The Goverment's Influence

What role does the government play in the mortgage market? All levels of government impact the mortgage market each through a different avenue.

The local level, county or city, influences the inventory of housing and job creation. Utilizing zoning laws, local municipalities can increase or decrease the rate at which additional housing units come on the market. By creating tax incentives they can attract or hold onto businesses, with the result of increasing the desirability of the community. Local government directly influences the supply/demand equation for housing inventory. This has a direct impact on house values.

Home resale values determine the amount of equity one has in his home and therefore the security of a lender. Mortgage defaults tend to increase in regions with flat or declining real estate value and tend to reduce during times of appreciation. We’re seeing this occurring right now. The areas with the greater defaults are also the areas with the greater depreciation in sale prices.

The State level and to a lesser degree, the local level, sees the housing and mortgage markets as a source of revenue. Government on all levels need funds in order to supply services to the communities. Generally speaking our elected officials prefer to collect the most amount of money from the smallest set of voters. For example, an increase in a sales tax impacts everyone. Those in office run the risk of not being re-elected if too many voters blame them for taking their hard earned money away from them. Collecting money through a real estate transfer tax or a mortgage tax only effects the voters who are conducting a real estate transaction. The set of voters in this category is only a small percentage of the voter population. An elected official stands exposed to lose a lot less votes in this case.

By increasing the cost of executing a real estate transaction the State, government effectively discourages sales. At this level the mortgage market is influenced through a reduction in transactions that results in a lower rate of appreciation or worse, acceleration in the rate of depreciation in a declining market.

For example, let’s look at a property being sold in New York City. The seller will pay a transfer tax to the State of approximately 0.4% of the sales price as well as an additional tax to the City of 1.0 to 2.625% (depending on the type of property) of the sales price. The buyer will be giving the State a mortgage tax of 0.8% of the mortgage amount and an additional 1.0 to 1.8% to the City. If the purchase price is $1 million or greater the buyer will be paying an additional 1.0% of the sales price to the State. These taxes provide a windfall of revenue during a rapidly appreciating market but can discourage sales in a down market. It’s easy to see how large an influence State and local governments can have on a local housing market.

The Federal Government has the largest direct impact on the mortgage market. Washington is constantly searching for the proper balance of taking as many people from being renters to being owners, maintain the integrity of the banking industry, keeping the cost of financing as low as possible for every American and at the same time allow the free market to do its job.

Until The late seventies, the Federal Government set mortgage rates nationwide. This provided a consistency that everyone looking to purchase a home would be facing a 30 year fixed rate mortgage at 8.75% (or whatever the rate at the time was) with 0 points. The downside to this approach was that a lender would only allocate capital to mortgages if they couldn’t get a better return than 8.75% on their money elsewhere. The availability of mortgages would vary over time, reflecting market conditions. It was decided that this was not a healthy situation, especially during a period of high inflation, which was the case at that time. The government decided it was better that mortgage money consistently be available to everyone and allowed mortgage rates to vary, based on market conditions. This created a situation where there would always be mortgage money available but the cost of the money would now reflect market conditions. This decision opened up various options to the borrower. He could now elect to pay points upfront in order to get a lower rate for the duration of the mortgage term. He could borrower money on an adjustable rate to lower the initial payments, etc. This free market of mortgage rates gave the consumer a multitude of choices and gave the industry the opportunity to create products to accommodate the different needs of the borrower giving him even more options. The downside here is that the borrower needed to develop the skill set necessary to make a proper & informed decision.

The bigger problem this created for the mortgage market was that this freedom of pricing combinations and types of mortgage products, could be used by criminals. The same tools that an applicant used to get the best mortgage for his needs could be used by the crimminal to confuse the applicant and take advantge of that confusion. White-collar crime comes in all shapes and sizes, from the lender looking to steal homes out from under an innocent borrower to the thief looking to rip off a lender. The industry, law enforcement and all levels of government are in a constant battle to minimize the criminal activities.

The conclusion here is that the positive effects of a free market mortgage rate environment gives the consumer greater access to mortgages and the ability to capitalize on a low mortgage rate when the time is right. The negative effect is that obtaining a mortgage has become more complicated for the consumer and both the consumer as well as the industry, needs to be diligent in protecting themselves from the criminal element.

