Draining the Swamp: Credit Scores and Housing Finance Reform

News that Senator Bob Corker (R-TN) is retiring from the Senate was not welcome news for advocates of reform in the government-controlled world of housing finance.  "A big loss," said John Thune (R-SD). "He"s always been a guy who"s really about trying to find solutions, common ground, and getting results."

Corker was indeed somebody who would work with his colleagues across the isle, but he was also willing to work period on difficult and contentious issues like housing, something few members are willing to do.  His departure leaves a considerable vacuum in terms of the capacity of Congress to engage on the issue of housing finance, much less pass legislation.

As the mortgage finance industry heads into the last quarter of 2017, we are still running about 30% down in terms of lending volumes compared to last year, the result of the post election pop in yields for US Treasury bonds that killed the declining refinance market.  No amount of innovation, quantitative easing from the Federal Open Market Committee, or new, more accommodating credit scores can make up for this sharp decline in production of mortgage loans. 

Meanwhile in Washington, the prospects for ending the decade-long conservatorship of Fannie Mae and Freddie Mac are dim at best.  In his statement to Congress last week, Melvin L. Watt, Director of the Federal Housing Finance Authority, said “ that these conservatorships are not sustainable and they need to end as soon as Congress can chart the way forward on housing finance reform.”  But nobody on Capitol Hill seems to consider the status quo a problem when it comes to Fannie Mae and Freddie Mac.

Watt is headed for a potential confrontation with the Trump Administration and Congress over the issue of maintaining minimum capital for the GSEs, but ultimately he must blink.  In his remarks, the former congressman from North Carolina seemingly made clear that he is preparing to modify the “sweep” of profits from both enterprises to the Treasury to prevent one or both from becoming technically insolvent, an eventuality that would require support from the Treasury. Watt stated:

 “Like any business, the Enterprises need some kind of buffer to shield against short-term operating losses.  In fact, it is especially irresponsible for the Enterprises not to have such a limited buffer because a loss in any quarter would result in an additional draw of taxpayer support and reduce the fixed dollar commitment the Treasury Department has made to support the Enterprises.  We reasonably foresee that this could erode investor confidence.  This could stifle liquidity in the mortgage-backed securities market and could increase the cost of mortgage credit for borrowers.”

While by law the Treasury’s ability to support the GSEs with new capital is limited, bond market investors and the credit rating community accords “AAA” ratings to Fannie and Freddie because of the fact of the conservatorship and the presumption of unlimited credit support from the United States.  Whether such confidence is reasonable given the current posture of Congress and the Executive Branch when it comes to the GSEs and federal debt more generally is another matter entirely. 

Watt is aware of this market reality and what a repeat of the 2008 bond market debacle would mean to the mortgage market and US taxpayers.  Yet despite his tough talk, it is not safe to assume that Watt will direct the GSEs to start accumulating capital. He said in blunt terms:

“FHFA has explicit statutory obligations to ensure that each Enterprise ‘operates in a safe and sound manner’ and fosters ‘liquid, efficient, competitive, and resilient national housing finance markets.’  To ensure that we meet these obligations, we cannot risk the loss of investor confidence.  It would, therefore, be a serious misconception for members of this Committee, or for anyone else, to consider any actions FHFA may take as conservator to avoid additional draws of taxpayer support either as interference with the prerogatives of Congress, as an effort to influence the outcome of housing finance reform, or as a step toward recap and release.  FHFA"s actions would be taken solely to avoid a draw during conservatorship.”

Watt may seem willing to make changes in the way that the GSEs compensate taxpayers for the continued sovereign credit support given to both enterprises, yet is unlikely to act.  But he continues to be skeptical of calls for FHFA to allow alternative credit scores when underwriting loans covered by insurance in the GSE market. “FHFA has received overwhelming feedback from the industry that it would be a serious mistake to change credit scoring models before the Enterprises implement the Single Security in mid-2019,” Watt told Congress, reflecting the view of many mortgage market participants.

The incumbent consumer credit bureaus – Experian, TransUnion and Equifax – have been pushing a weaker credit score as an alternative to the incumbent credit scoring monopoly held by Fair Issaac’s FICO model.  Huge amounts of money have been spent to promote the alternative scores, so far with little in the way of commercial success. Indeed, most media organizations are cowed into silence by the vast amounts of money flowing from Washington c/o Equifax and the other members of the credit score triopoly.

