creating pathways to sustainable homeownership that builds …€¦ · borrowers with low credit...

Creating Pathways to Sustainable Homeownership That Builds and Retains Wealth

EdwardDeMarco

May2017

Thechallengesofachievinghomeownership,particularlyforlower-andmoderate-incomefamilies,remainaperennialissueinhousingpolicy.Yetourpublicpolicydiscussionsofthesemattersseemoldandtired,especiallyinlightofthedevastationcausedbythemillionsofforeclosuresduringtheGreatRecession.Policydebatesseldomdwellonwhywepromotehomeownershipinthefirstplaceandwhetherourpublicpoliciesarealignedwiththoseobjectives.Also,partofthestalenessofourdebateisthatsuchdiscussionsoftenbecomeargumentsabouthowtobendunderwritingstandardstoencouragehomeownership.Weoughttobethinkinginsteadabouttheprocessofmovingfromrentingtoowning,howwehelpfamiliespreparetobesuccessfulhomeowners.

Tostimulatedebateandhopefullyofferfreshthinking,thisessayaddressesthefollowingfivequestions:

§ Whydoespublicpolicypromotehomeownership?§ Whatpathswouldassistfamiliesmigratingfromrentingtoowning?§ Howcanimprovedriskassessmentsreducemortgagedefaults?§ Whyshouldweshiftpolicyattentionfromdebttoequity?§ Howdoespublicpolicyencouragethedepletionofhomeequity?

Why Ownership? Inpublicpolicydiscussions,themostfrequentargumentforwhypolicyshouldpromotehomeownershipistheopportunityitcreatesforwealthbuildingbylow-andmoderate-incomefamilies.Renterspayastheygo,butyearsofrentpayingdonotcreateanasset.Forahomeowner,yearsofpayingthemortgageslowlyreducestheloanbalance,therebybuildingequityintheproperty.Usingdebttofinancethehomeisoneofthefewtimesfamiliesuseleverage,whichcanincreasereturnsifhousepricesrise(butcreatesaddedriskiftheydonot).Mosthomeownershipadvocatesalsoseethisasaformof“forcedsavings”thatallowsfamiliestograduallybuildwealth.Indeed,pastgenerationsusedtoholdmortgage-burning

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partiestocelebratethepayoffofthemortgage.Wikipediadescribessuchpartiesasa“twentieth-centuryAmericancustom”butnotesthatsuchevents“arenearlyunheardofinthepresent-dayUnitedStates...”1

Giventhattheaveragefirst-timehomebuyerownsthehouseforlessthantenyears—andformany,alotlessthantenyears,duringwhichtimehardlyanyprincipalispaiddownatall—iswealthbuildingagoodreasonforpublicpolicytoputafingeronthescaletoencourageownershipoverrenting?Moregenerally,fewpeoplebuyahouse,getamortgage,andthenholdboththehouseandthemortgageforthirtyyears.

Ahouseisaveryexpensiveassettomaintainovertime,anditsvaluecanfluctuatesubstantially,aswehaveallbeenrecentlyreminded.Theflipsideofleveragedinvestmentsisthatprincipalcanbelostquiteeasilyaswell.Homeownershipalsocarriessubstantialfixedcostsofentryandexit;thatis,buyingandsellingahousehasalotoftransactioncosts.Italsogivesahouseholdlessfreedomofmovementinresponsetochangingfamilyorjobcircumstances.Andhousingisanondiversifiedasset.

Beyondallthat,thereisageneralmisconceptionabouthouse-priceappreciation,perhapscreatedbytheinflationarygrowthinhousepricesduringthehigh-inflation1970sand1980s.RobertShiller,aNobeleconomist,hasmeasuredtherealgrowthinhousepricesoveracentury-plustimeperiodandconcludedthatreal(inflation-adjusted)housepriceshavelargelybeenflat:

Historically,however,investinginhomesjusthasn’trewardedmosthomeownersthatmuch.AsIhavecalculated,homepricescorrectedforConsumerPriceIndexinflationnationallywerenearlyflatforthecenturyendingin1990.Andwhennominalhomepricesaredeflatedbypercapitadisposablepersonalincome,itturnsoutthatrealpricesofexistinghomesfell12percentwhilerealpricesofnewlybuilthomesfell30percentfrom1975to2015.2

Nowthisisnottosaythereisnopublicpolicypurposetoexpandinghomeownershipopportunities.OwningyourownhousehasbecomeaquintessentialAmericanideal,andIamnotarguingitshouldbeotherwise.Whereyouareownerofyourownhome,youexerciseadegreeofcontrolandpersonalexpressionthatislessattainableinarental.Youarecommittedtothatproperty,andhenceitscommunity,inadeeperandmorepermanentway.Thesearelikelyprofoundandmeaningful,albeitintangible,goalsofmanyhomebuyers.

Withthosecautionarynotes,letusacceptthathomeownershipisvaluedandthereisageneralpublicpolicyinterestinensuringhouseholdsthatwanttoownwillfindacompetitivemortgage-financesystemreadytoprovidecredit.Further,letusalsoacceptthepotentialwealth-buildingaspectsofhomeownership.Butthenweshouldaskhowhousingfinancepolicymightmoreeffectivelyandconstructivelysupporthomeownershipopportunitiesanddosoinawaythatmaybetterencouragelong-termwealthbuildingratherthanexacerbatingfinancialriskforvulnerablefamilies. 1.“Mortgageburning,”Wikipedia,lastmodifiedNovember30,2016,https://en.wikipedia.org/wiki/Mortgage_burning.2.RobertShiller,“TheOverinflatedFearofBeingPricedOutofHousing,”NewYorkTimes,June10,2016,https://www.nytimes.com/2016/06/12/upshot/the-overinflated-fear-of-being-priced-out-of-housing.html.

