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   ARTICLE   |   From Scotsman Guide Residential Edition   |   August 2016

Heading Toward Another Fall?

“The Big Short” is a cautionary tale that the housing industry could be doomed to repeat

Heading Toward Another Fall?

It’s a safe bet that the vast majority of mortgage-industry professionals have seen the Academy Award-winning film “The Big Short,” which is based on the bestselling book by Michael Lewis. The core of the film revolves around analysis performed in 2005 by a hedge-fund manager, Dr. Michael Burry, on borrower-repayment patterns of mortgage-backed securities that were heavily laden with adjustable-rate subprime loans.

Burry believed these securities would begin to go bad once the first wave of interest rate adjustments began occurring in the second quarter of 2007. He also foresaw that these bad securities would eventually take the entire U.S. housing market down with them. Dr. Burry’s analysis led him to take a massive short position on the U.S. housing market by purchasing credit-default swaps against these specific mortgage-backed securities, hence the name “The Big Short.”

Dr. Burry’s short position did not cause the 2007 housing crash and ensuing Great Recession. He was, however, one of the first to recognize the danger posed by those bad securities as well as the numerous other factors at play. These factors included a lack of due diligence by rating agencies, loans with no income documentation — aka “liar loans” — and progressively lower credit-score requirements on subprime loans.

After the crash, numerous changes were made to prevent something like that from ever happening again. The biggest change was the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the creation of the Consumer Financial Protection Bureau (CFPB).

Dodd-Frank is a significant and historic piece of legislation designed to regulate every facet of the consumer-finance market, from applying for credit cards to purchasing homes and securing mortgages. The CFPB is charged with interpreting Dodd-Frank, writing rules based on this interpretation and enforcing these rules.

Cracking down

In the years since the crash, the CFPB has wasted little time enforcing Dodd-Frank. In fact, the CFPB website proclaims it has recovered more than $11 billion and offered financial relief to more than 25 million consumers from its inception through December 2015.

Many in the regulated industries, especially banks and mortgage companies, have gotten the message. Underwriting has been extremely tight in recent years, with only the most pristine borrowers surviving the rigorous credit and income checks of most banks.

According to the Ellie Mae Origination Insight Report, the average FICO credit score on denied applications for conventional mortgages fell below 700 for the first time in years this past January. The average denied FICO score was as high as 729 only three years ago.

Key Points

Three warning signs could point to a future housing-finance crisis

  1. High-risk collateralized debt obligations have been reborn as bespoke tranche opportunities
  2. New low-FICO,  low-income/employment home loans are beginning to appear
  3. Home Affordable Modification Program loans are redefaulting at high rates as the first wave of interest rate adjustments hits
  4.  

New danger signs

As tight as lending standards have been, several new developments hint that the danger of a big fall in the housing-finance market may not be fully in the past. First, Hollywood actually provided a little warning at the end of “The Big Short” stating that Wall Street last year began selling a new investment vehicle called a bespoke tranche opportunity, or BTO for short. A BTO is just another name for a collateralized debt obligation (CDO), the type of mortgage-backed security that created the conditions for the housing-finance collapse in the first place.

Second, new loans called asset-depletion loans, which accept subprime FICO credit scores down to 500, with no income and no job necessary, have recently become available. Asset depletion is a calculation that uses liquid assets to replace some or all of a borrower’s monthly income. This calculation generally considers the borrower’s total assets, rather than just the income generated by those assets.

If a borrower gets into trouble with an asset-depletion loan, it can actually eat away at the borrower’s assets until nothing is left. Granted these borrowers need sizable liquid assets to qualify, but if these high-risk loans become commonplace, and get securitized into BTOs, the industry could end up back in the same boat it was in during the years leading up to the housing crisis.

Third, redefaults on Home Affordable Modification Program (HAMP) mortgages are high. The HAMP program, created in an effort to keep people in their homes when massive foreclosures threatened the industry, tried to give otherwise eligible borrowers a second chance by cutting their interest to a 2 percent fixed rate for five to seven years. These low fixed-rate loans then convert to adjustable-rate loans for the remaining term.

Nobody wants a repeat of the past, even on a smaller scale, especially when the recovery is still quite fragile.

The vast majority of HAMP modifications were written in 2009 and 2010, and the first rate adjustments began in 2015. A report issued this past April by the Special Inspector General of the Troubled Asset Relief Program reviewed the performance of these HAMP mortgages after the initial rate adjustments. The report states: “As of January 2016, homeowners who received HAMP permanent modifications in 2009 redefaulted at rates ranging from 55 to 60 percent, and homeowners who received HAMP permanent modifications in 2010 redefaulted at rates ranging from 45 to 53 percent.”

Perfect storm

Although the housing market is not currently facing the same frenzy that led up to the 2007 collapse — after which as many as 9 million homeowners lost their homes — we could soon see a steep rise in foreclosures from redefaulting HAMP loans. In addition, with the HAMP program set to sunset at year’s end, many homeowners with outstanding HAMP loans have no backstop options if interest-rate hikes put their monthly mortgage payments out of reach — other than pursuing a short-sale, deed-in-lieu of foreclosure or a full foreclosure.

If we also see a wave of risky lending, through vehicles such as asset-depletion loans, it doesn’t take too great a leap of logic to speculate that the industry will suffer a rise in defaults from these loans. Nobody wants a repeat of the past, even on a smaller scale, especially when the recovery is still quite fragile.

In addition, as of this past February, 6.5 percent of U.S. homes are still underwater with negative equity, meaning we haven’t completely finished cleaning up after the Great Recession. Now is not the time to start speeding toward the next cliff.

• • •

Avoiding another housing-market crash will require diligence on the part of everyone in the industry. The CFPB must continue its efforts to clean up toxic loans left over from the past and lenders must not add to the problem by creating a new avalanche of risky mortgages — such as asset-depletion loans — in the pursuit of more business. Absent moderation, these new risky vehicles will just become the toxic loans of the future.

Originators also must resist the call to reduce or eliminate loan downpayments and continue to require borrowers to put some “skin in the game,” because unless everyone is invested in preventing the next crisis in the housing industry, no one will be truly safe. 


 


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