One of today’s economic puzzles is why the Federal Reserve’s low interest rates haven’t spurred a stronger recovery. A partial answer lies in the beleaguered housing market, which is a crucial channel through which low rates operate. Although housing has rebounded, the revival has been muted by banks’ tougher lending practices. Low interest rates don’t matter if lenders won’t lend or lend only to ultra-safe borrowers. Fed Chairman Ben Bernanke often complains of overly tight mortgage credit standards. But some of the toughness turns out to be the unintended side effects of other government policies designed to punish banks for the financial crisis.
Down in the housing market’s trenches, the shift in credit standards has been stunning. At the bubble’s height, “we had times when banks were lending if you had a birth certificate,” says Maria Wells, a Florida real estate broker. Now, she says, banks are so obsessed with making safe mortgages that the approval process drags on endlessly, and lenders routinely make last-minute demands for higher down payments or more documents (proof of income, payment history). “Sometimes deals don’t close,” she says. “Half of our sales are all cash.”
That exceeds the national average of about 30 percent, but both figures dwarf a more normal 10 percent for all-cash settlements, according to the National Association of Realtors. This is one indicator of scarce credit. Another is the higher credit scores of successful borrowers. Scores on loans backed by Fannie Mae and Freddie Mac — the firms providing federal mortgage guarantees — averaged about 720 (on a 300 to 850 scale) before the bubble. Now that’s risen “sharply” to 760, says Harvard’s Joint Center for Housing Studies. Guy Cecala, publisher of the respected newsletter Inside Mortgage Finance, reckons that at least half the population would have trouble qualifying under present credit scores.
All this has muffled housing’s recovery. Although sales, prices and building are rising, they don’t fully reflect pent-up demand. Construction starts on new units remain less than 1 million annually when underlying demand is 1.7 million, figures economist Mark Zandi of Moody’s Analytics. Demand reflects the formation of new households (67 percent), the demolition of older structures (21 percent) and second homes (12 percent).
Superficially, the case for stronger growth has seemed airtight. Five years after the financial crisis, foreclosures have abated. Interest rates remain low. For most of the past year, they averaged about 3.5 percent on 30-year fixed-rate mortgages; now they’re about 4.4 percent. Affordability is high, as low rates and low home prices keep monthly payments down. And, finally, there’s this: About 90 percent of new mortgages are sold to government entities (Fannie, Freddie, the Federal Housing Administration and the Veterans Affairs Department). The originating lenders don’t seem to bear much risk if mortgages default.
Appearances, though, are deceiving. Originating lenders (often large banks — Bank of America, JPMorgan Chase, Citigroup, Wells Fargo) can still be forced to absorb the costs of default. After the housing bubble, Fannie and Freddie sued banks, claiming the lenders should take back bad loans that reflected negligence or fraud. Banks have repurchased or negotiated settlements on $95 billion of Fannie and Freddie mortgages, according to Inside Mortgage Finance.
“On this point, the banks are right,” says Laurie Goodman, an analyst at Amherst Securities Group and the Urban Institute, a think tank. “They feel they have residual risk [for defaults] even though they’re paying Fannie and Freddie to take the risk” through fees. Defaults pose other potential costs, including damage to banks’ reputations. To avoid these costs, banks have embraced a simple strategy: Lend only to super-strong borrowers unlikely to default.
Heavily dependent on credit, housing is straining to get it. The whole sector has moved from bubble to bottleneck. Its contribution to the recovery may disappoint. First-time and minority buyers especially struggle to borrow. “We all agree that credit was way too loose” in the bubble, says Goodman. “But credit is way, way tighter now than it was in 2002 and 2003” before the bubble, she says.
Maybe falling unemployment and rising house prices — both credit pluses — will ease the anti-lending bias. Maybe regulatory changes involving Fannie and Freddie will encourage lending. Or maybe not.
Public policy faces a contradiction. There’s a powerful impulse to blame banks for the financial crisis and to “make them pay.” Just recently, the Obama administration sued Bank of America, charging it with fraud in selling $850 million worth of mortgage-backed bonds. (The bank denied the charge.) These attacks remind banks of mortgage lending’s perils. “Every time a lender is publicly sued or flogged,” says Cecala, “makes it less likely they’ll loosen standards.” What’s politically convenient is economically damaging. Which do we favor?