No sooner had the U.S. housing recovery begun than warnings of a new bubble started popping up across business blogs the web over. The premonitions are many and varied: some wonder whether prices are climbing back too fast, others worry that there are too many investors and too few traditional homebuyers, others fear that expectations about home prices are once again too optimistic. Others, less bearishly minded, are in wait-and-see mode. Here in California, one of the hot spots of the housing revival, a large real estate consulting group recently told me that while they do not believe the market is in a bubble now, there’s a possibility it will find itself in one in the not-so-distant future.
Without a doubt, there will be a new housing bubble at some point. Boom-bust cycles are almost a law of physics in real estate. The crucial question is how quickly a new bubble could form and whether it could be as dangerous for the wider economy as the last one has been. Unfortunately, the answer to either of those questions isn’t reassuring. Nearly seven years after the big bust of 2006, the U.S. is still working on new mortgage rules—and what’s been produced and proposed so far might still be too lax.
The guiding principles behind the mortgage regulatory overhaul, set out in the gargantuan Dodd-Frank financial reform act, were simple enough: first, lenders should be legally responsible to ensure that borrowers can actually repay their loans; second, mortgage originators that pack the loans into securities to sell to investors should be forced to “keep some skin in the game” —the idea here being that if they can’t pass on all of the risk to others, they’ll be more cautious. Dodd-Frank left it up to the bureaucrats to come up with specific rules that would help realize both goals.
Last January, the Consumer Financial Protection Bureau (CFPB), tasked with taking care of the first objective, released a new set of rules outlining how exactly lenders should go about determining homebuyers’ ability to repay. The rules, which will take effect next January, include a series of commonsensical guidelines such as limiting how much debt people can be allowed to take on compared to the size of their incomes and avoiding a series of risky practices such as mortgages with “teaser rates” that start out small and then rise exponentially. Lenders who do not want to follow these guidelines and return to the wacky underwriting practices and exotic mortgage products of the heydays of the housing bubble can still do so, but at their own peril: the new rules ensure that they face greater legal liability, so that, for example, borrowers can sue for damages in case of foreclosure. That might be a powerful enough deterrent. Crucially, though, the CFPB did not include any downpayment requirements.
The task of ensuring that mortgage securitization won’t return to being the pass-the-buck sport that spread subprime risk throughout the entire economy was up to the Federal Reserve. In 2011 the bank and other regulatory agencies issued a proposal to oblige securitization sponsors to retain at least 5% of the credit risk associated with the mortgage underlying a securitization, unless the homebuyer has made a 20% downpayment on said mortgage. The rules, though, aren’t final and in a February hearing before Congress Fed Governor Daniel Tarullo indicated regulators might wave the downpayment requirement and use something closer to the CFPB’s definition of a low-risk mortgage to determine which loans would be exempt from the 5% rule.
Under that scenario, Americans will have easy access to no-money-down mortgages—which tend to make defaults more likely because even a small drop in prices leaves homeowners owing more than their house is worth. Further, lenders can still securitize all but the junkiest, shadiest loans (in Canada, by contrast, only 28% of the mortgage market is securitized).
To be sure, it’s too soon to say that the incentives built into the new rules aren’t good enough. Credit conditions are still irrationally tight, with paranoid lenders currently denying loans even to worthy borrowers. With the housing market once again on an upward trajectory, though, that crisis mentality might soon fade away. That’s when we’ll know whether the new rules are a legislative masterpiece—or a bad case of too little and fairly late.
Erica Alini is a California-based reporter and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy. Follow her on Twitter: @ealini.