Housing Still in Cumulative Downward Cycle?

Why would financial institutions want to put home mortgages on their balance sheets right now?

Answer: they really don’t want to add mortgages to their balance sheets.

The consequence is that very tight credit standards exist for mortgages at the present time, a time when credit standards have usually been increasing as the economy comes out of a recession. A Federal Reserve report covering the third quarter of 2010 showed that 13 percent of bank loan officers stated that they were working with tighter requirements. Only 4 percent stated that they were working with easier ones.

Banks, of course, are not issuing non-governmental mortgage-backed securities. In fact, the amount of mortgage-backed securities outstanding has plummeted beginning in 2008. Federal Reserve statistics indicate that privately issued pools of home mortgages fell by $310 billion in 2008, by almost $340 billion in 2009 and have fallen by about $230 billion in 2010.

Agency- and GSE-backed mortgage pools are increasing but at a rate way below previous levels.
In 2008, home mortgages totaled over $11.1 trillion; at the end of the third quarter of 2010, there was only about $10.6 trillion in home mortgages outstanding in the United States, a 4.5 percent drop.

It is apparent that financial institutions do not want to hold mortgages on their own balance sheets and if they cannot securitize them and sell them then they just don’t originate them.

There appears to be two reasons contributing to this behavior. First, delinquencies and foreclosures are still increasing at near record rates. Trying to work out loans that are delinquent and carrying out the process of foreclosure takes time and human resources, resources that could be used to originate mortgages. Second, home owners do not seem to be borrowing if they don’t have to. Mortgage applications have fallen by more than a third from the levels reached in late 2008 and show an almost continuous decline in 2010. Why should home people move if they don’t have to and home prices continue to decline?

Furthermore, Fannie Mae and Freddie Mac have gotten very aggressive demanding that commercial banks buy back defaulted loans if it can be shown that the mortgages Fannie and Freddie acquired were not originated under stated underwriting guidelines. Financial institutions are scared due to the fact that if they have to buy back defaulted loans…it may put them out of business.

Why should the affected banks make any more loans if they might go out of business? Making loans under these circumstances is just a waste of time.

In terms of home prices, Zillow.com has reported that home prices will have dropped by about 7 percent in 2010. In 2011, Fitch Ratings has projected a further 10 percent decline in home prices.

The dynamics of the housing market, therefore, is that falling employment and incomes are still a problem in many sectors of the economy. Banks are not very willing to originate new home mortgages and have tightened requirements to obtain loans. Housing prices fall because the demand for homes has dropped and there is a large inventory of foreclosed properties on the market. This puts more homeowners “under water” with respect to the outstanding loan values they have. And the cycle continues…downward.

Given such a cycle, there is very little incentive for financial institutions to put home mortgages
on their balance sheets.

But, there is another possibility threatening the value of the home mortgages already on the balance sheets of commercial banks.

Fannie Mae and Freddie Mac are reported to be in discussions with people from the Obama administration seeking support for a program to write down loan balances on home mortgages where the borrowers mortgage is greater than the current market price of their homes.

Doing so would help these home owners by “forgiving” the amount of the loan that is underwater. This would reduce the probability of more foreclosures due to a mortgage being underwater and it would also have the effect of reducing loan payments. The “write down” would cost the American taxpayer as the government would have to pay for the amount written down.

Even more scary is the fact that if Fannie Mae and Freddie Mac start to reduce loan amounts to levels that are more consistent with current prices, what pressure would be put upon commercial banks to do exactly the same thing? And, this pressure would seemingly grow as the next Presidential election came nearer.

Commercial banks, both the largest 25 banks in the country and those smaller than these 25 banks, have slightly more than 14 percent of their assets in home mortgages. How much of a hit could these banks absorb and still remain solvent?

Even a little more “write down” in the face of all the other problems that reside on the balance sheets of the banking system would seem to be very troublesome. (See, for example, http://seekingalpha.com/article/241787-the-pending-2011-debt-refinancing-for-commercial-banks.)

The banking industry is fighting such a write down.

The problems existing banks are facing just seem to go on-and-on. Is it any wonder that the banking system, as a whole, is shrinking its loan portfolio? Is it any wonder that federal regulators are continuing to “prop up” the banking system so that these difficulties can be worked out as smoothly as possible? Is it any wonder that the banking system is not contributing to the economic recovery?

Even with some economic recovery taking place, there are still areas of the economy…housing and commercial real estate…that seem to be in on a cumulative downward cycle.