Why NAR Is Not Likely to Win the QRM Battle

Posted By 7DS April 21, 2011, Filed under: 7DS@ 11:08 AM

Courageous! But let's not forget they all died, to the man...

I have to imagine, given the focused readership this blog has, that most of you already know that NAR has been fighting a war against homeownership on multiple fronts in recent months. I’ve been doing the Chicken Little dance about these Federal issues for quite some time, after all.

One of those fronts is the “qualified residential mortgage” rule that various Federal regulators have now put forth as official proposed regulation (PDF) under the Dodd-Frank Act. (This post and this post have more background and information on the “QRM”.) In the last few days, we’ve seen NAR go to the mattresses over QRM; it is now fighting to preserve the mortgage interest deduction, fight the high down-payment rules that are baked into the QRM regs, and fighting to preserve Fannie Mae & Freddie Mac to name just three Big Issues.

But a couple of seemingly unconnected pieces of news makes me believe that NAR is rather unlikely to win the battle over QRM at least. It’s going against government, going against academic literature, and now going against market results. That’s not a #winning position, as a half-nutty drugged out Hollywood celebrity might say.

NAR Soldiers On

First, in case you missed it, the gist of NAR’s argument against the proposed QRM regulations is that it would wreck housing.

Here’s a post suggesting that home sales would shrink by a third under the proposed regs, which would require 20% downpayments:

Any time you can improve loan performance it’s a good thing, but to get these small levels of improvement, the market for home sales would have to shrink enormously, between 6.6 percent and 14.7 percent in the case of requiring a minimum 10 percent down, and between16.7 percent and a whopping 28.8 percent in the case of requiring a minimum 20 percent down. The market would shrink that much because requiring those higher down payments would drive huge numbers of households out of the market.

And here’s a letter that NAR, along with NAHB (Home Builders), Center for Responsible Lending (about whom I write about a bit in the AOL post linked to above), and Consumer Federation of America, sent to these Federal regulators:

This is not what Congress intended or what the data support. It is abundantly clear from the record that Congress created the concept of a QRM to provide strong incentives for prudent loan underwriting that takes into account several key factors and the way they are layered together – not to establish arbitrary down-payment requirements. Strong documentation, income to support the monthly payment for the life of the loan, reasonable total debt servicing loads, protections from payment shock, and prohibitions on high-risk loan features like negative amortization and balloon payments are the core underwriting factors that will lower the risk of default.

The reason why NAR is fighting so hard against the QRM, of course, is that the rule would likely devastate the housing market by driving demand out. Again, from the letter:

While we support a reasonable and affordable cash investment requirement, that requirement can be coupled with other underwriting features to ensure loan sustainability without unnecessarily narrowing access to credit. If the regulators impose a 20% — or even a 10% — minimum downpayment requirement as part of the new QRM framework, hundreds of thousands of creditworthy households will be excluded from homeownership because of the dramatic increase in the wealth required to purchase a home. Saving the necessary down-payment has always been the principal obstacle to buyers seeking to purchase their first home, particularly as homes have grown more expensive relative to incomes. Even with a substantial savings commitment ($3,000 per year), it would take a typical median income family (2009 real median household income in the U.S. was $49,777) 14 years to accumulate the cash needed to purchase a home with a 20% down-payment on a median priced home (approximately $170,000 in 2009 and 2010), assuming closing costs of 5% of home price. With a 10% down-payment requirement, it would take 9 years. This assumes a saving rate in excess of the current rate of 5.8%, one of the highest savings rates since the early 1990s. A high minimum down-payment requirement in the QRM will raise the cost of purchasing or refinancing homes unnecessarily and many will simply be priced out of the process—especially first time homebuyers who play an important role in a healthy housing market.

This is exactly the outcome I predicted for the last several months.

Going Against Government

Trouble is, fundamental to the idea of “sustainable homeownership” as proposed by the Obama Administration is the idea that fewer people buy homes — at a minimum, it means that fewer people buy homes under the same relaxed “unsustainable” standards of today. Otherwise, the phrase makes no logical sense. So NAR and its allies are faced with the daunting task of simultaneously saying “the bad old ways were bad, but we need to preserve them”. Just as a matter of logic, if 28.8% drop in transactions is a guaranteed horrorshow, but back in the Bubble, too many people who shouldn’t have bought a home bought one… what percentage is acceptable? 10% drop? 5% drop? 1% drop?

The agencies proposing the QRM rule are not rewarded for keeping homeownership levels high; rather, they are punished if banks fall off the cliff again, requiring yet another multi-trillion dollar bailout by taxpayers. The FDIC, the Federal Reserve, the SEC, and the Treasury all have a strong vested interest in protecting the banking system. (You may now commence railing against the greedy banksters and so forth and engage in conspiracy theories.)

