US: Housing clampdown

House Financial Services Committee Chairman Barney Frank will succeed this week in effecting the most extensive overhaul in US mortgage financing since the Great Depression.  Yet he may have even grander ambitions for government intervention in the housing sector.

Last month, Frank was instrumental in pushing the FHA Housing Stabilisation and Homeowner Retention Act through the House; the Senate is certain to approve its own version of the legislation this week.  The Act is designed to address two related problems:

• Fighting NINJAs: The dodgy business practices that produced the 'NINJA loan' phenomenon -- where sub-prime mortgages were doled-out to borrowers without reference to their income, employment status or assets.  Many of these individuals were financially unsophisticated and defaulted on their mortgages.
• Foreclosures: The current surge in foreclosures, which has been caused by a combination of sub-prime lending, the credit crunch that followed the property market implosion, and increasingly difficult economic conditions more generally.  Foreclosures are making the situation worse by increasing the losses incurred by investors and banks holding mortgage-backed securities and related derivatives, boosting direct bank losses related to their mortgage loan portfolios, and accelerating housing price declines as repossessed properties are dumped on an already distressed market.

Market or regulatory failures?

According to Frank and his Senate counterpart, Banking Committee Chairman Chris Dodd, the sub-prime crisis was both foreseeable and preventable.  They characterise it as largely a regulatory failure, as a decade of exceptionally low interest rates spurred increasingly irresponsible lending.  The Federal Housing Administration (FHA) should have recognised that this was going on, and agitated for stricter mortgage standards.

This is questionable, particularly because it may overemphasise the culpability of President George Bush's administration -- encouraging homeownership has been federal policy for decades.  Yet it is true that the increasingly disintermediated nature of the mortgage market -- where the banks and thrifts that issued loans often quickly sold them on to investors -- should have raised red flags.  It created a strong incentive to write new credit regardless of the risk considerations involved, since, in theory, some other sucker would be left holding the radioactive paper.  (A notion, many banks later discovered, which worked better in theory than in practice.)

Disintermediation also produced a second, related market failure.  Since banks no longer hold large portions of their mortgage portfolios on their own books; incoming payments are supervised by independent 'servicing companies' that do not have an economic incentive to avoid foreclose when loans go bad.  In the past, banks preferred to negotiate 'work-out agreements' with distressed mortgage holders, since outright foreclosure would usually result in a loss of at least 40% of the original value of the loan.  Now servicing companies often race to foreclose, evict the borrower, and sell on the property.  But dumping additional stock on an already oversupplied housing market has caused prices to plummet faster.

Regulatory 'cure'

The Act intends to address these problems through a combination of tighter regulation and the creation of an alternative to foreclosure.  Fortunately, as even his Republican opponents concede, Frank is experienced, exceptionally smart, and alert to the dangers of regulatory overkill, so the degree of market intervention does not appear excessive:

• Stricter disclosure: New measures would establish stricter disclosure rules, requiring lenders to detail the maximum monthly payment on adjustable rate loans, after the initial 'teaser rate' has expired.
• Immediate relief: The legislation also includes more provisions designed to provide immediate relief to homeowners who have fallen behind on their mortgage payments. A 'rescue refinancing' clause would allow qualified owners to refinance to government-backed mortgages, if lenders agreed to cut the principal balance of the loan to 85% of the property's current value.

This would destroy the market for NINJA loans, reduce the surge in foreclosures, and undermine the ability of some low-income individuals to become homeowners.  But in the context of the current mess, that hardly comes across as a negative market intervention.

More to come…

Although Bush opposes the measure, both the House and Senate bills are likely to pass with veto-proof majorities, guaranteeing that they will become law.  The overall impact of the Act is should be positive -- despite the regulatory clampdown.  However, if the housing market slide continues to deepen -- and the signs are that it will -- demands for potentially counterproductive intervention in the market could increase.