By Peter Coy One of the more puzzling aspects of the current housing boom is that mortgage lenders have been offering ever-sweeter deals on loans. These days it's increasingly easy to qualify for a loan with little or no money down.
The market is rife with interest-only loans, as well as "option ARMs" that allow borrowers to roll part of the interest they owe back into the principal on the mortgage (see BW Online, 6/16/05, "The Mortgage Trap"). It has gotten so bad that you hear anecdotes of some lenders not even requiring proof of income before handing over a million bucks to a homebuyer.
PROFITABILITY SLUMP. Why have lenders been so liberal when they run the risk that many of their marginal customers will go into default? The answer is surprising. Sure, long-term interest rates have at times continued to defy conventional wisdom and decline or hold steady even while the Fed hiked short-term rates. This gives lenders a lot of room to keep their rates to customers as low as possible.
But it turns out that's just part of the reason lenders are offering such unbelievable deals to their customers. Many lenders are just plain desperate for business, according to some experts. In a bid for market share, mortgage lenders are offering highly favorable terms to borrowers. That's forcing the rest of the industry to match their terms or lose customers.
The industry's underlying problem is simple: Overcapacity and a drop in profitability from its all-time high of 2003. And that's not the claim of an industry gadfly. It's the analysis of the sector's own top economist, Douglas Duncan, the chief economist of the Mortgage Bankers Assn. Duncan told BusinessWeek on June 23 that profits fell by 70% from 2003 to 2004 among 70 lenders that supply their internal data to the trade group.
GREAT FOR BUILDERS. The Mortgage Bankers Assn.'s profit numbers aren't available from any other source because most of the lenders are privately held and aren't required to reveal their P&L's to the public. Several of the biggest lenders are publicly held and have performed better than the industry composite.
Many experts credit the availability of cheap loans to a wide swath of the public as one of the factors behind the enormous run-up in housing prices, especially in coastal states. In the U.S., homes' appraised value made up 145% of nominal gross domestic product in March, while stocks and mutual funds were worth 82% of GDP, according to the Federal Reserve.
That's great for homebuilders, which are reporting some of the best profits in years (see BW Online, 6/22/05, "Builders Keep the Home Runs Coming"). But earnings for lenders have fallen off because there's less refinancing than in the peak year of 2003.
OVERCAPACITY CONCERN. Yet in spite of the profit pressures, Duncan told BusinessWeek that he believes lenders on the whole are behaving responsibly. One reason: If lenders resell a mortgage into the secondary market and then the borrower defaults, they can sometimes be forced to buy the loan back, eating the loss. He says he's not worried that the industry is setting itself up for a wave of defaults.
Analyst Paul Miller of the brokerage firm of Friedman Billings Ramsey agrees, saying the big lenders are being prudent and refusing to make loans that would violate their own standards for minimum projected profitability.
Nonetheless, the numbers that Duncan cites show why overcapacity is a concern. The lending business simply doesn't have enough customers to support its current size. In 2003, the industry originated about $3.9 trillion worth of loans, Duncan says. Last year, that figure dropped to some $2.6 trillion because interest rates rose, so although the new home market was hot, fewer people applied to refinance existing mortgages.
That left lenders with "lots of excess capacity," he told BusinessWeek. While lending might go up slightly in 2005, he says, it still won't be anywhere near the 2003 peak.
BILL WITH POOR PROSPECTS. Says analyst Miller: "The industry keeps coming up with cheaper and cheaper products to keep the pipeline full." Even after layoffs, "there are companies that are still too fat," he says. He predicts that some smaller firms will go bust if lending shrinks this year or next.
Congress is considering a proposal that would give the federal government authority over lending practices, which are currently governed by a patchwork of state regulations. The bill before Congress was introduced partly because of worries about foreclosure rates and whether lenders are ensuring that borrowers have adequate resources to repay loans. Most experts don't give the bill much chance of passing.
Still, the next time someone dangles an incredible loan offer in front of your face, you'll have a better idea why.
Coy is economics editor for BusinessWeek in New York