Holding the Housing Market Bag, Part I

COMMENTARY ABOUT THE future direction of the housing market is coming from every direction these days. As long as mortgage rates remain in their current range, the worst-case housing market scenario will be avoided. The cheap financing available today may bail out many of the 2004 and 2005 homebuyers who made the mistake of entering into “teaser” adjustable-rate mortgages. This includes those who, with the assistance of irresponsible mortgage lenders, “shoehorned” themselves into houses they could not afford under conventional financing arrangements.

But this does not mean that every bad financing decision will be papered over by cheap, plentiful liquidity. A certain amount of housing speculation-related losses are already “baked in the cake.” The bill will be coming due as 2007 unfolds, and it will show up in continued worsening of foreclosures and losses at the most aggressive lending institutions. There are already several signs of “Significant Shifts in Psychology” in lending practices, as Mish outlined in his Jan. 3 Whiskey & Gunpowder article.

Bankers will continue tightening lending standards as they become less certain about the value of the collateral against which they are lending. The lending environment in 2007 is most likely to be one in which those with good credit scores and incomes will be granted continued access to the liquidity pipeline. But those with subprime credit scores will likely find the lending window slammed shut. Soon enough, we’ll find out how many homebuyers were granted mortgages solely on the popular belief (circa 2005) that house prices in even the most undesirable locations “always go up.”

I recommend reading the Center for Responsible Lending’s recent report entitled “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners.” It provides a glimpse into the potential future regulatory environment facing mortgage lenders. A few more regulatory wrenches are likely to be thrown into the freewheeling machinery of the “mortgage-industrial complex.” Needless to say, this will not be good for the slowly deflating housing bubble.

A Bubble Exacerbated by Government Involvement

When studying the housing bubble’s formation, it’s crucial to take a good look at the federal government’s historical promotion of homeownership. The first influence that comes to mind is the obvious effect that GSEs Fannie Mae and Freddie Mac have had on mortgage banking; they constantly replenish the firepower of mortgage originators, allowing originators to rake in fees for each approval. Due diligence on risk now rarely goes beyond checking off credit score and income range boxes, often over the phone or online.

As part of the Great Depression-era New Deal, the Federal Housing Administration (FHA) was created to stoke the housing market. It accomplished this by providing default insurance for lenders leery of lending to homebuyers who were not able to afford the high down payments required for mortgages at the time. As with all government programs, politicians never respect the costs or consequences beyond the next election cycle. In hindsight, the consequences are clear: The artificial influence of government-subsidized housing is resulting, and ultimately will result, in a gross misallocation of resources, and usually asset bubbles.

There is an interesting parallel between the Federal Reserve and the FHA. They both interfere in the free market, and the consequences of this interference have been supercharging the business (and now housing) cycle. Just as the Fed thinks it knows better than the market what the optimal short-term interest rate should be, the FHA has developed into yet another conduit through which the federal government subsidizes the entire housing market, granting first-time buyers an artificial boost in home purchasing power.

Decades of housing market inflation attracted several private companies to enter the mortgage insurance business. They viewed it as a “no-brainer” investment to take on the risk of default in return for modest monthly premiums.

For now, it’s important to respect the government’s aggressive response to the private sector’s market share gains. This excerpt from President Bush’s FY 2007 federal budget proposal — which is likely to be received quite favorably by a Democrat-controlled Congress — includes initiatives to respond to increased competition from both “piggyback” financing and private mortgage insurance (emphases mine):

“The Federal Housing Administration (FHA) is currently undergoing a rapid transformation to enable it to expand homeownership opportunities for low- and moderate-income families. Traditionally, FHA has assisted homebuyers underserved by the conventional mortgage market to obtain mortgage credit at a reasonable cost. Since the 1930s, FHA has been a primary mortgage source for first-time and minority buyers.

“However, in the last three years, FHA loan volume has fallen precipitously. This is good news, in part. Lower interest rates have made unassisted mortgages affordable for more families, and the private sector has increased its use of automated underwriting, allowing it to offer loans on favorable terms to more homebuyers. This is a positive development, when the private sector is offering favorable terms to borrowers who previously would have turned to FHA. However, a small portion of borrowers may still be ill served by incurring higher costs or unfair terms as compared to a comparable FHA loan product.

“Premiums for FHA mortgage insurance currently do not vary according to a borrower’s credit risk or the expected cost from defaults, causing better borrowers to subsidize weaker borrowers. This has driven safer borrowers to seek alternatives offered in the conventional market and pay higher prices than they would have if offered FHA risk-based pricing. The budget proposes tiered risk-based pricing to address this issue, which will decrease homebuyers’ costs, and thereby increase access to homeownership. This type of pricing will enable borrowers to know why they are paying certain costs and how to lower them…

“To remove two large barriers to homeownership – lack of savings for a down payment and impaired credit – the administration proposes two new FHA mortgage products. The Zero Down Payment mortgage will allow first-time buyers with a strong credit record to finance 100% of the home purchase price and closing costs. For borrowers with limited or weak credit histories, a second program, Payment Incentives, will initially charge a higher insurance premium and reduce premiums after a period of on-time payments. In conjunction with risk-based pricing, these products will expand homeownership opportunity on an actuarially sound basis.”

