As summer turned to autumn, the Federal Reserve continued its practice of raising interest rates to stop and reverse the inflationary pressures on the U.S. economy that has become one of the foremost domestic issues of 2022. A natural outcome of raising interest rates is a litany of articles in the industry and popular press that cry the potential impact on the housing market. What will happen to defaults and delinquencies? What will happen to new home loan production? If we are in a price bubble, will it, or when will it burst and how low are prices likely to fall as a result. The ability of the industry press to recycle the same cautions may be justified, however, given historical data from periods of interest rate increases over the last ten years we suggest that the risk of widespread collapse of the housing market akin to 2008-2009 is overstated. We do believe, however, that the focus on the consumer response to higher interest rates is the wrong place to go looking for an taking actions to address the real risk in the housing finance system today.
What the Data Shows
SP Group examined the period between January 2013 and November 2019 that involved increases in mortgage interest rates to identify potential changes in the number of seriously delinquent FHA-insured single family home loans and any effect on the level of new loan applications. We used data published by the U.S. Department of Housing and Urban Development (HUD). The findings are represented in Figure 1.
During this period, there were three episodes where mortgage interest rates increased above 4 percent: March 2013, September 2016, and November 2017. Interest rates are depicted in the blue line in the figure. The red line is the number of seriously delinquent loans (i.e., loans past due more than 90 days). If there were a direct positive correlation between interest rates and the number of seriously delinquent loans, one would have expected the blue and red lines in the graph to change in the same direction at the same time, (assuming some degree of lag). Instead, serious delinquencies were on a steadily declining trajectory, except for late 2016, throughout all the three periods when mortgage interest rates rose above 4 percent.
In 2013, loan application volume did respond to the increase in interest rates, but one could argue that demand for new loans was declining even before mortgage interest rates increase in March of 2013. The number of new loan applications remained relatively stable throughout the period, with only a modest decline at the end of 2016 and again in November 2018.
So, Where is the Risk?
Even though the data does not suggest that an increase in mortgage interest rates will automatically result in an increase in the number of seriously delinquent loans, the fact that housing costs are rising along with other basics such as food, energy, health care and others is likely to result in an increase in the number of seriously delinquent loans.
In our analysis, we intentionally focused on the pre-COVID period because the extraordinary stress that the pandemic exerted on the economy would skew any attempt to understand interest rates, delinquencies, and new loan demand in a normal market. It is true, however, that institutions, working with government weathered the COVID crisis well, and one reason often mentioned to account for the lack of collapse in the housing finance sector was the degree to which institutional lenders had learned lessens from the 2008-2009 period and that they were more prepared to provide effective loss mitigation programs to borrowers in distress.
The real risk now is the potential that in the event of severe adverse economic circumstances, independent, non-bank lenders, who comprise approximately 90 percent of the new loan originations, will not be able to fulfill their responsibilities to fund principal and interest payments as required under their agreements with GNMA.
Laurence E. Platt, writing for Mayer Brown cited the need for more financial strength of independent, non-bank mortgage servicers.
The financial strength of independent, non-bank mortgage servicers has been under sharp scrutiny by the US Financial Stability Oversight Council (“FSOC”), the Conference of State Bank Supervisors (“CSBS”) and the Federal Housing Finance Agency (“FHFA”), along with Fannie Mae and Freddie Mac, and Ginnie Mae. At issue is whether such mortgage servicers can withstand an adverse economic environment.
Platt points to the need for heightened financial strength requirements for independent non-bank mortgage servicers seems to be the solution of choice for policy makers these days and despite initial difficulties in reaching consensus of standards, he notes that alignment will require non-bank mortgage servicers to amass more net worth, more capital and more liquidity than required under existing standards.
Platt correctly states that:
The underlying rationale for a different paradigm than exists today is that mortgage servicers are mere service providers and should not have to bear the servicing advance requirements when profound, material adverse changes occur in the economy at large, given that the servicer has no beneficial ownership of the pooled mortgage loans and the related securities. Ironically, the holders of Ginnie Mae guaranteed, mortgage-backed securities are insulated against the risk of borrower delinquencies in adverse economic circumstances, but their service providers are not. Maybe it is time to re-think the servicer’s advance obligations—not whether the securities holders should receive these advances, because that might turn themarket for Ginnie Mae securities upside down—but whether there should be a ceiling on the servicer’s obligation to make these advances to securities holders in periods of adverse economic circumstances. In other words, while policy makers are justifiably concerned about the potential impact of adverse economic circumstances on non-bank, independent mortgage servicers, maybe they also should be looking in the mirror to find solutions.