There is change in the wind regarding real estate mortgage financing for home buyers, but at present, no one seems to be confident that they know just what those changes will be. Real Estate sales and new home construction are vital to the health of the overall economy and the consensus seems to be that without a robust real estate industry, economic recovery will be difficult, if not almost impossible, to achieve in the short run. It is almost universally understood that the current economic downturn which began in 2008, was precipitated primarily by the mortgage meltdown. Although the first headline making news of the economic crisis was the failure of major Wall Street firms and the resulting “Wall Street Bailout” known as the seven hundred billion dollar Troubled Asset Relief Program or “TARP” which many regarded as just a government program to benefit investment firms and was often not closely associated directly with the mortgage market. The reality is that the Troubled Assets were “mortgage backed securities”. (Visit this authors Katy Real Estate, Cinco Ranch Real Estate, & Cinco Ranch Katy Texas website for more information on various topics such as this)
Countless articles and editorials have been published attempting to assign blame for the meltdown and resulting deep economic recession. Numerous proposals have been advanced to rectify the problem, but a realistic solution remains elusive. The truth is that the problem took many years to grow to a crisis situation and is extremely likely to take many years to correct. Rather than try to assign blame for the crisis or attempt to promote any specific “quick fix” solution, I think that it is useful to provide a perspective on what happened and how it happened. This perspective is coming from the observations of one who has been engaged in the real estate and home building industries for over forty years; not from an economist, government agency nor political party.
While we tend to regard the real estate mortgage market as we have experienced it over the past several years as “normal”, it is instructive to understand that what we have seen in recent years is not “normal”, but rather an aberation of of an historical view of mortgage financing. Prior to the Great Depression, long-term residential mortgages were relatively unknown and real estate was typically purchased for cash, or when financing was involved, a cash down payment of fity percent or more was required for financing the purchase of a home. The institution making the loan was a local bank or savings and loan association making the loan out of assets consisting of deposits by other customers of that institution and the note was retained by the institution making the loan and payments were collected by that institution for the life of the loan. After the Depression and World War II, the federal govenrment sought to stimulate the housing market and make it easy for returning veterans to purchase a home. Thus, the VA loan guarantee came into being and was quickly followed by FHA insured loans. Both programs served to enable vast numbers of buyers to purchase a home with less than a five percent cash down payment (in many cases with no down payment at all). These programs also introduced the concept of “long term” mortgage financing and extended the period of repayment to twenty years. At that time, the rate of home ownership was 43.6% and in a period of only forty years, that rate of home ownership soared to 64% and remained at that level for many years. Over time, private lenders (banks and savings and loan institutions) began offering long term mortgage financing and the down payment requirements for these type loans declined to an average of twenty percent. Down payment requirements for these loans were made available at less than twenty percent cash down payment for those borrowers who could meet strict financial underwriting criteria. There were now three avenues of financing available to would be homeowners. These were VA guaranteed mortgages, FHA insured mortgages and Conventional mortgages. All had their own distinctive advantages and disadvantages and their own qualification requirements, but regardless of the type mortgage selected, all had qualification requirements and financial verification procedures in place to assure that the borrower would, in fact, be able to repay the mortgage loan. Even with the introduction of VA loan guarantees and FHA insured loans, the loans made to individual borrowers were made from the assets of the individual institution making the loan and remained “on the books” of that institution. In the case of a default, that individual financial institution suffered a direct loss.
As home ownership and the price of housing soared over time, the demand for mortgage financing expanded beyond the ability of banks and savings and loans to meet the demand from their own assets and the “secondary mortgage market” was born. While the secondary mortgage market, which grew to mean Fannie Mae and Freddie Mac, did not actually lend money to individual borrowers, it did set the standards regarding qualification guidelines. Individual financial institutions came to be no longer lending their own funds on a long term basis, but rather “originating” the loan and then bundling the mortgage instruments and selling them to the secondary market. This greatly expanded the ability of individual institutions to make mortgage loans since their funds were quickly replenished and the liability no longer remained with the institution. The secondary mortgage market dictated the qualification requirements for mortgage loans since the guidelines had to be met in order for the loan to be purchased by the secondary market. An individual financial institution was not legally required to adhere to the “Fannie Mae guidelines” in order to make a loan, but those loans not meeting those guidelines could not be sold in the secondary market and would, therefore, remain on the books of the institution and count against the firm’s reserve requirements. In order for the secondary mortgage market to obtain the vast amounts of funds necessary to continue to purchase the mortgages generated by financial institutions, the mortgage backed security came into being. These mortgage backed securities allowed Wall Street firms to participate in the profits generated by real estate mortgages despite the prohibitions against their directly making mortgage loans. Over time, almost all financial institutions making mortgage loans packaged more and more of their loans into bundles sold to the secondary market, rather than retaining those loans. The “portfolio loans”, or those retained and serviced by the institution originally making the loan, grew to be a rarity and were often not competitive with other types of mortgage loans in regard to rates and terms. Although convential loans were not specifically guaranteed or insured by the federal government, virtually all mortgage loans became considered “federally related” loans and, therefore, had to comply with the Fannie Mae and Freddy Mac guidelines.