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Transitioning from Rental to Ownership Anoddityofpublicpolicytowardhomeownershipisthepeculiarlackofattentiontothetransitionprocessfrombeingarentertobeingahomeowner.Onefrequentlyhearscomplaintsaboutthechallengeofsavingforadownpaymentandcriticismoflendersfornotmakingloansto“credit-worthy”borrowerswithlowcreditscoresandsmalldownpayments.Ratherthanviewingtheseasinsurmountableobstaclesforhouseholdsforwhichlendersmustmaketheadjustments,whynotaskhowourhousingfinancesystemingeneral,andfederalprogramsandpoliciesinparticular,mighthelpfamilieshelpthemselvesinmeetingthesechallenges?MeetingToday’sChallenges:Savings,BorrowerEducation,andCreditRepairMeetingthechallengesofmanyoftoday’srentersdesiringtobecomehomeownersinvolvesthreesteps:(1)savings,(2)borrowereducation,and(3)creditrepair.Thesestepsrequiretimebutlackanyprocessintoday’ssystem.Intoomanysituations,addressingtheseissuesmaynotevenbeginuntiltheborrowerhasaneyeonaparticularhouse,orevenacontractinhand.

Savingforadownpaymenttobuyahousewasanexpectationforgenerations.Yetitmaybetruethatsavingforameaningfuldownpaymentishardertodaythaninthepast.Realwageshavebeenstagnantforyearsyethousepriceshavenot.Wehaveputyoungfamiliesonadebttreadmillearlywiththeenormousgrowthinstudent-loandebt.Thedemographicsofourcountryarechangingrapidly,andmanyyoungerAmericansdonothaveparentalassistancefordownpayments.Yearsofpastcreditsubsidieshavedrivenuphousepricesinmanypartsofthecountry.Andthehighcostofrentinmanyareasmakessavingwhilerentingverydifficult.

Thatdoesnotmeansavingisimpossibleandshouldnotbeexpected.While20percentdowncanbeaconsiderablechallenge,itisnotthenorm,especiallyforfirst-timehomebuyers.Ontheotherhand,3percentdownwithoutaplantohelpahouseholdbuildequityquicklyandestablisharainy-dayfundatthesametimeisrisky.Afterall,whenyougetupfromthesettlementtable,ifyouhaven’tput8to10percentdown,youstartoffunderwater.

Whilelittlepublicized,thereareprogramsouttheretohelpfamiliesbuildsavingsforadownpaymentandclosingcosts.Someoftheseoptionsaredescribedbelow.Butthebasiceconomicsmustbeunderstood.Adownpaymentgivestheborrower“skininthegame”thatprotectstheborrowerandlenderalike.Amongotherthings,adownpaymentservesasashockabsorberintheeventofanincomedisruptionorotheradverseeventaffectingtheborrower’sabilitytorepay.Iftheborrowerneedstosellthehouseforwhateverreason,adownpaymentatleastequaltoclosingcostscansavethefamilyfromadamagingforeclosureorshortsale.Anyrationalhousingpolicyshouldbemoreinterestedinincentivizingandassistingwithbuildingadownpaymentthaninincentivizingandfacilitatingadegreeofleverageonhouseholdbalancesheetsthatwouldresultinabankbeingclassifiedasundercapitalized.

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A2013workingpaperdescribesthesignificantincreaseindefaultandforeclosureprobabilityasloan-to-valueratioincreases(thatis,thelowerthedownpayment).Theseeffectsareevenmorepronouncedasborrowercreditscoresdecline,asshownbelowinexhibits1and26takenfromthepaper.3Readersshouldnotetheinflectionpointsacrosstheboardat90percentloantovalue;abovethatratio,foreclosureratesriseatanincreasingrate.Exhibit1.GSEmarketsegment

Source:FHFAWorkingPaper13-3.

3.KenLam,RobertDunsky,andAustinKelly,“ImpactofDownPaymentUnderwritingStandardsonLoanPerformance:EvidencefromtheGSEsandFHAportfolios,”FederalHousingFinanceAgencyWorkingPaper13-3,December2013,https://www.fhfa.gov/PolicyProgramsResearch/Research/PaperDocuments/2013-12_WorkingPaper_13-3-508.pdf.

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Exhibit2.FHAmarketsegment

Source:FHFAWorkingPaper13-3.

Borrowereducationalsoneedsgreaterattention.Therearecountlessprogramsoutthere.Oftenprivatelendersencourageborrowerstotakethetrainingbutitisnotrequiredtypicallyasamatterofpolicyinfederallendingprogramstargetinglow-andmoderate-incomehomebuyers.

Thereiswidespreadconcernatthelackoffinancialliteracyinthecountry.Thetimewhenafamilystartsthinkingaboutbuyingahousepresentsauniqueopportunitytofocustheattentionofahouseholdonitsfamilybalancesheet,itscashflow,itslong-termfinancialplan(includingeducation,healthcare,andretirement),anditsfinancialriskmanagement.Ifweareinterestedinhelpingfamiliesbecomehomeowners,especiallytoprovidethemapathtofinancialsecurity,thenweshouldthinkharderabouthowtodevelopatransitionprocessbeforehomebuyingcommences.Qualifiedhousingcounselingservicesarewidelyavailable,bothfromprivatesourcesandfromnonprofitgroups.TheU.S.DepartmentofHousingandUrbanDevelopment(HUD)hasanetworkofmorethan2,300certifiedhousingcounselorsnationwide.

Relatedtohousingcounselingiscreditrepair.AstheFHFAexhibitsshow,thelikelihoodofdefaultalsoincreasessharplyasabuyer’screditscoredeclines.Still,alowcreditscoreisnotabirthmark;itisnotindelible,beyondthecontrolofthehousehold.Itreflectspastcircumstancesandfinancialpractices.Creditscorescanberepairedandprogressinrepairingaweakscorecanbemadefairlyquickly.By

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educatinghouseholdsonwhatledtoaweakscoreandhowitcanberemedied,counselorsorlenderscangivefamiliesvaluableinsightsonprudentfinancialpracticesthatcanhaveotherlong-lastingbenefits.And,importantly,ifweopenthesecondarymarkettomorecompetitionandbreakfromthedominationofthegovernment-sponsoredenterprises'(GSEs)underwritingrules,perhapsnewandenterprisinginstitutionscandevelopevenmoresuccessfulandpredictivemeasurementsofahomeowner’swillingnessandcapacitytorepayaloan.

