The Housing Market's Biggest Hurdle

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Forget about optimistic headlines on the housing market.

Whether it's record low mortgage rates, improvement in the Case-Shiller Index, higher housing starts, or any other report, the headlines don't tell the whole story – and the story matters.

The real story is that the housing bubble was inflated by cheap and abundant mortgage financing and a sustainable recovery is only possible if that story has a second chapter.

But, that's not happening.

In fact, structural changes in the mortgage industry are about to make buying a home loan a lot tougher than it has been in the last quarter century.

Let's start with the premise that no matter how cheap a house is, and no matter how low interest rates go, nobody is buying anything if they can't qualify for a mortgage.

Or, if lenders decide to charge too high a rate because they're either not constrained by competition or they can't offload the mortgages they underwrite, how can there be a housing recovery?

The Changing Landscape in Mortgage Finance

Let's look at what's happening in terms of buyer qualification standards, competition in the mortgage industry, and lenders' ability to package and offload mortgages.

Lenders have been consistently raising standards for borrowers. Long gone are the days of the famously named NINJA loans, as in: no-income, no-job, no-assets, no-problem.

The primary reason standards have risen is that buyers of securitized loans crammed with mortgages have "putback" rights that force mortgage lenders to buy them back.

Fannie Mae and Freddie Mac, who ultimately bought hundreds of billions of dollars of mortgage-backed securities, have been forcing lenders to buy-back billions of dollars of non-performing mortgages.

In 2011, Fannie and Freddie demanded $33 billion in mortgages be bought back. That was a 10% increase over what they putback to lenders in 2010.

Basically, the standards by which lenders were supposed to judge borrowers were overlooked or fraudulently misrepresented. Other factors, like faulty appraisals, are also a factor in accessing the covenants that lenders have to abide by when they sell mortgages.

I'll come back to higher borrower standards in a moment, but the standards issue flows immediately into what's happening on the competitive landscape today.

Big banks not only got heavily into the mortgage origination business during the boom, they also bought mortgages that were already underwritten from "correspondent" lenders.

Correspondent lenders have contractual relationships with bankers that allow them to sell the mortgages they make to the banks, thus freeing up correspondents' invested capital to underwrite more loans.

Correspondent lenders are not depository institutions.

They are usually private companies that have their own capital to make loans or borrow money through what's called a warehouse line of credit.

Here's how it works.

A mortgage broker (an originator) will take an application for a mortgage and pass it along to an underwriter (who reviews the documents and approves the loan). The underwriter, usually a mortgage banker, will fund the loan from the warehouse line of credit he has, make the mortgage, and then sell it to a bank where he is a correspondent lender.

Fewer Correspondent Lenders Means
Less Competition

But, a lot of big banks are getting out of the correspondent lender business because the loans they bought from these lenders are being putback to them by institutions like Fannie, Freddie and insurance companies.

It is why Bank of America is winding down its correspondent relations and recently said it wasn't renewing "certain contractual delivery commitments" it had with Fannie Mae.

Fannie says that it cancelled the arrangement because Bank of America wasn't honoring its demands to buyback some $5.45 billion in non-performing mortgages. That spat is playing out in full public view and will have ramifications for the entire industry.

CitiMortgage, a division of Citigroup and the nation's sixth-largest residential mortgage wholesaler, on Feb. 1 said it would cease table-funding loans as it prepares to exit the wholesale origination business.

Metlife recently shuttered its home lending business after unsuccessfully trying to sell it.

Also, Ally Financial, which is in serious trouble, is presumably looking to get out of the mortgage business altogether, that is if it can't sell pieces of itself or itself entirely.

And just this week Wells Fargo, which has a 34% share of the correspondent market, sent around an internal memo (which was leaked to National Mortgage News) that it was dumping 86 third party originators they used to buy mortgages from.

That's bound to have an effect on the third party originating business since in the fourth quarter of 2011alone Wells bought almost $55 billion from third party originators.

These structural changes in the mortgage industry will reduce competition and ultimately increase the cost of money to buy a home.

It's not because there will be less money to lend. The end game is to eliminate the middlemen so the big lenders can fatten their profit margins.

And once there are only a handful of big players left offering mortgages, their pricing power will be almost monopolistic and undoubtedly raise the cost of borrowing for homebuyers.

Tighter Standards in the Housing Market

Back to buyer standards.

There's currently a heated battle going on to determine what a qualifying mortgage "QM" is and what a qualifying residential mortgage "QRM" is.

What the general guidelines need to be for each of these are being debated by regulators and industry insiders to make it easier for lenders to package "standardized" and qualified mortgages into security pools.

But, there's a huge problem with establishing a QM standard.

If the new standards are more restrictive, they will limit credit access to a wide cross-section of would-be homebuyers.

As a result, regulators are having a hard time determining what percent of defaults in the future might be prevented, as opposed to what percent of loans would be excluded under QM standards.

The QRM issue is all about an even higher standard of loan, that if met, wouldn't require the originator to retain a 5% interest in those loans as an additional reserve.

But these issues aren't even the industry's biggest problem.

Even now, there's still no resolution about the future of Fannie and Freddie.

