Only a few weeks ago, we pointed out a remarkable development in the US mortgage market that has significant implications not only for mortgage borrowers, but perhaps the broader economy as a whole: Wells Fargo, formerly America's foremost mortgage lender, had seen its share of the market eclipsed by Quicken Loans - the Detroit-based, nonbank lending behemoth that pioneered applying for mortgages on the Internet with its now-famous Rocket Mortgage (readers will remember RM's celebrity-packed SuperBowl spot).
Many factors (aside from Wells' own criminality, which recently drew a strong, but ultimately meaningless, rebuke from the Fed) have contributed to this shift, as Bloomberg points out.
But as it turns out, the rising dominance of nonbank lenders like Quicken could portend a massive, bad-debt fueled binge reminiscent of the circumstances that led up to the housing crisis. That is to say, a wave of bad debt could create a cascading wave of defaults with repercussions far beyond the housing market.
Considering all the restrictions that Dodd-Frank and other post-crisis regulations slapped on mortgage lenders, one might wonder how this might be possible.
Of course, as Bloomberg explains, instead of making the market safer, regulators are inadvertently enabling the rise of lenders like Quicken who aren't bound by many of the rules that restrict banks' mortgage-lending practices. As a result, Quicken Loans is effectively free from many of the regulations that have forced some of the biggest mortgage lenders into a period of retrenchment...
Make no mistake, regulators have done plenty to rein in the mortgage business since the 2000s. New rules require that lenders carefully assess borrowers’ ability to pay, and that mortgage servicers -- which process payments and manage other relations with borrowers -- give troubled customers plenty of opportunity to renegotiate their debts before resorting to foreclosure. The Federal Reserve performs regular stress tests to ensure that banks have enough capital to weather defaults.
Problem is, the requirements have weighed most heavily on traditional, deposit-taking banks. The added hand-holding required in mortgage servicing, for example, has roughly quadrupled the cost of handling delinquent loans, turning them into major loss-makers. Together with stringent capital requirements, this has all but guaranteed that banks will lend only to people with the most pristine credit. In some cases, they have given up the business entirely: Late last year, Capital One announced it was exiting mortgage origination because it was “structurally disadvantaged."
Because they're not FDIC-backed, the shadow (aka "nonbank") mortgage lenders have much more latitude to approve mortgages to borrowers with lower credit scores. This is a huge advantage in a market where supply is limited, which has helped squeeze home prices to their highest levels on record - surpassing even the pre-crisis peak from June 2006.
As we've pointed out many times (but most recently last month), with home prices in 80% of US cities growing twice as fast as wages, American working- and middle-class families are finding it increasingly difficult to support their families - let alone afford a home.
Just the other day, we highlighted the cognitive dissonance between data showing US household debt of about $13.15 trillion, of which nearly $1 trillion is the credit card debt alone. Households, it seems, are truly on a dangerous debt binge. Yet, as the economists keep telling us, the US economy has almost never been in better shape...
...Of course, the reality is that the economy looks just peachy if you're a wealthy individual who owns lots of financial securities...
...This has accounted for the bulk of assets gained during the recovery, as the hart above illustrates...
Meanwhile, nonbank lenders are happily courting these already debt-burdened borrowers by signing the up for mortgages with higher interest rates, even though many banks - who will now only deal with borrowers with the most pristine records - won't touch these customers. This has caused the average FICO score for loan originations at these lenders to fall precipitously, as Bloomberg adds.
The non-banks’ growth has been breathtaking. At the end of 2016, such unaffiliated mortgage companies accounted for more than 40 percent of new conventional mortgages (those eligible for sale to government-controlled guarantors Fannie Mae and Freddie Mac), twice the share they accounted for just eight years earlier. They’re also responsible for a decline in credit standards: The average FICO score at origination stood at 730 at the end of 2017, down from 750 five years earlier. For loans guaranteed by the Federal Housing Administration -- an area where the non-banks’ share is greatest -- the average FICO score has fallen to 680.
And the shift has been even more extreme among companies that provide mortgage-servicing...
The shift has been even more extreme in mortgage servicing. Non-banks now service about 51 percent of all loans packaged into new Freddie Mac securities, according to mortgage analytics firm Recursion Co. That’s more than double the share of just five years ago. For securitized FHA loans, the share stands at a staggering 83 percent. Again, banks are leaving the business: Last year, CitiMortgage announced it would exit by the end of this year, transferring the servicing rights for about 780,000 mortgages.
Quicken Loans and its ilk might argue that their gains are a result of their cutting-edge technology (offering mortgages over the Internet?, the banks say. Why didn't we think of that!). But this simply isn't true.
What accounts for the non-banks’ appetite? They might argue that their processes and technologies give them greater confidence in their underwriting. But one can’t ignore the reality that, thanks to relative lax regulation, they also have less at stake. By operating with less capital, they can reap very large returns in good times. In bad times, however, they might not have the capacity to withstand losses or deal with the servicing burden created by widespread delinquencies. As a result, a large swathe of the country’s lending and servicing system could implode when the next crisis hits.
The only sensible solution, Bloomberg posits, would be to level the playing field by adopting additional regulations specifically aimed at these non-bank lenders. But this, too, would come with risks that could potentially harm consumers...
The only solution is to level the regulatory playing field between the banks and the non-banks. This means raising capital requirements for the latter, and subjecting them to stress tests. Difficult as this might sound, the Dodd-Frank financial reform legislation actually created an institution tailor-made to handle such systemic issues: the Financial Stability Oversight Council. The council should put non-bank mortgage lenders at the top of its agenda this year.
Of course, given what looks like a market peak, this might not be such a bad thing...
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Another factor enabling this expansion is the continued dominance of Fannie Mae and Freddie Mac. All together, Fannie and Freddie guarantee some $4 trillion in residential mortgages, accounting for some 40% of the US market. And as we pointed out late last year, the hope that the two mortgage giants - which were nationalized during the crisis following a $187 billion taxpayer bailout - could be wound down under federal oversight has all but vanished.
Today, Senators on both sides of the aisle have concluded that they are too big and too risky to replace. Proposed legislation in 2018 will see them maintain their position as the beating heart of the US mortgage industry, rather than replacing them, like the Senate tried and failed to do four years ago.
Once again, government regulations - that were intended to protect consumers - are instead creating the unintended consequence of making consumers increasingly vulnerable to the same types of predatory lending practices the regulations were initially designed to stamp out.
We didn't think so...