Larry Summers Asks Questions: Why Haven't the Conforming Mortgage Cap Amounts Been Raised?

Larry Summers:

Economists' forum: A premise of the US financial system is that banks accept much closer supervision in return for access to the Federal Reserve’s payments system and discount window. The problem this time is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of non-banks is in question, both because of concerns about their economic fundamentals and because of cascading liquidations as investors who lose confidence in them seek to redeem their money and move into safer, more liquid investments. Central banks that seek to instil confidence by lending to banks, or reducing their cost of borrowing, may, as the saying goes, be pushing on a string. Is it wise to push banks to become public financial utilities in times of crisis? Should there be more lending and/or regulation of the non-bank financial institutions?...

[W]hat is the role for public authorities in supporting the flow of credit to the housing sector? The lesson learnt during the S&L debacle was that it was catastrophic to finance home ownership through insured banking institutions that borrowed short term and then offered long-term fixed-rate home mortgages. Now a system reliant on securitisation, adjustable rate mortgages and non-insured financial institutions has broken down.

I am among the many with serious doubts about the wisdom of the government quasi-guarantees that supported the government-sponsored entities, Fannie Mae, the Federal National Mortgage Association, and Freddie Mac, the Federal Home Loan Mortgage Corp , as they have operated in the mortgage market. But surely if there is ever a moment when they should expand their activities it is now, when mortgage liquidity is drying up. No doubt, credit standards in the subprime market were too low for too long. Now, as borrowers face higher costs as their adjustable rate mortgages are reset, is not the time for the authorities to get religion and discourage the provision of credit...

These are wise questions. I don't understand why the conforming mortgage dollar caps have not already been raised substantially.

Comments

[RNA]

I'll ask a question: why should the caps be raised?

The caps were set nationwide and are raised with inflation -- that's the way it works. In places like CA, property values have soared way above inflation.

But again, what's the public policy rationale for raising the caps? It appears that all that would do is support bubbly real estate prices. What's the public policy rationale for that?

[Nicholas weaver]

Also, lets face it, if you are getting over a $400k loan on a house, you SHOULD have to pay a real interest rate and need real proof of income.

Thats a lot of money, and a lot of debt to service even if you have a 6-figure income.

[HankP]

So, there are serious questions about the wisdom of the quasi-guarantees offered by Fannie Mae and Freddie Mac, but we should raise the limits on conforming loans anyway? Looks like the very definition of encouraging moral hazard to me.

[David Lloyd-Jones]

Brad,

In doubting the wisdom of government guarantees to quangoes (quasi non governmental organizations, a phrase which Americans would be well-advised to take on board) Larry is of course half right and completely fashionable. Moral risk, moral risk, urk, urk, let's all run around in circles and screech "moral risk."

(Is it too much to hope that some people might remember that the answer to moral risk is the police function. of course there is always moral risk, and what any reasonable society does is police it. Like that's why it's called "moral." Of course Gardner or Means or somebody pointed out that in America regulators tend to be colonized by the regulated -- a tendency of everywhere and anytime -- but maybe America had brought this tendency to a high perfection...)

There are of course times when the guarantees Larry natters about are foolish. No homecoming Veterans (uh, are we missing something here? There are hundreds of thousands of returning Veterans who need government help to get on their feet after the Hell they have gone through). No vast number of poor blacks who somehow never got that 40 acres and a mule? No striving Latinos who could use "A hand up, not a hand out," a saying from my friend Maggie. Right now in the US might be such a time; I'm not up to date on it. Maybe Larry knows more than I do. Obviously he knows more about women than I do, so he may be more informed on other fronts.

On the other hand, the return of the veterans in 1945, which defined America from 1945 up to maybe Little Rock*, was a time for it, a policy of government helping the best, or even the most, of the people, to be right. The GI Bill, in its various forms, is one of the best things the human race has ever concocted.

In the next generation the biggest thing the human race does will be a similar project for the peoples of China. (I know nothing about India, but I can imagine the possibility that the same thing may be true there and in Pakistan.)

