The AEI International Center on Housing Risk and Housing Risk Indices

Briefing by Edward Pinto and Stephen Oliner

December 16, 2013

The Center’s Goals, Products, and Motivating Principle

• Goals: To equip investors, lenders, borrowers and policymakers with the information they need to assess and mitigate risk in housing and mortgage markets.

• Products: An unprecedented set of tools for measuring housing-related risk. Transparent and objective measures.

• Motivation: The recent financial crisis largely stemmed

from a failure to understand the build-up of housing risk. Better information can dampen the boom-bust cycle and make corrections less damaging.

The Need for Information on Housing Risk

• Essential for financial market stability. – In the US, residential mortgage debt totals $11 trillion – the

largest debt market after US Treasuries. – Lack of meaningful and timely housing risk indices has reduced

investors’ ability to limit exposure to unsafe mortgages.

• Essential for household financial stability. – Houses are highly leveraged purchases, so declines in home prices

can be very damaging. – Since 2007, about 8 million American households have lost their

homes and 10 million no longer have any equity.

Lessons from 2007 Housing Collapse

• Mortgage loans are only as sound as the practices used to underwrite and originate them.

• Market stability depends on the preponderance of loans being low risk, defined as good performance under stress.

• Political pressures are likely to degrade sound lending practices over time.

• Lack of robust risk measures limits the market’s ability to impose discipline.

• Bottom line: Transparent and objective measures of mortgage risk, home-price risk, and the capital adequacy needed to evaluate and manage housing risk.

A Century of Lessons

• The deterioration of lending standards from the early 1990s to 2007 has historical precedents.

• Earlier episodes: 1926-33, late 1950s and 1960s, and early 1980s.

• Mortgage default rates rose in every case, sometimes to disastrous levels.

• Prudent lending practices (or at least less risky practices) were then re-established and defaults declined.

• The pattern is clear: the abandonment of sound mortgage underwriting standards leads to trouble.

Steps to Date Are Inadequate

• After the 2007 collapse, government policy initially attempted to curb perceived risk factors. But, ultimately, traditional, common-sense credit standards were not adopted. – The regulations to implement the Dodd-Frank Act ignore down

payments and credit standards, and impose illusory limits on debt loads.

• The government has not provided tools to adequately measure housing risk.

• Without such measures, housing market will remain vulnerable to what caused the latest collapse: the gradual abandonment of sound mortgage underwriting standards.

Home Prices Once Again Deviating from Rents

* All-transactions index until 1990:Q4, purchase-only index thereafter.Source: AEI International Center on Housing Risk, www.HousingRisk.org, based on data from Bureau of Labor Statistics and Federal Housing Finance Agency.

Gap of about 11% in 2013:Q3, which opened up in only 6 quarters. Gap of same size in 2002:Q3 took twice as long to open up.

1983 1984 1985 1986 1988 1989 1990 1991 1993 1994 1995 1996 1998 1999 2000 2001 2003 2004 2005 2006 2008 2009 2010 2011 201350

100

150

200

250

300

350

400

50

100

150

200

250

300

350

400

BLS rent index

FHFA house price index*

Index, 1983:Q1 = 100

2002:Q3

What Will the Center Do To Fill the Void?

• The Center’s signature products are new indices of mortgage risk, collateral risk, and capital adequacy – the AEI/Pinto-Oliner risk indices. – Objective measures, produced in nearly real time.

– Freely available at the Center’s website (www.HousingRisk.org).

• The Center’s international members are working on new risk indices for other countries.

• The Center will sponsor US and international conferences. • The Center’s nearly two dozen members will conduct a

broad research agenda and provide commentary on issues related to housing risk.

AEI/Pinto-Oliner Risk Indices

• National Mortgage Risk Index (NMRI) – Classifies loans into low, medium, and high risk based on default

experience of 2007 vintage loans with similar characteristics. – Covers all gov’t-guaranteed mortgages and 85% of total market.– Limited to purchase loans now; refi loans to be added in 2014.

• 10-metro Composite Collateral Risk Index (CRI)

– Metro areas chosen to represent housing market in U.S. as a whole.– Expected release dates: DC-area index, early 2014; other metro

areas, by mid-2014.