Going Against Research

And as it comes to mortgage default, this is the research NAR is relying on. It purports to show that there is very little correlation between higher down payments and mortgage default:

A further analysis of this data shows that boosting down payments in 5% increments has only a negligible impact on default rates, but it significantly reduces the pool of borrowers that would be eligible for the QRM standard (see attached Chart). For example, moving from a 5% to a 10% down payment on loans that already meet all of the other QRM standards reduces the default experience by an average of only two- or three-tenths of one percent. However, the increase in the minimum down payment from 5% to 10% would eliminate anywhere from seven to 15% of borrowers from qualifying for a lower rate QRM loan (see Table below). Increasing the minimum down payment even further to 20%, as some of the QRM regulators are proposing, would amplify this disparity, knocking 20 to 25% of borrowers out of QRM eligibility, with only small improvement in default performance of about eight-tenths of one percent.

Well, knocking out 25% of borrowers for a 2/10ths of a percent improvement seems ridiculous.

And yet, there be some problems.

First, any research being produced by a partisan organization — particularly one whose official website looks as if it was slapped together by a couple of out of work teenagers — needs to be beyond reproach to be taken seriously. I looked for the lengthier study itself, but could not find it, but this chart and the accompanying words confuse me:

NAR’s blog says, in regards to this research:

In an analysis of the performance of loans made between 2002 and 2008, loans on which the down payment is increased from 5 percent to 10 percent showed improvement of between 0.1 percent and 0.5 percent. No, those aren’t typos. The gains are that small.

There was a little bit better improvement when down payments were increased from 5 percent to 20 percent. Performance improved between 0.3 percent and 1.6 percent.

But what the chart appears to suggest is that the reduction in default rate in 2002 was 0.6% by going from a 5% to a 20% downpayment. In 2003, that was 0.3%, and so on. And the series stops in 2008. The foreclosure crisis didn’t really take off until sometime in late 2008, since the Housing Bubble burst sometime in 2007. Where’s the 2009 and 2010 data? Is that data unavailable, or did CMBP leave it out because it shows something else? (If the “Year” doesn’t mean the year of the default, but the year of the mortgage origination, and default rate was measured in 2010, then that’s a different story — but the research doesn’t say that. And that chart is a horrible way of saying that.)

Second, research by a lobbying organization has to deal with existing academic literature that suggests otherwise. The major study I’m familiar with (which happens to have great list of resources and papers and studies in this area) is by Todd Zywicki of George Mason University called The Housing Market Crash. In the paper, Zywicki finds that levels of home equity is the primary predictor of mortgage defaults:

As noted above, a primary factor driving foreclosure is the presence or absence of equity in the property. Thus, loans with little or no down payments (such as those with high LTV or mortgages combined with piggyback loans) offer an unusually powerful incentive to default if property values fall. Lower downpayments are correlated with higher rates of default and lower LTV ratios are reflected in lower risk premiums in interest rates. One study found that conventional mortgages with loan-to-value ratios at origination of 91–95 percent were twice as likely to default as loans with LTVs of 81–90 percent and five times more likely to default than those with LTVs of 71–80 percent. (Emphasis added)

Contrary to CMBP’s findings, it appears that going from 20% down payment to 5% down payment increases the risk of default by 500%, not 3/10ths of 1 percent.

Plus, there is this paper by the St. Louis Fed that strongly suggests that laying the blame for the foreclosure mess at the feet of loose lending standards, no-doc loans, and the like (that NAR is suggesting was the real problem) is simply incorrect. I’m not quoting this paper, because it’s full of formulas and economist jargon, but those interested can wade through it.

And here’s the New York Fed:

While our exercise is thus limited, our results confirm the finding from previous research that borrower equity is a critical determinant of loan performance, and strongly suggest that loan modification programs will likely be more effective in limiting foreclosures and avoiding “lockin” if they are attentive to borrower incentives to pay. (Emphasis added)

The idea that high homeowner equity doesn’t contribute to lower default rates is, to be sure, a novel one. And one that will need a lot more evidence than has been presented so far.

The Strategic Default Problem

What the Zywicki paper — and others like it — point out is the single greatest fear of lenders and bank regulators today: strategic default. Strategic default essentially upsets the moral underpinnings of debt, even secured debt like the mortgage on a house, in that the borrower makes a promise to repay the loan and there is a strong moral component to paying one’s debts. From the Zywicki paper:

Kenneth Lewis of Bank of America recently observed that while in the past, consumers would default only after falling behind on car payments, credit cards, and other debts, there has been a general change in social norms regarding mortgage default. Today, Bank of America reports a growing number of borrowers who are current on their credit cards but defaulting on their mortgages suggesting that “[a]t least a few cash-strapped borrowers now believe bailing out on a house in one of the easier ways to get their finances back under control.” This temptation is especially strong for those homeowners who put little or nothing down or borrowed against their home equity.

