A closer look at the markets that are under greatest stress — mortgage lending

It seems like every week we hear about some sort of trouble with the mortgage market — from Standard & Poor’s warning about loan stress to warnings that interest rates could rise enough to bring banks to the edge of insolvency.

Most problems have been centered on interest rates and defaults, and on areas that have not yet shown signs of distress, such as California. But even some mortgage investors, whose money funds are prized by bond investors, are concerned that this may be the prelude to a serious market dislocation.

Lenders have tightened their criteria, and some of their biggest banks, such as JPMorgan Chase, have pledged to reduce their real estate lending volumes to protect themselves from loan losses. The Federal Reserve, responding to the S&P warning on mortgage problems, has raised the specter of a slowdown in mortgage lending.

Recently, concerns have focused on how the new regime of mortgage regulation, with tougher mortgage underwriting standards, might create new risks and make it harder for would-be borrowers to buy a home.

Still, it’s worth thinking about how the rules have already changed, even if it’s still too early to see clear signs of crisis, and what might lie ahead.

Nowhere are the changes more profound than in the treatment of equity. Before the reforms, banks were allowed to keep up to 70 percent of the equity in mortgage-backed securities they issued. The new rules require that a higher share of equity be contributed by the investor, which will force banks to write down more expensive loans.

While the percentages are changing, the rule does give lenders the same flexibility to allocate equity and protect against losses as they always had. But banks have leeway, but they also need the equity to compete for borrowers.

Under the new rules, lenders also need to wait at least 90 days between the last payment and the last date on which they can foreclose on a home. This is intended to give lenders time to work with borrowers who are in danger of defaulting — and to prevent lenders from attempting to push out borrowers in trouble, which in some states is illegal.

In other areas, the rules address less important risk factors that mortgage investors demand. For example, securitizers can no longer sell mortgages with loans whose closing costs are high or that still have some residual risk of principal or interest payments that are not paid off in full.

This has a number of advantages. First, it reduces the amount of refinancing that has to be done and may cool the housing market’s overheated end-of-year frenzy. Second, it makes it less likely that a loan will default, either because the borrower is forced to pay more than he can afford, or because he isn’t able to get the property sold fast enough to avoid foreclosure.

Some banks, including Bank of America, have complained that the new regulations are burdensome. But the risk of a market dislocation has become so great that they need to make such changes.

Read the full story at The Wall Street Journal.


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