Updated: Oct 6
Why supporting supply side housing policy and resisting credit box expansion is important.
Recently, there has been momentum toward expansion of the "credit box." Think of the credit box as credit policies that guide mortgage lending; like FICO score cutoffs, LTV thresholds, and debt-to-income requirements. This article explores the paradox that expanding the credit box creates an environment counterproductive to affordable housing. We provide several sustainable affordable housing policy suggestions.
In late 2020, the CFPB announced the relaxing of the Qualified Mortgage Debt To Income rule. This rule required at least 43% of a borrower's income to be available to service their mortgage debt. The relaxation will give lenders more flexibility to assess the ability to repay. This should increase the availability of credit, especially to those on the margin from an income capacity standpoint.
In June 2021, as reported in a Marketwatch article, the Supreme Court decision could help advance Biden’s housing agenda — starting with the firing of the FHFA director. Some interpret this as increased political pressure to expand the mortgage credit box.
One of the great lessons of and contributors to the Great Recession was expanding the credit box. Driving higher homeownership rates with demand side credit standards is like playing with fire.
From an economist’s standpoint -> these sort of policy changes, relaxing credit standards, shifts the housing demand curve to the right. This shift has the effect of maximum upward leverage on short-run housing prices, especially given the housing stock is generally fixed in the short run. Paradoxically, expanding the credit box causes housing to become less affordable. Please see the following economic framework:
Economists are trained to follow the organizational incentives as a way to understand the participating agent’s motivation. A quick incentive review suggests, those who need affordable housing the most may least benefit from expanded credit.
Expanded credit box - incentive review:
From a lender’s standpoint -> good news, more demand for loans, revenue goes up.
From the housing manufacturer's standpoint -> good news, more demand for houses, revenue goes up.
From the politician's standpoint -> good news, expanding the credit box and increasing the homeownership rate is a positive narrative during the typical 2 to 6-year election window.
From the property investor’s standpoint -> good news, increasing property prices equate to more properties that meet or exceed property cash flow and return thresholds.
From the mortgage investor's standpoint -> mixed news, more volume creates more short-term revenue, but a lack of affordable housing and an increase in associated embedded credit (collateral) risk may sow the seeds for a major housing market correction. There are such powerful lessons from the last financial crisis. (1)
For those mortgage borrowers at the margin -> mixed news (at best) and trending bad, even though more credit will be available, upward pressure on housing prices will cause housing to become less affordable. This greatly reduces the benefit from credit availability and creates risk for those that need affordable housing.
There are some nuances to particular housing demand policy changes. Higher demand alone may not motivate home builders to build more affordable homes. Also, it is yet to be seen if a particular policy change, incrementally, will move the needle on housing prices. The point is, the cumulative effect of relaxed housing demand policy increases housing price pressure in the short run until market supply equalizes in the long run. Like a dog chasing his tail, this creates a self-reinforcing housing inflation cycle, where long run housing supply is challenged to equalize.
As such, generally, stable demand-side and active supply-side focused housing policy are necessary to create sustainable affordable housing:
A stable and consistent housing demand policy. Demand standards, as related to Mortgage Credit Policy, are influenced by regulators such as the CFPB and FHFA. Mortgage Credit Policy is set by Investors like the GSEs / FHA / GNMA, and banks. I am not taking a position on the particular credit policy. The idea is that it remain stable and is a stranger to use as a short term policy tool. [Set it and forget it (2)]
Active supply-side housing policy focus. That is, focus on the appropriate housing stock supply policy. Examples include:
Reduced local zoning and related “NIMBY” friction to housing development.
Tax policy that aligns local housing impact of employees with tax burden to their employers. (3)
Reduced local rent control and related market distortions.
Tax incentives and immigration vouchers to incentivize builders to build affordable homes. (4)
There has been recent state and local government movement toward banning or reducing local single-family zoning. California signed SB9 into law, effective January 1, 2022. This follows Minneapolis and Oregon in 2019. California is generally the poster child for affordable housing challenges and a general lack of housing supply. In 2021, California has 12% of America’s population, but hosts 28% of its homeless. (5)
SB9 will make it easier to build apartments and convert existing single family homes to up to 4 unit multi family homes. Also, there is a provision requiring owner occupancy, so the immediate benefit to property investors maybe muted.
