The pandemic revealed not only fractures in our public health system but also deep faults in our financial system, particularly our mortgage finance system. Coming only a decade after the passage of the Dodd-Frank Act, the stresses revealed in 2020 were only contained with massive amounts of stimulus and forbearance. Highly leveraged positions among mortgage dealers and buyers suggest the stresses in the mortgage system are continuing to mount despite these recent measures. Whether the high costs sustained in the pandemic will be willingly incurred when we hit the next inflection point is an open question. Either way, buckle up—it will likely be a bumpy ride.
Perhaps the biggest change in our mortgage system since the passage of the Dodd-Frank Act is the increased dominance of nonbank mortgage lenders and servicers. Prior to the 2008 crisis, depositories dominated both the origination and servicing of mortgages. Whether intended to be held on portfolio or securitized, institutions like Wells Fargo and Bank of America drove the mortgage market. Today, firms like Lakeview, PennyMac, Mr. Cooper, and Rocket are the biggest players.
These new players lack the diversity found among depositories and the stability provided by deposit funding. With balance sheets comprised of mortgages, mortgage-backed securities (MBS), and mortgage servicing rights (MSRs), nonbank mortgage companies are exposed to considerable interest rate risk. To mitigate this risk, they rely on warehouse funding from depositories. In times of economic stress, this can be unreliable as we saw when the Federal Reserve eased interest rates in the Spring of 2020. Several nonbank mortgage companies neared insolvency due to the swift decline in the value of MRSs and MBS with the introduction of lower interest rates.Â
The structure supporting MBS trading presents another weak spot in the mortgage system. Generally, Fannie Mae and Freddie Mac do not sell MBS directly to investors. Instead, they create MBS via a swap transaction with mortgage originators who bring them mortgages. These mortgages are pooled into an MBS and guaranteed by Fannie Mae or Freddie Mac. The resulting MBS are then swapped back to the original lender. Many lenders, especially nonbank lenders, subsequently sell the MBS to a dealer who specializes in buying and selling MBS.
These dealers sell the MBS to investors or hold the MBS in inventory until an ultimate investor is found. Normally, the primary dealers hold around $30 billion to $40 billion in agency MBS pass-through inventory. These dealers entered 2020 with closer to $50 billion in inventory, but as the initial flight to quality took hold in January 2020, dealer inventories dropped by almost half. Over the course of February 2020, dealer inventories doubled, entering March with over $50 billion held. In just two weeks, by March 18, 2020, those inventories would surge to $80 billion. MBS dealers were coming under pressure. They had to hold capital against their growing positions, capital they did not have. At the same time, buyer interest was disappearing.Â
The primary dealers who intermediate the MBS market also intermediate the Treasury market. To some degree, the ability of dealers to hold MBS inventory has been limited by the expansion of outstanding Treasury debt. Post-2008 reforms, such as the Liquidity Coverage Ratio, encouraged banks to hold more Treasuries and MBS. Such holdings left dealers closer to their internal risk concentration limits when COVID-19 struck, reducing their ability to serve as MBS market makers. The primary dealer market for MBS is also highly concentrated, with the 10 biggest dealers handling almost 90 percent of the trading volume. Difficulties among just a few of these could result in major disruptions to the MBS market.Â
Many take comfort in believing mortgage credit quality is leagues beyond that witnessed in 2008. Such comfort is mistaken. Yes, the median FICO score for newly originated mortgages is currently around 30 points higher than witnessed in 2008. But does that represent a real reduction in risk?Â
Under COVID debt relief, reporting for many types of loan delinquencies was paused. In addition, households received significant direct financial support during the pandemic. The result was a significant upward shift in credit scores, between 10 and 20 points in 2020 alone for borrowers with low credit scores.
Regulators and Congress have imposed other changes that have increased credit scores. One example has been medical debt. The Consumer Financial Protection Bureau estimated its newer treatment of medical debt, including industry changes instituted in March 2022, will increase, on average, consumers’ FICO by 25 points. It should be clear that most, if not all, of the perceived improvement in borrower credit quality between now and 2008 is the result, not of actual quality improvements, but of regulatory changes to credit reporting.Â
Commentators also point to the strength of aggregate household balance sheets. For instance, the Federal Reserve estimates that in 2024 Q1, the aggregate homeowner’s equity, as a percentage of real estate owned, was 71 percent. While that is a big cushion, it is not unprecedented. Similar heights were witnessed in the 1950s, 1970s, and 1980s prior to painful housing corrections in those decades. Â
While aggregates can be instructive of broader trends, they do not accurately reflect the experience of individuals. We do not all share home equity. Total aggregate equity never went negative in the 2008 crisis, yet many families still found themselves underwater. The tails of the distribution have been getting worse, and it is the tails that cause the crises. According to the Urban Institute, the median combined loan-to-value at origination is now 95 percent, whereas it was closer to 80 percent going into 2008. Perhaps the most reckless trend has been the explosion in high debt-to-income (DTI) lending. The American Enterprise Institute reports that over a third of recent mortgage originations have DTIs in excess of 45 percent.
Today, we have a mortgage finance system built upon highly leveraged nonbanks and even more highly leveraged borrowers. If we experience a sustained period of significant job loss, there’s little standing between the mortgage market and calls for a taxpayer bailout.
EXPERT INVOLVED
Dr. Mark A. Calabria served as the Director of the Federal Housing Finance Agency, as a member of the Financial Stability Oversight Council, and as a senior member of the staff of the United States Senate Committee on Banking, Housing and Urban Affairs. He is an expert in residential and consumer finance regulation and markets, as well as the prudential regulation and supervision of systemically important financial institutions.
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