Surelyencouraging,orevenrequiringorsubsidizing,suchborrowereducationandcreditrepairisabetterapproachthanpushinglenderstomakeloanstothosewithweakcreditscoresandlimitedunderstandingoftherisksandconsequencesoffailingtostaycurrentonamortgage.Suchanapproachisaboutdealingwithrootcausesofpastfinancialchallengesandcreatingopportunitiesforgreaterfinancialsecuritygoingforward.

Inshort,worryingaboutwhetherhousingfinancereformwillcontinuetodeliveraflowofsubsidizedmortgagestohouseholdswithlittlesavingsandweakcreditisthewrongconcern.Instead,weshouldbeaskingwhetherandhowthehousingfinancesystem,throughgovernmentprogramsandagencies,butalsothroughnonprofitorganizationsandprivatelenders,candotheharderworkofhelpingfamiliespreparetobecomesustainablehomeowners.Suchanapproachmaydelaythetimeatwhichahouseholdcanbuyahousebysomemonths,ormaybeevenayearortwo.Oritmightleadtobuyingaslightlylower-costhouseinitially.Butifitcanmateriallyimprovetheoddsofthehouseholdavoidingdefaultanditsconsequentlong-termdamage,whileitbecomesbetterinformedaboutmanagingfamilyfinances,wecanimprovetheoddsofachievinglong-termfinancialstabilityforthatfamilyand,yes,wealthbuilding.

Systemsandprogramsexisttoday,andothersareunderdevelopmentorcouldbedeveloped,tohelpachievethisoutcome.DownPaymentAssistanceNumerousdownpaymentassistanceprogramsexist,althoughtheydonotseemtogarnermuchpublicity.Mostaretargetedtolow-andmoderate-incomehomebuyers,andoftentofirst-timehomebuyers.Perhapsbecausetheymayslowdownthehome-buyingprocessorrequireadditionalresearchorpaperworkormeetings,theyarenotsoughtoutbyallwhomaybenefitfromthem.Ratherthanattemptingtocataloguesuchprograms,Iidentifyahandfulheretoillustratetheirprevalenceandtoencouragegreaterattentionto,andfundingof,suchprograms.Notalldownpaymentassistanceprogramsarethesame,nordotheyallworkwell.Successfulprogramsarelikelytoincentivizetheborrower’sownsavingsandinvolveborrowercounseling;questionableprogramsofteninvolvesellerfinancingoftheassistance.

Statehousingfinanceagenciesareacommonsourceofdownpaymentassistanceprograms.Thesevaryinstructure.Forexample,somearegrantsandothersareno-interestsecondliensthatmaybeforgivenovertime.Theyhaveeligibilityrulessetbythestate.Localhousingagenciesandnonprofitorganizationsarealsoanimportantsourceofhome-buyingassistanceandmanyoperatetheirowndownpaymentassistanceprograms.Anoteworthyaspectofmostoftheseprogramsistheconcurrentcounselingthat

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goesonaspartoftheeducationandborrower-preparationprocess.Almostalltheseentitiesinvestameaningfulamountofdirecttimewiththepotentialhomeownerdiscussinghisorhergoalsandreadinessforhomeownership.Thissortofcounselingmaysometimesleadtoconversationsthatthehouseholdisnotreadyforhomeownership,whichhelpsthehouseholdavoidtheconsequencesofafutureforeclosure.Manyprivatelendersofferdownpaymentassistance,eitherdirectlyorthroughnonprofitpartnersorlocalgovernmentalagencies.TheFederalHomeLoanBankSystem,throughitsAffordableHousingProgram,offersdownpaymentmatchingfundstofirsttimehomebuyersthroughtheirmemberbanks,thrifts,andcreditunions.Thesematchinggrantsmayprovidetwodollars,threedollars,orevenfourdollarsforeverydollarsavedbythehomebuyer.TheFederalHomeLoanBankofNewYorktakesanoteworthyapproachtothisprocess.Itrequirespotentialfirst-timehomeownerstosignupforamonthlysavingsprogramattheirlocalbank.Thefamilycommitstosaveacertainamounteachmonthforaperiodoftime,typically10to24months.Duringthistime,thefamilyundergoeshome-buyingandfinancial-educationtraining.Whentheyarereadytobuy,theHomeLoanBankprovidesuptofourdollarsforeverydollarthefamilyhassaved,uptoalimitof$7,500.Forexample,afamilythatsaves$150amonthforayearcouldhave$9,000atsettlement.4

Anonlinesite,DownPaymentResource.com,maintainsaninventoryofnearly2,400downpaymentassistanceprogramsacrossthecountry.Themosttypicalbenefitamountis$10,000.5In82percentofthe513countiesitstudiedinconjunctionwithRealtyTrac(aprivatefirmthatprovidesinformationontheforeclosuremarket),theaveragedownpaymentassistanceavailableexceeded3percentofthepriceofthemedian-valuedhouseinthatarea.Thatstudyalsofoundthattheaverageassistanceamountwasmorethan$12,000.6

Finally,afederalprogram,IndividualDevelopmentAccounts(IDAs),offereligiblehouseholdsasourceofmatchingfundstotheirownsavingsthatcanbeusedforadownpayment.AstudybyCFEDandtheUrbanInstitutefoundthatlow-incomehomebuyersusingIDAstopurchaseahomehadrelativelylowerforeclosureratesduringthefinancialcrisis.Theresearchersattributedtheapparentsuccessofthisprogramforlow-incomebuyerstothescreening,creditcounseling,anddownpaymentassistanceoftheIDAprogram.7

Takenasagroup,downpaymentassistanceprogramshaveseveralimportantadvantagesthatarguefortheirexpansionrelativetocreditsubsidyprograms.Theprogramstypicallymatchorsupplementtheborrower’sownsavings,therebyincentivizingnotsubstitutingfortheborrower’sownsavings.Oftentheprogramsincludeafinancialeducationcomponentandcounseling,whichhelpinformtheborrowerand

4.FormoreinformationontheFederalHomeLoanBankofNewYork’sFirstHomeClub,SMseehttp://www.fhlbny.com/community/housing-programs/fhc/index.aspx.5.DownPaymentResource,accessedFebruary19,2017,http://downpaymentresource.com.6.“DownPaymentAssistanceProgramsSaveQualifyingHomebuyersMoreThan$17,000onAverageOverLifeofLoan,”RealtyTrac,June8,2016,https://www.realtytrac.com/news/home-prices-and-sales/2016-down-payment-assistance-affordability-analysis/.7.IdaRademacheretal.,“WeatheringtheStorm:HaveIDAsHelpedLow-IncomeHomebuyersAvoidForeclosure?”CFED/UrbanInstitute,April2010,http://cfed.org/assets/pdfs/WeatheringTheStorm_Final.pdf.

