CRO Outlook

The Forecast for U.S. Housing Risk: Cracks in the Foundation?

The American housing market has fared well this year, but there have been some ominous signs lately – particularly in the nonbanking sector. Should we be worried about housing risks across the short and long term or is the market now fortified from systemic threats?

Friday, October 7, 2022

By Clifford Rossi


The general prognosis for the overall economy in the U.S. and abroad doesn’t look bright, with increasing inflation, soaring interest rates, and massive volatility in financial markets. One exception amid this disorder seems to be U.S. housing, which, until recently, has been on fire – benefitting from a historically low mortgage-rate environment

However, clouds are on the horizon and there are rumblings that all may not be well with U.S. housing. Given that there so many variables affecting the track of this market, it’s logical to now scrutinize its key risk drivers, to gain some insight on whether we’re looking at a Cat 5 hurricane or merely a steady rain.

Home Prices and Mortgage Performance

We all know that subprime mortgages fueled the global financial crisis (GFC) of 2008. Fortunately, we avoided another housing market calamity amid COVID-19, partly because of the implementation of extraordinary, pandemic-driven monetary and fiscal policies.

Generally speaking, the fate of the housing market is driven by two forces: individual borrowers and institutions. U.S. housing debt now stands at $11.39 trillion (or 71% of total debt), and has been growing steadily since the second quarter of 2013.

Factors affecting mortgage performance include the direction of home prices and interest rates; borrower, product and property risk characteristics; the degree of market speculation; and the quality of the loan manufacturing process.

Home prices over the last several years have been abnormally elevated, due in large part to low housing inventory levels. An average market historically would have five to six months of supply, but conditions have been far lower over the last year or so. Supply in the U.S. housing market bottomed out at 1.6 in January 2022, before doubling to 3.2 months in August.

In a recent statistical analysis of market fundamentals of the top 10 metro areas, I determined that eight of those markets were significantly overvalued – while the other two were overvalued in 2021 and early 2022. Indeed, housing prices are now declining, as mortgage rates have sharply risen and mortgage demand has decreased. Home prices in many of these imbalanced markets should remain moderate over the next year, held in check by nagging short-supply issues.

Another sign of potential problems: rates on fixed-rate 30-year mortgages have increased from an average of 3.22% in the first week of January to 6.7% today. On the average loan balance of just under $300,000, that adds about an additional $625 to the payment each month, or an 18% increase (roughly) in the borrower’s debt-to-income (DTI) ratio. In addition to higher gas, food and other household goods and services prices, borrowers will be increasingly challenged financially.

Clifford RossiClifford Rossi

The degree of mortgage market speculation, as we’ve mentioned, is another factor worthy of consideration. Compared to the average of 5.1% between 1999-2022 (but below the high of 7.8% in 2014), market speculation appears to be somewhat elevated today, with investor-owned properties accounting for 6.1% of loans purchased by Fannie Mae.

A bright spot in all this gloom is that mortgage product risk is relatively low. In fact. the degree of risk layering seen during the mortgage boom years ahead of the GFC is nonexistent.

According to historical mortgage data compiled by Fannie Mae (one of two U.S. mortgage government-sponsored enterprises), only .39% of loans purchased in 2021-22 featured all of the following: FICO scores less than 660, combined loan-to-value (LTV) ratios greater than 80% and DTI ratios greater than 35%. In contrast, between 2005 and 2007, 3.06% of all loans purchased by Fannie Mae suffered from the aforementioned characteristics.

A final factor affecting mortgage performance is loan manufacturing quality. During the GFC, defects in credit underwriting and collateral valuation led to significant loan repurchases. Since 2008, however, considerable attention has been given to the loan origination and servicing process, as well as to controls improvement. What’s more, the operational mortgage process risk has been significantly reduced by the development of lower-risk products.

More good news: the amount of equity in mortgages originated over the last five to 10 years provides an ample buffer against headline-like mortgage defaults, even if the economy suffers a moderate downturn.

In short, despite the expectation for home prices to fall and for borrower financial capacity to be tested amid a sputtering economy, borrower mortgage performance should not be of major concern, generally speaking, for the housing market or credit investors.

The Nonbanking Wildcard: An Institutional Weaknesses?

Anytime there’s talk of a downturn, the specter of 2008 tends to come back in that discussion in terms of systemic risk. This time, as they say, is somewhat different, partly because both Fannie Mae and Freddie Mac (the other U.S. mortgage GSE) are financially stronger than they were before the GFC – and still remain wards of the state in conservatorship.

Likewise, as a result of higher regulatory capital requirements, depository capital levels are stronger today. Moreover, even private mortgage insurers are in a much better position to weather another 2008-style crisis, following the GSEs’ implementation of risk-based capital requirements for these firms.

The wildcard, however, is the so-called nonbank originators and servicers of mortgages. It’s important to keep in mind that, thanks in part to depositories fleeing the industry in the wake of the GFC, more than 90% of all government mortgages originated in mid-2021 were by nonbank companies. Furthermore, this figure stands at about 70% for GSE-eligible mortgages.

The problem is that these companies are incredibly risky from a counterparty standpoint. They depend on short-term revolving lines of credit to fund their business, and highly volatile Level 3 fair valuation mortgage servicing rights (MSRs) are among their largest assets.

Compared with depositories, nonbanks are also thinly capitalized – and their safety and soundness regulation is relatively light. That translates into underdeveloped risk management practices for this industry segment, particularly compared to their depository counterparts.

If a liquidity event were to materialize and liquidity were to dry up – induced either by, say, currency volatility or an overly aggressive central bank policy – nonbanks would be the proverbial canary in the coalmine.

Should a large nonbank servicer tip over, this could spell trouble for a federal agency like the Government National Mortgage Association (aka Ginnie Mae), which would need step in and find alternative servicers. That, in turn, could destabilize the housing market, even though the GSEs claim they now have greater flexibility to deal with such a trauma.

Parting Thoughts

When economic headwinds appear on the horizon, it’s natural to wonder how the U.S. housing finance system will fare, considering what markets endured after 2008. But things are very different now.

Despite the prospect of declining home prices and deteriorating financial capacity, mortgage products and borrower risk profiles are much safer than before the GFC.

Large equity cushions and better origination processes and controls should limit credit risk deterioration in the event of a significant downturn in the economy. Nonetheless, an unexpected liquidity event could result in a major shake-up of nonbank originators and servicers, which could materially disrupt the otherwise smooth operation of the housing finance system.

Clifford Rossi (PhD) is a Professor-of-the-Practice and Executive-in-Residence at the Robert H. Smith School of Business, University of Maryland. Before joining academia, he spent 25-plus years in the financial sector, as both a C-level risk executive at several top financial institutions and a federal banking regulator. He is the former managing director and CRO of Citigroup’s Consumer Lending Group.


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