Is mortgage credit headed for a quality dropoff? Or is it already here?
Edward Pinto and Stephen Oliner of the American Enterprise Institute’s International Center on Housing Risk recently reported their analysis of nearly 21 million agency loans and noted several trends toward risk.
Among their findings: The National Mortgage Risk Index (NMRI) for the FHA and the Rural Housing Service continues to rise and peaked in June.
“Unless household income accelerates, then we will have to have an increase in [government] leverage from what’s already a high level,” Pinto said. The pair’s research covered 9.5 million purchase loans and almost 12 million refinance loans made from November 2012 until June 2016.
Another concern is the number of risky loans compared to the level conducive to long-run market stability. Low-risk loans accounted for just 37% of June’s volume. For first-time buyers, the low-risk share was only 23%.
Part of that is due to the continuation of credit easing. The largest share of loans—more than 40%—are classified as high risk, which is “not an indication for a stable market in the long run,” Pinto said.
Risk of defaults increases
With both the NMRI and loan volumes increasing, aggregate default risk—the combined effect of loan-level risk and volume—has been rising, with FHA accounting for more than half of the aggregate agency risk.
“We are seeing some pickup in the Fannie and Freddie loan volume,” Pinto said. “There is competition between Fannie and Freddie, but they haven’t made significant inroads into FHA.”
Demand continues to strengthen, both for composite agency purchase and refinance loans and first-time home buyers, Pinto said. Agency purchase loan volume in June was up 10% from a year earlier; volume for first-time buyers was up 11%.
“We are still away from peak, which is traditionally in August and September,” he said. “If you look at the peak from last year, indications are we’re going to break through that quite substantially this year.”
Setting up for future trouble
The bad news for buyers is that it’s a seller’s market, which diminishes affordability.
“We saw that huge run up in the late 1990s through 2006,” Pinto said. “We’ve retraced about a third of the drop that occurred from 2006 to 2012, so housing is becoming less affordable. That’s driven by the monetary policy of the Fed and easier lending through higher leverage, which creates the potential for damage down the road.”
One factor helping more people purchase homes is very low down payment requirements. Nowadays, 70% of first time homebuyers pay just 5% down. For repeat buyers, the median down payment is about 10% -- a historically low number, Pinto said – and for Ginnie loans, which account for almost 60% of agency first-time buyer volume, the median down payment is only 3.5%. The only category with substantial down payments are the repeat buyers from Fannie and Freddie.
Debt-to-income distributions also have been shifting higher as house prices outpace income gains, Pinto said. FHA has DTIs as high as 57%; the GSEs have some as high as 50%—figures that present long-term sustainability problems.
Same risk factors, different players
Oliner said the key risk factors for loan default are:
• Credit scores below 660.
• High debt-to-income ratios.
• Down payments of 5% or less.
Oliner said all three factors have been on the rise since 2013.
“An increasing share of loans have all these characteristics and are on 30-year terms,” Oliner said. “So with a low down payment and a 30-year loan, a buyer has very little equity going in and none for a long time afterward.”
In the past year, a shift to higher DTIs has been the principal driver of risk.
Nonbank lenders stoking trouble?
Additionally, the growing number of non-bank loan originators has contributed to the rise in overall risk, according the AEI experts.
“There wasn’t a lot of difference in 2012, but by time of the latest data, that gap [between banks and non-banks] had widened dramatically,” Oliner said. “Banks have been reducing risks, mainly by shifting away from subprime borrowers and lower down payments, while nonbanks have been lowering standards for every one of the risk factors.”
Not only are they offering riskier loans; they are offering more of them, with nonbanks having gone from a 28% market share of purchase loans to a 58% share.
When calculating aggregate risk, the refinance market brings up the curve because it generally brings in an influx of lower-risk borrowers. So while the present re-fi boomlet will contribute to a lower NMRI, Oliner said “that should not be taken as a rise in credit standards.”
Concerns spread across the map
Finally, Oliner noted, the rise in mortgage risk is quite widespread: More than 80% of states have seen increases.
Of those that have had a decline, most are states with very small populations. “Previously FHA benefited from poaching other agencies and increasing the quality of its pool,” Oliner said. With that happening far less, “the underlying riskiness of FHA loans is starting to be apparent in data and is rising in many states.”
Two of note are California and Texas. California has a problem with affordability, particularly in the San Francisco area, yet state-level MRI is close to the national average because California’s economy is doing well.
“But long term, house prices look high compared to fundamentals,” Oliner said. “Affordability is deteriorating.”
The level of risk in Texas is above the national average because low oil prices have hurt many of its localities.
“In the near term, there is substantial house price risk for Houston,” Oliner said. “Mortgage rates now are low, but they’re not likely to be so in the future. Texas is more like the nation as a whole. Affordability is eroding, but from a better point.”
Citing the decades of research his colleague Ed Pinto has done in housing and loan risks, Oliner concluded the report by pointing out that those who forget history are doomed to repeat it.
“This is a usual historical cycle,” he said. “We’re heading in a direction that is not going to end well unless we can cap leverage. It doesn’t help affordability.”
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