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maykeephouseholdsnotreadyforhomeownershipfromputtingthemselvesinahigh-risksituation.Theseprogramsalsomaybetargetedtoadefinedsetofeligibilitycriteria,whichfocusesthesupportonthosedeemedeligibleratherthancreatingageneralsubsidyforallborrowersthatsimplydrivesuphouseprices.Rent-to-OwnandOtherAlternativePathstoOwnershipBecomingahomeownerdoesnotalwaysneedtofollowthepathof“buyahouseandgetamortgage.”Ifwewanttobeseriousinthinkingaboutreal-lifeaffordabilityandaccessproblemsandthestrugglessomefamiliesface,weoughttoconsiderotherpathstohomeownership.

Rent-to-ownprogramshavebeenaroundformanyyearswithmixedsuccess.Arguablytheyhaveworkedbetterintheorythaninpractice.Still,sincethefinancialcrisis,renewedattentionhasbeenpaidtothistransitionalapproachfromrentingtohomeownership.Rentingahousewithanoptiontopurchasethehouseatalaterdate,usuallyataspecifiedprice,ifdoneproperlyallowsapotentialhomebuyertheopportunitytobeginlivinginahouseinadesiredcommunityeveniftheprospectiveownerisnotreadytoactuallybuy.Therentalperiodallowshouseholdsthechancetocontinuesavingforadownpayment,improveadamagedcredithistory,orotherwiseimprovetheirfinancialsituationbeforelockingintotheresponsibilitiesofownership.

Becausethereisnostandardcontractorapproachwithrent-to-ownprograms,consumer-protectionissuescanarise.Someprivatelendershaveattemptedtorespondtotheseconcernsbyestablishingcleardisclosuresandqualificationstandards.8Timewilltellwhetherandhowthesenewapproachestoanoldproblemworkout.9Thelargerpointhereisthatprivate-marketparticipantsaredevelopingnewapproachestoreachhouseholdswithdifficultaccesstohomeownershipandprovideoptionstailoredtotheircircumstanceswhileshowingagreaterconcernforconsumerprotectionsthaninthepast.Suchapproachesshouldbeencouraged,studied,andevaluatedasopportunitiestocreateaccesstohomeownership.Inlightofpastproblemswithsomerent-to-owntransactions,Ibelievethatprivatefirmspromotingthispathwouldbewelladvisedtodevelopandpublishclearconsumer-protectionstandardstowhichtheywillholdthemselves.Inparticular,thestandardsshouldbeclearlystated,simple,andfair.Amongotherthings,thisincludesaclearunderstandingofwhathappensshouldafamilydecidetheyareunableordonotwanttoexercisetheoptiontopurchasethehouseandwhatthefinancialimplicationswouldbe.

8.HomePartnersofAmericaandTrioaretwoexamplesofthismodernizedapproachtocreatingatransitionpathfromrentingtoowning.Theirapproachesarenotidentical,andjustasinbuyingahomeoutright,consumersshouldeducatethemselvesbeforesigningacontract.Formoreinformation,seehttps://homepartners.com/andhttps://www.thinktrio.com/default.php.Land-leasecontractsareadistantcousintorent-to-owncontracts.Effortstomakethisformofhomepurchasemoreconsumerfriendlymayalsoopenanotherconstructivepathtohomeownershipforthoseunabletopurchaseahomedirectlyduetotheirfinancialcircumstances.9.ArecentissuebrieffromtheCenterforAmericanProgressnotesthe“checkeredpast”ofrent-to-ownarrangementsbutalsoidentifiespromisingpublic-sectorandprivate-sectorapproachesforrenttoownleadingtohomeownership.SeeSarahEdelman,MichelaZonta,andJuliaGordon,“LeasePurchaseFailedBefore:CanitWorkNow?,”CenterforAmericanProgress,April29,2015,https://www.americanprogress.org/issues/economy/reports/2015/04/29/112014/lease-purchase-failed-before-can-it-work-now/.

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Suchanapproachwouldaddcredibilityandtransparencythatwouldgiveconsumersandhousingadvocatesalikegreaterconfidenceintheintegrityoftheprocess.Thereisalsoincreasedinteresttodayinsharedappreciationmortgages.Asharedappreciationcontractaddstoaborrower’sdownpaymentwithaprivatecapitalinvestmentinexchangefortheinvestorsharingintheupside(ordownside)thatthehomebuyerrealizesovertime.

Finally,marketplacelenders(alsoreferredtoaspeer-to-peerlendersorfintechfirms)inthesmall-businessandstudent-loanmarketsarebeginningtoemergeinthehousingfinancesector.Theuniquedata-drivenapproachestolendingarealsoapromisingopportunityfornewmarket-drivenalternativestocreatepathwaystohomeownership.

Thechallengetheseexamplesprovidefuturehomebuyers,policymakers,governmentagencies,nonprofits,andfor-profitlendersandcapitalsourcesalikeisthis:Howcanwefosteralternativepathstohomeownershipthatusetheinnovationandresourcesofprivatecapitalcombinedwithclearinformationtoconsumersandprotectionsfromdisreputablepractices?Acommonthemefoundtodayacrossnumerousnonhousingmarketsisthedisruptionofnewapproachesandtechnologycreatingnewopportunitiesforconsumers.Farfrombeingimmunetosuchchange,housingfinanceshouldembracethepossibilitiesandpotential.