Formation of the Private Mortgage Insurance Industry

The private mortgage insurance industry was invented in 1957 by Max Karl, the founder of Mortgage Guaranty Insurance Corp., after he observed a disconnect between those who could not afford a 20% down payment on a house and lenders who, for good reason, avoided extending mortgages with greater than 80% loan-to-value ratios. The word “private” describes this industry because up until Mr. Karl’s entrepreneurial venture, the FHA had a monopoly in the mortgage insurance business.

Memories of the Great Depression were still fresh in the minds of bankers in those days. They respected the importance of avoiding overexposure to mortgage debt in a long economic downturn where job losses were involved. But Mr. Karl clearly saw an opportunity to bridge the gap between mortgage buyers and mortgage sellers by assuming a portion of default risk in return for premium payments.

This was yet another step in the evolution of the insurance industry. Now instead of assuming the risk of property destruction or auto accidents like traditional insurers, mortgage insurers would shoulder the risk of default on the part of homeowners with less than 20% equity in their homes. This has undoubtedly contributed to the nonstop buying pressure on housing over the past 50 years.

This sounds like a cash machine-type of business, provided that premiums are priced at a highly profitable level (“piggyback” loans and the FHA are a threat to this) and housing prices do not increase far faster than incomes (they have). Most importantly, the willingness of lenders to extend mortgages must not fall short of the level required to keep prices elevated in areas characterized by high default risk (this appears to be happening right now). These three conditions are not running in favor of mortgage insurers, so it’s time to consider how bad losses can be.

Private Mortgage Insurance:
The First Line of Defense Against Mortgage Default Risk

The private mortgage insurance (PMI) industry provides a crucial role in the process of bringing homeownership within reach of buyers who lack the savings for the traditional 20% down payment. Down payments are important to minimize moral hazard; this is a situation where the buyer has no “skin in the game” and loses his or her incentive to avoid default. Other than the damage that personal bankruptcy imposes on credit scores, homebuyers who put no money down have nothing to lose by defaulting on the mortgage and turning the keys over to the bank.

The lack of savings and the innate American desire for homeownership among middle-class households has led to great demand for PMI. Large institutional buyers of mortgages, like Fannie Mae and Freddie Mac, usually require loans to be “conforming,” or have a loan-to-value ratio of no higher than 80%. Since their charters require Fannie and Freddie to concentrate on the low-to-mid-sized market, nearly all first-time homebuyers must either get a second loan to help fund this 20% down payment or purchase PMI.

In return for PMI premiums that typically add a few hundred dollars per month to the mortgage payment, mortgage insurers expose their capital to a certain percentage of default, usually in the 25-30% range. Importantly, this is the “top” 25-30%. Banks and GSEs are the ones insured against the first 25-30% of losses. Beyond this first line of defense, shouldered by the mortgage insurer, these providers of mortgage credit must absorb any losses that remain.

For bankers and mortgage-backed security investors, PMI represents “credit enhancement,” because it substitutes the insurer’s creditworthiness for that of the homeowner. Industry sources peg the average insured mortgage at about $175,000, so I am referring to the creditworthiness of first-time homebuyers, not the wealthy.

So the industry’s risk exposure is concentrated on first-time buyers who bought with down payments in the range of 5-20% as the market reached the speculative stage in recent years. A historically consistent price consolidation would wipe out most of these down payments, putting many of these mortgages underwater. From there, the only step to widespread defaults would be a slowing job market.

Many of you can recall the stories of desperate mortgage brokers stretching to the limit of their fiduciary duty — recommending no-documentation, interest-only, pay-option, and even negative amortization mortgages to clients with little warning of the fine print behind them. In 2004, as the Fed began to “tap on the brakes” of monetary policy, mortgage brokers hit the gas pedal to the floor with very loose credit conditions. Countless billions in new credit was created to grant homebuyers the purchasing power they needed to hop aboard the great housing market gravy train.

So who is left “holding the bag” in the aftermath of the greatest housing bubbles in history? History will be the ultimate judge, but mortgage insurers played a crucial role in support of the bubble and have yet to experience their day of reckoning. In Part II of this article, I will profile the most dominant mortgage insurer in the business, and why it’s exposed to far more risk than the consensus appreciates.

Good investing,
Dan Amoss, CFA

January 8, 2007