In this context, this little announcement by FICO Labs, in which they purport to have created a way to predict borrowers likely to walk away from their mortgages, is interesting:

The strategic default borrower, according to FICO Labs, is one with a reputable credit score, low levels of revolving credit, little retail balance and a short occupancy in their current residence. By these characteristics, the strategic borrower is money conscious, has a low probability of past defaults and has little attachment to their property.

I’d be curious to see if this new product does in fact predict such people; otherwise, all sorts of borrowers with good credit scores, no credit card debt, and no department store debt — in short, financially responsible folks — might suddenly find banks leery of lending to them.

We can go on and on, but the point is that there is existing academic research on the issue of equity and default; the Federal regulators are assuredly aware of them. One study by an interested party — a lobbying organization at that — is not dispositive, unless said study is ironclad.

Going Against the Market

And finally, all of the above would have been bad enough for NAR’s chances. Compounding the problem is this piece of seeming good news:

Wells Fargo reported record earnings of $3.8 billion, or 67 cents per share, for the first quarter of 2010. That’s up 48 percent from $2.5 billion for the same period last year, and up 10 percent from the $3.4 billion the bank brought in during the fourth quarter of 2010.

How did Wells Fargo achieve such a magnificent result? I mean, 48% increase in profits year over year is pretty good by any standard. Turns out, Wells Fargo wrote fewer mortgages:

The California-based lender’s first-quarter profit beat analysts’ estimates, but the market didn’t look too kindly on the underlying numbers that showed revenue was down $1.2 billion from the previous quarter. That decline included a $741 million drop in mortgage banking fee income.

While revenue slipped, Wells Fargo says its numbers were boosted by improving loan quality. The nation’s No. 1 mortgage lender was able to release $1.0 billion from its reserves set aside to cover expected loan losses.

Wells Fargo also disclosed that layoffs of full-time mortgage employees totaled 4,500 during the first quarter as both new lending and refinance activity took a hit.

Why is this bad news for NAR’s fight against QRM? So Wells Fargo is making fewer loans, getting rid of bad ones off its portfolio, and firing loan officers and such. So what?

The “so what” is this piece of news about one of its archrivals, Bank of America:

On Friday, Bank of America Corp. Chief Executive Brian Moynihan abruptly shook up his management team and accelerated a planned exit of Chief Financial Officer Chuck Noski, who spent less than a year on the job. The move came as the bank announced a 36% drop in first-quarter earnings, reinforcing Bank of America’s status as a laggard among major U.S. banks.

I like the phrase “accelerated a planned exit”. I suppose that has to go up there with “kinetic military action” as one of my favorite euphemisms of the year so far. In contrast to Wells Fargo, who increased earnings by 48%, BofA saw a 36% drop — hence, the panic firing of the CFO, shakeup of the senior management team, and a CEO under siege.

Why would that be? The answer in part is Countrywide:

Dragging on its profits is California lender Countrywide Financial Corp., acquired by Mr. Moynihan’s predecessor in 2008. Of all the problematic acquisitions in the financial industry, few have caused their buyers as much trouble.

The $4 billion deal ballooned the bank’s mortgage portfolio just as the housing market crashed. More than 85% of its 1.3 million mortgage customers from Countrywide are now at least 60 days behind on payments.

Read that last sentence again. More than 85% from Countrywide are delinquent.

Is it any surprise that the big banks are in support of the Federal regulations on QRM? That at least Wells Fargo wants the requirement to be 30% downpayment instead of 20%? Given the troubles that Moynihan is facing, and the robust growth at Wells Fargo, there isn’t a bank CEO who isn’t going to be reducing his exposure to mortgages. Improving loan quality is absolutely the key to survival for not just the bank, but for the CEO who likes his paycheck, perks, and private jet.

Conclusion?

You never know with politicos in Washington DC, but given the above, I’m finding it difficult to be optimistic about NAR’s chances of defeating the QRM regs.

Whether the regulators promulgate the QRM rule or not, the big banks will require high downpayments on their own initiative. What this QRM fight boils down to then, is an attempt by the big banks to impose costs on the smaller community banks who are going to have a tough time competing with the giants. And the regulators, having no incentive to allow for cheap mortgages under this Administration’s stated goals, but all sorts of incentives not to have another bank implosion under their watch, are going to be as risk-averse as possible.

Doomsaying is finished; you may now return to your regularly scheduled programming about Facebook lead generation.

-rsh

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