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Regulating Loan Amounts Would Help Prevent the Next Housing Bubble

Published by Lawrence Roberts | December 26th 2008 | Views:

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The parameters of the forming limitations on the debt-to-income ratio and combined-loan-to-value are essential to prevent bubbles in the housing market and to prevent the banking system from becoming imperiled in the future. Loan amounts much be tethered to incomes and limited by existing property values. Without these limits, prices can take flight with lender capital. During the crash, lenders saw values drop below their loan amounts, and they lost a great deal of money.

People will commit large percentages of their income to house payments when prices are rising quickly; however, they do this out of fear of being "priced out" and greed to make a windfall from appreciation. These are the beliefs that inflate a bubble. Borrowers cannot sustain payments above the traditional parameters for debt service without either defaulting or causing a severe decline in discretionary spending. The former is bad for the banks, and the latter is bad for the entire economy. This must be prevented in the future. There are a number of reasons why high combined-loan-to-value lending is a bad idea: it promotes speculation by shifting the risk to the lender, it encourages predatory borrowing where borrowers "put" the property to a lender, it promotes a high default rate because borrowers are not personally invested in the property, it discourages saving as it becomes unnecessary, and it artificially inflates prices as it eliminates a barrier to market entry. . These borrowers were often qualified only on their ability to make the initial payment, and these borrowers were generally not capable of making the fully amortized payment when the loan reset after 2 years. Regulations like this would prevent a recurrence of the foreclosure tsunami triggered by the use of this loan program.

It is also important to ban negative amortization because it would allow the loan balance to grow beyond the parameters of qualification, and it invites property speculation. Perhaps borrowers would not be concerned because they would receive debt forgiveness of the expanding balance. Lenders should be wary of these loans after their dismal performance in the deflation of the bubble, but institutional memory is short, and these loan programs could make a comeback if they are not specifically outlawed. This provision is careful to allow interest-only loans. They are still a high-risk product, but an argument can be made that these loans have a place, and there is no need to completely ban them. They will not have a future as an affordability product capable of driving up prices if the borrower must still qualify for the fully amortized payment.

For the lending provisions to have real impact, they must apply to both purchases and to refinances, thus the clause, "Loans for the purchase or refinance of residential real estate." If the rules only applied to purchases, there would be a tremendous volume in refinances to circumvent the regulations. The caps on debt-to-income ratios, mortgage terms and combined-loan-to-value only have meaning if they are universally applied. The combined-loan-to-value standard is based on the "appraised value of the property at the time of sale or refinance." The new appraisal methods will have impact here. It is important that the records need only be accurate as of the time of the transaction. If a borrower experiences a decline in their income or if the property declines in value to where they no longer meet the loan standard, it does not mean they can go petition for debt relief.

The regulations would only need to apply to loans "secured by a mortgage and recorded in the public record." People can still borrow money from any source they wished as long as the lender knows they will not have any claim on residential real estate. If a lender wanted to issue a loan secured by real estate outside of the outlined standards, the borrower would not have to pay back that money. If a borrower has non-recorded debts which create a totally indebtedness requiring more than 36% of their gross income, they would not be eligible for a home equity loan even if they met the other qualifications. In such circumstances, it is better to limit borrowing than increase the probability of foreclosure.

Many states have non-recourse laws on their books. These laws serve to protect the borrower from predatory lending because the lender cannot go after other assets of the borrower in the event of default. In theory this should make lenders more conservative in their underwriting; however, the behavior of lenders in California, a non-recourse state, during the Great Housing Bubble was not conservative. These laws do serve to protect borrowers, and they should be enacted for purchase-money mortgages in all 50 states.
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