Mortgage Credit Determinants: Traditional Income or Down payment?

Banks do not seem eager to create more mortgage availability

by Ron D’Vari, CEO, James Frischling, President, & Roger Pietka, AssociateNewOak

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Government-sponsored enterprises (GSEs) have been promoting credit-availability mortgage products since last October and are supporting 97% loan-to-value (LTV) mortgages. However, the banks are not convinced of the wisdom of such products as evidenced by Bank of America CEO Brian Moynihan’s statement at the bank’s investor conference.

The banks don’t seem eager to create more mortgage availability, particularly for high LTV mortgages. In their experience, banks have found high-LTV borrowers are more susceptible to default. This conclusion is supported by recent history and can be rationalized by the fact that there is little incentive for such borrowers to honor an underwater first lien obligation on their house when faced with negative equity.

At the same time, self-employed high-net-worth individuals with alternative sources of income seeking higher-balance, lower-LTV loans are also facing strict credit criteria due to regulatory capital requirements. Such mortgage products fall into the non-qualified mortgage (non-QM) category, and banks are still evaluating their strategy around these products. Credit risk is measured by three factors:

  • 1) ability to repay,
  • 2) willingness to repay, and
  • 3) ability to collect or collateral

Arguably, lower-LTV mortgages are safer in terms of recovery. High-net-worth, combined with a higher equity basis in a home, supports willingness to repay, final collectability and lower severity if there are bumps in the circumstances of the borrower. However, current regulatory standards don’t fully recognize that and emphasize the traditional sources of income from regular employment more. These factors make higher-LTV QM mortgage products more susceptible to volatility in the housing and job markets, affecting ability to repay and willingness to pay due to negative equity.

All eyes on the European Central Bank

The European Central Bank (ECB) is expected to unveil its quantitative bond-buying program on Thursday and, with the Eurozone under pressure, the announcement will have a major impact on global markets. The upcoming election in Greece and the risk that a Syriza party victory would result in the pursuit of debt relief has raised some concerns and re-opened the conversation about a Greek exit from the European Union (EU).

More recently, the Swiss National Bank’s decision to remove the cap on its currency has caused havoc in the foreign exchange markets, but all of this is relatively small when compared to what’s expected from the ECB. The markets are expecting a large-scale quantitative easing (QE) program and the risk that the size of the package may disappoint is a real concern. Germany has been skeptical about ECB bond buying, with concerns about its effectiveness and its risk-sharing nature. Without Germany’s support, it will be difficult for the ECB to deliver the grand package the markets want and expect.

...banks have found high-LTV borrowers are more susceptible to default

The U.S. Federal Reserve moved quickly and sizably in response to the global financial crisis, and expectations have grown that the ECB will need to take a page out of the U.S. playbook. The lack of a fiscal union in the EU and the different approaches of EU members’ fiscal housekeeping make a large-scale move by the ECB a delicate challenge. The markets may not be expecting a U.S.-style “shock-and-awe” QE program, but they are still looking for a large program of around one trillion euros. The negotiations will be difficult and securing a consensus a challenge. The announcement isn’t just about the QE package, but will also signal the strength of the EU and confidence in the ECB. The stakes are high and the global markets are watching.

Federal Government tiptoes further into higher-education, raising risk for colleges & universities

Today the current total outstanding student loan debt in the United States stands north of $1 trillion. During the course of their education, the average student will incur approximately $32,000 in debt obligations, an increase of nearly 70% since 2000. Further, more than 90% of the outstanding debt is publicly guaranteed, and secured by the full faith of the United States.

As this debt figure grows in line with the overall general cost of education, it comes as no surprise that the government would begin to attach strings to the system, being the guarantor of this trillion dollar obligation. In the municipal market, an increased Federal presence may introduce more volatility to the heretofore stable higher education sector. The process began on December 19, 2014, when President Obama released a 17-page proposal for a national college ratings system that will assess universities based upon access, affordability and student success outcomes. The idea is to better gauge the likelihood that a student will have the ability to repay their debt, and determine whether rising tuition rates are justified by post-education success.

The methodology is to give a three-level “good, bad, or mediocre” rating which will ultimately determine government-funded appropriations towards the institution. The system is expected to be online by the start of the next school year, though this may be an aggressive expectation considering the scope of the undertaking and the understanding that all schools cannot be painted with the same brush. A few weeks later, the president announced his plan to make two-year community college programs free, subsidizing the costs through state (25%) and federal governments (75%).

The rationale for this new program may be found in current unemployment statistics: currently 9.1 million Americans are unemployed while 4.8 million jobs remain unfilled. To the president and his cabinet, this gap exists due to a mismatch in qualified employees and professional jobs, and it could be narrowed by subsidizing the cost of an associate’s degree, providing an eventual positive effect on the overall economy. This effort, however, does not come without a price. It is estimated that over the course of 10 years the program will increase higher education spending by nearly $60 billion.

For municipal bond investors, these new federal initiatives may introduce greater volatility into the higher education sector. An eventual ranking of colleges and universities on the basis of potential “return-on-investment” may lead to sharper differentiation among these credits. Those schools which have taken advantage of the low-interest rate environment and invested heavily in their capital programs may find themselves unable to raise fees sufficiently to cover the new debt. Lower-ranking institutions may enter into a kind of “death spiral” as admissions decline and financial aid providers direct their funds elsewhere. On the flip side, community colleges may stand to benefit from additional state and federal subsidies, although in the long run, dependence on the federal role may turn out to be a double-edged sword.