“We have looked deeply at these issues, and this process has raised additional concerns,” Watt noted in a barely disguised rebuke for the consumer data triopoly.  “For example, how would we ensure that competing credit scores lead to improvements in accuracy and not to a race to the bottom with competitors competing for more and more customers?  Also, could the organizational and ownership structure of companies in the credit score market impact competition?”

There are certainly legitimate concerns about competition in the consumer credit market, yet the more important issue is how a change would impact the primary and secondary markets for mortgage credit.  The bond market in particular is very opposed to any change in how default risk probabilities are measured, including both investors and the credit rating agencies that serve institutional investors.

The fact is, the bond markets like having one benchmark for measuring default risk, a fact that seems to elude advocates of "competition" in credit scoring.  Having multiple benchmarks is not about competition but rather intellectual chaos.  And as the old saying goes, be careful what you wish for, you may get it. 

Fact is, were FHFA to allow for the use of multiple credit scores in underwriting loans that back Fannie Mae and Freddie Mac securities, investors and credit rating agencies would be compelled to “score” the different models. Based on what we know today about the respective credit score products, the alternative score being pushed by the three incumbent consumer credit repositories would almost certainly trade at a discount to the FICO score used in most default models.

Watt’s comments make clear that he understands that “competition” in credit scores is really about opening the credit box to higher risk borrowers.  But thanks to the benevolence of central bankers, such worries are very distant from the minds of people who live and work in Washington. 

For the past decade, the FOMC has wrapped such concerns as market liquidity and default risk with a comforting blanket of cheap money.  When banks and the GSEs come to grips with the hidden default risk currently embedded inside trillions of dollars worth of new mortgage production, the conversation about housing finance reform may take on a bit more urgency and seriousness.  But sadly, Senator Corker will have left the building.

No, Harvey Won't Help America's Flagging Housing Market

Authored by Danielle DiMartino Booth via DiMartinoBooth.com,

Something is up, or more likely down, with the U.S. housing market. And the reconstruction after Hurricane Harvey may not do much to help.

Here"s the evidence:

The latest take on home-builder sentiment showed that buyer traffic stubbornly remains in negative territory, despite some of the highest readings of the current cycle on builders" expectations for sales gains in the next six months.

In addition, recent mortgage rate declines have not led to an increase in applications to buy a home. Over the past few weeks, purchase activity has slumped to a six-month low, even though rates are at their lowest level since November. This defies a central tenet of the housing market that falling rates naturally lead to an uptick in sales.

As for actual sales volumes, both new and existing July home sales missed forecasts by wide margins. At an annualized rate of 571,000, new home sales dropped to a seven-month low, well off their long-term average pace of 727,000. The number of homes on the ground rose to 276,000 units, the highest since June 2009. At July"s pace, it would take 5.8 months to clear the inventory.

The existing home sales report that followed was similarly weak, with closings sliding to the lowest since August 2016. Not only was the 5.44-million annualized pace 110,000 units below forecast, July"s figures reveal the all-important spring selling season was something of a bust, given July"s data captured contracts signed from April through June.

Prices have been and remain the main impediment. The median new home sales price of $313,700 marked the highest July price on record and is up more than six percent over last year"s level. At an annual gain of 6.2 percent, the best that can be said of the median sales price for previously occupied homes is that it"s off the record pace it set in June. Corroborating the slowdown in sales, both the Federal Housing Finance Agency and S&P Case-Shiller home-price indexes have softened unexpectedly.

As has been the case since housing collapsed over a decade ago, the missing contingency in the current recovery is the first-time home-buyer. In a normal market, first-timers comprise 40 percent of buyers. In July, they made up a third of the market, which is one of the highest reads of the current cycle.

What"s certain is that the run-up in home prices has not been helpful for millennials aiming to stop renting or even move out of their parent"s homes. The latest results from the University of Michigan Survey of Consumer Confidence Sentiment speak volumes. While all buyers have expressed dismay at home price gains, those between the ages of 18 and 34 have been particularly alarmed.

The survey also showed an expanding pool of those with a dour perception on housing. Thanks to high prices, both upper- and lower-income cohorts as well as those in the West and the South now say they"re pessimistic about buying a home. Likewise, prime-age buyers (ages 35-54) are now echoing their younger counterparts" laments about prices.

Looking ahead, pending home sales suggest the summer"s data are anything but an aberration. The pending home sales index has fallen in four of the last five months, with July coming in particularly weak, down 0.8 percent compared to the consensus forecast, which called for a rise of 0.4 percent.

