The meltdown of the subprime mortgage sector last year triggered a stampede to quality in a broad range of U.S. credit markets. The mortgage-backed securities markets have been hit the hardest, particularly the subprime, near-prime, and jumbo components. Even the prime secondary markets served by Fannie Mae and Freddie Mac have staggered as the financial health of these government-sponsored enterprises (GSEs) has deteriorated.
The root cause of the turmoil in mortgage securities markets is an unanticipated weakening of home prices that has been broadening and deepening (by most measures) since 2006. Downward momentum in national average home prices has been accelerating in recent months, seriously weakening the quality of outstanding mortgages and fueling expectations of further price declines. This process has virtually shut down fully private mortgage securities markets and has caused yield requirements in GSE markets to widen out considerably.
The turmoil in secondary-mortgage markets naturally has disrupted the primary markets, where prospective home buyers shop for credit. The Federal Reserve’s quarterly surveys of senior loan officers at commercial banks document a dramatic cumulative tightening of home mortgage lending standards during the past year (through April). The tougher standards include larger down payments, lower debt-to-income ratios, and higher credit scores.
The tightening of lending standards documented by the Fed has been most severe in the subprime market, but the market for nontraditional mortgages (including interest-only and payment-option ARMs) has been seriously constricted as well. Even the prime conventional market (served by Fannie Mae and Freddie Mac) has seen a dramatic cumulative tightening of lending standards during the past year. The broad-based tightening process obviously has weighed heavily on home sales, which have been falling sharply despite attractive interest rates in the prime market and rebounding affordability measures that fail to take changes in lending standards into account.
The weakness of home sales and prices, the record volume of vacant housing units on the market, and the persistent upswing in mortgage foreclosures certainly have caught the attention of financial institutions that lend to builders and developers. Recent NAHB surveys of build-ers document substantial tightening of lending conditions for new projects as well as unfavorable adjustments to outstanding loans for land acquisition, land development, and construction (AD&C loans).
The Federal Reserve’s quarterly surveys of bank lending officers show substantial cumulative tightening of lending standards for commercial real estate loans, a category that includes residential AD&C loans. The federal regulators have actively encouraged this tightening process, raising alarms about portfolio concentrations and stressing the risks of AD&C lending to depository institutions and their supervisors.
The progressive tightening of lending standards in home mortgage and residential AD&C markets will not ease off until home sales are rising, the inventory overhang is falling, and home prices are stabilizing.