The local, i.e. country, government standing behind its most obviously productive and decent people and families is an obvious ploy for success.

This is what America did in 1945, and what I hope China will see its way through the morass of corruption and confusion to do in the next few years.

Um, America might do worse than to return to that vision: the joint ain't perfect yet.

******

Little Rock (if not Autherine Lucy's rape) may date the beginning of the end of the Republican Party in North America, although they have stumbled on for most of the generation since.

Mike Nichols, who is currently married to one of the apparently dumb blondes of American news, said it best: "Ike was thinking of holding Thelma Mothershed, Elizabeth Eckford, and Melba Pattillo's hands. But he couldn't figure out whether to use the ovehand grip."

Ike's Federalization of the National Guard was the potential the Republican Party had -- and his chickenshit (more the much greater ignorance and stupidity of the Republicans in the House and Senate than Ike's) were the sign that the Republicans were, as they now clearly are, unworthy of America.

It's been fifty years now, but I think it's now clear. Enough!

**************

Do I have a solution? Of course I do: I'm David Lloyd-Jones, King Of Paradigms.

A Whig party.

No, neither the Greens, whose Ralph is apparently as crazy as any Trot you will meet in any meeting of the more impassioned crazies, nor the Libertarians -- who at least have the virtue of consonance with their beliefs by being disorganized -- promise much.

What could be a core of such a new party? I dunno. But I have an illustrative thought.

My guess is the division of the Democratic Party provides the best hope. Will Rogers' famous "I am a member of no organized party; I am a Democrat" remains wise.

Perhaps Senator Obama, running as a Whig, against President Clinton, in '12, and then winning against who knows who in '16, is American democracy's best hope.

I just turned 64 years old, but I am happy to find that some of my younger friends are doing well. In the generation behind Obama and Clinton there is much excellence, thought, adventure, fun, glee, and sound policy.

America is in a terrible situation right now, flat on its back in humiliating defeat.

The future, however, is probably better.

[fatbear]

The great majority of bad sub-prime loans are already UNDER the limits. Alt-A loans may be slightly larger, but even there most are under the caps. So, what would raising the caps do for those mortgagors?

Mortgage liquidity drying up is not the problem; sloppy mortgage underwriting and even worse MBS due diligence got us here (and throw in a little mortgagor/broker/originator fraud for good measure).

One can feel sorry for those folk trying to buy over-priced houses without the requisite financial ability - that seems to be the cohort Summers is trying to salve. But a tight mortgage market will help them more by forcing sellers to lower prices; and it is a dubious argument to posit that anyone should be buying a house with a 100% LTV 2/28 IO ARM.

One wonders what horse D.E.Shaw & Co. has in this race, and if there is concern for Larry's favorite non-bank.

[Richard Green]

Raising the conforming loan limit would not make much difference to the sub-prime sector.

But the problem is that the spreads on non-conforming prime mortgages have risen--for no good reason. Investors just seem to be afraid of any non-conforming mortgage. The coastal markets rely on these mortgages, and so unless spreads return to normal, we can expect to see even larger house price declines in these markets than we are already seeing.

The problem with raising the limit for the GSEs is that they showed us in 2003 and 2004 that they cannot be entirely trusted with their charters. Fannie Mae is still not current on its financial statements, and
Freddie Mac just caught up after being behind since '03. Had any other financial company performed this way, it would have been delisted from the New York Stock Exchange.

So pick your poison: allow companies that made big-time mistakes to get bigger, or allow the housing market in certain regions to deteriorate more rapidly. My inclination would be to do the former, but there are no good choices.

[Richard Green]

Raising the conforming loan limit would not make much difference to the sub-prime sector.

But the problem is that the spreads on non-conforming prime mortgages have risen--for no good reason. Investors just seem to be afraid of any non-conforming mortgage. The coastal markets rely on these mortgages, and so unless spreads return to normal, we can expect to see even larger house price declines in these markets than we are already seeing.