For years, Lawrence Yun, chief economist at the National Association of Realtors, has cited constrained inventories of homes as the main driver of any weakness in the sales figures. After the recent spate of disappointments on the pending home sales front, Yun added the following perspective on prices: Over the past five years, median home prices have risen 38 percent while hourly earnings have increased by just 12 percent. This yawning gap has pushed affordability to its lowest level since 2008.

Tellingly, the most recent data from Challenger, Gray & Christmas revealed a jump in construction worker layoffs. The mitigating factor will be the tremendous demand for workers to repair and eventually rebuild Houston and the surrounding region after the devastation wreaked by Hurricane Harvey.

What is less of a certainty is the long-term effect of the storm. About 1.2 million homes in and around Houston were at moderate to high risk for flooding but aren’t in a designated flood zone that would have required insurance. Many will qualify for federal disaster relief. Still, the government program comes in the form of low-interest rate loans to help shoulder the burden of repair costs at a time when many households are already buried in debt with precious little in savings; as the third quarter got underway, the saving rate fell to 3.5 percent, a fresh low for the current cycle.

Although many have drawn comparisons to the aftermath of Hurricane Katrina, Harvey will affect more than twice as many mortgaged properties. According to Black Knight Financial Services, of the 1 million or so mortgaged homeowners in the disaster area, more than 300,000 could become delinquent within two months, and 160,00 are at risk of becoming seriously delinquent inside a four-month period.

As per the Mortgage Bankers Association, homes in foreclosure nationwide totaled 502,437 in the second quarter, exemplifying the very real potential for Harvey to leave a huge scar on the housing market.

It is clear investors are banking on the rebuilding effort becoming its own macroeconomic engine of growth. With housing clearly peaking, the nearer-term risk is that Harvey’s devastation solidifies broader market woes.

Fannie, Freddie Would Need $100BN Bailout In New Financial Crisis

While the latest Fed stress test found that all US commercial banks have enough capital to survive even an "adverse" stress scenario, a severe recession in which the VIX hypothetically soars to 70, the two US mortgage giants would not be quite so lucky: according to the results from the annual stress test of Fannie Mae and Freddie Mac released today by their regulator, the Federal Housing Finance Agency, the "GSEs" which were nationalized a decade ago in the early days of the crisis, would need as much as $100 billion in bailout funding in the form of a potential incremental Treasury draw, in the event of a new economic crisis.

Under the "severely adverse" scenario, i.e., a "severe global recession" U.S. real GDP begins to decline immediately and reaches a trough in the second quarter of 2018 after a decline of 6.50% from the pre-recession peak. The rate of unemployment increases from 4.7% to a peak of 10.0% in the third quarter of 2018. CPI declines to about 1.25% by the second quarter of 2017 (so not that much further from here) and then rises to approximately 1.75% by the middle of 2018. Outright deflation is not even considered.

In addition, equity prices fall by approximately 50% from the start of the planning horizon through the end of 2017, and equity volatility soars, approaching levels last seen in 2008. Home prices decline by approximately 25% , and commercial real estate prices fall by 35% through the first quarter of 2019.  The Severely Adverse scenario also includes a global market shock component that impacts the Enterprises’ retained portfolios. The global market shock involves large and immediate changes in asset prices, interest rates, and spreads caused by general market dislocation, uncertainty in the global economy, and significant market illiquidity. Option-adjusted spreads on mortgage-backed securities widen significantly in this scenario.

Most interesting is the following provision in the "severly adverse" scenario: the global market shock also includes a counterparty default component that assumes the failure of each Enterprise’s largest counterparty. Which, of course, is ironic because the Fed"s own stress test of commercial banks did not anticipate any bank failing. The global market shock is treated as an instantaneous loss and reduction of capital in the first quarter of the planning horizon, and the scenario assumes no recovery of these losses by the Enterprises in future quarters.

The two companies, which buy mortgages from lenders, wrap them into securities and make guarantees to investors in case the loans default backing more than $4 trillion in securities, would need to draw between $34.8 billion and $99.6 billion in U.S. Treasury aid under a “severely adverse” scenario, depending on how they treated assets used to offset taxes, of which $42.6 billion would go to Freddie and $57 billion to Fannie. The losses would leave $158.4 billion to $223.2 billion available to the companies under their bailout agreements.

