Affordable Housing Institute : US

(Return to Part 1)

 

Reducing WACC: decreasing lender risk

 

How then can policymakers reduce WACC?  Only by decreasing lender risk, which means that somebody else has to pick up a risk normally taken by the lender.  There are four obvious ways, two that change the borrower’s risk profile, two that change the government’s.

 

Option 1: Increase the borrower’s risk profile

 

The pressure points derive directly from the algebra:

 

1.         Push down the interest rate by using a variable-rate loan (link in .pdf).  Normally, the yield curve is positive: interest rates for longer maturities are higher than shorter, because lenders are hedging against the likelihood of inflation change during the interval.  A fixed-rate loan protects the borrower because it assures a level monthly payment.  In a variable-rate loan, the first few payments are certain, but after that they could rise.

 

2.         Push down the debt service constant by using (a) longer-term loans or (b) interest-only loans.  (In mathematical terms, interest-only is equivalent to a loan of infinite term.)  In essence, both of these allow the borrower to reduce the amount she pays to reduce the outstanding principal.  Although principal repayment is a lender protection (less debt, therefore more equity buildup), it is also a borrower savings account, and at some level, borrowers should have flexibility to decide how rapidly they wish to save. 

 

            The effects of changing from fixed to variable, and from self-amortizing to interest-only, are quite powerful, as shown in the following Table 2:

 

Table 2

Comparison of Debt Service Constants and Buying Power

(Figures adapted from US market conditions, June 2005)

 

	Interest rate	Term	Constant (1)	Multiplier (2)
Fixed-rate mortgage	5.50%	20	8.25%	4.04
Fixed-rate mortgage	5.50%	40	6.19%	5.39
Adjustable Rate Mortgage	4.00%	25	6.33%	5.26
Interest only mortgage	5.50%	¥ (3)	5.50%	6.06

 

1. Calculations assume level monthly payments. 

2. “Multiplier” means the maximum house price as a multiple of annual income, assuming the indicated mortgage, and payments equal to one-third of income.

3.  An interest-only mortgage has the same debt service constant as one with infinite term.

 

The above table shows that a borrower who gets a nice conservative fixed-rate mortgage with a short (twenty-year) term will secure a mortgage equal to 4.04 times her annual income.  Offer that same borrower a forty-year term and she can get 5.39 times her income.  (Curiously, that is precisely the same boost to buying power she will capture by going with an adjustable-rate mortgage.) And yet the biggest boost comes from taking the fixed-rate loan, but making it interest-only.

 

Is it any wonder that, in an environment where home prices are rising, buyers are increasingly opting to get into the game and stretch their buying power by using variable-rate loans or interest-only loans? 

 

This works fine so long as rates stay stable or prices keep rising, but if prices stop rising, or interest rates spike up — and it will be no surprise to you that these two things often go together — then the buyer’s equity headroom not stops rising, it starts compressing down on the buyer with breathtaking speed and can crush not only the equity but the borrower:

 

 

“By its light I saw that the black ceiling was coming down upon me, slowly, jerkily, but, as none knew better than myself, with a force which must within a minute grind me to a shapeless pulp.” 

– The Adventure of the Engineer’s Thumb, March, 1892

 

Few affordable-housing home buyers truly understand how the whipsaw can work against them.  Fewer still are well-equipped to deal with macroeconomic reversal.  No wonder that not far behind the buyers are:

 

• The breathlessly anxious newspaper stories about “some economists” and “some home advocates” worrying that the buyers are juicing themselves with the financial equivalent of speed.
• The consumer-protection advocates claiming (often quite rightly) that subprime lending and racy techniques are invitations to fleece the financially unsophisticated.
• Reformists calling for government to protect borrowers somehow from predatory lending.

 

Option 2: Shift risk (systemic) to government

 

Even subtracting the overwrought prose, in policy terms there’s no question that buyers who gear themselves to a higher multiple are absorbing a higher level of personal risk.  Governments don’t like this, especially since the risks are systemic (that is, beyond the borrower’s control), meaning that borrowers could be hit with them in bulk even though the borrower ‘has done nothing wrong.’ 

 

Moreover, since the affordable homebuyers normally have poorer credit, less equity, or higher leverage, normal market pricing means they will pay higher interest rates — which, as we have discussed, works directly against affordability.  So governments traditionally intercede in one of two ways:

 

3.         Push down the interest rate by making the debt safer through government credit enhancement.  If the lender whose borrower defaults can collect from the government, the lender has a much better credit, and therefore will happily offer a lower interest rate.  So this method is time-honored and time-tested in both ownership and rental contexts.

 

• Ownership.  Ever since 1949, the Federal Housing Administration (FHA), Veterans’ Administration (VA), and a myriad of state and local programs have offered government-funded or government-backed loans, all in the name of bringing down the interest cost. 

 

 

 

• Rental.  Since 1963 FHA, HUD, and state housing finance agencies have used Section 221d3, Section 236, and Section 221d4 and its progeny (207, 220, and 231) to offer government mortgage insurance on forty-year fixed-rate financing. 