The Federal government has had an ongoing goal to increase the number of homeowners in the country. The basis of this focus on homeownership, is the wealth of most American families found in the equity that is built up in their home. The thinking goes that as more people own homes, there will be more families building up equity and therefore, personal wealth. Various government departments and agencies are constantly looking to design programs to aid the first time homebuyer. It’s because of this effort the FHA program was developed. A government insured program that helps people purchase homes with little or no money down, less than perfect credit and/or need more generous qualifying ratios. The government has also encouraged the GSEs as well as the rest of private industry, to create programs to accommodate the needs of first time homebuyers.

It doesn’t matter what industry we talk about, you won’t know that you pushed a standard too far until problems arise. An engineer can’t tell you how much weight a piece of steel can hold without first taking a sample and placing increasing weights on it until it finally breaks. We have pushed the underwriting standards of the mortgage industry to its limits. We know this because we are currently suffering the consequences, increasing number of defaults, foreclosures and depreciation of home values.

The best example of the negative impact of government pressure is what’s currently going on with the GSEs (Fannie Mae and Freddie Mac). They had record profits a year ago. The government reminded them that they have certain obligations, one of which is to keep the cost of mortgages down for as many consumers as possible. The GSEs responded by cautiously loosening their credit standards to permit the better quality Alt-A and subprime borrowers to be eligible for their loan products. This had the positive effect of lowering the cost of financing for these individuals. It also has the negative effect that the GSEs are currently suffering huge loses. In hindsight we can see that the standards shouldn’t have been made as liberal as they were. There was no way of knowing how far they could go without suffering the consequences of going too far.

The current market conditions are leading many to conclude that we should go back to the old ways of lending. Banks holding all mortgages in their portfolio, only lend to individuals with the best of credit, require substantial down payments and don’t let a borrower spend too much of his income on housing expenses. It’s believed that these standards need to be written into law by the government. This would be the worst possible path for the government to take. It would be an over-reaction to the current situation and by putting the standard into law, make it extremely difficult to correct the new problems that this would cause.

The government needs to concentrate on keeping the criminal out of the industry. This is done though mandating accountability of all individuals and entities in the mortgage process and creating monitoring systems that are capable of identifying every company and person that was involved in a particular mortgage. This way when problems arise, patterns will be found and the people and entities responsible for the damage become exposed. Any other government intervention needs to be kept to a minimum.

Overview of The Mortgage Market

With all that’s been written over the last few months about the mortgage market we need to step back and look at all the workings of this market. One obvious conclusion that can be made from what we’re reading is that the market is much more complicated than anyone ever imagined. In this respect the news media has done a fine job. On the other hand, by focusing on one or two issues, the media is creating the condition that will draw the reader to conclusions that may not be valid.

What I want to accomplish over the next few weeks is to give you an overview of how each player fits into the mortgage market and how the actions of each player impact the actions of all the other players.

The financial marketplace, which includes the mortgage market, can be best described as an ecosystem. Just as we now recognize that driving a car not only depletes the world’s oil supply is also impacts the temperature in Antarctica which in turns impacts the temperature of the oceans which in turn has an impact on the seacoasts around the world. As in the global climate, the decisions made by every player in the mortgage process, from the applicant, through the banks, the government and every step in between will have an effect on the overall process.

When a scientist or engineer looks to address a complex interaction such as what I’m describing here they will start by analyzing each component by itself. From there they will determine how the components impact the others with the ultimate goal of building as complete a model of the workings of the system as possible. This method of analysis is what I will be using in this study of the mortgage market.

I am going to begin with identifying each player in the process. From there, I will describe the problems each faces and the directions that can be chosen. I will be identifying the pros and cons of the various choices and the motivations that are behind each decision. This is not a witch-hunt; I’m not looking to accuse any one player as the cause of the mortgage meltdown we are now dealing with. The goal here is to gain a better understanding of how decisions are made at each step.

The players in the mortgage market are:
The applicant – the person looking for a mortgage.
The originator – the individual working for a broker or lender who is the source of information for the applicant.
The broker – a middleman that works with the applicant to find a lender that will commit and fund the mortgage.
The lender – the entity who commits to and funds the mortgage.
The wholesaler – an entity that doesn’t deal directly with the applicant but funds mortgages for the lender or broker.
Wall Street – we will use this term to encompass all the entities that package mortgages, securitize the package and then sell securities to investors.
The investors – an entity that invest money in order to get a return that is reflective of the amount of risk it is taking.
The Rating Agency – An entity that is in the business of evaluating the risk that a particular investment has. The investor looks to this rating as an aid in determining what investment to make.
The GSE – Government Sponsored Entity, chartered by the Federal Government for the purpose of supply liquidity to the mortgage market and to help more Americans become homeowners.
The Government – All levels of elected leadership whose purpose is to increase the well being of each citizen they govern.