The US government nationalized Fannie and Freddie in 2008, injecting them with $187.5 billion in bailout money. Nearly ten years later they will have repaid taxpayers about $275.9 billion by the end of next month, assuming they pay their combined September dividend of about $5 billion. The companies have as much as $258 billion in taxpayer funding available under the terms of the PSPA funding commitment.

According to Bloomberg, the surprisingly large funding "stress" gap is likely to be used both by proponents of letting the two companies build a larger capital buffer and by some policy makers who think such an effort isn’t needed.

Recall that one of the longest-running financial debates within the financial community is whether the Treasury overstepped its boundaries when it bailed-in GSEs shareholders as part of their rescue in 2007, with various activist shareholders demanding a return to the pre-bailout status quo, a move which would likely result in substantial equity upside. Under the current terms of their bailout agreements, Fannie and Freddie are required to turn over nearly all profits to Treasury in the form of dividend payments. They are currently permitted to retain a capital buffer of $600 million apiece, a level which will fall to zero next year.

FHFA Director Mel Watt has warned against letting the buffer disappear and said he may allow the companies to build some capital. The retained earnings, which would cut the taxpayer dividend, would only be enough to protect against small losses rather than the dramatic impact of a severe crisis, Watt and other FHFA officials have said.

Meanwhile, as the debate over the proper size of the GSE buffer continues, the two companies have taken other steps over the past eight years to reduce their risk of losses in another crisis and reduce their reliance on a loss buffer. The companies’ books of business are experiencing their lowest default rates in years, and both have accelerated sales of new securities designed to protect them from some losses if defaults increase.

While the losses projected in Monday’s report will not be large enough to eat through the full funding commitment available to the two companies, Mel Watt and others have said that they’re unsure of how the mortgage-bond market would react if the funding started to fall. Under the bailout agreements, the funds can’t be replenished. They can, however, be bailed out all over again and likely will be if the "severely adverse" scenario envisioned indeed strikes.

The silver lining in this year"s report is that Fannie and Freddie’s bailout funding need was lower than estimated in prior years, "reflecting both slightly different tests and improving risk profiles at the companies." Last year, FHFA said the companies would need as much as $126 billion, while in 2015 the agency said they would need up to $157.3 billion.

How The Obama Administration Quietly Bailed Out Private Equity Landlords At The Expense Of The Middle Class

Authored by Yves Smith, originally posted at NakedCapitalism.com,

So how much did Blackstone promise to give to the Obama library for this huge grift, um, parting gift?

As regular readers may recall, private equity firms piled into buying foreclosed single family homes on the belief that if the government (in this case, Fannie and Freddie) was selling, they wanted to be buying. And they also convinced themselves that technology would somehow allow them to manage geographically dispersed single family homes, which is inherently a hand-on business, more efficiently than mom-and-pop or small scale operators, many of whom had a cost advantage by having some of the principals provide services (as in doing their own plumbing and electrical, so effectively “buying” those services at wholesale prices).

The most disciplined operators did well by getting in early and buying only very discounted properties, so that they had a good cash on cash return on the rentals. It would be attractive for them to hold long term, which would also give them lots of latitude regarding an exit. The lack of time pressure would mean they could sell the homes individually, even through “rent to own” deals with the higher credit quality tenants.

But many of the early entrants kept on buying long after prices were bargain basement, and it was clear due to the press reports of widespread mis-management and tenant abuses that they were cutting corners on maintenance due to having underestimated costs and complexity. Any real estate manager will tell you that running down the asset is foolhardly.

The logical time to start to exit was 2014, but the private equity property owners were whacked by the Bernanke taper tantrum. The most straightforward exit was to turn the properties and the management compan into a REIT, but only a couple of deals got done before that window closed. The next strategy was rental securitization, which we regarded as a terrible idea given the awful track record of mortgage servicing, and that a rental securitization involved much more in the way of moving parts that mortgage servicing. Again, a few transactions got out the door, but the market foundered after a Blackstone securitization saw a big drop in rental income in the quarter immediately following the public offering.

So in its waning hours, the Obama Administration gave a completely unjustified bailout to private equity landlords, that Fannie Mae is guaranteeing the income of all but the bottom tranches of Blackstone’s latest rental securitization.

