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
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 boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
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