The US mortgage market that triggered the global financial crisis, remains severely exposed to bad debt, harbouring “liquidity risk that no one is talking about” according to a report authored by the Federal Reserve and Berkeley University of California
The US economy remains significantly exposed to mortgage default according a new report. Research carried out by the Brookings Institute, in conjunction with the Federal Reserve (America’s central bank) and Berkeley University, has produced a report entitled Liquidity Crisis in the Mortgage Market, revealing that non-bank lenders have provided mortgages to borrowers who would not be lent to by a bank resulting in “a liquidity risk no one is talking about”.
“Non-bank mortgage companies are vulnerable to liquidity pressures in both their loan origination and servicing activities, and we document that this sector in aggregate appears to have minimal resources to bring to bear in a stress scenario,” says the report.
“We show how these exact same liquidity issues unfolded during the financial crisis, leading to the failure of many non-bank companies, requests for government assistance, and harm to consumers. The extremely high share of non-bank lenders… suggests that non-bank failures could be quite costly to the government, but this issue has received very little attention in the housing-reform debate.”
Ironically, such exposure can be attributed to the legislation that was passed following the sale of sub-prime mortgages that created a credit crunch for banking institutions in 2007. That in turn triggered the global financial crisis that has shaped the (mis)fortunes of millions over the last ten years. After the crisis, Congress and financial regulators increased regulation of the credit risk associated with mortgage lending, including the enforcement of stronger underwriting standards. Conversely, this provided a window for non-bank lenders to provide credit to those rejected by their banks. As of 2016, non-bank financial institutions originated close to 50% of all mortgages and 75% of mortgages with explicit government backing.
The paper, by You Suk Kim, Steven M. Laufer, and Karen M. Pence of the Federal Reserve Board and Richard Stanton and Nancy E. Wallace of the University of California at Berkeley, argues that liquidity risk associated with the non-bank mortgage sector was a key driver of the original financial crisis. Worryingly, those same vulnerabilities are not only still present, but pose an even greater risk to the system today because the non-bank sector is an even larger part of the market. Non-bank mortgage originators and servicers—i.e., independent mortgage companies that are not subsidiaries of a bank or a bank holding company—are subject to far greater liquidity risks but are less regulated than bank-lenders and servicers.
The research also suggests that mortgages issued by non-banks are of lower credit quality than those originated by banks, making non-bank lenders more vulnerable to delinquencies triggered by a fall in house prices through the higher costs of servicing delinquent loans. A larger fraction of non-bank originations are insured by the Federal Housing Administration (FHA) or Department of Veterans Affairs (VA).
The high rate of defaults on non-bank mortgages, many of which are now state owned, is cause for concern. Among the state orchestrated mortgages in Government National Mortgage Association (Ginnie Mae) pools, the data indicates that mortgages originated by non-banks are twice as likely as bank-originated mortgages to be two or more months delinquent.
The authors warn that in the event of a crisis, non-banks have limited resources to draw upon and the government would probably bear the majority of increased credit and operational losses. Further, failure of these non-banks could result in a considerable contraction in mortgage credit availability, especially for lower-income and minority borrowers, who are more likely to receive mortgages from non-bank lenders.
No “bullet-proof” solutions
In looking at solutions to such exposure, the report’s authors suggested a closer relationship between mortgage specifications and economic realities. One of the proposals they consider would automatically index mortgage payments to local economic conditions. Under this proposal, mortgages wouldn’t operate under a rigid contract that sets a fixed or variable rate. Instead, payments would automatically adjust as local economic conditions change. Because such a system would circumvent financial intermediaries, homeowners could see much faster debt relief during economic downturns than was provided by debt relief programs during the last housing crisis; notably the Home Affordable Refinancing Program (HARP) and the Home Affordable Modification Program (HAMP).
The report’s authors also stress that although indexed mortgage contracts would allow for quick debt relief, their implementation requires policymakers to have a solid understanding of the market’s underlying risk structure and how that would relate to the new indices. Additionally, they say government will still have to rely on post-crisis debt relief solutions because of the difficulty in predicting how markets will evolve.
Tellingly, after evaluating several proposals and data-sets, the authors conclude that there is no single “bullet-proof” solution. They argue that national-level policies—for example monetary policy tools—are likely to be too blunt.
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