Since December, the International Center on Housing Risk at the American Enterprise Institute has been publishing its monthly National Mortgage Risk Index (NMRI). The index measures how the mortgages originated in a given month would perform if hit with a repeat of the recent financial crisis. We developed the NMRI to help inform policy makers and the public about the safety of new mortgage lending. The NMRI shows that recent mortgage loans would not perform well under stress, despite the common perception that mortgage credit is tight, with only the highest-quality borrowers able to get a loan.
A few facts show why the common view is off the mark. In recent months, fully half of the home purchase loans covered by the NMRI had a down payment of 5 percent or less. With so little money down, many recent borrowers would be underwater after only a modest decline in house prices. In addition, for nearly half of the recent home purchase loans in the index, the borrower's monthly payments on their mortgage and other debt as a share of their pre-tax income (the debt-to-income ratio, or DTI) exceeded 38 percent, the traditional threshold for acceptable payment burdens. Many borrowers with a high DTI would find it difficult to make their monthly payments if they came under even moderate economic stress such as a temporary layoff or a reduction in work hours.
In February, the index indicated that 11.6 percent of recent home purchase mortgage loans, roughly one in nine, could be expected to default under severe stress. To put this number in context, in 1990 − before the loosening of lending standards that culminated in the meltdown in the housing market – the NMRI was at about 6 percent. Thus, the current level is nearly double what would be consistent with reasonably solid underwriting standards. This is largely due to a decline in down payments and a rise in DTIs.
The Federal Housing Administration (FHA) is the prime source of this risk. In February, virtually all of the home purchase loans it guaranteed had a down payment of less than 5 percent, and one-third had a FICO credit score below 660, the demarcation line for subprime credit. In addition, two-thirds had a DTI greater than 38 percent, and even more worrisome, one in six had a DTI above 50 percent. Unlike the VA loan guarantee program, FHA does not use a residual income test to determine the borrower's ability carry such a high debt burden.
Stable housing markets depend on the preponderance of loans being low risk—ones that are unlikely to default even under stress. In February, only 43 percent of home purchase loans were rated low risk, raising serious questions about the ability of much of today’s loan production to withstand a stress event. FHA is especially vulnerable in this regard, with less than 2 percent of its recent insured loans rated as low risk.
Despite this unsafe risk profile, all of the loans covered by the NMRI meet the definition of a Qualified Mortgage (QM) set by the Consumer Financial Protection Bureau. The QM rule was intended to ensure that mortgage borrowers have the capacity to repay their loans. However, the QM rule has no required minimums for the borrower's down payment or credit score. And although it sets of maximum of 43 percent for the borrower's debt-to-income ratio, loans guaranteed by Fannie Mae, Freddie Mac, FHA, and other government agencies have broad exemptions from the DTI limit. It is clear that the QM credit box is too broad and deep to support a stable housing market.
QM’s illusory safety net is especially worrisome for lower-income borrowers who continue to be placed in high-risk loans they may not be able to afford. Our state-level mortgage risk indices reveal that the states with the lowest median household income, as estimated by the Census Bureau, are at or near the top of the list for mortgage risk. These states include Alabama, Arkansas, Louisiana, Mississippi, and West Virginia. The common element linking these states is their heavy reliance on FHA loans. Instead of ensuring lower-income borrowers are on a road toward homeownership based on prudent credit standards, federal housing finance policies place such borrowers on a path where once again ‘mortgage’ becomes another word for trouble.
The last financial crisis was too painful for us to repeat. Had the NMRI been available before the crisis, it would have shown that mortgage risk had been rising at an unsustainable pace for many years before 2007. And had this rising risk been transparent, borrowers would have been forewarned and lenders could have revised underwriting practices, moderating the bubble.
Federal housing policies continue to place borrowers, particularly lower-income borrowers, in harm’s way, and the Center's mortgage risk indices are shining a light on these previously opaque risks. Our mission is to provide policy makers and the general public with the information necessary to prevent a repeat of the devastating housing bubble and subsequent crash that wreaked such havoc on the economy, financial markets, and individual neighborhoods across the country.
Pinto and Oliner are co-directors of the International Center on Housing Risk at the American Enterprise Institute.