The year 2014 is shaping up to be a transitional one for the residential mortgage industry. Home prices are likely to continue to improve, albeit more slowly than over the past 24 months, when the narrowing of the spread between real estate-owned (REO) and retail sales was the biggest driver of visible home price appreciation (HPA). Thousands of pages of new rules and regulations (care of the regulatory experiment known as Dodd-Frank) will go into effect. Banks will continue to shrink their mortgage lending and servicing operations, and non-banks will continue to grow. A lot of people and infrastructure deployed to deal with distressed loans and mortgage refinancing will be repurposed to serve performing assets and new mortgage originations. But the process of making these necessary operational changes over the next year is likely to be a bumpy road filled with challenges.
The U.S. housing market, a critical driver of the economic recovery, is showing increasing signs of improvement. In many markets throughout the United States, prices are rising, construction crews are finally starting to build again and distressed sales are falling. While most analysts expect home price appreciation to slow in 2014, the gains made over the past two years seem real and sustainable. The one caveat to this upbeat assessment, however, is that the new laws and regulations put in place since 2010 are sharply reducing the availability of credit to consumers. The latest data from the FDIC (Q3 2013) shows that bank portfolios of one- to four-family loans are continuing to shrink.
The number of cash buyers of real estate is falling fast as the prospects for an easy buy-and-flip strategy are disappearing with the supply of bank REOs. While there remains a substantial supply of REO properties held by various U.S. government agencies–probably more assets than were held by commercial banks–the disposition of these assets is likely to occur at prices that are much closer to comparable retail home valuations than were the deeply discounted REO sales of the post-2008 period.
The January 2014 effective date of many of the regulations promulgated by the Consumer Finance Protection Bureau (CFPB) pursuant to the Dodd-Frank law is shaping up to be an unmitigated disaster for many organizations and individuals in the mortgage sector. The number of changes and arbitrary decisions imposed upon the industry by the CFPB are going to fundamentally change the economics of the lending business–one reason why so many banks and non-banks are shrinking or exiting the mortgage lending arena. Some firms have operated in the distressed servicing business for years have been able to adapt quickly, while many other firms focused on performing servicing and loan origination have not been so fortunate.
Implementing new operational standards with respect to issues such as ability to pay, debt-to-income ratios, record keeping, diversity, and fair lending is causing lenders and servicers alike huge headaches and costs. For many smaller firms, the solution will be to partly or entirely withdraw from mortgage lending. Unfortunately, Dodd-Frank and the regulations issued by the CFPB do not address the financial crisis at its core, and instead penalize both lenders and consumers operating in the residential mortgage market.
Under these laws, lenders are encouraged to originate “qualified mortgages.” These low-risk loans include those backed by the Federal Housing Agency (FHA) and the Veterans Administration (VA), conventional loans bought by Fannie Mae and Freddie Mac, and some “portfolio” loans, which are mortgages that lenders originate and then keep. But qualified mortgages exclude many of the mortgage-loan options that have been available in the past. The terrible irony of Dodd-Frank is that it seeks to address the misdeeds of Washington and Wall Street by reducing the availability of credit for American consumers at both ends of the credit spectrum. The people and companies in the mortgage sector are paying the price for this experiment in social engineering with lost jobs and economic opportunities.
Literally tens of thousands of mortgage professionals have lost their jobs and their livelihoods over the past year due to Dodd-Frank and the new CFPB regulations. And the process of employee redundancies and changes to existing mortgage businesses at both banks and non-banks is ongoing. Some of the largest banks in the U.S. have already provided guidance to investors of double digit reductions in mortgage lending volumes in 2013.
Residential loan origination volumes are likely to drop more in 2014, suggesting that the recovery in the housing market is waning. Key indicators such as the Mortgage Bankers Weekly Application Survey are down almost 50 percent compared with a year ago. The most recent earnings results from large banks such as JPMorgan Chase, Citigroup and Wells Fargo confirm that the mortgage market is undergoing significant structural change unrelated to interest rates or other short term factors. Leading housing analysts such as Michelle Mayer at Bank of America are cutting back estimates for HPA in 2014. Indeed, Meyer believes that Q2 2013 was the peak in home prices for this cycle.
Because of the punitive capital and liquidity rules of Basel III, most commercial banks will no longer touch a new one- to four-family mortgage loan with a FICO score below the mid-700s–loans that will generally require a 50 percent capital risk weight. Non-agency loans will have capital risk weights of twice that for agency-qualified loans held in portfolio—in addition to Basel III penalties for liquidity. These higher capital requirements (coupled with an extremely hostile regulatory environment) are driving major banks toward significantly reducing their headcounts.
SunTrust Bank, for example, just exited the wholesale lending business, which means that there are no longer any major U.S. banks in wholesale lending. Wholesale was traditionally a non-bank business, but the major commercial banks came to dominate the sector over the last 15 years. We are now coming full circle, with non-bank lenders acquiring valuable wholesale lending teams from banks.
The changes in risk preferences dictated by Dodd-Frank and Basel III for commercial banks have enormous implications for the mortgage market. Real estate professionals, for example, know that their clients are having a tough time getting loans from commercial banks, so this creates a big opportunity for non-bank firms willing to work with prime and below-prime customers. Over the course of 2014, look for more non-bank lenders to expand their lending operations into market segments that commercial banks are unwilling or unable to serve.
As we head into 2014 under enhanced regulatory scrutiny, growing uncertainly concerning mortgage rates and varying predictions for what the future might hold in terms of home prices, one thing seems relatively certain. The mortgage industry is headed toward a bit of a shake up. Non-banks will continue to grow market share as commercial banks shrink, both in terms of lending and loan servicing. It is worth recalling that Wells Fargo, still today the market leader in both categories, actually withdrew from mortgage lending in the early 1990s. Though we have yet to fully realize (or in some cases even imagine) the possible business and economic implications of having stricter regulations, increased liquidity requirements, and a related shift in bank and non-bank players, these events are sure to change the face of lending for some time to come. And while there are a number of things the industry is already doing to prepare for what is to come, it remains difficult to forecast what awaits us around each and every bend. As these changes continue to take shape moving forward, perhaps our best course of action is to simply buckle up and hold on.
Christopher Whalen is executive vice president and managing director of Carrington Holding Company LLC. Christopher is also the author of the book, Inflated: How Money and Debt Built the American Dream, now in a second printing from John Wiley & Sons. He may be reached by e-mail at [email protected]
or visit www.rcwhalen.com.