The problem with raising the limit for the GSEs is that they showed us in 2003 and 2004 that they cannot be entirely trusted with their charters. Fannie Mae is still not current on its financial statements, and
Freddie Mac just caught up after being behind since '03. Had any other financial company performed this way, it would have been delisted from the New York Stock Exchange.

So pick your poison: allow companies that made big-time mistakes to get bigger, or allow the housing market in certain regions to deteriorate more rapidly. My inclination would be to do the former, but there are no good choices.

[John Emerson]

I love avant-garde finance. I don't understand it, almost nobody understands it, and the people who do succeed in figuring it out are often crooks. Scholes, Merton, Schleifer, Enron, BCCI.

Yeah, I'm a Luddite with no respect for my betters. And also a paranoid who believes that finance rules the world, and The Times, and The Post, and the Democratic Party..... and so on.

[anne]

When Fannie Mae proposed adding to its loan portfolio by buying troublesome mortgages, the proposal was immediately turned down. The idea was to connect the mortgage holder to a household to allow problems to be worked through rather than allowing a loss of a home.

The proposal was helpful, but was rejected along the terms that Republicans have been quietly fighting Fannie Mae for years. There is concerted pressure by wholly private mortgage issuers to end the cost advantgae of Fannie Mae which is gained through the implicit government guarantee of Fannie Mae mortgages. An end to the guarantee would raise the cost of mortgages, and has been resisted successfuly so far.

From my perspective, Fannie Mae has allowed for fair mortgage extension to middle and lower income households that has gradually increased homeowning these several decades. I find no problem with Fannie Mae or the proposal to increaseholdings at present, but the Administration finds a problem.

[anne]

John Emerson,

I do not properly understand the current liquidity flucatuations we are experiencing, and worry about my lack of understanding, but you need to set down the express concerns you have more clearly.

[Nicholas Weaver]

"But the problem is that the spreads on non-conforming prime mortgages have risen--for no good reason."

There is a very good reason, there IS a risk premium involved in underwriting a $500-1000K loan.

An additional 100-150 basis points seems very reasonable at least until you know that the brokers are starting to behave (remotely) honestly and that housing prices are not going to drop significantly more.

After all, this is what the GSE's have always claimed to be their lot in life: providing a guarentee which can act as a ~100 basis point discount on conforming loans.

[Richard Green]

According to Loan Performance Data, the serious delinquency rate among prime conventional conforming loans in March was .69 percent; for Jumbos it was .28 percent.

By definition, prime Jumbos are those that have either LTVs at 80 percent or below or have private mortgage insurance. The borrowers have good FICO scores.

More to the point, the weird thing is not the existence of a spread between conforming and non-conforming loans (Fannie and Freddie have some sort of ambuguous government guarantess), but rather that the spread changed so much so quickly.

[kharris]

The point about Fannie and Freddie proposing to buy bad loans below the conforming limit gets at a big problem. Raising the cap addresses the trouble faced by better-off buyers, but not the trouble faced by lower-income buyers. The caps exist specifically because high-end buyers are expected to fend for themselves. This may not be a good time to be a stickler, as Summers points out, but our society already provides considerable advantage to the better off (the mortgage interest exemption, for instance). If we a going to craft a bail-out, it should not be a bail-out that only works for the better off.

[ShortWoman]

I am reminded of an old cartoon gag. Foghorn Leghorn taunts a dog, who runs after his tormentor as fast as he can, only to find himself caught short by the rope tying him to the doghouse.

Think of buyers as the dog, Foghorn Leghorn as the housing bubble, and the cap as the rope. The cap -- by being indexed to the under-measured inflation rate instead of housing prices directly -- has probably helped slow price increases in the most overvalued markets.

What I find interesting is that almost nobody is talking about the demand-side problems that have caused real estate to be so expensive in those markets: an aggressive "ownership society" propaganda campaign; areas where buildable, commutable land is scarce but the population is growing; rent controls in some cities creating artificial scarcity of rented housing; speculators.

