Federal Reserve Chair Janet Yellen said in June: “It is difficult for any homeowner who doesn’t have pristine credit these days to get a mortgage. I think that is one of the factors that is causing the housing recovery to be slow.”

The chart below shows that the rate of growth of mortgage applications in the US, according to the Mortgage Bankers Association of America, has been pretty much stagnant over the recent weeks (shown in the red circle).

us-mortgage-applns-growth-3-years

Chart courtesy: http://www.tradingeconomics.com

Yellen also laid the scant progress in the housing sector at the door of interest rates that rose last year.

Banks wary

In July, JPMorgan Chase & Co. (NYSE:JPM) chief Jamie Dimon also raised a red flag on loans that are originated by banks but guaranteed by the FHA. The agency‘s aggressive litigation that led to banks having to cough up billions in mortgage related settlements has understandably made banks swing to the other end of the pendulum as far as housing lending is concerned – they now err on the side of caution while assessing the credit worthiness of a housing loan applicant.

“The real question for me is should we be in the FHA business at all,” Dimon said on a conference call related to the bank’s second-quarter earnings. “We want to help there, but we can’t do it at great risk to JPMorgan. Until they come up with a safe harbour or something, we are going to be very, very cautious in that line of business,” he noted.

Banks having to reassume the liability for mortgage loans that go bad is known as a ‘put-back.’

Wells Fargo & Co (NYSE:WFC) CEO John Stumpf similarly echoed his misgivings regarding these risks emerging from loans originated by his bank, guaranteed by government agencies such as Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), and then coming home to roost at the bank’s door upon the borrower’s default.

“If you guys want to stick with this programme of ‘putting back’ any time, anyway, whatever, that’s fine, we’re just not going to make those loans and there’s going to be a whole bunch of Americans that are underserved in the mortgage market,” Mr Stumpf told the Financial Times in an interview, on the subject of home loans for people with less-than-perfect credit scores.

Slow mortgage market

Borrowers’ ability to repay housing loans must now be assessed under new rules issued by the Consumer Financial Protection Bureau that became effective in January.  With banks unwilling to shoulder risk under a new regulatory environment, and the housing market still in recovery mode after the financial crisis, the mortgage market is understandably slow.

Some banks have been forced to try and recoup volumes by relaxing their credit standing requirements in respect of larger loans for pricier properties (the so-called “jumbo loans”), though they hastily assure that this is without risk.

It appears therefore that banks can relax credit requirements on larger loans (read: non-FHA) but are unable to do so on the smaller loans that need to be guaranteed by the FHA, and carry the put-back risk.

Mortgage structure breaking down

Apart from the aforesaid risks, banks are now ensnared in a circle of dilemmas that could lead to a breakdown of the country’s housing mortgage structure, according to Richard X Bove, VP Equity Research at Rafferty Capital Markets.

“The demand for housing is being reduced because low income households (first-time buyers) are being pushed out,” he says in his research note ‘Housing Prices About to Fall – Time to Get Serious About Understanding Mortgages and Housing’ of August 27, 2014.

Richard Bove cites the aforesaid put-backs, huge litigation penalties and arduous regulations that have inhibited banks’ willingness to advance housing loans. He also observes that the wind down of the Fed’s QE system as well as the fact that Fannie Mae and Freddie Mac have become net sellers of mortgages, mean major sources of demand for mortgages are drying up.

With no takers, banks are left holding the bag on any mortgages they originate. “No bank that I am aware of will write a 30-year fixed rate mortgage to be held on its portfolio,” says Bove. “If the bank cannot sell the loan it will not make it. The preferred loan is a 10-year variable rate mortgage. Banks will write these loans.”

And therein lies the rub…

Unfortunately, there is a vast difference between the monthly pay-out on these two types of loans.

According to Bove the average monthly cost of a $225,000, 30-year fixed rate mortgage, with a 4.25% coupon, is $1,107, while that for a $225,000, 10-year variable rate mortgage, with an estimated 5.50% coupon, is $2,442, (i.e. more than double).

“As banks go from the 30-year to the 10-year, monthly housing costs soar and housing prices tumble,” warns Bove. “This process is now underway. Initially, it impacts housing sales. Ultimately it drives housing prices down for everyone.”

Correlation study

To buttress his observation, Bove and associate Satyam Arora crunched some numbers to assess the correlation between housing sales, housing prices and monthly housing cost, and came up with the following results:

Bove-study

The study is very illuminating – clearly there is a marked positive correlation between rising housing sales and house prices (green rectangle) – rising prices boost sales, it seems. On the other hand housing sales are negatively correlated with mortgage rates and monthly costs (red rectangles) – rising finance costs reduce housing sales.

Says Bove: “Conclusion is one of falling dominoes.”

infographic