The “State” of Affairs in Mortgage Lending

by Brian Pretti CFA, Contrary Investor. June 22, 2007

Late in 2005, I wrote extensively about OCC (Office of the Comptroller of the Currency – US bank regulator), then suggested guidelines regarding mortgage-lending practices for the banks in this country. The reason it’s important to keep tabs on the OCC is that they lead real world occurrences or economic outcomes in a very big way in terms of time. Again, I first brought up, illuminated and discussed important suggested mortgage lending guidelines by the regulators in late 2005, but as it turned out, it was really summer to fall of 2006 when these guidelines were ultimately implemented after what was one heck of an extended comment period for the industry. In other words, had one been listening to and watching the OCC, one could have seen the peripheral tightening in macro mortgage credit availability coming much more than a mile away. Of course, one could also have anticipated the change in housing market dynamics that was to come as a result of credit market change. It's one of the main reasons I've spent so much time reviewing housing market stats over the last year and one half.

So now that the downturn in real world housing and the already implemented tightening in bank related mortgage credit underwriting has occurred, the worst of macro credit market dynamics related to housing is really behind us, right? I wish I knew the answer, but for now, I'm still listening. So I thought it important, in light of what has already occurred over the past year and one half in both the housing and mortgage lending industries, to share with you some thoughts based on a recent speech by John Dugan. Who's John Dugan? He holds the position of Comptroller, that's all. I'll cut right to the bottom line. Dugan gave a speech a few weeks back that basically translate to the fact that the OCC is not done tightening mortgage credit guidelines for lending institutions. Directly between the regulatory crosshairs at the moment are stated income loans. If you'd like to read the speech for yourself, have at it at http://www.occ.treas.gov/ftp/release/2007-48a.pdf. But I'll give you the highlights right here and tell you what I believe to be the very important issues set against current mortgage lending experience.

Dugan said such uses of stated income lending should be the exception, rather than the rule, for three key reasons:

Stated income is too great a temptation for misrepresentation and, in its most extreme form, outright fraud.
The practice also undermines transparency: "How can lenders seriously talk about debt-to-income ratios, for example, if the denominator of 'income'; is really an unknown variable that can be whatever the borrower says it is?", (he asked).
It is not a safe and sound underwriting practice to make mortgage loans that substitute future house price appreciation for borrower income as a key source of repayment, as appears to have been the case in many sub prime loans underwritten in the last few years.

Again, what's above is a very brief recap of the important issues from Dugan's speech. But the important point in this whole listening exercise is that stated income lending is the next attack point for the regulators in their ongoing scrutiny of mortgage lending. It's clear as a bell. And given the history of OCC commentary and ultimate translation into real world outcomes, we should expect yet another round of bank related mortgage credit tightening later this year, possibly by the end of summer. Be prepared because it’s coming. And why is this important? Because we're now looking at future tightening of credit standards migrating up the mortgage credit food chain. As I've discussed in the past and as you know from listening to the mainstream financial media, pundit after pundit has proclaimed that mortgage credit problems of the moment are contained and sub-prime woes are not about to seriously injure either the housing industry or macro US economy. But the key issue in my mind is that Alt-A lending has simply been a breeding ground for low and no-doc lending.

Over a year ago, I dedicated virtually an entire discussion to a study done by First American. I want to go back and dredge up some of this data related to the character of Alt-A lending. First, please be aware that the First American data is through the year 2005, so we are missing 2006 to date experience. But importantly, here's the macro character of Alt-A lending at that time that surely still has implications today.

