The mortgage market has been chugging along without many hiccups since the 200809 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, todays secondary market consists primarily of high-quality agency paper with little credit risk, but theres 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 Universitys Stern School of Business and director of Sterns 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 Moodys 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 thats difficult to sell politically, says Zandi.
As rates have been scraping zero for some time, mortgages have been more of a buyers 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, thats been going on, but its 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, theyre able to quickly refinance loans for borrowers. Compared with banks, nonbanks arent regulated and dont 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 theyll 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 werent originated properly. Nonbanks dont 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, theyd be safer, says Van Nieuwerburgh.
Whats 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 Principals 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 arent as heavily regulated, and our usual defenses of bank regulations and supervision and consumer protection arent as strong for those type of institutions, says Van Nieuwerburgh. Nonbank originators arent regulated by the Federal Deposit Insurance Corp. and wont 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 hasnt looked at all the originators, says Jeffery Elswick, director of fixed income at Frost Investment Advisors in San Antonio. If its a small company thats 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 dont begin to appear so that taxpayers arent on the hook once again.
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