cater more to the lower-income, first-time home buyer,” says Principal’s Davis. Higher-credit loans are generally sold to Fannie Mae and Freddie Mac, whereas Federal Housing Administration loans with low-downpayment requirements go into Ginnie Mae securities.

As the market continues to grow, nonbank originators have the potential to collectively create systemic risk. “The biggest problem is that they are not banks, and they aren’t as heavily regulated, and our usual defenses of bank regulations and supervision and consumer protection aren’t as strong for those type of institutions,” says Van Nieuwerburgh. Nonbank originators aren’t regulated by the Federal Deposit Insurance Corp. and won’t be able to draw on the FDIC during bankruptcy, as banks can. They do, however, undergo audits and exams under the supervision of the Consumer Financial Protection Bureau. The CFPB protects the consumer without dealing with the potential for systemic risk of these entities. “Because of the size of the market, the CFPB hasn’t looked at all the originators,” says Jeffery Elswick, director of fixed income at Frost Investment Advisors in San Antonio. “If it’s a small company that’s not public, you have to talk to the company. You have to ask.”

The government has become an integral player in all parts of the mortgage market as investor, guarantor and regulator. While waiting for reform, though, the hope is that cracks don’t begin to appear so that taxpayers aren’t on the hook once again.

Get more on regulation.