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Test for Biden administration as reformers want nationwide caps on mortgage loans

A housing bubble burst in 2008 pushing the U.S. into deepest recession since the Great Depression. In the aftermath, many nations developed new tools designed to take the air out of real-estate bubbles before they burst. The U.S. has lagged in some respects, in part because of the deregulatory zeal of the Trump administration.

Some reformers, sensing danger, want the Biden administration and the Federal Reserve to develop new tools and take action to catch up. Others worry that efforts to deflate bubbles will, in the end, only hurt the poor and the middle class.

Developments this year have focused attention on the issue. Home prices are rising at their fastest pace in history , fueling concern that a new real estate bubble has formed.

These double-digit home price increases have led some to call on the Fed to raise interest rates. So far, Federal Reserve Chairman Jerome Powell has resisted those calls, arguing that higher rates damage the entire economy and lead to job losses at a time when the effects of COVID have already left millions of Americans unemployed.

Raising rates "in order to address asset bubbles...[is] not something we would plan to do." Powell told reporters earlier this year. "We would rely on macroprudential and other tools to deal with financial stability issues.

So far, nothing has been done, despite protest from some Fed officials like Boston Fed President Eric Rosengren, who recently argued that a "boom and bust cycle" in real estate is incompatible with financial stability.

Jeremy Kress, a former attorney in the banking regulation and policy group at the Federal Reserve and professor at Michigan's Ross School of Business criticized the Fed for not using a tool already in its arsenal -- the countercyclical capital buffer.

This rule allows the Fed to require banks to fund themselves with greater amounts of equity in the form of retained earnings or money raised from stockholders and less from debt, he said.

"By raising capital requirements during boom times, that could put a break on runaway asset prices," Kress said. "The Federal Reserve, in contrast to other countries, has never turned on this discretionary buffer. Perhaps now might be a good time to activate it."

There are other, more specific, ways the government could target bubbles in the housing market.

Gregg Gelzinis, associate director for economic policy at the Center for American Progress told MarketWatch in an interview that the Financial Stability Oversight Committee, the group of the heads of regulatory agencies created in response to the financial crisis, would be more effective if Congress gave it the power to set nationwide limits on how much money banks can lend to purchasers of real estate.

"The suite of tools regulators have are imperfect, and there are other tools that that Congress could grant them to could bolster the arsenal," Gelzinis said. Regulators in the UK and some countries in Europe can put limits on loan-to-value ratios that change based on the state of the economy. "You have one cap in normal times and another when the market is overheating," he said.

See also: An inflation storm is coming for the U.S. housing market

Former Federal Reserve Vice-Chairman Donald Kohn made a similar point in a 2017 speech that Washington regulators "need the power to put limits on loan-to-value and debt-to-income measures, when loosening standards, perhaps occurring outside the banking system, threaten financial and economic stability."

A loan-to-value ratio measures the size of a mortgage loan relative to the value of the property used to purchase it. High LTV ratios may suggest speculative behavior because the buyer could take out such a risky loan on the expectation that the property would rise in value.

According to the International Monetary Fund (/Users/matthewschristopher/Downloads/MPHPEEA.pdf), 19 different European countries have instituted loan-to-value caps that range from 30% to 100%, with higher limits on loans for first-time homebuyers and lower caps on those buying second homes and investment properties. The IMF study said the results of these policies often slowed the pace of price growth in a given real estate market, though in some countries with severe constraints on the supply of new homes, those effects were muted.

The Consumer Financial Protection Bureau, which was created by the Dodd-Frank financial reform law in part to protect Americans from predatory mortgages, has the power to set these types of standards. In 2013, the regulator implemented a debt-to-income limit of 43% for mortgages, if issuers wanted to qualify for a safe harbor that would protect them from customer lawsuits. A debt-to-income ratio compares how much the borrower's monthly repayments are compared to monthly income.

Under the Trump administration, however, the debt-to-income limit was scrapped for a market-based approach that relies on private underwriters to determine whether a borrower is likely to default on a mortgage loan.

"The way they've done it, very few mortgages are actually going to be affected," Laurie Goodman, a former mortgage banker and a housing-finance expert at the Urban Institute told MarketWatch. "What they've done is avoided a major credit tightening by adopting the rule they did."

The Task Force on Financial Stability, a group of private scholars, former regulators and industry practitioners issued a report in June that discussed the costs and benefits of LTV caps. They wrote:

The Urban Institute's Goodman, who is a member of the task force said that mortgage lending is already very conservative even without federally mandated loan-to-value caps. She said in recent years mortgage lenders have been demanding higher down payments and credit scores in recent years, a trend that accelerated during the pandemic as lenders worried about the state of the economy.

"There is no question that credit was too loose in 2005 to 2007 period," she said. "As far as I'm concerned that pendulum has swung way too far in the other direction." Goodman argued that current banking standards, driven by government regulation as well as industry fear of repeating last decade's crisis, has left too many Americans from "accessing the single greatest wealth building tool of homeownership," she said.

Indeed, consumer rights and civil rights groups have applauded the CFPB's decision to scrap a hard DTI cap and consistently advocate for policies that create better access to reasonably priced home loans. In April, a group of civil rights organization wrote to the CFPB's Acting Director Dave Uejio (/Users/matthewschristopher/Downloads/CFPB-2021-0003-0030_attachment_2.pdf) to keep the Trump-era mortgage rules in place.

"An unnecessarily restrictive definition of a qualified mortgage would push a considerable share of creditworthy borrowers -- including a large share of borrowers of color -- out of the mainstream mortgage market and possibly out of the mortgage altogether," they wrote.

Meanwhile CAP's Geliznis argued that there are other steps the Financial Stability Oversight Council could take that would increase financial stability without necessarily making it harder for average Americans to secure a mortgage. He argued that nonbank mortgage servicing companies, that originate and service loans, but do not hold them on their books, pose a greater threat to financial stability than lax lending standards and that FSOC should consider designating the largest of these firms as systemically important, and therefore subject to greater regulation.

Goodman disputes the idea that another potentially ruinous real estate bubble is forming, driven by low interest rates and lax regulation. Instead she argued the evidence is clear that today's rising home prices are largely the result of a surge in demand for new homes, led by a demographic wave of millennial buyers looking for their first homes and other buyers fleeing cities for suburban single family homes in the wake of the pandemic.

"The problem is about too much demand and not enough supply," she said. "The cost of production has gone up, land values are sky-high, you've got all sorts of zoning restrictions that increase land values," and builders wonder "how many borrowers can afford what it actually costs you to produce."