Entities can play multiple roles in the mortgage market. For instance a commercial bank can be a lender (writing mortgages directly), a wholesaler (taking applications through mortgage brokers and other lenders), a broker (by placing mortgages that do not fit their standards with other lenders), a wall street firm (handling securitization) and at the same time act as an investor (through purchasing securities).

When I am discussing players I will not be talking about specific entities but positions in the industry. Each player has a different prospective on the market. For example, the applicant simply wants to borrow money at the lowest cost that fits his needs whereas the investor is looking for highest rate of return with the lowest risk. No decision is pure, that is, every decision will have both positive and negative results. A decision made with the best of intentions can suffer from the law “of unexpected consequences” turning a good idea terribly bad. The mortgage industry has felt the effects of this law more times than anyone wants to count.

You’ll see several examples as you continue to read this blog.

Subprime Meltdown - How widespread is it?

I've been having an ongoing discussion of the mortgage market with a client of mine (Bill) for some time now. I thought our latest series of e-mails were very interesting so I thought I would post them here for your comments.

Yesterday Bill wrote, "Don, It seems the big banks have pretty heavy exposure to the debt they enabled. Economic rule number one is when there's easy money to be made, pigs will wallow in mud and in this case their own excrement as Merrill has done. They say humans and pigs share 97% of the same genes. Too bad the 3% aren't all the undesirable ones. Human greed is reliable, and it is always the setup for the crisis. Let's see how bad this gets. I was relying on this aspect of human nature in my assessment of the crisis that is unfolding. It looks bad from everything I read."

I responded with, " There's no question that Merrill made some bad business decisions. I do find it interesting the brokerage houses such as Merrill are now regularly being identified as banks, but that's a different issue. As bad as Merrill played the market, Goldman represents the other end of the spectrum; look at today's Times. Every so often you read about some investor or hedge fund looking at buying heavily discounted securities and/or insolvent mortgage companies. The market is bad right now and it may get worse before it gets better but there is a lot of money sitting on the sidelines positioned to take advantage of buying opportunities. We can't lose sight of the fact that the high foreclosure rate in the subprime arena represents a small percentage of the mortgages in the MBS market. The entire world of MBS has suffered in price yet the majority of the mortgages in the pool are performing. It's only a matter of time before the investor community takes advantage of this."

"I agree with what you say that it's probably a small percentage, but other stories also indicate that people overextending themselves straddled all income classes. Let's agree that the nonperforming percentage is small, the accelerant is the amount of leverage that was taken on by the holders of those assets. When the stock market crashed in 2000, the investors that used leverage to purchase securities exacerbated the natural downturn. That's why the hedge funds are blowing up over this. Then you have Merrill that did what Lucent did during the .com craze, they funded their own sales. Chaos theory says that small events when they weave themselves through a system, have profound effects on the overall system. I tend to believe in that science, and currently there's a lot of evidence supporting that position. I have been reading about Goldman Sachs, but think about if a second. If they only concluded the problem was small, they wouldn't have taken the contrarian position and they wouldn't be so exemplary. It's the fact that the problem is bigger than everyone thought makes them so uncommon because they had good acumen when others didn't." - Bill

I ended the day with, "Yes, people overextending themselves throughout all income classes. You need to look at 2 things. First, the number of people overextended is relatively small compared to the total population of homeowners. Then secondly, not everyone that is currently overextended is going to go into default. For example, someone who is temporarily unemployed is overextended but living off of saving or additional borrowing. He will work his way through this situation without going into default.
It's not a good comparison when you compare housing to the stock market. Stocks can be bought or sold on a phone call, there is mob psychology as well as panic thinking that influences the market moment to moment. The housing market operates on a much longer timeline and current market value is not something you can open to a newspaper section and get today's price on your home. This creates a buffering effect that forces people to cool down before reacting.
This is both a positive as well as a negative but in the end, you don't see the equity of your home moving up and down on a daily basis as you see your stock portfolio move. We're not even considering the fact that your home serves the duel purpose of a shelter as well as an investment, something that does play an important role.
I don't think Goldman realized the magnitude of the decision they made. The impression I got from the article was that they made a business decision that the risk outweighed the reward when looking at MBS and they invested accordingly. In hindsight the risk proved to be substantially larger that they anticipated. Instead of making a prudent business decision it turned out to be a brilliant business decision.
There is no question things are not good in this economy. The question is how bad is the economy and how large an influence has the housing market had. There is a layering of influences going on and housing is just one of them. It's a long list: oil prices, the Iraq war, the trade deficit, the ongoing cost of terrorism, etc. When you begin to identify all the ongoing issues you can't help coming to the conclusion that it's amazing the economy is as healthy as it is.
This housing problem is going to nowhere near the magnitude of the dot com collapse. It's just not that far reaching."

