A decade after housing bust, mortgage industry on shaky ground, experts warn

Despite tough banking rules put in place after last decade's housing crash, the mortgage market again faces the risk of a meltdown that could endanger the US economy, warn two Berkeley Haas professors in a paper co-authored by Federal Reserve economists. The threat reflects a boom in non-bank mortgage companies, a category of independent lenders that are more lightly regulated and more financially fragile than banks — and which now originate half of all US home mortgages.

"If these firms go out of business, the mortgage market shuts down, and that has dire Implications for the overall health of the economy," says Richard Stanton, professor of finance and Kingsford Capital Management Chair in Business at Haas. Stanton authored the Brookings paper, "Liquidity Crises in the Mortgage Market," with Nancy Wallace, the Lisle and Roslyn Payne Chair in Real Estate Capital Markets and chair of the Haas Real Estate Group. You Suk Kim, Steven M. Laufer, and Karen Pence of the Federal Reserve Board were coauthors.

During the housing bust, non-bank lenders failed in droves as home prices fell and borrowers stopped making payments, fuelling a wider financial crisis. Yet when banks dramatically cut back home loans after the crisis, it was non-bank mortgage companies that stepped into the breach. 

Now, nonbanks are a larger force in residential lending than ever. In 2016, they accounted for half of all mortgages, up from 20 per cent in 2007, the Brookings Institution paper notes. 

Their share of mortgages with explicit government backing is even higher ê non-banks originate about 75 per cent of loans guaranteed by the Federal Housing Administration (FHA) or the US Department of Veterans Affairs (VA).

Non-bank lenders are regulated by a patchwork of state and federal agencies that lack the resources to watch over them adequately, so risk can easily build up without a check. While the Federal Reserve lends money to banks in a pinch, it does not do the same for independent mortgage companies.

In stark contrast with banks, independent mortgage companies have little capital of their own and scant access to cash in an emergency. They have come to rely on a type of short-term funding known as warehouse lines of credit, usually provided by larger commercial and investments banks. It's a murky area since most non-bank lenders are private companies which are not required to disclose their financial structures, so Stanton and Wallace's paper provides the first public tabulation of the scale of this warehouse lending. They calculated that there was a $34 billion commitment on warehouse loans at the end of 2016, up from $17 billion at the end of 2013. That translates to about $1 trillion in short-term "warehouse loans" funded over the course of a year.

If rising interest rates were to choke off the mortgage refinance market, if an economic slowdown prompted more homeowners to default, or if the banks that extend credit to mortgage lenders cut them off, many of these companies would find themselves in trouble with no way out. "There is great fragility. These lenders could disappear from the map," Stanton notes.

The ripple effects of a market collapse would be severe, and taxpayers would potentially be on the hook for losses posted by failed mortgage companies. In addition to loans backed by the FHA or VA, the government is exposed through Ginnie Mae, the federal agency that provides payment guarantees when mortgages are pooled and sold as securities to investors. The mortgage companies are supposed to bear the losses if these securitised loans go bad. But if those companies go under, the government "will probably bear the majority of the increased credit and operational losses," the paper concludes. Ginnie Mae is especially vulnerable because almost 60 percent of the dollar volume of the mortgages it guarantees comes from nonbank lenders.

Vulnerable communities would be hit hardest. In 2016, non-bank lenders made 64 per cent of the home loans extended to black and Latino borrowers, and 58 percent of the mortgages to homeowners living in low- or moderate-income tracts, the paper reports.

The authors emphasise that they hope their paper raises awareness of the risks posed by the growth of the non-bank sector. Most of the policy discussion on preventing another housing crash has focused on supervision of banks and other deposit-taking institutions. "Less thought is being given, in the housing finance reform discussions and elsewhere, to the question of whether it is wise to concentrate so much risk in a sector with such little capacity to bear it," the paper concludes.

Stanton adds, "We want to make the nonbank side part of the debate."