December 16, 2014

Because of the widespread belief that homeownership is valuable, the recent decline in the homeownership rate has generated some dismay. The rate, which had peaked at 69.1% in 2005, shortly before the financial crisis, has since fallen to 64.8%. This is the lowest it has been since 1995. 

I don’t share the dismay about the decline in the homeownership rate because a higher rate is not necessarily better.  When homeownership reached its peak in 2005, many owners could not afford the houses in which they were living. The important thing is not the homeownership rate but whether the homeownership process is efficient and fair. If it is, then whatever homeownership rate emerges is the optimal rate.

The homeownership process is the network of rules and practitioners that a home buyer typically encounters in becoming a homeowner. The major rules are the underwriting standards that determine whether or not a potential home buyer will qualify for the mortgage needed to execute the purchase. The practitioners usually include a real estate agent, a mortgage loan originator, and sometimes an independent counselor. 

Existing underwriting rules are a weakness.  In a knee-jerk regulatory reaction to the financial crisis, documentation requirements, which are a critical component of underwriting rules, were tightened unreasonably. This made some high-quality loan applicants, especially among the self-employed, ineligible for no good reason. None of the agencies seem to be concerned about this.

A major weakness of the home ownership process is the mortgage loan originator (LO). This is the individual who takes the borrower through the loan process, applies the underwriting rules, and is a major source of information and advice about the options available to the borrower.

The typical LO is an expert on mortgages and the mortgage process, where the typical loan applicant is a novice. The problem is that the LO has a financial incentive to use his information advantage for his own benefit rather than for the benefit of the applicant.      

LOs are compensated by commission calculated as a percent of the loan amount, payable only if the loan closes. Their financial interest is in taking the loan to closing with the least expenditure of time. The LO’s commission is not affected by how carefully he examines whether the borrower:

·        Should take an adjustable rate or a fixed-rate loan, and if the latter, the best term.

·        Should buy down the interest rate by paying points, or buy up the rate in order to receive a rebate.

·        Should reduce the down payment to conserve cash or increase it to reduce the mortgage insurance premium.

Neither is the LO’s commission affected by what happens to the loan after the closing. Defaults and foreclosures are somebody else’s problems.

Given this terrible incentive structure, I am frequently surprised at encountering LOs who are consummate professionals, acting in the best interest of the applicant and investing the time needed to do the job right. Unfortunately, there aren’t enough of them, and there is no reliable way for a home buyer to find one.

A widely held view is that the best antidote for the conflict inherent in the LO mechanism is the use of counselors who have the requisite knowledge but no financial interest in the transaction. They may be paid by the borrower, lender, or insurer but payment is not related to the size of the loan, or to whether or not the loan closes. A few studies have found that home buyers who were counseled have lower mortgage delinquency rates than buyers who were not.

On HECM reverse mortgages, counseling is required for all borrowers. I had an opportunity to query 13 of them on their reaction to the counseling: 5 said it was worth the time, 5 said it was a waste of time, and 3 were on the fence.

HUD, which administers the HECM counseling program, appears favorably disposed to counseling. It is developing a pilot program in which borrowers will have their FHA mortgage insurance premiums reduced if they agree to undergo counseling.

The downside of counseling is that someone must pay for it, and it introduces another time-consuming step in the process. A major complaint against counseling in the HECM market is that transactions are often delayed waiting for a counselor to become available.

There is another approach that does not require an additional participant in the process performing an additional function. This is to certify LOs who meet all the requirements of consummate professionals. I will discuss this approach next week.