In December of 2012, I provided a description of the housing recovery from the eyes of mortgage investors who could see the recovery but worried about tightening credit conditions. Six months later, it seems things have actually gotten worse, at least for borrowers with lower credit scores.
Earlier this month on May 6th, the Federal Reserve issued its April 2013 Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices. This survey examines changes in the supply and demand dynamics for loans to businesses and households using responses from "…68 domestic banks and 21 U.S. branches and agencies of foreign banks."
A few days later, Federal Reserve Governor Elizabeth A. Duke used some of these data and other sources to speak at the Housing Policy Executive Council in Washington, D.C. on "A View from the Federal Reserve Board: The Mortgage Market and Housing Conditions." The data show that at the same time the housing market is finally recovering from the last recession, credit conditions continue to tighten. In particular, borrowers with lower credit scores are not qualifying for home loans. The answers in SLOOS suggest that these numbers reveal a tightening and not just a lack of demand for these loans (Duke notes that the hard data on making a conclusive assessment are not yet available). From SLOOS:
…most banks indicated that their willingness to approve GSE-eligible home-purchase loan applications to borrowers with FICO scores of 680 or 720 was about unchanged relative to a year ago. In contrast, about one-third of respondents indicated that they were less likely to approve home-purchase loan applications insured by the Federal Housing Administration (FHA) with relatively low FICO scores…
…Modest to moderate net fractions of banks indicated that they were currently less likely to approve [a GSE-eligible, 30-year fixed-rate home-purchase loan] with a FICO score of 620, depending on the down payment, though most of those were smaller banks. Willingness to approve applications for most of the other FICO score-down payment categories was reportedly about unchanged from a year ago…
Roughly one-third of banks also responded that they were less likely than a year ago to approve an FHA-insured home-purchase loan with a FICO score of 580 or 620 and the FHA minimum down payment of 3.5%.
The downgrade in credit conditions for mortgages to lower-quality borrowers stands out because "domestic banks, on balance, reported having eased their lending standards and having experienced stronger demand in several loan categories over the past three months." Moreover, "a significant net fraction of banks" reported an increase in demand for prime mortgages. The April 2013 survey is the fifth one in a row reporting an increase in net demand for prime residential mortgage loans. The recovery is in full swing, but it is touching a limited sliver of buyers.
(You can get the breakdown of the specific numbers in a table attached to the survey summary).
The next few charts from Duke's talk tell the story of tightening conditions for borrowers with lower credit scores:
Purchase Originations by Credit Score for Prime Mortgages
Credit (FICO) scores on New Prime Mortgages
Share of Purchase mortgages Guaranteed or Insured by the Federal Housing Administration (FHA), Department of Veteran Affairs (VA), or the Rural Housing Service (RHS)
Credit Scores on New FHA Mortgages
Of course, the good part of this story is that the housing recovery is getting built on a foundation of creditworthiness. The downside is that the normalization of the housing market is likely still years away as first-time homebuyers seem to be suffering particularly hard from the currently tight credit conditions. The chart below shows that buyers with lower credit scores have practically all been driven out of the critical first-time homebuyer segment:
Share of First-Time Mortgage Borrowers with Credit Scores Below 620
(The absolute numbers for first-time homebuyers were not provided but anecdotal evidence from the earnings reports of homebuilders suggest that until recently first-time buyers have been notably absent from the housing recovery).
A normal recovery should show an extension of credit down the ladder as financial institutions become more confident in the strength of the job market, income levels, and the stability of the economy. Remember, the problem of loaning to borrowers with lower credit scores is NOT an inability to payback ANY loan but the greater discipline and attention to affordability that a lending institution must apply to making such loans. The contraction of credit to homebuyers with lower credit scores underlines a toxic mix of on-going tentativeness about the general economic recovery and a natural wariness regarding the new rules and regulations that make loans to lower-quality borrowers much more expensive to manage.
A surprisingly high number of respondents from the banks appear to have very low expectations for the housing recovery. An unsurprisingly high number of these respondents are demonstrating strong tentativeness in the face of a changing and harsher regulatory environment. From SLOOS:
Roughly three-fourths of respondents viewed either the outlook for house prices or economic activity as at least somewhat important factors currently restraining their bank's [Residential Real Estate] RRE lending. Three-fourths of banks also cited the risk of putback of delinquent mortgages by the GSEs as an important factor restraining their current ability or willingness to approve home-purchase loans…a large fraction of banks reported an increase in the importance of this factor over the past year. Four-fifths of respondents indicated that the 'risk-adjusted profitability of the residential mortgage business relative to other possible uses of funds' was an important factor restraining RRE lending, and a large fraction of banks also reported an increase in the importance of this factor over the past year.
These are not sentiments from a recovery and certainly not from a bubble (some are fearing a bubble just because some select markets have fully recovered from the housing crash). Instead, these are sentiments from a market that is bouncing along its bottom (as has been my standing prediction from 2009/2010). As Duke notes, housing market activity on a nationwide basis remains quite low:
…Existing home sales are currently at levels in line with those seen in the late 1990s, while single-family starts and permits are at levels commensurate with the early 1990s. And applications for home-purchase mortgages, as measured by the Mortgage Bankers Association index, were at a level in line with that of the mid-1990s…The subdued level of mortgage purchase originations is particularly striking given the record low mortgage rates that have prevailed in recent years.
Duke also notes that capacity constraints in the real estate lending industry are at least partly to blame for a contraction in credit conditions. While applications for refinancing have generally trended upward since 2008, the number of real estate credit employees remains close its recession lows. Lending institutions have chosen to deploy their limited staffing toward refis and away from less profitable loans to borrowers with lower credit scores:
…preliminary research by the Board's staff suggests that the increase in the refinance workload during the past 18 months appears to have been associated with a 25 to 35 percent decrease in purchase originations among borrowers with credit scores between 620 and 680 and a 10 to 15 percent decrease among borrowers with credit scores between 680 and 710.
Overall, Duke remains optimistic that housing demand will continue to improve along with a firmer economic recovery. However, this demand may get channeled into the rental market if credit conditions remain tight. I also believe important implications remain for monetary policy since none of these issues get resolved with more accomodative policy. However, tighter conditions will certainly choke off any hope that might exist for broader participation in the housing recovery. Ultimately, to the extent that the market is not able to properly price risk, the housing market will not work well for a large segment of people who are still trying to recover from the recession.
Be careful out there!