This article examines the role of loan-to-value ratios in mortgage loan originations and addresses the need to curb bond market volatility by limiting lender risk-taking.
Despite lessons learned from lending practices that precipitated the Great Recession of 2008, Wall Street Bankers still prefer the government to let the financial markets freely maneuver an unregulated course. However, real estate and business markets thrive on credit (money), and the origination of loans extending that credit must be regulated to fence in the greed of investment bankers pulled toward the blackhole of undisciplined competitive advantage. Opponents leaning against increased regulation fail to see how the deregulated home loan market (which began in 1982) encouraged “brinksterism:” an ever-faster communal push toward failure, unimpeded by rules-of-the-road.
As a nascent bill, the contents of what became the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) would have muffled the extreme highs and lows of the credit correction cycles that have precipitated the real estate booms and busts during the past two decades.
However, only the politically viable components were enacted as law. In the early ‘90s, members of Congress were as eager as they are now to limit loan-to-value (LTV) ratios on real estate loans. Reasonable LTV ratios and FHA-type restrictions would have eliminated the speculative lending practices we have experienced since 2001. The resulting FDICIA only established guidelines, thanks to complaints from bankers that lending limits would be costly to manage and growth-prohibitive for their institutions. With greatly reduced downpayment requirements and no punitive stick to force adherence to Congressional suggestions, the lender’s natural predator (regulation) was effectively de-fanged. Thus, failure became the only remaining curb to growth, as is always the case with the deregulation of money.
Perhaps the most detrimental consequence of Congressional failure to implement effective regulation is a continued boom-bust cycle abetted by the bubble-producing mentality that real estate values are always headed up. This myth of ever-skyward real estate prices leads to speculative pricing condoned by mortgage lenders making riskier home loans to the most questionable of homebuyers.
A recent economic letter by Jeffery Gunther of the Federal Reserve Bank of Dallas titled, “Taming the Credit Cycle by Limiting High-Risk Lending,” speaks to the influence speculative pricing had on loans: an estimated 35 – 40 % of subprime mortgage originations in 2005 and 2006 had an LTV of 90 % or higher. This low-downpayment practice by the growth-hungry, regulation-averse Wall Street banking industry is directly, and perhaps singularly, responsible for housing bubbles. Certainly the greater implication of deregulation is that light-on-equity mortgages now worth nickels on the dollar weigh down the entire financial community (real estate construction and sales volume in particular) and, by extension, burden the United States taxpayer with the resulting bailouts.
The manufacturing-based economy from which we are evolving might have done better with less regulation because wealth in such an economy is created by wage-earners who produce goods and services. In contrast, the current economic model is fueled by credit—the availability of cash acquired through loans. To be effectively risk-free, loans must have tangible assets attached to them. Collateral of sufficient value ensures the credit supply is driven by paying customers rather than lenders blowing through a money supply supported by the unlimited capacity of the Federal Reserve.
Our present real estate valuation situation is directly connected to the deregulation commenced three decades ago: a one-two punch delivered whole by the permissive attitude of Wall Street. Bankers’ instincts to attain ever greater competitive advantage over their equals (when rules allow it) predetermined their failure. One exception: they successfully created ever riskier loans with greater profits to attract more and more investors, giving themselves the profit advantage necessary to retain investors at the expense of their peer bankers.
What regulations, if enforced as law rather than as humble guidelines, would prevent housing bubbles in the future?
It is imperative that LTV standards on real estate loans require owners to maintain equity in the property based on the actual value of the mortgaged home. To accomplish this, lending parameters must be legislated to keep lenders in conformance. Leaving property valuation up to brokers and appraisers has never and will never replace the lender’s responsibility for sufficient property values. Without fencing to circumscribe lending limits, Wall Street’s investment in real estate-related activities will always be corruptive; especially when the Federal Reserve massively increases the money supply during periods of growth (as in the 2001 – 2004 period). Any new regulations born out of the climax of Wall Street’s failures in 2008 must take LTV standards into account.
Lenders are now playing it safe in our post-collapse era. However, once positive momentum returns to real estate markets, these same lenders will turn their competitive-advantage instincts toward riskier loans, creating a supply of speculative credit (via over-leveraged LTV mortgages) to fuel the demands of homebuyers and homeowners with less and less to put up as collateral. Thus we see how bouts of cyclical euphoria germinate and bloom.
Such extreme real estate market swings are another target of the Gunther letter: a consistent application of LTV and downpayment requirements would spawn steady growth and rein in the wobbly to-and-fro of bubble-driven booms and their subsequent debilitating corrections. The greater implication of added regulation is that rules will not only deter the origination of risky mortgage loans, but also prevent them from becoming the sole assets backing up risky bonds. It was the goal of lenders to originate loans and quickly sell them into the bond market. In that process, called securitization, they supplied worthless paper to individual investors who were pooled together to cement the Ponzi-esque market collapse of 2008.
The real estate industry would also benefit by avoiding the onslaught of tens of thousands of erstwhile, newly-dubbed licensees looking for a hit-and-run advantage and searching for huge profits produced by the unique mix of price momentum and fast, easy money.
It is jobs and the ownership of real estate and businesses that give the U.S. economy a solid bedrock for sustained growth. In turn, the Federal Reserve supplies the money which is brokered by bankers to provide liquidity—loans—for real estate and business deals. As the middlemen, bankers of all stripes must be regulated to corral their activities, as accomplished by fencing in Bulls.