Fed’s High Wire Inflation Fighting Effort Risks Triggering a Recessionary Fall

Imagine a high-wire act performed without a net.  That describes the Federal Reserve’s effort to curb inflation without crashing the economy.  Success will bring applause and relief; failure, a brief downturn, at best, with a prolonged recession the worst case outcome. 

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Was the homebuyer tax credit an imaginative response to a weak housing market and a fragile economy, or “a failure of imagination,” and a costly failure, at that?

Critics, and there are many, take the latter view, insisting that the credit simply accelerated sales that would have occurred anyway, providing  a federal subsidy to buyers, who, for the most part, didn’t need it. Some analysts estimate that for every four buyers who took advantage of the credit, three would have bought without it. 

Supporters, and there are many of them, too, contend that the credit did precisely what it was designed to do – brought more buyers into a lagging market, stabilized home prices, and created the foundation for a sustainable recovery.  “The tax credit has done its job,” Lawrence Yun, chief economist for the National Association of Realtors, said in a press statement.

Introduced in the spring of 2008, the credit ($7,500 to start) was one of several initiatives Congress approved in an effort o repair the nation’s battered economy.  As the financial crisis continued to deepen that year and public anger over the banking industry bail-out grew, Congress revised the housing incentive, increasing the credit to $8,000 and eliminating the requirement that buyers repay it over a 15-year period.  Fearful that ending the credit (which was scheduled to expire in November of last year) would derail a fragile recovery, Congress extended the program and expanded it once again, adding a smaller ($6,500) credit for existing homeowners to the first-time buyer incentive.

The NAR attributes the March surge in home buying activity (pending sales jumped by more than 20 percent over the year-ago pace) to the momentum provided by the credit.  But critics suggest those gains will come at the expense of second half sales.  Federal funds would have been better spent, some critics say, by helping struggling owners avoid foreclosures, holding down burgeoning inventories of unsold homes and reducing the downward pressure on home prices.  

Other analysts see more positives than negatives in the program.  The credit may not have boosted sales dramatically, Mark Zandi, chief economist at Moody’s Economy.com, acknowledged.  But it provided a significant psychological boost.  “The credit helped to stanch the price declines,” he told the New York Times, and that “had a substantial benefit for the entire economy.  The home is still the largest asset on most people’s balance sheet,” he noted, ‘so when prices are falling, nothing works for most families. But now people can take a deep breath and think clearly again.”   

RESPA HEADACHES

The revised RESPA regulations are creating headaches for lenders and borrowers alike, at least one survey has found.  This won’t come as a surprise to the loan officers and mortgage brokers on the compliance front lines, but the survey, conducted by The Work Number (a subsidiary of Equifax) provides some statistical evidence of the warnings industry executives sounded before the Department of Housing and Urban Development adopted the new RESPA rules and the problems about which they have been complaining since the changes took effect in January of this year.

Designed to make mortgage disclosures more comprehensible and more useful to borrowers, the RESPA revisions mandate a number of changes, primary among them:  Lenders must use a new, standardized Good Faith Estimate (GFE) form (detailing all loan terms and closing costs), and a new HUD-1 Settlement Statement, comparing the estimates with the final costs, which in most cases can’t exceed the estimates by more than 10 percent. 

Nearly 75 percent of the 3000 industry executives responding to the survey said borrowers are often “confused” by the new disclosure documents they receive and 79 percent said the RESPA changes have increased the time required to process loan applications.  Respondents cited a number of specific problems, including:

  • The cost to lenders of inaccurate GFE estimates, which can’t be passed on to borrowers; and
  • The delays resulting from revised disclosures, which often require rescheduling the planned closing date.
  • Although most of the survey respondents (74 percent) said the new RESPA regulations have not created a loan processing backlog, many also agreed that this may change when loan origination volume increases as the economy improves.

As for other changes, more than 35 percent of the respondents said they are submitting more requests for the verification of borrower income and 23 percent said they are requesting those verifications earlier in the application process.  

POSITIVE SIGNS

After months of grim loan delinquency reports, there are finally glimmers of consistently good news: consumer loan delinquencies declined broadly in the fourth quarter, posting the second consecutive month of improving numbers.  The American Bankers Association (ABA) reported that delinquencies fell broadly in 8 of 11 categories in the fourth quarter, pushing the composite ratio (for 8 closed-end installment loan categories) down by 4 basis points, to 3.19 percent  of all accounts, compared with  3.23 percent in the third quarter of last year.  Bank card delinquencies fell 38 bps to 4.39 percent (below the 5-year average); direct auto loan delinquencies fell10 bps (from 2.04 percent to 1.94 percent; and personal loan delinquencies fell from 3.74 percent to 3.63 percent. 

Moving in the opposite direction, home equity loan delinquencies   increased from 4.30 percent to 4.32 percent, setting another unfortunate record.  But delinquencies on home equity lines of credit fell from 2.12 percent to 2.04 percent – the first decline in this category in six quarters. 