• Capital Adequacy Index (CAI)– Assesses capital reserves at institutions with large mortgage

exposure. – Under development. Expected release date: Spring 2014.

ICHR Members

• Nearly two dozen top domestic and international economists, scholars, and practitioners with decades of experience in housing finance and policy.

• Primary developers of the AEI/Pinto-Oliner Risk Indices:– Edward J. Pinto, resident fellow at AEI and co-director of the IHRC. – Stephen D. Oliner, resident scholar at AEI and co-director of the

IHRC.– Morris Davis, academic director of the Graaskamp Center for Real

Estate at the University of Wisconsin and visiting scholar at AEI. – Michael F. Molesky, an economist and leading expert on mortgage

default risk and insurance regulation.

Measuring Mortgage Safety

• Why measure mortgage safety under stressful conditions? – Cars are safety rated for crashworthiness at 35 mph, not 5 mph. – Homes in the paths of hurricanes are rated for safety based on 125

mph winds, not 30 mph. – Similarly, mortgage loans should be risk-rated under the stress of a

substantial drop in home prices—not flat or rising prices.

• Lessons learned from loan performance under extreme stress also can substantially reduce default rates and market losses during periods of moderate stress as well.

NMRI for Home Purchase Loans

* Index changes measured from first month shown.Source: AEI International Center on Housing Risk, www.HousingRisk.org. Separate index not available for VA guaranteed loans. RHS is Rural Housing Service.

Tracks nearly all loans with a Federal guarantee (about 75% of all loans). All indexes shown are high relative to prudent standards and have edged up lately.

Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-134%

8%

12%

16%

20%

24%

4%

8%

12%

16%

20%

24%

Fannie/Freddie: +0.7, from 4.9% to 5.6%*

Composite: +0.3, from 10.6% to 10.9%*

Stressed default rate

FHA/RHS: +0.9, from 22.3% to 23.2%*FHA/RHS accounts for 30% of all purchase loans and is the main factor behind high level of composite index.

Recent rise in composite index also reflects increase in Fannie’s risk level and market share. Details below.

Calibrating Mortgage Safety

• Benchmarks for October composite NMRI of 10.9%. – 1990 vintage. Composite index ≈ 6%. A time when the

preponderance of loans were safe.

– 2006-07 vintages. Composite index ≈ 20%. A time of exceptionally lax lending standards.

• Benchmarks for FHA and Fannie/Freddie.– FHA: 1936-55 vintages ≈ 3% or less, compared to 23.2% now. The

earlier period was the Golden Age of prudent FHA lending.

– Fannie/Freddie: 1988-90 vintages ≈ 4%, compared to 5.6% now.

Purchase Loan Origination Shares, by Risk Level

Source: AEI International Center on Housing Risk, www.HousingRisk.org.

Less than half of new purchase loans are low risk, and the share has edged lower in recent months. Likely would lead to market difficulties in event of recession.

Aug-13 Sep-13 Oct-1320%

25%

30%

35%

40%

45%

50%

20%

25%

30%

35%

40%

45%

50%

Low risk

High risk

Medium risk

Low risk defined as stressed default rate of less then 6%, medium risk is 6% to 12%, and high risk is 12% or higher.

GSE Low-Risk Origination Shares, Purchase Loans

Source: AEI International Center on Housing Risk, www.HousingRisk.org.

Stable for Freddie Mac at 70-75%. Lower for Fannie Mae and declining. Dropping as well for the two GSEs combined as Fannie has taken market share from Freddie.

Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-1360%

62%

64%

66%

68%

70%

72%

74%

76%

78%

60%

62%

64%

66%

68%

70%

72%

74%

76%

78%

Freddie Mac

Fannie Mae

Combined

Note: FHA/RHS low-risk share (not shown) is less than 1%.

Fannie Mae Share of GSE Purchase Loan Volume

Source: AEI International Center on Housing Risk, www.HousingRisk.org.

Has increased since Q2, coinciding with greater riskiness of Fannie’s loan acquisitions.

2012:Q4 2013:Q1 2013:Q2 2013:Q3 2013:Oct58%

60%

62%

64%

66%

68%

70%

72%

74%

Future NMRI Releases

• The NMRI for November and December will be released at 10 AM on January 27, 2014.

• Subsequent releases are expected to be on the last Monday of each month.