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Q&A: AEI's Pinto wary of risk in boom's late stages

On Monday, the American Enterprise Institute released a new report detailing its National Mortgage Risk Index (NMRI). The index is a stress test of sorts, measuring the viability of nearly all government-backed loans originated since September 2012. The loans are measured against the onset of the financial crisis in 2007 as a stress event.

EdPintoWith the NMRI’s composite index matching its peak of 13.1 percent this past November, Ed Pinto, co-director of AEI’s Center on Housing Markets and Finance, is wary of its steady upward climb. AEI’s numbers paint a picture of a tug of war between government-backed mortgage agencies for subprime-loan share in the entry-level market — a scenario that Pinto said is unsustainable and "unconscionable. "Scotsman Guide News spoke with him to parse the numbers for potential causes for concern.

What do these November risk numbers tell us in simple terms?

There were jumps [in the risk indices] across the board. The composite risk went up about half of a percentage point year over year. All of our indices, except [the one tracking the] Rural Housing [Service], either set new highs or matched previous highs. The trend, as usual, was led by FHA (the Federal Housing Administration). Their risk index for the month of November stood at 28.5 percent. That has been going up about 1.5 percentage points a year for quite a number of years, so FHA is really the subprime leader in the housing market. For context, we define loans that have a risk score above 12 — which means they have a 12 percent likelihood of defaulting under stress — as being subprime. Ninety-three percent of FHA’s loans have a score above 12, so you can see how risky those loans are.

How much reason is there for genuine concern?

The mortgage-risk index that we’ve built is really measuring leverage. There are different kinds of leverage, but look at income leverage. How much house can you buy with the same amount of income? The Rural Housing Service has had no change in the risk index in the last six years and their debt-to-income ratio has actually gone down. The income leverage for FHA, on the other hand, has gone up — 60 percent of all of FHA’s purchase loans in November had debt-to-income ratios above 43 percent. Almost 30 percent of their borrowers are at 50 percent. Nearly a third of Fannie Mae’s loans are above 43 percent. That [one-third share] is up from about 12 percent in early 2013.

Now, why is that 43 percent threshold so important? Because in the beginning of 2013, the Consumer Financial Protection Bureau ruled that qualified mortgages needed a DTI of 43 percent or less. However, they exempted Fannie, Freddie, FHA, VA and Rural Housing from that rule. We call this “the patch,” and [government lenders] have taken advantage of it in order to greatly inflate income leverage.

The reason that’s important is because house prices can’t continue to go up faster than incomes and inflation forever. If you have a debt-to-income ratio, you have a limit, and eventually that limit becomes binding. But the patch takes that limit away, and so we see Fannie, Freddie and FHA giving loans to [borrowers with] increasing debt-to-income ratios month after month. Instead of a debt-to-income ratio providing friction against rising house prices, it’s in fact promoting rising house prices. If you ease credit during a seller’s market, which we’ve had since mid-2012, if it’s a strong enough seller’s market, there’s no more supply. You’re providing additional wherewithal to bid up the price of houses.

Instead of making housing more affordable, the patch is making housing less affordable. For one thing, it’s driving housing prices up — particularly at the entry level — much, much faster than incomes. On the low end, house prices are now $20,000 more [expensive] than they would have been if they had just gone up the normal amount without this affecting the market.

Is this level of risk at all comparable to risk levels we saw before the bubble burst?

I’ll be clear: The level of credit risk today is not as high as right before the bubble burst. However, the rate of real house-price change is running neck and neck with what started the boom in 1997 and continued until 2006, early 2007. The boom that has been going today started in 2012 and is continuing today. That boom has retraced the same boom that occurred last time up to about 2003. The nominal price-income ratio has retraced 53 percent of the drop that had occurred after the crash. We’ve reflated house prices.

People say, “Well, isn’t that good?” Well, the problem is, most of that reflation is happening at the low end of the market, the entry level. That’s the exact part of the market that has the highest-risk loans. The risk index for first-time buyers goes up month after month relentlessly, while the index for repeat buyers is absolutely flat over six years.

The danger is that house prices have gone up very rapidly at the entry level while first-time buyers buying these entry-level homes are highly leveraged. While I will admit that they’re not as highly leveraged as they were in 2006, there’s no end in sight to housing prices going up very rapidly. At some point — and we can’t say when it will happen — there will be a reversion. The longer this goes on, the more risky it is for those homebuyers. And, given the sheer level of price increase that has occurred and the high debt levels that these buyers have, we think that this could be a serious event. Not necessarily as serious as last time, but serious enough to really harm many first-time buyers who, whenever the loan occurs, might have got the loan within the prior three or four years.

Is there a viable solution, especially given that so many millennials are aging into prime first-time homebuying age?

The fix, we think, is simple. You let the patch expire on its own terms. You don’t extend it. The market will adjust to get back to 43 [percent]. We don’t think that’s going to substantially eliminate first-time buyers from the market. It just means that first-time buyers who are more capable of paying the prices that we’ve driven them up to at the moment will be able to buy houses with somewhat lower levels of risk. Our data right now shows that first-time buyers are about 55 percent of the market. That might go down a tad, but we don’t expect a huge change in that. The people who maybe don’t get a house at this juncture, do you really want them buying a house six years into a boom being as overleveraged as I just described? I think not. 


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