Improving Risk AssessmentsOneofthelessproductiveargumentsinaffordablehousingtodayiswhetheraccesstocreditistootight.Amorethoughtfulapproachwouldconsidertwoquestions.First,dounderwritingstandards,boththoseappliedbyprivateandgovernmentlendingprogramsandthoseimposedbyconsumer-protectionrules,produceaprudentframeworkforanalyzingaborrower’sprobabilityofdefaultandhencecreditworthiness?Second,arecollateralriskassessmentssufficienttoprotectboththehomebuyerandthelender?AbilitytoRepayandResidualUnderwriting:RecognizingtheRisksfromIncomeandExpenseVolatilityOneofthemoreconsequentialregulationsresultingfromtheDodd-FrankActistheConsumerFinancialProtectionBureau’s(CFPB)AbilitytoRepayRule.10Hailedbysomeasamuch-neededconsumerprotection,therulerequireslendersto“makeareasonable,goodfaithdeterminationofaconsumer’sabilitytorepay”amortgage.11Otherstakealessenthusiasticview,claimingtherulestifleslenders’abilitytomakecreditjudgmentsand,insodoing,limitscreditaccess.12Clearly,aborrower’sabilitytorepaywasnotahallmarkofmuchoftheprecrisislending,whichmoreoftenconcerneditselfwiththevalueoftheunderlyingcollateral.Still,asissooftenthecasewithWashingtonpolicymaking,housingfinancereformmustgrapplewithanenormous—andironic—loopholeinthisrule. 10.Seehttps://www.consumerfinance.gov/policy-compliance/rulemaking/final-rules/ability-repay-and-qualified-mortgage-standards-under-truth-lending-act-regulation-z/.11.Ibid.12.Asjustoneexample,see“Brief:RepealingDodd-Frank,”HeritageActionforAmerica,March17,2016,http://heritageaction.com/sentinel-brief/repealing-dodd-frank/.

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TheCFPBdraftedtheruletolimitmortgagecreditwhenthecombinedmonthlydebtsoftheborrowerexceed43percentofmonthlyincome.However,itmadeanexceptionforanymortgagethatqualifiedthroughtheautomatedunderwritingsystemsofFannieMaeorFreddieMac.Ontheonehand,theCFPBwasrecognizingthattheseproprietarysystems(blackboxes,somemightsay)havebuiltintotheirdecisionprocessamethodforweighingotherrelevantrepaymentfactorsbeyondincome.ButtheloopholecreatedaclearcompetitiveadvantagefortheGSEsrelativetoothermarketparticipants.Ratherthanhelpingtograduallyshrinkthegovernment’senormousfootprintinthemortgagemarketpostcrisis,thisruleenhancedit.

TheAbilitytoRepayruleneedstohaveaconsistentstandardforalllenderswithoutreferencetotheGSEs.Absentabettersolutionthanwehavetoday,therulewillcontinuetomakeobtainingmortgagecreditharderforretirees,theself-employed,singleearnerswholiveinurbanareasandchoosetospendalargeshareofmonthlyincomeonhousing,thoseinnewjobs,andotherborrowerswhorelyonassetsorothersourcesofrepaymentbeyondjustwageincome.

Anotherunderwritingstandardthatcouldbenefitfromreexaminationisknownas“residual-income”underwriting,oftenemployedbytheVeteransAdministration(VA).Simplyput,ratherthanjustmeasuringdebt-to-incomeratios,theVAalsorequireslenderstoprepareamonthlybudgetwiththeborrowertoseethe“residualincome”leftaftermakingtheproposedmortgagepaymentandmeetingotherdebtsandexpenses.TheborrowermusthavesufficientresidualincomeaccordingtotheVA’sguidelinesinordertoqualifyfortheloan.AstudybytheUrbanInstitutefound“strongevidencethattheresidualincometestmaybeacriticaldifferentiatingfactor”inexplainingthebetterloanperformanceofVAloanscomparedtocomparableFederalHousingAdministration(FHA)loans,whichlackthistest.13ThissuggeststhattheFHA,andborrowers,maybenefitfromtheFHAaddingaresidual-incomeunderwritingtesttoitsunderwriting.

Finally,twofactorsaffectingborroweroutcomesthatareespeciallyimportantinthemarketforlow-andmoderate-incomehouseholdsdonotgetenoughattentioninpolicycircles.Thefirstisthestabilityofaborrower’ssourceofincome,notjusttheamount.Incomesourcesrelativelyimmunefromcurtailmentduetoarecessionorbadweatherorsuchmakeforalessriskyborrowerthanincomesourcespronetosuchdisruptions.YetCFPBrulesandFHAlendingguidelinesarelimitedinhowtheyconsiderthisriskfactor.Anemergingliteraturepointstothegrowthinincomevolatility,particularlyamonglower-andmiddle-incomehouseholds.14Theincreasingimportanceofincomevolatilityisariskfactorthatmortgageunderwritersandpolicymakersalikeshouldbefactoringintotheirwork.

13.LaurieGoodman,EllenSeidman,andJunZhu,“VALoansOutperformFHALoans.Why?AndWhatCanWeLearn?,”UrbanInstitute,July16,2014:11,http://www.urban.org/sites/default/files/publication/22776/413182-VA-Loans-Outperform-FHA-Loans-Why-And-What-Can-We-Learn-.PDF.14.JonathanMorduchandRachelSchneider,TheFinancialDiaries:HowAmericanFamiliesCopeinaWorldofUncertainty(Princeton,NJ:PrincetonUniversityPress,2017).SeealsoMichaelBarr,NoSlack:TheFinancialLivesofLow-IncomeAmericans(Washington,DC:BrookingsInstitutionPress,2012)andJ.M.Collins,ed.,AFragileBalance:EmergencySavingsandLiquidResourcesforLow-IncomeConsumers(London:PalgraveMacmillan,2015).Scorelogixhasappliedthisconceptofincomevolatilityinproducinganalternativeconsumercreditscore.Seewww.scorelogix.com.