In a locally constrained housing market and if demand is artificially spurred by accommodative credit policy, housing values have nowhere to go but up. The winners in a fast-moving housing market are typically the first movers. These are likely to be property investors and other more sophisticated demand participants. (6) A longer-term supply-side housing policy focus is needed if the goal is to provide affordable housing and appropriate homeownership levels. (7) This aligns with the reality that it takes time for housing markets to respond to demand changes. Once the flow of new housing supply becomes available in a particular market, it would certainly make sense to align mortgage credit policy to the needs of the new borrowers. The long-term health of the mortgage finance industry is aligned with appropriate supply-side housing policy.
Ultimately, order of operations matters. Spurring demand in a hot housing market is like using gasoline to put out a fire. Best to focus on supply-side housing policy to provide long-term, sustainable affordable housing and appropriate homeownership levels.
(1) So let's dig into credit (collateral) risk a bit. Higher collateral values, narrowly defined, are a good thing for credit risk. Higher collateral value lowers the LTV and reduces credit risk. The problematic side to the higher collateral value issue is housing value volatility. One of the pillars of the U.S. Mortgage Finance system is the assumption of home value stability. Home values, like most asset prices, are mean-reverting. If housing values persist at higher than average growth rates, by statistical definition, they will correct. It is not a matter of "whether," it is a matter of "when." As we saw in the great recession, large corrections can be unexpected, may occur quickly, and create momentum of their own and create significant, hard to reverse economic damage. In particular, people that are marginal credits and in need of affordable housing, tend to be especially sensitive to a correction cycle, creating more significant credit damage for both people and investor portfolios.
(2) "Set it and forget it" credit policy. The idea is, for GSE and government based mortgage market makers and insurers, credit policies are based on long-term, multi-economic cycle modeled drivers, like prepayment speeds and especially for credit loss assumptions. In the context of credit loss, using long term loss assumptions will:
Reduce the change frequency of loss assumption and related credit policy, guarantee-fee or loss related pricing.
Act as a countercyclical "planned inertia" demand policy tool.
In "hot," low loss, high demand markets, long term credit and pricing assumptions will be higher than those in the short-term "hot" market. This has the effect of reducing demand toward the mean and for the investor to accumulate excess loss reserves.
In "cold," high loss, low demand markets, long term credit and pricing assumptions will be lower than those in the short-term "cold" market. This has the effect of increasing demand toward the mean and for the investor to release accumulated loss reserves.
(3) Amazon announced an Affordable Housing program.
"The bulk of its investment will be through low-cost loans to preserve or build affordable housing, Amazon said. The company also will offer grants to public agencies and minority-led housing organizations."
(4) Jeffrey Hulett, America's Mega Forces - Making the most in a time of change. We introduce the “The Community Invitation program” as a related economic solution.
(5) The Economist, California ends single-family zoning
(6) Property investors and more sophisticated demand participants will siphon consumer surplus related to a housing transaction. Supply-side policy to normalize housing stock may provide more consumer surplus to the borrow / homeowner and reduce the consumer surplus available to property investors.
(7) Appropriate homeownership levels - is generally defined as the homeownership level associated with credit qualified borrowers. Credit qualification means those borrowers having the capacity and willingness to repay their mortgages. A significant criticism of the U.S. Government following the 2007-08 Financial Crisis was the enabling of lending to credit unqualified borrowers. Related causal conclusions of the U.S. Government's Financial Crisis Inquiry Report included "Collapsing mortgage-lending standards" and "Widespread failures in financial regulation and supervision." As such, not all people are credit qualified for mortgages. Pretending like all people are credit qualified (Collapsing standards) and then pretending like the loans were good (Widespread regulatory failures) is certainly a recipe for disaster.