[Walker]

I got the impression Mr. Summers was referring to Fannie Mae and Freddie Mac conforming loans. Have the rules changed?.

Is " the serious delinquency rate among prime conventional conforming loans in March was .69 percent" an unusually high percentage?

Aren't "conforming fannie or freddie loans" required to be based on a 20% loan to value ratio?

Isn't the ratio of monthly mortgage payment to monthly income regulated ( 26%? ) and "vetted" as well as a "cap" ( 36%? )for the ratio of all monthly revolving credit payments to monthly income.

Aren't all these qualifying ( for Fannie and Freddie backed loans) criteria strictly verified?

They used to be. Appraisals can be distorted by many conditions but the distortion or falsification of income qualification can be pretty easily ferreted out and is fraud. The 20% margin used to provide, well a sufficient margin.......

[Richard Green]

The serious delinquency rate among prime mortgages has stayed fairly constant going back to the beginning of 2005--in fact, if I read the loanperformance graph correctly, it is down a little bit.

Fannie/Freddie may do loans without private mortgage insurance up to 80 percent LTV; beyond that borrowers need PMI. But payment to income ratios are not regulated--Fannie/Freddie may do as they please. Nevertheless, it is my impression that they use payment-to-income as one underwriting standard. FICO and LTV are the most important, thought, in the sense they are the strongest predictors of default.

[Bill]

We all know with hindsight that the S&L debacle would have been smaller, and therefor the commercial real estate bust smaller, if we didn't change the rules in 1982 (I think it was called St. Germain?) 2 million foreclosures is a lot, but it will be over with faster than any remedy will allow us to get over this problem. And every quarter point cut on the fed funds rate will help some homeowners retain their homes on the margin, without blowing the bubble back up. A society with 100% mortgages is not sustainable. Let's get back to reality. Let's intervene, but only to the extent fully required to keep things from spiraling terribly out of control.

[Matthew Saroff]

Well, I have an answer for Brad on my blog. (http://40yrs.blogspot.com/2007/08/in-which-i-disagree-with-brad-delong.html)

Before we try anything, we have to:

* Decide who we are bailing out
* Determine what changes we need to make in regulation to prevent further occurrences.

[Lord]

It started out as an underwriting problem but it has spread considerably; mortgage liquidity is now a problem. The GSEs did very little of these bad loans; the problem is they are not being allowed to write good ones. When markets panic, sense must be made of them, not the encouragement of further panic.

[RNA]

>>> But the problem is that the spreads on non-conforming prime mortgages have risen--for no good reason. Investors just seem to be afraid of any non-conforming mortgage. The coastal markets rely on these mortgages, and so unless spreads return to normal, we can expect to see even larger house price declines in these markets than we are already seeing.

******

No, the spreads ballooned for a very good reason -- MBS buyers realized (belatedly, stupidly) that mortgage broker underwriting standards can't be trusted. This issue doesn't exist for conforming mortgages because Fannie and Freddie take the risk.

[Walker]

And so Fannie Mae and Freddie Mac take the risk because the risk is qualified by a substantiation of the credit worthiness of the mortgagor and the asset.

What again is the problem with Mr. Summer's proposal to expand the dollar caps?

And does the loan performance graph information show what percentage of the troubled GSE loans have the higher LTV ratios and are insured?

[Jonathan King]

Richard Green writes:
> But the problem is that the spreads on non-conforming
> prime mortgages have risen--for no good reason. Investors
> just seem to be afraid of any non-conforming mortgage.
> The coastal markets rely on these mortgages, and so
> unless spreads return to normal, we can expect to see
> even larger house price declines in these markets than
> we are already seeing.