            4.         Increase leverage (higher LTVs), typically by government credit enhancement.  Just as mortgage insurance lowers the lender’s risk, it also enables higher lending up to the amount of the FHA insurance cap (typically 90% LTV).

 

The risks of high leverage

 

“Certainly it makes sense for government to use its credit to enable its citizens to become homebuyers,” Watson said. 

 

“To a point,” replied Holmes.  “High leverage lowers debt service coverage, which is the financial cushion or shock absorber for ongoing viability.”

 

Over decades, markets have found that loan-to-value ratios should seldom exceed 80%, which is (generally) equivalent to 125% debt service coverage.  When government uses its credit-enhancing power to push up leverage, and push down debt service coverage, it:

 

• Increases the risk of default
• Increases its financial severity to the borrower. 

Since this happens for borrowers who have already been pushed to their borrowing capacity (it always makes sense to maximize the amount of cheap debt one can borrow).

 

Indeed, lending programs that use above-market leverage and below-market debt service coverage have a negative overall expectation, so the Federal government rations its use of these programs through a budget commodity known as credit subsidy.  Thus, these lending programs typically add a mortgage insurance premium (MIP) to the interest rate, in effect giving back some of the rate advantage to create a pool of funds to cover the higher-than-market losses that result.

 

A mortgage insurer is vulnerable to agency risk if its independent underwriters are not applying proper diligence in underwriting new loans (one such fiasco was the mid-1980’s 221d4 ‘coinsurance’ program).  So in more modern forms, the insurer — such as the Federal government — uses a structured form of risk-sharing (between Federal and state agencies) to assure that the originator is appropriately at risk.  Fannie Mae has brought risk-sharing to its most advanced state with its Delegated Underwriting and Servicing (DUS) program. 

 

“Shrinking debt service coverage or the loan-to-value gap is like narrowing the safe path along the abyss.” Holmes murmured.  “Eventually it can become as treacherous as the walk to Reichenbach Falls.”

 

 

“Not much fun at Reichenbach, no.”

 

Mortgage insurance pools work fine in situations of normal equilibrium; they even work fine in a large and diversified nation (like the US) where a recession in one region is being counterbalanced by an economic surge in another region.  But a large exogenous systemic shock — Arab Oil Embargo, anyone? — can affect the entire inventory, because, as Napoleon said, “My troubles come not in spies but in battalions.”  Major exogenous shock can:

 

1. Raise the cost of capital (higher interest rates are both an effect and a cause of recession).
2. Lower borrowers’ ability to pay by impairing their earnings.
3. Reducing the realizable value of their homes, possibly below the outstanding loan balance. 

With high leverage, the amount of equity cushion can be small, and the flop from positive equity to irretrievably undercapitalized can occur in a matter of weeks –

 

 

“What do you mean, the loan is non-conforming?”

 

– indeed, by the time anyone realizes it is happening, it has occurred, at scale, and irrevocably (at least without a major market repricing).

 

 

“Can we talk about restructuring my loan?”

 

Indeed, as a strategy, over-levering housing programs has a miserable track record, with such systemic failures as:

 

• The nationwide Section 236 defaults of 1974-76 (which led to the creation of Section 8 Loan Management Set Aside, originally known as “bailout”).
• The early-1980’s 221d4 coinsurance debacle.
• The early 1970’s near-bankruptcy of New York State’s Urban Development Corporation (see page 6, link in .pdf)
• The first great REIT collapse (also mid-1970’s) that put the whole REIT sector into disgraced financial exile for twenty years.
• Most famous and most severe — the 1985-88 savings and loan crisis, which cost US taxpayers many billions of dollars and led — catastrophe is often a precondition to improved regulation — to sweeping regulatory changes (including the Financial Institutions Reform, Recovery and Enforcement Act, FIRREA). 

Most significantly from a policy perspective, the government’s options were in several of those cases greatly limited because the government had used Federal credit enhancement (FHA insurance on Section 236 and 221d4, S&L deposit insurance) that meant restoring market equilibrium would cost the government additional billions — so the government unwilling lurched into a variety of portfolio and programmatic recapitalizations of varying effectiveness.

 

Indeed, it is reasoning by experience that leads many to recommend a similar strong-regulatory structure be imposed on the Government Sponsored Enterprises (GSEs), who also exploit proprietary Federally-endorsed extremely high gearing that places US taxpayers at grave systemic risk.

 

 

“Now let’s review the GSEs’ balance sheet, shall we?”

 

“Egad, Holmes, it’s diabolical!” exclaimed Watson.  “You mean to tell me that when government steps in to help deliver affordable housing, it not only risks bankrupting innocent home buyers, but it can also put its very solvency at risk?”

 

“To say nothing of imperiling the borrowers.  This is why hard equity also plays such a prominent role in affordable housing finance.” 

 

Watson shook his head.  “Well, is that everything there is to know about hard debt?”

 

 

 

Holmes smiled.

 

“Education never ends, Watson.  It is a series of lessons with the greatest for the last.”

– The Adventure of the Red Circle, April, 1911

 

But don’t go away, housing policy detectives!  Holmes and Watson will be back soon with another thrilling post on hard equity, The Adventure of the Six Simoleons!

 

 

“The blog voice will speak again soon …”