The government policies promoting home ownership to an ever expanding proportion of the population are a noble objective, but as is often the case, were pursued without regard to the law of unintended consequences. Almost every financial institution in the nation was virtually compelled to promote the government objective of expanding home ownership to ever increasing segments of the population or suffer substantial consequences from federal agencies and regulators. The ideal of promoting home ownership became more important than sound underwriting and business practices and those institutions that did not make those loans that promoted the government policies, were subject to severe penalties and sanctions and the avoidance of those sanctions became more important than sound business practices. Also, with the mortgages themselves having been sold into the secondary mortgage market and then packaged by the secondary mortgage market into morgage backed securities, the individual financial institutions were relieved of the possibility of loss from defaults. All of this worked extremely well so long as real estate values were increasing rapidly and in the event of a foreclosure, the entities owning the mortgages were left with an asset that was typically more valuable than the outstanding balance of the loan and the costs associated with disposing of the asset. Where the law of unintended consequences took over with a vengeance was when the values of the homes securing the mortgages not only stopped increasing rapidly, but rather began rapidly declining in value. The mortgages and the securities that they backed became what are now known as “Troubled Assets” and required a massive federal bailout to prevent the failure of financial institutions in general and a meltdown of the entire national economy.
Now that the immediate crisis is perceived to be past and the nation’s economy is showing some signs of growth, much attention by government agencies and regulators has become focused upon fixing the problem and more specifically in assuring that it does not happen again. The focus of these efforts are naturally directed at regulations regarding mortgage financing and extensive changes are expected in the mortgage finance industry. While massive changes are predicted and very significant changes have been proposed; even announced to be implemented April 1st of this year, few substantive changes have actually taken place as of this date. In order to avoid a repeat of the foreclosure crisis, the current administration and federal regulators have proposed changes that are almost certain to raise the interest rates and fees on mortgage loans; particularly low down payment loans. We have already seen some changes in FHA insured financing including the raising of required credit scores and a substantial increase in the monthly Mortgage Insurance Premiums for those loans. It has also been recommended that the required minimum cash down payment be increased from the current 3.5% to 5%. Other proposals include raising the requirements for non-government (conventional) loans to a required twenty percent cash down payment in order for the loan to be considered “qualifying” under the regulatory standards. Also, the proposed regulations may require that the financial institutions originating mortgage loans be required to retain at least five percent of the loans on their own balance sheets. There is also talk of eliminating Fannie Mae and Freddie Mac and letting the private sector provide its’ own secondary mortgage market although there has been no credible plan put forward as to how that might be accomplished.
Since the announcements of regulatory changes have been delayed (until when none seems to know), there is a great deal of uncertainty in the mortgage industry and each institution is left to try to predict what those specific changes will be and take steps to protect their assests by adopting practices that they believe will be in keeping with the new regulations they know are coming, but have no specific information as to what the regulations actually are. The guidelines provided to mortgage loan officers in the field by the institutional investors often change daily, if not more frequently, making it difficult for the loan originator to be confident that a borrower who is today “qualified” will actually be funded when it comes time to close the real estate transaction.
While we do not know what the specific changes will be, it is pretty much a certainty that mortgage interest rates will increase substantially from today’s historically low rates and that down payments and associated mortgage fees are very likely to rise noticeably. Higher cash down payment requirements will certainly shrink the pool of prospective purchasers of residential real estate and higher mortgage interest rates, coupled with higher fees and more stringent loan qualification guidelines will eliminate many more prospective borrowers; even those who are able to accumulate sufficient savings to make the larger cash down payments. The one absolute certainty is that substantial changes are coming. Exactly what those changes will be remains a mystery and are subject to change, even after they are announced. It has been said that “a camel is a horse that was designed by a committee” and it may not be far from reality to expect that changes to the mortgage finance industry designed by elected officials, government agencies and federal regulators are likely to resemble a camel rather than a horse.
Author, David Bell, is a veteran real estate expert with over 40 years of experience. You may visit his website at jdavidbell.com which focuses on real estate in the Katy Texas area which is just west of Houston Texas. In addition to Cinco Ranch Real Estate he lives in and specializes in Falcon Point Homes.
