Real estate Easing mortgage access: What could possibly go wrong?

On 22 February 2023, the Department of Housing and Urban Development (HUD) announced that the mortgage insurance premium (MIP) on FHA endorsed loans would be reduced by 30 bps to 0.55% from 0.85%. HUD estimates that this reduction will reduce the annual borrowing cost for the average FHA borrower by USD 800. According to HUD “the 30 basis point annual MIP reduction will apply to almost all Single Family Title II forward mortgages insured by FHA. Further, the reduction applies to all eligible property types, including single family homes, condominiums, and manufactured homes, all eligible loan-to-value ratios and all eligible base loan amounts.” The annual MIP reductions are effective for all mortgages endorsed by FHA on or after 23 March 2023. HUD estimates the year one cost of the program to be about USD 678MM. Source: HUD

One of the key differences of the current housing cycle as compared to the housing bubble period that preceded the 2008/2009 global financial crisis (GC) is the substantially higher quality of mortgage underwriting post the GFC. Largely gone are the no doc/low doc, stated income and NINJA loans (no income, no job no assets) as well as loans at exceptionally low loan-to-value ratios (LTV) to low credit quality borrowers. This is not to say that there is no risk in the mortgage system. However, by and large mortgage underwriting standards and credit quality has been substantially better over the past decade.

A significant portion of FHA loans are made to borrowers with very low, subprime or just above subprime status with high LTVs and elevated debt-to-income (DTI) ratios. One positive is that LTVs for borrowers with FICO scores # 619 have declined over the past several quarters, although they still remain above 90%.

Historically there has been a strong relationship between lower credit quality borrowers, particularly those with high LTVs and DTIs and increased delinquency, default and ultimately foreclosure rates. One of the key contributors to the plethora of “strategic defaults” during the great financial crisis (GFC) was the little skin in the game many homeowners had in their homes—that is extremely high LTVs or very little equity.

We wish to emphasize that we are not calling for another mortgage market collapse similar to that witnessed during the GFC. That said, one of the key contributors to the pre-GFC housing bubble was the plethora of higher risk mortgages.

We believe a key impetus for HUD in lowering the MIP was to make housing more affordable for lower credit quality borrowers. While this may be a laudable goal, as we have stated in prior written reports, best-intentioned policies often lead to unintended consequences. In January 2015, HUD reduced the FHA MIP by 50bps to 85pbs. In HUD's own words in a report published on 29 September 2016, “We find that lowering the annual MIP in 2015 substantially increased the number of loans to lower credit score, high-LTV borrowers—who as a group heavily rely on FHA insurance.”

There was a noticeable pickup in HUD market share pursuant to the January 2015 MIP reduction. Although this clearly benefited a group of borrowers who might otherwise have been unable to access the mortgage market, the question ultimately becomes, was overall affordability improved? Both new and existing home prices continued their strong upward trend in 2015 and beyond. We do not mean to imply that the lowering of the MIP was the key driver of this. Rather that home price affordability was more negatively impacted by rapidly rising prices rather than advantaged by a lower MIP. In our view all that was done was to enable lower credit quality, high LTV and DTI buyers to buy homes.

One of the key issues plaguing the US housing market is the dearth of available inventory. Although there has been some retrenchment of median home prices from extremely elevated levels we believe the ongoing shortage of homes for purchase, combined with elevated mortgage rates, will keep affordability very challenged, particularly for first time buyers.

Is HUD truly making housing more affordable or is policy being utilized to push less qualified buyers into purchasing a home when they lack the financial wherewithal for the rigors of homeownership?

Another concern surrounds the potential impact on the FHA's Mutual Mortgage Insurance Fund (MMI). The MMI effectively acts as an insurance pool to cover those FHA mortgages that eventually default. There is a statutory requirement for the MMI to maintain a reserve level of 2% of FHA endorsements in force. The fund MMI currently stands at approximately 11%. As such, there is little worry of a stress situation for the MMI. That said, during the global financial crisis, the MMI reserves were negative and the MMI required a taxpayer-funded bailout. Although seemingly unlikely today given the strong reserve levels, future stress in the MMI is possible given the high level of lower credit quality borrowers utilizing FHA mortgages and the policy-induced MIP reduction recently enacted by HUD.

Among our biggest concerns in the real estate market, either residential or commercial, is the impact of policy. While there was much blame to go around for the suboptimal behavior during the housing bubble that ultimately contributed to the GFC, we believe misguided policy at the federal level was a significant contributor to ultimate collapse in the housing market in 2008. To be clear, we are not implying a repeat of the housing collapse is on the horizon. We believe many supporting factors exist that should better insulate the housing market from significant distress in the current cycle. That said, we all need to remain vigilant of the potential unintended consequences of policy decisions, particularly those made with nationwide elections not far off in the future.

Main contributor: Jonathan Woloshin

Read the original report Easing mortgage access: What could possibly go wrong? 24 February 2023.

This content is a product of the UBS Chief Investment Office.