Five years into the global economic meltdown that began in the subprime portion of the U.S. mortgage securities market, the American housing sector is still fighting a war on several fronts. A lack of financing and a shrinking pool of buyers are problems enough.
But first and foremost — in terms of negative factors on housing — is over-regulation of the banking sector, which has greatly increased friction in obtaining real estate financing, dampening sales activity.
The Dodd-Frank Act is part of the problem. The documentation and due diligence steps needed to close a conforming loan in today’s market are several times more onerous than under pre-crisis procedures. In 2010, for example, the Fed imposed new regulations on the appraisal process — probably a good idea but at the time it negatively impacted home sales.
Dodd-Frank, which is still being phased in, places limits on the lending process that are meant to prevent a repeat of the fraud and poor underwriting practices that figured prominently in the subprime debacle. But are these new regulations preventing fraud or killing the U.S. economy?
Phillip Schulman, a partner at the Washington, D.C., law firm K&L Gates, told an audience of real estate agents in May that Dodd-Frank “came down hard on loan officers and mortgage brokers. Why? Because they were the ones working with the borrowers.” In the future, all originators will be qualified, licensed and registered, as well as issued a unique identifier, he said. “Anytime there’s a violation committed by a loan officer, it’s going to be reported in a nationwide system,” Schulman said.
The institutionalization of U.S. banking industry regulation post Dodd-Frank is meant to keep consumers and taxpayers safe, but the Obama administration has yet to hold any of the executives of failed Wall Street firms accountable.
What is clear is that Dodd-Frank made it harder for many Americans to get loans. The drop in home sales volumes decimated nonbank brokers who once fed the majority of mortgage origination production into the banking channel. The attrition in the loan origination sector is exacerbated by Dodd-Frank.
Dodd-Frank is also having a heavy impact on financing for residential and commercial real estate via the 5% risk- retention rule. These “skin in the game” provisions are causing a further negative shift in risk preferences for mortgage securities generally — on top of the seismic shift already caused by the crisis. Not only are end investors wary of new mortgage structures, but bank sponsors are increasingly unwilling or unable to carry the capital cost of mortgage securitizations.
Even while it pretends to protect consumers, Dodd-Frank hurts them by crippling the existing bank-centric market for housing finance and increasing the role of government. As U.S. Rep. Jeb Hensarling, R-Texas, predicted in June of 2010:
“Why would we enact any legislation that would harm the ability of small businesses to access credit in the midst of a credit contraction? How many more jobs have to be lost? Under this bill it is simply inevitable that the big will get bigger, the small will get smaller, the taxpayer will get poorer, and the economy will become more political.”
SHORT-SIGHTED FED POLICIES
Today, the Federal Housing Administration is the dominant player in the origination of conforming residential mortgages, with Fannie Mae and Freddie Mac taking a declining share of the shrinking market. The market for nonconforming mortgage securitization deals remains essentially paralyzed by a combination of Federal Reserve interest rate policy and aggressive underwriting by some large banks. These two factors prevent yield spreads from widening enough to attract investors back to the private-label market.
For example, the funding advantage of the top four banks under the Fed’s zero interest rate, or ZIRP, allows them to underprice loans vs. smaller competitors. So while the Fed justifies part of the current monetary policy mix as necessary to revive housing finance, the distortion of the money markets caused by this same policy thwarts that objective.
This is not to say that there is no activity in the nonconforming loan market, but these initiatives will take years to reach sufficient scale to offset the lost lending capacity in the bank market for real estate finance. With the conforming market running under tighter rules and the nonconforming sector essentially running off, the available pool of finance available to support real estate continues to shrink.
The one area where Dodd-Frank holds promise concerns a national standard for originating, selling and servicing mortgages, but this happy destination remains a long way off. Meanwhile, the basic legal and informational problems exposed by the subprime crisis remain largely unaddressed. As Adam Levitin, Andrey Pavlov and Susan Wachter note in a December 2012 article in the Yale Journal on Regulation:
“[P]rivate risk capital is unlikely to return on any scale until the informational problems in housing finance are resolved so that investors can accurately gauge and price the risks they assume. The Dodd-Frank Act represents a first step in reforming the U.S. housing finance. It takes a multilayered approach, regulating both loan origination and securitization. Dodd-Frank’s reforms, however, fail to adequately address the opacity of credit risk information in mortgage markets and thus are insufficient for the restoration of private risk capital.”
So while Dodd-Frank was intended to fix what was wrong with the American financial system, the opposite seems to be the case when it comes to housing. Instead of increasing market transparency, the rules are making it more opaque.
Combined with the new capital rules under Basel III, housing finance seems destined to become a predominantly nonbank activity. House Financial Services Chairman Spencer Baucus, R-Ala., noted in a report on the anniversary of Dodd-Frank:
“Requiring greater margin and capital requirements on companies that never got in trouble leads to fewer jobs. It’s going to lead to greater volatility in food and energy prices, and a loss of capital investments.”
But one wonders if Baucus and his other colleagues on Capitol Hill understand just how negative the impact is on the existing housing sector with legal constraints like Basel III and Dodd-Frank. The increased capital requirements of Basel III and the specific sanctions on housing assets alone are sufficient to push activities such as mortgage conduits into the nonbank sector, as we learned at HousingWire’s REthink Symposium. As one Washington insider observed to me over dinner recently, the net effect of Dodd-Frank is going to be the expansion of the nonbank, gray market financial sector, which is precisely where a large part of the subprime crisis began. As the House report on Dodd-Frank observes:
“The Dodd-Frank Act compounds the government’s disastrous foray into housing policy. First, the Dodd-Frank Act simply overlooks the proximate cause of the financial crisis: the government’s efforts to support an affordable housing policy through the government-sponsored enterprises Fannie Mae and Freddie Mac. Hundreds of billions of dollars into the GSE bailout without end, there is nary a word about the GSEs in the 2,000-plus pages of the Dodd-Frank Act. … While government becomes the biggest source of consumer credit in the United States, the Dodd-Frank Act hobbles the private mortgage market through onerous regulations with unintended consequences, thereby ensuring that housing will remain in limbo for some time to come, as investors, securitizers and lenders try to navigate its cumbersome and unworkable rules.”
Dodd-Frank also impacts manufactured homes, which are usually financed via high-cost mortgages. The law creates a new standard for a “high-cost mortgage” loan which is based on interest rate spreads that fluctuate over time. A July 2011 report from The Manufactured Housing Institute states that “the law does not prevent ‘high-cost mortgage’ loans from being made, but it does make it more difficult to make these loans, and it imposes a significant level of potential legal liabilities making them virtually impossible to securitize.”
Manufactured homes are typically sold to subprime borrowers, thus the double-digit coupon for financing some of these affordable dwellings. Many borrowers in America today are in fact subprime borrowers, but neither Dodd-Frank nor Basel III recognizes this fact. Instead these prescriptive regulatory regimes are intended to choke off lending to precisely those people and markets that need credit.
Until these misguided initiatives are reversed, the outlook for the housing sector and the banks which support it with financing will remain under a cloud.