Let us stress that there is absolutely no policy justification for this. The mission of the government sponsored agencies is to promote home ownership, not to give real estate speculators a “get out of losses or underwhelming returns for free” card. Even worse, rather than forcing the private equity industry to take some well-deserved lumps for miscalculation, it will encourage them to continue to compete with lower-income prospective homeowners for purchasing properties. That means it will be even more difficult for young people to buy homes. Lambert has pointed out repeatedly in his stats wrap in Water Cooler that real estate markets are suffering from a shortage of homes. Having private equity continue to be on the prowl for lower priced properties that they know they can unload from an economic perspective means that the pauperization of the middle class is now official policy.

Even though this guarantee clearly had to have been worked out during the Obama Administration, Blackstone did not make it public until it updated its filing with the SEC this week. It looks an awful lot like the timing was designed to make sure that the disclosure came after the new Trump team was in charge, meaning Obama would be unlikely to face the criticism he deserves, and the Trump Administration would be certain to let the deal stand.

*  *  *

By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Wolf Street

Invitation Homes, the 2012 buy-to-rent creature of private-equity firm Blackstone, and now owner of 48,431 single-family homes, thus the largest landlord of single-family homes in the US, accomplished another feat: it obtained government guarantees for $1 billion in rental-home mortgage backed securities.

The disclosure came in an amended S-11 filing with the SEC on Monday in preparation for Invitation Homes’ IPO. Invitation Homes bought these properties out of foreclosure and turned them into rental properties, concentrated in 12 urban areas. The IPO filing lists $9.7 billion in single-family properties and $7.7 billion in debt.

Some of this debt will be refinanced with the proceeds from the sale of the $1 billion of government-guaranteed rental-home mortgage backed securities.

The government agency that has agreed to guarantee the “timely payment of principal and interest” of these “Guaranteed Certificates,” as they’re called, is Fannie Mae, one of the government-sponsored entities (GSE) that has been bailed out and taken over by the government during the Financial Crisis.

This is the first time ever that a government-sponsored enterprise has guaranteed single-family rental-home mortgage-backed securities, issued by a huge corporate landlord. It’s an essential step forward in financializing rents: taxpayer backing for funding the biggest landlords.

Government guarantees allow the mega-landlord to sell these securities at a lower yield and thus offer landlords like Blackstone’s entity even cheaper financing for future home purchases, and thus lower costs and greater profit potential.

During the next severe economic downturn, Fannie Mae and its sister Freddie Mac would need between $49 billion and $126 billion in taxpayer bailout money, according to the stress test conducted by the Federal Housing Finance Agency. The results were released in August last year. So why fret about one more billion?

Blackstone is the trailblazer in financializing rents. It pioneered the post-Financial Crisis buy-to-rent scheme, explicitly encouraged at the time by Fed Chairman Ben Bernanke and the Department of the Treasury, as they were trying to bail out the banks by finding willing and able buyers for foreclosed homes – big institutional buyers that could feed at the nearly-free money-trough the Fed had put out there.

And Blackstone was a trailblazer in the next logical step: issuing the first rent-backed structured securities in November 2013. The deal was collateralized by rental income from 3,207 homes. Moody’s, Kroll, and Morningstar – all paid by Blackstone – rated nearly 60% of the securities AAA. The remaining tranches carried lower ratings. The deal flew off the shelf. Now all larger buy-to-rent companies are using rent-backed structured securities for funding.

This too is going to happen with government guarantees on rental-home mortgage-backed securities. It’s a sweet deal for the issuer: low-cost funding, made possible by government guarantees, is always welcome. Other corporate landlords will follow in Blackstone’s footsteps.

Not all of it will be guaranteed by the government: To satisfy “credit risk retention requirements,” Invitation Homes “would purchase and retain the Subordinate Non-Guaranteed Certificates,” amounting to 5%, or $50 million, of the $1 billion in securities. That’s all the cushion the taxpayer has before losses begin to hit home, so to speak.

The GSEs were founded to promote homeownership by subsidizing it with at first implicit, and since the Financial Crisis explicit, government guaranteed mortgages. But this deal represents a big shift: now, in a delicious Wall-Street irony, the government subsidizes the largest landlords and enhances their profits from renting out single-family homes that individual homeowners had lost during the housing collapse and foreclosure crisis.

There is a darker side to corporate ownership of single-family rental homes and the financialization of rents: soaring evictions, according to the Atlanta Fed, which explicitly blames the Fed and Bernanke. Read…  Evictions by Wall-Street Mega-Landlords Soar, Financialization of Rents Cause “Housing Instability”: Atlanta Fed