I am not sure the problem you pose is really the one we have. It is clearly possible that markets have over-reacted to the "turmoil" (as people are calling the recent non-liquidity event). There almost certainly isn't a strong argument for a single, fairly arbitrary limit to the dollar value of a conforming mortgage. I think there *are* strong arguments for two other things. The first, loan-to-"value" ratios, is part of being a conforming loan. I put the word "value" in quotes precisely because it is the value part that is very dubious, particularly on the coasts. I live on the edges of a tony DC suburb (Potomac, MD) in a townhouse development where you can rent a 3 BR townhouse for about $2000. In most situations, you would then expect the sales prices of these town houses to be somewhere between 100 and 120 times the monthly rent, or $200,000 to $240,000. I think you could reasonably argue that the units on the for sale market are in better shape than the rentals, but the likely cap on rent around here would be $2500 or so (or else you would rent an actual house for $3000 or somewhat less).

The problem is that people are trying to sell these townhouses for $450,000 to $500,000 (down from $500K+ last year). There is no justification, however, for why the buy/rent ratio should be over 200. Jumbo mortgage or no jumbo, conforming loan or not, These suckers are going to have to go down by maybe 25% in real terms before the notion of using comps to establish value means very much. So I say: sure, kill off the $417K conforming loan maximum, but put in a 150:1 buy/rent ratio. Legitimately expensive places would be served more fairly, but crappy townhouse developments of the late 70s would have serious issues.

[Queequeg]

By definition, prime Jumbos are those that have either LTVs at 80 percent or below or have private mortgage insurance. The borrowers have good FICO scores.

No, by definition, jumbo mortgages are home loans for more than $417,000 (this year).

By definition, prime mortgages are for borrowers with good credit scores.

"Prime" and "jumbo" have nothing to do with loan-to-value ratio or mortgage insurance.

Brad, if they raised the conforming caps, they merely would blow more air into an already popping bubble. I live in an expensive area where prices dropped 5 percent in July, and I work with a newlywed who plans to start a family soon; she and her husband are saving like mad to buy a house. Raising the conforming limit would penalize them by retarding the fall in prices.

Larry Summers elides the fact that raising the conforming limits would create winners and losers. The losers would tend to be responsible savers who didn't buy a house when prices were unsustainably high; the winners would tend to be people who bought houses that they couldn't really afford, and who want to find a buyer to bail them out.

Let's help the responsible people by encouraging prices to fall quickly in bubbly areas.

[Queequeg]

That first graf was supposed to be in italic. Imagine quotation marks around it.

[christofay]

Some hot air was blown into the rising value of homes by appraisers who inflated their estimates in the home buying and mortgage creation steps.

Shilling also shows how home prices inflated beyond their historical rate of appreciation where a return to the norm would be expected.

[Walker]

There sure seems to be quite a bit of Puritan sentiment to punish those who have indulged in the pursuit of worldly real estate pleasure. One might be surprised at how many end up taking a dose of that tonic. Right down to the candlestick maker.

Besides that seems to be missing the point. Doesn't Mr. Summers proposal in effect broaden the scope of federal regulation of the mortgage martkets and therefore get more of this vice under control?

[Richard Green]

OK--here is how the Fed defines prime.

http://research.stlouisfed.org/publications/mt/20070601/cover.pdf

The definition of prime depends on both FICO and LTV--as it should.

SOURCE: Hancock, Diana; Lehnert, Andreas; Passmore, Wayne
and Sherlund, Shane M. “An Analysis of the Potential Competitive
Impacts of Basel II Capital Standards on U.S. Mortgage Rates and
Mortgage Securitization.” Basel II White Paper No. 4, Board of
Governors of the Federal Reserve System, 2005.

[Holdie Lewie]

Richard, the chart on that PDF does mention loan to value, but lenders simply don't consider LTV to be important when they distinguish prime from subprime. LTV affects the rate, but rates can vary on prime loans.

Elsewhere in the document you link to, there's a citation to the subprime guidance that the Fed, FDIC, OCC and OTS proposed last year (and which was adopted this year). That guidance says that it's difficult to come up with a tight definition of subprime, but that low credit score and high debt-to-income ratios are the main determinants.

DTI is more important than LTV when it comes to defining subprime.