If one principle in financial regulation reached a consensus in 2014, it’s that decreased leverage creates stability throughout the system. Leverage describes the amount of debt used to finance a financial institution’s assets. It can significantly increase profits, but it also increases risk. Overleveraged companies turn small setbacks into major events, and their subsequent insolvency can cascade through the financial system and lead to government bailouts. The financial crisis of 2008 was fueled by highly leveraged companies making ultimately unsuccessful bets on the mortgage market.
But there’s still a large — and widening — disconnect between how regulators treat leverage for banks and for homeowners, and a recent move by mortgage giants Fannie Mae and Freddie Mac could reintroduce dangerous risks into the housing market.
On the bank side, Sens. Sherrod Brown (D-OH) and David Vitter (R-LA) teamed up last year on a bill that would significantly reduce leverage for the largest financial institutions. It never got a vote, but this year, it won the argument. The Federal Reserve increased the leverage ratio for banks in April, to double the international standard set by the Basel III process. It then added a liquidity coverage ratio, forcing banks to have enough funds on hand to maintain operations for 30 days. The Fed then announced at a Congressional hearing in September that it was working on a “capital surcharge” for the largest banks.
The proposed rule, announced just last week, would force the eight biggest banks to carry as much of 11.5 percent of their risk-weighted assets in equity, one and a half times the international standard. While not at the 15 percent level favored by Brown and Vitter, all of the movement by the regulators has been in their direction. “The Fed’s move today is a simple matter of common sense,” Vitter said last week, “and we’ll continue fighting to build on this and protect the taxpayers from financial risks.” New global rules issued by the Financial Stability Board, a global regulatory body, get even closer to the standard set in the Brown-Vitter bill.
Banks like JPMorgan Chase, which faces a $22 billion capital shortfall under the proposed Fed rule, can raise capital through methods like retaining their earnings. Or they could shrink to avoid the additional capital requirements. Fed Chair Janet Yellen hoped the rule “would encourage such firms to reduce their systemic footprint and lessen the threat that their failure could pose to overall financial stability.”
The presence of risk-weighting in the capital rules means that banks can merely shift their mix of assets to “lower-risk” ones to stay within the rules, and the prospect exists for gaming the system. But we are moving toward an environment where financial institutions have enough capital to absorb their own losses rather than relying on taxpayers. And despite cries from Wall Street that higher capital requirements would inhibit economic growth, they have actually had virtually no effect on lending volumes or costs.
But if the Fed reducing leverage at banks stabilizes the financial system without deterring the economy, why are other regulators so adamant on increasing leverage for homeowners?
After all, that’s the practical effect of mortgage giants Fannie Mae and Freddie Mac giving the green light to homeowners to borrow $97 for every $100 used to purchase a home. The new down payment rules theoretically make it easier for homeowners to get into a mortgage, but it also makes it easier for that mortgage to fail. And we have a very recent, very painful precedent of what can happen if a lot of homeowners default on their loans all at once.
The rules work like this: Fannie and Freddie, which mainly purchase eligible mortgages and package them into securities to provide more funding for the housing market, previously would not buy loans where customers made down payments of less than 5 percent. They have now created circumstances where loans would qualify with down payments of 3 percent. That means that a modest 3 percent shift in the value of the home would put the borrower underwater (if you add in closing costs, the borrower could be underwater the moment they sign their name to the mortgage).
This is intended mostly to help first-time homebuyers, particularly those who may have the income to afford a mortgage but not the assets to put a lot of money down. First-time homebuyers have dropped to 29 percent of purchases since the housing bubble collapse, well below the historical average of 40 percent.
The Federal Housing Finance Agency says that qualifying loans must be fixed-rate mortgages, strongly underwritten to ensure ability to pay. “These underwriting guidelines provide a responsible approach to improving access to credit while ensuring safe and sound lending practices,” said Mel Watt, director of the FHFA. However, buyers with credit scores as low as 620 can be eligible for the program.
Contrary to some housing advocates’ claims, lowering down-payment requirements does increase risk of default. Dean Baker confirmed this by looking at the advocates’ own studies. A Center for Responsible Lending report shows that default rates on loans with down payments between 3 percent and 10 percent are 45 percent higher than loans with higher down payments. A “fresher” analysis from the Urban Institute showed a similar discrepancy, which the study masked by comparing default rates between 3 and 5 percent. If you do a more legitimate comparison, you find that low down payments are far more likely to default. And these are the studies from advocates!
The bigger fear is that, once you open up the credit box, you won’t be able to stop yourself. Maybe it starts by targeting specific “responsible” borrowers, but there’s always someone on the other side of that line who could be brought in by pushing the envelope a little more. This underwriting drift put us in the predicament we saw during the housing bubble’s implosion.
The worst part of increasing leverage for homeowners is what recent history shows us about the aftermath. Highly leveraged banks received government support; highly leveraged homeowners received almost nothing but a foreclosure notice and a ruined credit history. We should not be in the business of encouraging people with average incomes to take on hundreds of thousands of dollars in debt in a way that adds to their risk of default. Because there’s no safety net for them if they fail.
If these mortgages were so safe, banks would not wait for Fannie and Freddie’s go-ahead to issue them on their own. But they would rather offload the risk to the government and take back the profits. Homeowners don’t have that luxury.
As Kevin Drum points out, excessive leverage was the main driver of the financial crisis. When it comes to banks, regulators and experts seem to understand that. But when it comes to homeowners, they ignore that lesson, even though leverage on consumers is no less dangerous, and possibly even more so, than leverage on financial institutions. In fact, overleveraging homeowners with debts they cannot afford will unquestionably backfire on banks over time.
Underwriting standards have eased for just about every financial product except mortgages, and the government, wanting to reverse housing market sluggishness, wants to push mortgages over the edge as well. That drive for short-term economic gain simply generates unavoidable risk. We would justly decry the abandonment of bank leverage rules; the same rules should apply to protect homeowners.
Top Reads from The Fiscal Times: