Deja vu all over again: Fueling the next housing meltdown

Low down payments, risky mortgages guaranteed by government entities, rising defaults -- haven't we been here before? Isn't this the same mix of easy money and poor risk-management that blew up the housing market in 2007 and 2008?

You'd think the mortgage industry and the federal government would have learned their lesson since the housing bubble's collapse. But you'd be wrong. Essentially, nothing has changed, except the names of the government-sponsored enterprises.
Freddie Mac and Fannie Mae, the GSEs that fueled the great housing bubble of 2002 to 2007, melted down once a substantial portion of the trillions of dollars of risky mortgages they'd underwritten began defaulting. Now that taxpayer-funded bailouts have footed the bill, Fannie and Freddie are mere shadows of their former freewheeling selves.

In a rational world, mortgage lenders of all stripes would be tightening up requirements for lending and demanding old-school down payments of 20 percent. Putting down a fifth of the value of the home gives borrowers some skin in the game -- some exposure to the risk that the lender assumes by underwriting a mortgage in a still-shaky housing market.

Private mortgage lenders have indeed tightened up risk management, and are requiring 20 percent down payments, our Federal government is playing the same old housing-bubble game of allowing super-low down payments and guaranteeing risky mortgages.

The "new" lenders of last resort are actually old players pulled from the bench: the Federal Housing Administration and Ginnie Mae. While both have been underwriting mortgages for decades, their role in the total U.S. mortgage market has leaped from minor roles to dominant players.

Where FHA backed less than 3 percent of all new mortgages in 2006, its share of the business has ballooned to nearly one-quarter of the mortgage market. In August, mortgages from the FHA and the Veterans Administration (for qualified veterans) backed 40 percent of loans for all home sales.

FHA loans require down payments of as little as 3.5 percent. With an $8,000 Federal first-time-buyer tax credit, it's possible to purchase a $225,000 home with almost no cash out of pocket and gamble on future gains in housing equity. If your investment (and risk of loss) is essentially zero, then your leverage is off the charts. A few hundred bucks in closing costs might yield thousands of dollars in profits -- if housing prices start rising.

And if prices keep declining, then a newly minted FHA-guaranteed homeowner can walk away, with no financial losses, except a ding to their credit rating. Considering the potential upside, that's a risk-return ratio worth gambling on. And that's exactly what got us in the miss in the first place.

Judging by the skyrocketing default rates on FHA and Ginnie Mae–underwritten loans, it appears the Federal government has loosened lending standards, in a desperate -- and desperately misguided -- ploy to goose the housing market. According to the The Wall Street Journal and the Mortgage Bankers Association, 7.8 percent of FHA loans at the end of the second quarter were at least 90 days late -- about the same as national rates.

But as my colleague Lita Epstein recently observed, loan losses are eating into FHA's wafer-thin reserves. FHA is required to maintain a reserve level of at least 2 percent of loans, but it doesn't take a math genius to look ahead to see what happens to reserves when 8 percent of its mortgage portfolio is going south: Yup, another taxpayer bailout of yet another government-backed mortgage guarantor that overextended itself and trashed prudent risk management to flog a weak housing market higher.

When will we as a nation conclude that lowering down payments to near-zero, giving away tax money, and loosening lending standards are ultimately imprudent and counterproductive? What incentives are created by a "to heck with risk management" system, in which the moral hazard (risk) to play is cut to near-zero -- for both the borrower and the loan originator?

The incentives are all to play fast and loose with money that someone else -- the taxpayer -- is backing. If the current "housing recovery" is built on such shaky foundations, it won't take much to shake it apart again.

Charles Hugh Smith writes the Of Two Minds blog and is the author of numerous books, most recently Survival+: Structuring Prosperity for Yourself and the Nation.
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