The Next Housing Bubble

The Next Housing Bubble

A bid to get banks to lend more to subprime borrowers will fail because of new regulations.

“Only after the speculative collapse does the truth emerge.”

—John Kenneth Galbraith

Is President Obama trying to reflate the housing bubble? Zach Goldfarb of the Washington Post recently reported that the administration “is engaged in a broad push to make more home loans available to people with weaker credit.” The story cites officials who say this approach “will help power the economic recovery,” while skeptics warn that it “could open the door to the risky lending that caused the housing crash in the first place.” Yet next week, a meeting is scheduled at the White House where Obama will reportedly ask the largest banks to “open the spigot” for new mortgage lending.

The pipeline to consumers with lower credit has indeed been reduced to a trickle. Laurie Maggiano, director of policy for the Treasury's Homeownership Preservation Office, told attendees at a recent summit sponsored by Housing Wire that, while the housing crisis is in full recovery, consumers continue to lack confidence. “Between 2007 and 2012, new home purchases dropped 30% for those with a FICO score over 780, said Maggiano,” according to Housing Wire. “In that same period of time, new home sales dropped 90% for borrowers with a FICO score between 620 and 680.” These declines in lending volumes are the result of various new laws and regulations that are supposed to limit risk and protect consumers. But does anyone in Washington really understand how Basel III, Dodd-Frank, and various court decisions and settlements have impacted housing finance?

The fact that home mortgage loans are hard to come by is not news to most Americans, but within the Obama White House and in Congress it is apparently a revelation. President Obama spent his first term ignoring the housing market meltdown. Then treasury secretary Timothy Geithner went so far as to say that, because of concerns about “systemic risk,” executives of the largest banks couldn’t be prosecuted for securities fraud, the key cause of the 2007 financial meltdown. This “stay out of jail” card apparently included Geithner’s political sponsor and predecessor at Treasury, Robert Rubin, who watched the failure of Citigroup from the chairman’s office but said under oath he did not know of the bank’s problems.

The primary thrust of Washington policy since the crisis has been to raise capital requirements for banks and otherwise convince lenders not to make subprime mortgage loans. But now, with tax credits and loan refinance programs pretty much done, mortgage volumes are falling fast, this even as Americans celebrate a 10 percent rebound last year in home prices. Obama’s newfound enthusiasm for home ownership comes because estimates for new loan originations in the U.S. mortgage market are in a precipitous decline, from $1.7 trillion in 2012 to $1.4 trillion in 2013 and perhaps below $1 trillion next year.

The new Basel III capital rules and Dodd-Frank “reform” legislation discourage banks from making all but the least risky mortgage loans. Yet the systemic risk profile of the top institutions remains unstable. FDIC Vice Chairman Tom Hoenig noted in a speech last week that despite the higher capital standards implied by Basel III, the effect is largely an illusion in terms of reducing the riskiness of large banks. The biggest banks use the complex risk weighting process to conceal real hazards that only the traditional leverage ratio, long championed by the FDIC under former Chairman Sheila Bair, exposes.

“Using this leverage ratio as our guide, we find for the largest banking organizations that each dollar of assets has only 4 to 6 cents funded with tangible equity capital,” Hoenig notes, “a far smaller buffer than asserted under the Basel standards.”

The combination of Basel III, the consumer protection provision of Dodd-Frank and the settlement by various state attorneys general to address “foreclosure abuse” (committed by the very same large banks) has radically changed the landscape of the mortgage-finance industry. The new “qualified mortgage” regulations promulgated by the Consumer Financial Protection Bureau (CFPB) essentially ensures that the bottom 50 percent of American consumers will have virtually no access to home mortgages other than through government-subsidized loans. The market for private-label mortgages is virtually non-existent, although institutions such as Redwood Trust, Credit Suisse and JPMorgan have issued a few securitization deals. These deals involve prime loans with low loan-to-value ratios that are hardly typical of the average U.S. mortgage. More importantly, these deals are probably not profitable to the issuers. Total private mortgage-securities issuance in 2013 will probably be less than $50 billion.

The current situation regarding the trends in the U.S. mortgage market is bad enough. But over the next three years the combination of Basel III, the badly considered CFPB rules and the huge legal and operational cost of dealing with legacy mortgage issues is going to drive most commercial banks out of the residential-mortgage business entirely.

Jay Brinkman, chief economist of the Mortgage Bankers Association, noted in a presentation to American Enterprise Institute that the cost to a bank to originate a new mortgage loan is over $5,000 today. This amount is twice the average income to the bank from the same loan and several times the pre-crisis cost. Just imagine how financial markets will react when Wells Fargo, the largest U.S. mortgage lender, announces its withdrawal from much of the mortgage business. (My friend Mark Fogarty, veteran mortgage-market watcher at Source Media, reminds us that Wells actually did drop out of the mortgage business in 1990 after the S&L crisis.)

The deteriorating economics of the lending business for banks is already visible in the loan-production data cited above. U.S. banks’ portfolio of mortgages known as 1-4 family loans is essentially flat—this as media reports trumpet the recovery of the housing market. In fact the rebound in U.S. home prices has generated no net increase in bank credit for the housing sector. Sales of loans by banks to the various federal housing finance agencies are also falling, begging the question as to the nature of the supposed recovery. (You can see many of these charts in a recent presentation I made to AEI.)

My view is that the observed increase in home prices around the United States has less to do with a traditional economic recovery and more to do with reduction in the vast flow of distressed loans and foreclosures that have dominated the U.S. housing sector for the past five years. No doubt Fed Chairman Ben Bernanke and his colleagues on the Federal Open Market Committee will be disappointed to learn that their massive expansion of the U.S. money supply is not producing the desired results. The “recovery” in housing is not normal, nor is it likely to endure unless job creation and income growth follows.

So when the heads of the largest banks meet at the White House to talk about the U.S. housing market, President Obama is likely to be disappointed when he asks them to open the credit spigot. Banks are constrained from writing all but the highest-quality mortgages, and this situation will not change unless major changes are made in Basel III and Dodd-Frank.

The mortgage settlement of the state attorneys general is another serious obstacle to increasing the flow of mortgage credit to American consumers. But nothing short of new federal legislation can alter the template that these aspiring governors have fashioned to advance their political careers.

But you can be sure that a year from now, all of the politicians who spent the past five years fretting about the abuse of American borrowers—during and after the subprime-mortgage bust—will be making political hay by talking about the dearth of mortgage credit. Such is life in the world’s greatest democracy.

Christopher Whalen is an author and investment banker who lives in New York. His website is

Image: Wikimedia Commons/Matthew Trump. CC BY-SA 3.0.