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Second,whateverthestabilityofanincomesource,borrowersarevulnerabletolifeevents.Stuffhappens,anditoftencostsmoney.Whetheritisaleakyroof,afailedheatingsystem,ahealthissue,acarrepair,orafamilyconcern,allborrowersfacetheriskoflarge,unexpectedexpenses.Theavailabilityof“rainy-dayfunds”toassistwithsucheventscanmakeadifferenceintheborrowerremainingcurrentonamortgage.Lendingprogramsshouldencourageborrowerstobemindfuloftheimportanceofliquidsavingsinadditiontosavingsforthedownpaymentandtheneedforresidualincome.15

Inourenthusiasmtohelpfamiliesbecomehomeowners,wesometimesforgetjusthowclosetothefinancialedgemanypeoplelive.Agreatersensitivitytothisfact,combinedwithgivingmorethoughttoensuringfamilieshavesufficientshockabsorbers,maynotmakecreditmoreavailablebutitwouldsurelyhelpleadtomoresuccessfulmortgage-lendingoutcomes.CollateralRiskConsiderations:HousePriceVolatilityandHomeInspectionsThepostcrisisfocusonaborrower’sabilitytorepaytheloanshouldnotcauselendersorpolicymakerstoneglectcollateralriskanditsimplicationsfortheaffordabilityandsustainabilityofhomeownershipforlow-andmoderate-incomefamilies.Whiletheborrower’sabilitytorepayis,andshouldbe,theprimarylendingconsideration,thecollateralitselfalsomatterstotheoverallriskassessmentinthelendingprocess.Ifocushereontwoaspectsofcollateralrisk:house-pricevolatilityandhomeinspections.

Itisamistaketotreathouse-pricevolatilityasaconstantacrosshousesandanevengreatermistaketoassumethatlower-costhouseshavelesshouse-pricevolatilitythanhigher-costhouses.Infact,theoppositeistrue.Lower-valuehousesinagivencommunitytendtohavegreaterhouse-pricevolatility.Thisisexacerbatedwhenlandvalueisasubstantialcomponentofoverallhousevalueandwhentheconstructionqualityislower.Disturbingly,house-pricevolatilityisalsogreaterinminoritycommunitiesthannonminoritycommunities.16Theimplicationforpolicymakersisthatencouraginghomeownership,especiallyhighlyleveragedhomeownership,inlower-incomeandminoritycommunitiesplacesthosehomebuyersatgreaterriskthanborrowersincommunitieswithmoremiddle-valuedhomes.Ofcourse,lower-incomefamiliesalsotendtohavegreaterincomevolatilitythandootherfamilies,layeringanotherriskfactorontothehomeownershippropositionforthesefamilies.

TheconclusionfromapaperbyYuZhouandDonaldR.Haurinisworthconsidering:

Knowledgeabouthousepricevolatilityalsoshouldbeanimportantinputtohousingpolicy.Whetherlow-incomehouseholdsshouldbeencouragedtobecomehomeownersdependson

15.InabookdescribingthelessonslearnedfromapartnershipamongSelf-Help,theFordFoundation,andFannieMaetopromotehomeownershipforlower-incomehouseholds,theauthorsdescribeapprovinglyahypotheticallow-incomeborrowerwhoselenderrequiresamonth’smortgagepaymentinreserveaswellascarefulscreeningandborrowereducationaspartoftheunderwritingprocess.AllthesethemesareconsistentwithwhatIamdescribinghere.SeeRobertoG.Quercias,AllisonFreeman,andJannekeRatcliffe,RegainingtheDream:HowtoRenewthePromiseofHomeownershipforAmerica’sWorkingFamilies(Washington,DC:BookingsInstitutionPress,2011).16.YuZhouandDonaldR.Haurin,“OntheDeterminantsofHouseValueVolatility,”JournalofRealEstateResearch32,no.4(2010).SeealsoStephenOliner,“TheHousingBoomandBustinLosAngelesUndertheMicroscope:LandPricesHoldtheKey,”UCLAEconomicLetter,November2015,andDiegoEscobariandDamianS.Damianov,“Atimeseriestesttoidentifyhousingbubbles,”JournalofEconomicsandFinance39(January2015):136–52.

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manyfactors,oneofwhichisthehousepriceriskthattheywouldbear.Ourfindingthatlow-qualityhouses(andlow-valuedhomes)haverelativelyhighpricevolatilityisdirectlyrelevant.

Otherhousingmarketparticipants,suchasmortgagelenders,alsoshouldbeinterestedinthecorrelatesofhousepricevolatility.Forexample,bothdefaultriskandtherateofrecoveryofcollateralvaluesarerelatedtohousepricevolatility.Onewouldexpectlenderstopricethisriskinthecostofamortgage.Thus,risk-basedpricingofmortgageswouldaccountforthecharacteristicsofboththeborrowerandthedwelling.17

Theseconclusionsreinforcetheimportanceofencouragingprospectivehomeownerstosaveforadownpaymentandbuildequityquicklyinordertoreduceleverage.Theyalsopointtotheimportanceofconsideringresidualincomeandtheavailabilityofotherassetsinunderwritingmortgagesinlower-incomecommunities.Thestability,notjusttheamount,ofincomeisalsorelevant;thelessstabletheincomesource,themoretheseotherfactorslikedownpaymentandcashreservesmatter.Thepointhereisnottodiscouragehomeownership;itistobemorerealisticabouttherisksinvolvedsothatriskmitigatorscanbefound.

Oneofmygreatestconcernswiththeunrestrainedadvocacyof“accesstocredit”forriskierborrowersisthelimitedconsiderationofthecostsoffailureonthoseborrowersandtheircommunities.Whenahomeownerdefaultsonamortgage,thefinancialcatastrophe,includingthelossofthehomeandthelong-termcreditscoredamage(whichmayimpedefuturejobopportunities)aresubstantialbutgenerallyunderstood.Lessunderstoodarethebroaderhealthconsequencesforthehomeowners,theirchildren,andeventheirneighbors.Jones,Squires,andRonziodocumenttheseimpactsduringtheGreatRecession,whichincludephysicaleffectssuchashypertensionaswellasmentalhealthimpacts,bymappingthemagainstmeasuresofinequality.18Ourhousingpoliciesdonotconsiderthesecosts.Iftheydid,wemightbelesstolerantoftheforeclosureratesourcurrentpoliciesgenerate,particularlythroughtheFHAprogram.

