Much of the housing boom can be attributed to the current lending environment. Housing prices are an indicator of where things are going. But its tough to analyze lending since the stats are few and far between.

In other words: the cart before the horse.

I have long vented about the perils of weak underwriting standards and the pressures placed on appraisers by the structure of the lending system, namely collateral valuation (appraisals). A double hat tip to Barry Riholz for articulating this point so clearly in his post Is a Housing Crisis Approaching? [Big Picture] via the very good Roger Nusbaum post in SeekingAlpha.

Barry’s post is based on a seminal piece in Barrons about loosening underwriting standards by Lon Witter [subsc]. Roger adds another related link with great info [RGE Monitor] as well.

the U.S. has is a lending bubble. His evidence is how loose the lending standards have become, and why not? The banks ultimately just flip the loans to the Fannie Mae (Federal National Mortgage Association, on the NYSE: FNM), where foreclosures and defaults become the headache of buyers looking for greater risk and return.

(And if that doesn’t make you squeamish, simply look at the recent accounting scandals at Fannie Mae.)

Traditionally, Mortgages have been low risk lending, as the loan is securitized by the underlying property. When banks were lending less than the value of the property (LTV), to people with good credit, who also were invested in the property (substantial down payments) you had the makings of a very good business: low risk, moderate, predictable returns, minimal defaults.

Lenders have encouraged people to use the appreciation in value of their houses as collateral for an unaffordable loan, an idea similar to the junk bonds being pushed in the late 1980s. The concept was to use the company you were taking over as collateral for the loan you needed to take over the company in the first place. The implosion of that idea caused the 1989 mini-crash.

The problem here is: what happens if the values of homes begin to decline as inventory builds and rates rise? What does the lender do? They had better decide to start caring about values as well as credit in order to make intelligent loans. Underwriting standards have to rise to avert a lending crisis.

WAMU is the posterboy for weak underwriting. They built their growth and aquisition engine around mortgage lending during the housing boom. As mortgage rates increased and the housing market started to cool in the way of lower transaction volume, what department did they cut to save money? You guess it: The appraisal department. Recently they pulled completely out of the valuation process [Soapbox] and have begun to rely on appraisal management companies [Soapbox] exclusively, which are notorious for attracting the worst element in valuation. The appraiser who work for them are usually form-fillers and provide no analytical service. [Disclaimer: My firm worked for WAMU from the first days of their expansion in New York and saw the problems first hand. They recently jettisoned every appraisal firm across the country (we were one) as part of their cost-cutting move.]

Barry’s post analyzes WAMU’s market position in his post.

Right now, many mortgage lenders are still hanging in there, any way they can. I yearn for the day they actually want to understand what their risk is. Unfortunately, only a select few actually get this point.


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5 Responses to “Confusing A Housing Bubble For A Lending Bubble”

  1. frugal says:

    When loans on FNM’s book start to default, eating up its paltry reserve, government will need to bail FNM out, and bond market will have a huge collapse along with a $US crisis. Housing market after that is in the dead water.

    Hope it’s not that bad, but it appears to be where we are going.

  2. Sandy Mattingly says:

    I get what you are saying about declining loan standards generally increasing risks of default.

    But I don’t buy the junk bond analogy, at least as applied to Manhattan coop or condo purchases. Seems to me that the junk bond abuse was about issuing high rate debt to finance the purchase of an entity whose operating cash could not support the debt service, so (formerly healthy) entity cratered.

    For people who own a Manhattan loft, the key to their security is their income (backed by their wealth if they run into a temporary shortfall) – so long as they can continue to make the payments there is a sense in which the value of their apartment (even in a declining market) is irrelevant. Their wealth suffers, but not their ability to remain in the apartment.

    This assumes that they have not taken one of those exotic variable rate mortgage instruments, but I don’t see Riholz and Witter putting emphasis on the kind of loan, just the loan standards.

    I don’t have a source, but I remember reading something to the effect that Manhattan apartment buyers used funky loans less often than the national average (perhaps another function of the coop boards’ role as conservative gatekeepers??). Maybe you have some local data close at hand, JM.

    So I get it that the lending industry may be in for a tough time due to changed standards. I am not convinced that it means tragedy for people who already own an apartment that they can afford to carry, until those folks have to move – especially if they have to move up in the market.

  3. Jonathan J. Miller says:

    Sandy, your paragraph 1 discussion sounds eerily like the disparity between rental income and sales value.

    The real issue here I think is the fact that a large portion of loans are not 30 year fixed and resets are going to play out if rates continue to climb (flat or down since July though). Nationally, if values decline in certain markets and rates rise, they will be unable to refinance. So its not just contingent on a sale. However, with economic conditions weakening (even though GDP was revised up a little from last month), it seems like rates will remain where they are and possibly decline next year if things get worse. Inflation is the wild card in that respect.

  4. Sandy Mattingly says:

    Are there any Manhattan-specific data about the mix of mortgages (between 30 year fixed, re-setting ARMs and other exotica)? It would be interesting to see if Manhattan apartment owners are more insulated from this kind of risk.

    For those homeowners facing rate resets, what are they waiting for?? A two percent swing in Old Rate to New Rate would be … what … about a 20% increase in P&I?? A 3% swing would be about a 35% increase, roughly, yes?

    If they are still on the sidelines, they either have the nerves of successful poker players or the naiveté of buyers who tell their seller’s agents how much they can afford to spend.

  5. Jonathan J. Miller says:

    Not that I am aware of. I was asked this question today from someone in academia doing research. As far as resets go, its tough to make the call. If you are in at 5.5% and rates are now 6.5% and you have 1 more year, do you increase your payments or do you ride it out and see. Its sure not clear what rates are going to do over the next year. What if rates drop?