Character Point	% Of Alt-A Loan Market
ARM share	64%
Interest Only	28
Negative Amortization (Option ARM)	30
Piggy Back Loan	54
No/Low Documentation	81
Prepayment Penalty	48
Non-Owner Occupied	22

As you'd guess from looking at the data above, no and low documentation loan share of the Alt-A market is the critical issue of the moment in light of current OCC scrutiny. This is basically "stated income" loan territory, the next ground zero for regulatory focus. You get the picture. In a nutshell, Dugan's comments that really represent broader OCC thinking are telling us what's to come. Of course there will be the obligatory comment period where the homebuilding and lending industry can rant and rave. But much like original guideline tightening of last year, the ultimate finality of guideline results from the OCC in the summer of 2006 were extremely close to the original OCC concerns and proposed guidelines handed down in late 2005. So as we look ahead, we expect stated income lending to be under full attack by the OCC come the latter part of this summer. Dugan was simply kind enough to give us full warning. So is mortgage-lending tightening contained to sub prime? Not if you are "listening" to Dugan. As I've said many a time, the bottom calling for the industry and for the mortgage credit markets will continue unimpeded. It flares up again every few weeks. But what's to come later this year in terms of further credit tightening will not at all be a help to those not just looking, but needing to refinance loans resetting at ever higher rates, let alone engage in new purchase activity. Mr. Dugan, thanks for the heads up. We're listening.

As a quick note, in recent weeks a number of consumer groups have called upon the Fed themselves to take action in "stamping out mortgage lending abuses", inclusive of requiring proof of income from borrowers. As you'd guess, a few politicians have even joined along in the chorus. But as we all know, the time for the Fed to have taken action, if you will, came and went years ago. Even former Fed Governor Ed Gramlich, of course trying to distance himself from this issue, hit the tape recently in stating that he brought up to Greenspan the idea scrutinizing lenders back at the turn of the decade. Supposedly Greenspan dismissed Gramlich's proposal. Nonetheless, we continue to see regulators swinging into action now that the damage has already been done. The important point being, this swinging into action, as least per what I expect to come from the OCC this summer, will only prolong the slide in housing.

I'll leave you with a few last charts that dovetail into this warning from the OCC as to what's further to come. As I look at the complete housing cycle and the dynamics of the most current cycle, credit availability and terms of that availability are only half the story. The other half is price. Of course credit availability and terms drove housing prices, so it’s a bit of a chicken and egg scenario here. Nonetheless, as mortgage credit terms and conditions are continually rationalized, as clearly is the ongoing case here as per our friends at the OCC, we need to remember to focus on the dynamics of price.

Having said this, let's take a quick birds eye overview of the very long term as it pertains to anecdotes of price. First, chronicled below are household real estate values as a percentage of disposable personal income. In other words, relative to changing household income over time, where are prices (values of residential real estate)? To be honest, the charts speak for themselves. Set against income, prices (the Fed's definition of market value of real estate) currently remain at unprecedented levels. I've tried to draw in the long term up channel in this relationship.

Finally, a look at household residential real estate values as a percentage of GDP. Very simple as I'm just trying to get a sense for long term asset class pricing relative to what is the solid benchmark of ongoing GDP growth. Is it fair to say that virtually never has residential real estate been more important to the US economy than has been the case in the last few years? That's a completely fair statement. Again, you can see the attempt to accurately draw in the long term channel. Just as a comparative measure, you may remember that in the late 1990's, the value of the US equity market as a percentage of GDP peaked near the 180% range.

If I had to guess, I'd say both of these relationships ultimately return to their long term up channels at best. For now, both of these relationships loudly scream that even currently existing prices are still an issue for a healthy housing industry recovery. We're not there yet. These charts tell us that to return to the long term channels as drawn, further double-digit price declines are still in order. We'll just have to see what happens ahead.

One last thought and I'll call it a day. The National Association of Homebuilders reported their June industry survey results earlier this week. Well what do you know, a new cycle low and a level last seen near the early 1990's recession. Big surprise, right?

Interestingly enough, directly in the survey report the homebuilders cited tightened mortgage lending standards as having a "serious impact" on industry conditions. (Shh. Don't tell these folks it’s about to get worse, Okay?)

Brian Pretti

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Brian Pretti CFA | Editor and Publisher, Contrary Investor
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