Aseparatebutalsoimportantaspectofunderwritingthepropertyisthelikelihoodofcostlyrepairs.Mostlower-costsingle-familyhomestendtobeolderconstruction.Thishighlightsanotherimportantriskfactorforlow-andmoderate-incomehomebuyers—theriskthatthehousemayrequiresignificantrepairsorupgradesafterthefamilymovesin.So,thehome-buyingprocessneedstoconsidernotjusttheaffordabilityofthemonthlymortgagepaymentbutalsotheprobabilityofneedingtofinancemajorrepairs,whetheranewroof,electricalupgrades,foundationreinforcement,oranyotherofacountlessarrayofpossibleissues.

Arigoroushomeinspectionbeforepurchasebyatrainedprofessionalisoneriskmitigator.Butsuchinspections,whilerecommended,areseldomrequired.Moreover,homeinspectionsaddtoclosingcosts,areasontheymayoftenbeskipped.FHAloansrequireahomeappraisalthatincludesanassessmentofwhetherthehomemeetsHUD’sstandardsforhealthandsafety.VAloansrequireahome

17.ZhouandHaurin,390–91.18.AntwanJones,GregoryD.Squires,andCynthiaRonzio,“ForeclosureIsNotanEqualOpportunityStressor:HowInequalityFuelstheAdverseHealthImplicationsoftheNation’sFinancialCrisis,”JournalofUrbanAffairs37,no.5(2015).

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appraisalofwhetherthehomemeetsVA’sminimumpropertyrequirements.Whileeachoftheseishelpful,greaterconsiderationshouldbegiventoaprofessionalhomeinspection,notjustappraisal,thatcaninformthehomebuyerofdefectswithkeysystems.

Whensomeonebuysahousewithlittlemoneydownbecauseheorshecannotaffordtosaveforadownpayment,theriskoffacingapaymentshockbecauseofanunexpectedexpense,suchasatherepairorreplacementofcriticalsystems,isexacerbated.Ahousing-policyapproachthatismorefocusedonthesustainabilityofthehomepurchasethansimplescoringthesaleitselfwouldplacemoreemphasisonthesetypesofriskstothehomebuyer.

Ifwecanacknowledgetheseriskfactorsratherthanignorethem,ourhousingpolicymightsteertowardwaysofreducingtheserisks.Suchanapproachwouldnotonlyadvanceaccesstocreditbyreducingriskbutalsoincreasethelikelihoodthatextendingcreditwouldleadtoasustainablemortgageandultimatelyfinancialsecurityandlong-termwealthbuilding.

Equity Building: Good for Consumers, Taxpayers, and Financial Markets Afamily’shousingwealth,infinancialterms,istheirequityinthehouse:thevalueofthehouseminusthemortgagebalanceoutstanding.AsIdescribedinarecentMilkenInstituteReviewarticle,muchoffederalhousingpolicypromotinghomeownershipisactuallyadebtpolicy;itsubsidizesandincentivizestakingondebttoownahomeratherthanbuildingequityinthehome.19Themortgageinterestdeduction,thecreditsubsidyintheFHAprogram,andtheonceimplicit,andnowexplicit,federalsupportofFannieMaeandFreddieMacallsubsidizeleverage,thatisborrowing,ratherthanincentivizingorsubsidizingequity.Sinceequitybuildingisthepublicpolicyobjective,thisseemsacuriousapproach.

Ifpolicymakersreallywanttopromotesustainablehomeownership(reducingdefaultrateswhileincreasingtheprobabilitythathomeownershiptrulycreatesapathtolong-termwealthbuilding),andiftheywanttoencourageprivatelenderstomakemortgagecreditwidelyavailabletolow-andmoderate-incomefamilies,reducesystemicriskandprotecttaxpayers,theyshouldembracehousingpolicythatpaysgreaterattentiontoequitybuilding.

Therearemanywaysthiscouldbedone,someofwhicharedetailedintheMilkenInstituteReviewarticle.Higherdownpaymentrequirementsand/orgreaterfundingfordownpaymentassistancearestraightforwardoptions.Shorterloanamortizationperiodsorsplittingaloanintotwopaymentstreamssoequityisbuiltfasterintheinitialyearsofownershipwouldhelp.Providingmorelendingoptionsmighthelpreachthisgoal.Forexample,interestingworkattheFederalReserveonanalternativethirty-yearmortgage,orthe“WealthBuildingHomeLoan”championedattheAmericanEnterpriseInstitute,attempttotackletheseissues.20

19.EdwardDeMarco,“Homeownership,WealthCreation,andFinancialStability,”MilkenInstituteReview,FourthQuarter2016.20.DianaHancockandWaynePassmore,“Costoffundsindexedmortgagecontractswithgovernment-backedcatastrophicinsurance(COFI-Cats):Arealisticalternativetothe30-yearfixed-ratemortgage?,”JournalofEconomicsandBusiness84

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Theseproposalsareimportanttohighlightbecauseeachdemonstratesthatthereareanalystswithfreshideasouttherewrestlingwiththeseproblems.Themorethatpolicyofficials,academics,researchers,lenders,andothersfocusonthechallengesdescribedintheprecedingpages,thequickerwecangettobetterideas.Policymakerscannotlegislatethecreationofbetterideas,buttheycanwriterulesthatfosterthem.Thesebetterideasmaybethebreakthroughsweneedtocreateaprivatemarketwheremortgagecreditiswidelyavailableandthehomeownershipitcreatesistrulyaccessible,affordable,andsustainable.

Equity RetentionTothispoint,Ihavearguedforamoreconsideredprocessforpreparinglow-andmoderate-incomefamiliestobecomesustainablehomeowners.Thechallengedoesnotendoncethesaving,borrowereducation,andcreditrepairarecompleteandthefurnituremovedin.Fortheborrowertoremainsuccessfulinmakingmortgagepaymentswhilebuildingwealthovertime,theborrowerneedstoretainequityasitisbuilt.