They're supposed to be wound down, but they can't be. They are the ultimate buyer of the majority mortgages made and there is no private solution that is capable of replacing them.

And until there is, the battle over government intervention in the housing market will continue.

Yes, everyone wants to fix housing.

But, in an election year, are people going to be screaming for more taxpayer breaks for banks that originate mortgages and sell them to Fannie and Freddie so they can make more loans and profits while putting taxpayers at risk?

No matter what the headline news is about housing, the truth is unless there's an assemblyline-like fix down at the financing factory, don't count on a sustainable recovery in housing any time soon.

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Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. wim | March 23, 2012

    I live in Belgium and now I fully understand why you Americans have and will keep a long lasting housing and banking and government problem. This is all a big Ponzi scheme.
    I hope the hangover from moneyaddiction and poweraddiction after the next failed wars will sober most of you up.
    Good luck

  2. richard | March 23, 2012

    Solution: get the gov`t out of everything period end of problem!

  3. Paul | March 23, 2012

    Here's another Belgian's comment : I agree that the banking sector and dirty politics screwed up the "free" (meaning allegedly non-manipulated) US market, but then again so did the banking sector and even dirtier politicians in Europe. I believe that upcoming American politicians are first sent over to Europe for "training", so that they can better mess up things at home… After all, we've had far more centuries of "creative manipulations" in the home countries and the colonies !

    • JAMES OTTESEN | March 23, 2012

      I'm happy to hear all of the good advice our friends in Belgium have to offer. Just
      maybe, in spite of being the strongest nation in the world, we can learn a great deal from
      their observations AND experiences.

      Thank you.

      Jim

  4. Bob Wood | March 23, 2012

    If everybody with an "underwater" mortgage stopped making payments those greedy banks would quickly restructure (downward) and the NINJA mortgages would likely be written off. Let's all become "submariners"! United we can stand, independently we're drowning.

  5. Alex | March 23, 2012

    For four centures the banks provided loans based on callateral value. After the congress screwed up the first time by telling banks they cannot reject a person to own a home (especially, minorities), the second srewed up – by establishing unrealistic requirements for home loan and rejecting any tangible assets as collateral. Recently, I tried to get a $200K mortgage from BoA and Wachovia (Wells Fargo) – previously, both loans I took from these banks were paid off within five year period. I offered my two homes (both 100% paid off) appraised by the county $550K and $375K as collateral but since I'm self employed and do not have salary both banks rejected me in loan to buy rental property I was putting down 30% !! ($300K total, $100K in cash). In addition I have 810 credit rating – never in my life I delayed any payment on credit cards, etc. The question – what kind of banking business is it?

  6. David | March 23, 2012

    So why are all the housing stocks going up? Is this another major bubble? Thanks for the sober truth – sounds like no one is willing to take the risk any more, and that's the way it should have been from the beginning, then there wouldn't have been the housing collapse. Why has there been almost no financing in Latin America – because there was no institutional lending except at very high prices. So now the lenders here are having to accept the true risks of financing. Interest rates must rise as you point out.

    And when will the government get on board and stop subsidizing home ownership by ending the write off? Maybe when they come to accept that the deficit must come down?

  7. Mark | March 23, 2012

    To Wim above

    We might have a LOT of problems over here in the US that will go on for a long time,
    but have you heard of countries named Greece, Spain, Portugal, Irleand, Italy, etc…. I think
    you Europeans have enough problems of your own.

    • Dani Janes | March 26, 2012

      Asbsolutely right on. Why are so many Europeans trying to come to the US and Canada if it is so wonderful in Europe?
      It is certain that the American financial sector is too much of a free enterprise and an unregulated industry and needs serious restructuring.
      Unfortunately, in the last couple of decades the politicians and captains of the American industry were so greedy that they almost destroyed the international reputation of the US and the American way of life, namely inovation, management, manufacturing and democracy.
      However, I believe that the American spirit is not dead and that it will come back strong and shine brightly.
      Go America.

  8. Kevin Donnelly | March 23, 2012

    Surely the best analysis of the housing debacle to date.

  9. Fulon D Hill | March 23, 2012

    Let's say you go into a car dealer and ask how much is a particular car. The dealer demands a fee to even tell you. Then he is unable to tell you how much the interest rate on the loan will be until the deal is final. How many car dealers will you pay the fee to in order to compare and be sure you are getting a fair deal? Right. None. Unfortunately, this is the way real estate deals are done. Of course, if you are willing to pay an extra fee, they will "lock in" the current interest rate. Mortgages are the only product or service we buy without knowing the costs up front. After all the fees are added on and you sit down in the escrow office to sign the papers committing yourself to pay more than $100,000.00, if you take time to read the papers they get all impatient! BTW, the mortgage will be sold to someone else before you make the first payment, so you don't know who you are doing business with. Good luck.

  10. Citizen Tom | March 25, 2012

    I am all in favor of higher standards for residential mortgages, however, it would be a big mistake
    not to require the originator to retain at least a 10% interest in those loans. What we don't want is
    an originator to make a loan, and then spin it off to a third party with no consequences to the originator!
    In the old days, banks kept most of the loans they made on their own books. Can you imagine
    how carefully they vetted home buyers when they knew that those loans would remain as part of
    their loan portfolio?

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