Sunday, December 12, 2010

Spiraling Down: Housing Recovery Make Take Time

DECEMBER 13, 2010
Housing Shaky as Lenders Tighten
By NICK TIMIRAOS, Wall Street Journal

Economists are worried that the housing sector may be heading into another downdraft as mortgage lenders continue to tighten already restrictive lending standards.

Such a scenario seemed less likely earlier this year, when home-buyer tax credits fueled a surge in sales. But sales have plunged in the second half of the year after those credits expired. New and existing home sales were down by more than 25% in October from a year ago.

Meanwhile, applications for mortgages have hovered near their lowest levels in more than a decade since May, even though mortgage rates have tumbled to their lowest levels in 60 years, with average 30-year, fixed-rate loans bottoming at 4.21% in October.

"We must realize that having very tight credit at the bottom of the cycle is a mistake. We are retarding the recovery," says Kenneth Rosen, a housing economist at the University of California at Berkeley.

The U.S. has normally relied on an expanding housing market to help lift the economy as it exits a recession by fueling manufacturing, consumer spending and job growth. In the first year of all postwar recoveries, residential investment has accounted for nearly one percentage point of gross-domestic-product growth, says Doug Duncan, chief economist at Fannie Mae. But today, it has accounted for around 0.1 percentage point of GDP growth.

Given the glut of foreclosures that will continue to hit the market, "at a time when you need more borrowers, you actually have less," says Laurie Goodman, senior managing director at Amherst Securities Group LP.

Lenders clamped down on the lax standards that fueled the housing bubble three years ago by requiring larger down payments, higher credit scores and greater documentation of borrowers' incomes and assets.

Economists say lending standards typically ease at this point in the business cycle as banks look for new business. But that isn't happening now because private lenders have ceded the market to government entities Fannie Mae, Freddie Mac and the Federal Housing Administration. Those agencies, saddled with losses, are under heavy political pressure to avoid taking any new risks. "The general feeling is, 'Let them be as tough as they want,' " says Guy Cecala, publisher of Inside Mortgage Finance.

During the third quarter, 13% of bank loan officers surveyed by the Federal Reserve reported that standards had grown tighter, while fewer than 4% said standards had loosened.

"Right now, we're in that vicious cycle where we tighten, which makes things worse, so we tighten, which makes things worse," says Bob Walters, chief economist at Quicken Loans. "How do you get out of that cycle? Folks in government are going to have to stand in and make some calls."

Banks have become more restrictive in part because Fannie and Freddie are stepping up demands for banks to buy back defaulted loans when they can prove that the mortgage didn't meet underwriting guidelines, an expensive proposition for banks.

"Originators are scared to death. We are being intensely cautious because we understand that the franchise could be on the line," says Mr. Walters. He says tightening could continue "for at least a year, maybe longer."

Loan officers say one of the biggest problems right now is a requirement that borrowers prove their incomes by relying on at least two years of tax returns. That often trips up self-employed workers and small-business owners who take deductions that shrink their taxable income. It could also sink borrowers who were unemployed for a short time or had a recent salary reduction.

The consequence is that lending is bifurcating into two worlds. Salaried workers who can easily document their earnings are able to qualify for mortgages with down payments as low as 3.5% through the FHA. Self-employed borrowers are having a harder time even if they have assets stashed away.

Ivy Zelman, chief executive of housing research firm Zelman & Associates, says there are reasonable concerns that the government has provided "too much liquidity" in some markets through the FHA. But she says it's also the case that originators aren't always taking a careful look at an individual's ability to repay a loan, "and that could be preventing some truly good borrowers from getting loans."

Another worry is that the industry has also come to rely too heavily on credit-score cutoffs, something loan officers say can inhibit common sense underwriting. While the FHA has a minimum credit score for low-down-payment loans of 580, many banks won't sponsor loans with credit scores below 640. Average credit scores for borrowers with FHA-backed loans surpassed 700 in October for the first time.

No one wants a rerun of the past five years, when carelessness in underwriting fueled a painful explosion in mortgage liquidity. But the inverse carries its own dangers today: By imposing rigid standards that shut out qualified borrowers, banks and the government risk making it harder for the housing market to dig out of its hole.

Write to Nick Timiraos at