EarlierinthispaperInotedthattheprimarypublicpolicypurposeforpromotinghomeownershipislong-termwealthbuildingforfamilies.Butthechallengeisnotjusttopromoteequitybuildingbuttoalsoconsiderthegovernment’scurrentincentivesforborrowerstodepleteequity.Therearetwohousingfinancesubsidiesthatactuallyencouragepeopletowithdrawequityfromtheirhomes.

Thefirstincentiveisthemortgageinterestdeduction,whichappliesnotjusttopurchase-moneymortgagesbuttorefinancing.Cash-outrefinancingallowsthistaxbenefittosubsidizenonhousingconsumption.Bydoingso,itaddsrisktothehousingfinancesystemandencouragescontinuedleveragebyhomeowners.

Thesecondincentiveistheavailabilityofgovernment-backedsecuritizationforrefinancedmortgagesthatinvolvecash-outand/ortermextensions.Aswiththetaxbenefit,cash-outrefinancingusinggovernment-backedsecuritizationsubsidizesnonhousingconsumption.Allowingtermextensions,arefinancethatresultsinpushingoffthedatethemortgageisfinallypaidoff,increaseshouseholdleverageandthusrisktothehouseholdandtofinancialmarkets.Theserialrefinancingofmortgagesinordertoextractequityorextendtheloantermrunscountertothepolicyobjectiveofwealthbuildingandmisappropriatesthesubsidy.Thisisnottosaythatpeopleshouldnotbeabletorefinance,orthattheyshouldnotbeabletoremovehomeequitywhentheyrefinance.Butitdoesraisethequestionastowhythegovernmentguaranteeshouldbeusedtosubsidizesuchactivity.Therearelogicallimitsthatcouldbeconsidered.Ioffertwosimplesoneshere.

First,thegovernmentcouldlimitthedeductibilityofinterestinthecaseofrefinancingthatwithdrawsequityorextendstheloanterm(onlyweaklimitsexisttoday).

(March–April2016):109–130;“TheWealthBuildingHomeLoan:Providinghomebuyersastraight,broadhighwaytobuildingwealth,”AmericanEnterpriseInstitute,mediarelease,September8,2014.

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Second,thegovernmentguaranteeofmortgagesecuritizationcouldbelimitedtopurchase-moneymortgagesonly.Oncetheguaranteehashelpedtheborrowerachieveownership,anyrefinancingoftheoriginalobligationcouldbedoneinpurelyprivatemarkets,absentthegovernmentguarantee.Thatwouldbothlimittheguaranteetoassistingwithhomepurchasesandremovethesubsidyforextractingequityfornonhousingpurposes.

Torepeat,Iamnotobjectingtorefinancingperse,ortotheextractionofhomeequity.WhatIamsayingisthatwecouldmoreappropriatelyfocusgovernmentsubsidizationofmortgagesonfacilitatinghomeownershipandequitybuilding.Beyondthat,theprivatemarketwouldoperateabsenttaxpayersupports.

ConclusionHousingpolicyneedstopaygreatattentiontobuildingpathwaystosustainablehomeownership.Waivingcommonsenseunderwritingrulestoenlargethepoolofhomeownersiseasy.Andsolongastheeconomyremainshealthyandhousepricesrise,theriskoftenpaysoff.Butwhenthatisnotthecase,thedamagetotheveryhouseholdspolicyintendedtohelpisenormous.Itwouldmakemuchmoresensetofocuspolicyeffortsoncreatingpathwaystohomeownershipthatleadtomoresustainableoutcomesandtoengageprivatelendersinthiseffort.

Whileweallwelcomethewealth-buildingresultsfromyearsofsuccessfulmortgagepayments,wecannotlosesightthathomeownershipisprimarilyconsumption,notinvestment.Itsreturnstendtobelowandvolatile.Policyeffortstopromotehomeownershipshoulddomorethantheydotodaytoprotectvulnerablefamiliesandtoproducemoresustainablemortgages,evenindifficulteconomicenvironments.AversionofthispaperwaspresentedattheConferenceonHousingAffordabilitysponsoredbytheAmericanEnterpriseInstitute,theBankofIsrael,theBoardofGovernorsoftheFederalReserveSystem,TelAvivUniversity,andUCLAonApril6,2017.TheauthorwishestothankhiscolleagueMichaelBrightforcommentsandinputonthiswork.

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About the AuthorEdDeMarcoisaseniorfellowinresidenceattheMilkenInstitute.HehasbeennamedpresidentoftheFinancialServicesRoundtable’sHousingPolicyCouncil,effectiveJune1,2017.BeforejoiningtheMilkenInstitute,DeMarcowasa28-yearcivilservant,culminatingwithhisroleasactingdirectoroftheFederalHousingFinanceAgencyfromSeptember2009toJanuary2014.Therehedealtwiththechallengesofmanagingthemega-institutionsFannieMaeandFreddieMac.DeMarcocraftedthe2012FHFAStrategicPlanforEnterpriseConservatorshipsandtheassociatedscorecardsandsetintomotionthecreditrisktransferandcommonsecuritizationinitiativesthatunderpinadministrativeeffortstoday.About the Center for Financial MarketsBasedinWashington,D.C.,theMilkenInstituteCenterforFinancialMarketspromotesfinancialmarketunderstandingandworkstoexpandaccesstocapital,strengthen—anddeepen—financialmarkets,anddevelopinnovativefinancialsolutionstothemostpressingglobalchallenges.About the Milken InstituteTheMilkenInstituteisanonprofit,nonpartisanthinktankdeterminedtoincreaseglobalprosperitybyadvancingcollaborativesolutionsthatwidenaccesstocapital,createjobs,andimprovehealth.Wedothisthroughindependent,data-drivenresearch,action-orientedmeetings,andmeaningfulpolicyinitiatives.©2017MilkenInstitute.ThisworkismadeavailableunderthetermsoftheCreativeCommonsAttribution-NonCommercial-NoDerivs3.0UnportedLicense,availableatcreativecommons.org/licenses/by-nc-nd/3.0/