The ABA’s chief economist, James Chessen, described the improving delinquency numbers as “a very positive and hopeful sign.  People are actively reducing their level of debt relative to their income and are rebuilding their savings,” Chessen said in a press statement accompanying release of the ABA’s quarterly delinquency report.  But he also cautioned that the weak job market continues to create a drag on the economic recovery.  “It’s still a very stressful time for many families,” he noted, “and [that stress] won’t disappear until more people have jobs. This will keep delinquencies elevated for the next several quarters,” Chessen predicted. 

FHA STRAINS EASING

Sharing in the good news on loan delinquency rates, the Federal Housing Administration (FHA) reported that its delinquency and claims rates continued to decline in February, falling to the lowest level since last summer.  The decline in the number of loans three months or more past due -- from 5 percent to 4.8 percent of FHA-insured loans outstanding  -- halted what had been a dizzying spiral in the agency’s losses and an unsettling decline in its capital ratio, both trends reflecting the central role the FHA has played in government efforts to stabilize the housing market. 

Agency officials and industry analysts credited the aging of the FHA’s portfolio (loans originated in 2007 and 2008 are moving past the points at which delinquency risks are greatest) and agency efforts to cull the lenders responsible for the largest percentage of FHA losses for the improved performance. 

The FHA recently adopted new rules, increasing net worth requirements for approved lenders (beginning next year) from $250,000 to $1 million. That is the first step in a phased process that will set the net worth benchmark three years from now at $1 million plus 1 percent of total loan volume in excess of $2.5 million. Additionally, the new rules will eventually end independent FHA authorization for mortgage brokers.  Beginning in January of 2011, brokers will be required to originate loans through approved lenders, although they will be allowed to continue originating loans independently between   now and then. 

FHA officials have rejected suggestions that they increase minimum down payment requirements for borrowers in order to reduce the agency’s risks and relieve the pressure on its insurance fund, arguing that the change would disqualify more than 300,000 first-time buyers for whom an FHA-insured loan is the only financing option.  The agency currently insures 30 percent of home purchase loans, compared with a market share of only 3 percent just four years ago. 

Testifying recently before a Congressional committee, FHA Commissioner David Stevens said another recent policy change – increasing the up-front premiums paid by most borrowers by 225 basis points – will do more to bolster the agency’s capital ratio, generating $5.8 billion compared with the $500 million in additional revenues a down payment increase would produce. 

Some industry analyst have warned, however, that the agency is seriously underestimating its portfolio risks, increasing the likelihood that taxpayers will have to cover future losses. “It’s hard to imagine that [the agency] won’t be returning to Congress several times….It’s just inconceivable that the loans…will not cause very large losses,” according to Andrew Caplin, an economist at the Federal Reserve of New York,  and one of the authors of a working paper analyzing the FHA’s loan risks. 

 That study estimates that 40 percent of the FHA’s insured loans are underwater, with as many as 14 percent of them exceeding the value of the underlying homes by more than 115 percent, putting them at significant risk of “strategic defaults”  by owners who decide it is in their financial interests to walk away.

“You look at all the areas in which they’re underwater, you look at the unemployment rate in [those] places, you look at how little was invested up front,” Caplin told the Wall Street Journal, “and you know that a lot of these mortgages aren’t coming back.”

A PERSISTENT PROBLEM

The virtual disappearance of subprime lending has made a significant dent in mortgage fraud, but the problem persists, despite intensive efforts by state and federal law enforcement agencies to combat it.  A fraud index created by First American CoreLogic has declined to 84 from a 2007 post subprime peak of 112 as lenders have tightened their underwriting standards and eliminated stated income (“liar”) loans and other products susceptible to fraud.  Nonetheless, CoreLogic estimates that .55 percent of home mortgages originated last year (1.22 percent of FHA-insured loans) involved fraud.

Separately, the Mortgage Asset Research Institute estimates that mortgage fraud increased by 7 percent last year -- an improvement over the 26 percent increase reported the previous year, but evidence that fraud remains a serious problem, “growing and escalating in complexity,” according to the Institute’s most recent annual report. 

The report notes several factors driving fraudulent activity, including: 

  • New opportunities (created by foreclosures and other financial problems) for fraudsters to take advantage of consumers;
  • A desire by consumers to maintain boom period  lifestyles they can no longer afford;
  • Consumers who remain “desperate” to become homeowners; and
  • New technology that makes it easier for fraudsters “to access information, conduct criminal activities and remain anonymous via the internet.”

Misrepresentation of employment and income remain the most common sources of fraud, according to the report, with the manipulation of deposit verifications, escrow and closing costs, and credit reports also ranking high on that list.  “The bad news is that because of its adaptability, fraud can never be completely eradicated,” the report notes.  “But the good news is that using industry-submitted information, like that used to generate this report, and proper due diligence standards, it can be proactively defeated.”

Underscoring those conclusions, Denise James a co-author of the report, told reporters:  “It is critical for those in the industry to reassess their processes, work together by sharing information and reporting [fraud], and ready themselves for  [the] more complex schemes” the industry will have to combat in the future.