What's your opinion? We all see events differently. By sharing our views we can each develop a better viewpoint and therefore be better equipped to make decisions.

Housing Fundamentals

In an article written by Floyd Norris in the New York Times on Nov 9, 2007 entitled
"Blame for Poor Home Sales? It’s the Press, a Builder Says" there are some interesting observations on our housing market from a builder that builds homes all over the country.

The news media is extremely effective at keeping the public informed. Unfortunately in their quest to distribute information there is a magnifying effect. When housing values were growing non-stop a few years ago, all we read about was how people were getting rich in real estate. There was praise for the wealth created in the economy due to the rising home values. The mortgage industry's creativity in developing programs that allowed renters to buy homes with little or no money down was credited for the increases in the percentage of homeowners in the country. The combination of easy lending, low interest rates and raising home values was the perfect storm to keep the economy humming along. This helped fuel the real estate boom.

Today we are dealing with a different picture. Home values have been dropping, lending standards have tightened and the attitude that every American should own their own home has changed to home ownership in not for everyone. The industry has given mortgages to people that couldn't afford them and the industry professionals should have known better.

The magnifying effect of the news media is now working in reverse. Instead of inflating a hot real estate market it is now taking a bad situation and making it worse. "The housing market is horrible in most parts of the country, says the chief executive of the luxury home builder Toll Brothers, and he fears it will not get better until the newspapers stop saying how bad it is."

Robert I. Toll, the chief executive, studied the markets his company is involved in and handed out grades. Most got a mark of "F" or worse. "The fact that I differentiate between F, F-minus and F-minus-minus" shows just how bad things are, he told analysts during a conference call. He said those grades go from miserable to outright purgatory."

Toll Brothers is not building in every area of the country so this study is not very scientific but it does have its use. Mr. Toll goes on to say, " Nearly all the decent grades went to markets in and around New York City."

What makes our region different? There are certain things that cannot be questioned. One is the law of gravity & another is the concept of supply and demand. If you look at the regions of the country that have the largest declines in home values, you will find they typically have one thing in common. That is, too much available housing. Inventory increases for one of two reasons or both. There is too much new construction with the result that supply is out of balance with demand or the area is suffering from a decline in population that again is destroying the balance.

There will always be certain cities or regions that suffer an economic downturn. Typically they are cities that depends on one specific business or industry for employment. When that company or industry suffers problems and is forced to reduce the number of people they employ, the ecomony of that city suffers. With fewer jobs, people are forced to relocate elsewhere. The city is ecomonically weakened and there is no reason for anyone to move into the homes that have been left vacant, therefore, resulting in a drop in home prices. Even during the growth years of the housing market, there were areas of the country where prices came down.

The more common reason however, is over building. If you look at the cities with the largest drop in home values, you will find they have been over-developed. Even in a region with a growing population, it is possible to build faster than the rate of population growth. If the rate of increase in residents begins to drop that only makes things worse.

Now let's take a look at our region, New York City and its surrounding areas. What are the two obvious problems that we deal with? First, there is a scarcity of apartments. This is due to a constant increase in the population. Second, it's extremely expensive, if not impossible in many parts, to build additional housing. "Buildable" vacant land is virtually non-existent. To build new housing, a builder usually needs to purchase an existing structure, tear it down and then build something new. We don't have the ability to increase our housing stock by any significant number. This combination of population growth and restrictions on building creates a buffer from house values taking a serious drop.

The cost of a commodity will not decrease as long as the demand for that commodity is increasing. No matter how out of hand a market gets, eventually the laws of supply and demand will bring things back to normal.

If you're thinking about buying a home but you're waiting for prices to collapse, you may want to rethink that position. Local housing demand is going to prevent any serious drop in prices. Although lending standards have tightened, mortgages are still being granted and at historically low interest rates. If inflation becomes a problem, cheap money will disappear, thus making owning a home more & more expensive.

No one can predict the future. Don't let the "magnifying effect" of the news media determine the decisions you make. Look at all the facts as objectively as possible, draw you own conclusions and make the decision from there. If nothing else, it will be your decision!