Mortgage Reform: A Few Good Ideas, But ...

Includes: FMCC, FNMA, IYF
by: Karl Denninger

A quick look at the manager's amendment proposed and adopted for the financial reform bill finds some things to like - provided it's implemented correctly.

Let's have a peek.

First, it requires that Fannie (FNM) and Freddie (FRE) shall have a study performed to end their conservatorship, with the focus and intent being the minimization of cost to taxpayers. One of the outcomes could be the liquidation of the entities (good), privatization (good luck), full Federalization (a disaster) or split-off into smaller firms (eh, ok, provided there's no federal assistance.)

Also among the entries in this amendment is a prohibition on the trading of derivatives linked to any carbon market. No, really, you mean Congress is not going to allow the banksters to rob us (again) via any so-called "cap and trade" farce? We'll deal with the farcical notion that carbon is a "pollutant" (in the form of CO2) another time; I will simply note that one man's hate is another's love, and that higher CO2 atmospheric levels promote faster growth of all things green. Cogitate on that one, then consider that the evidence for so-called "man-made global warming" is hardly conclusive.

Next up are some common-sense prohibitions on abusive reverse mortgage practices. These products are exclusively for older Americans to start with, and that we need to codify this sort of anti-abuse prohibitions now is outrageous. Where were these prohibitions when these "products" were first marketed? And don't start with this "private party" crap - these things have been Federally insured since the beginning, which means they also have had Federal reach. This is a good reform but that we need to undertake it at all is an outrage of the first order.

Next is the grand-daddy and the true topic on which I had intended to focus - SA3945, dealing with mortgage standards, adding Section 942. In particular it requires:

  • That income and assets be verified, ending "liar loans." Specifically, previous employment and credit history must be verified.
  • Requires not less than a 5% down payment and "credit enhancement" (PMI) for LTVs over 80%. This sounds good but is not good enough - that minimum down payment should be at least 10%, and further, any down payment requirement must be from seasoned funds - that is, savings, or it will be gamed through "seller contributions" and similar nonsense.
  • There is a bar on extending any revolving line of credit to fund residential mortgage loans. This is a good thing in that it closes one of the (many) loopholes, but it is by no means sufficient.
  • Fully-amortized amounts must be used for qualification and a DTI relationship ("back end ratio") must be adhered to. Nice try Mr. Corker, but unless you specify the DTI you get nowhere with this one.

There are other provisions in the manager's amendment that bar "Pay Option" mortgages that negatively amortize. These "products" were not mortgages in the first instance, in that there was no reasonable expectation that you would wind up with a clean tittle at the term of the note.

As such, it is my contention that these "mortgages" were all fraudulent at inception and should have resulted in felony charges right up front. I'll take an ex-post-facto fix for this by simply banning them, but we should be chasing down the writers of these "notes" and jailing them instead.

These provisions, along with a proper implementation of down payments, would end permanently housing bubble games. But there are problems with the language as adopted.

First, it exempts "non-profits." Nehemiah anyone? This sort of crap has to stop or we will never, ever stabilize housing. It is a mockery of so-called "down payment" requirements when one can go around it through so-called "non profits" that in fact exist as a funnel for money intended to undercut both mortgage standards and full and fair price disclosure on the HUD-1!

If a seller "funds" such a "gift" the entire purpose of the so-called transfer is to create an artifice that inflates the reported price of the transaction. This has to be recognized as what it is - a fraud upon the public.

When it comes to DTI ratios, we know what's stable and what's not. Specifically, a 36% back-end maximum, or DTI for all mandatory debt-service is reasonably safe and sustainable. DTIs beyond that level are not.

HAMP has failed it's essential purpose as in many cases borrowers even after modification have DTIs at or beyond 50%. This is ridiculously unsound and leaves the borrower just one personal economic challenge away from foreclosure and bankruptcy - a leaking roof, a bad water heater, a blown transmission or wrecked car and you're cooked.

In addition there is an embedded 12% loss in all real estate transaction "round trips," as the Realtor's Guild has pretty much established the commission of 6% for each "side" (buy and sell) of a transaction. As such 6% of the value of the property is effectively dissipated for each transaction.

The impact of this structure is that when one buys real estate if they are forced to sell within a short period of time they are virtually guaranteed to lose roughly 10% of the "value" of said property. This has to be absorbed via the down payment.

Down payments also reduce leverage. With a 10% down payment leverage in the transaction is limited to 10:1. But with a 5% down payment that same transaction has 20:1 leverage - a clean doubling. 20:1 is well into dangerous territory, as we found during the financial crash of 2008 and 2009. We can't have big financial institutions run 20:1 leverage across hundreds of billions of diffuse credit book - we certainly can't have someone in a focused risk running 20:1 leverage!

We must stop writing mortgages in this nation that put borrowers in this situation. The only way to do this is to demand at least 10% down in cash, with no games such as the 501c nonsense, and to cap DTI at origination at 36%, again with iron-clad language prohibiting any sort of gaming of the ratios.

We also must force qualification on a 30 year fixed-rate mortgage or the actual note's fully-amortizing rate, which ever results in a higher payment.

Had we enforced 10% down payment minimums and a 36% back end ratio, along with qualification on terms no more "hinky" than a 30 year fixed-rate note as a matter of Federal Law in 2000 there would have never been a housing bubble in the first place.

If the average household income in an region is $100,000, then the maximum total debt load of said household would not be able to exceed $36,000 annually. This would cap housing expense around $28,000 a year for most people if they decided to finance a single car and have a small credit card balance. If we assume hazard insurance and property taxes run $5,000 annually (probably reasonable for most of the nation) this results in $23,000 available for mortgage payments, capping the average home price in that region at $321,282.

Now apply this to regions where average household income is about $100,000 and tell me what you think of the sustainability of our housing market at today's prices - but more importantly, look at history.

These ratios were present - for the most part - before the bubble really got going. They were, in fact, how I had to qualify for a loan back in the 1990s.

If we want safety and soundness to return to mortgage lending, these are the rules we must apply - without exceptions.

Disclosure: No positions