The COVID-19 pandemic has unleashed numerous unexpected economic consequences. One that has turned out to be good for the economy but could end up being disastrous is the boom in mortgage refinancings.
Just like with the last financial crisis, there are signs that the surge in U.S. consumers seeking to take advantage of ever lower borrowing costs are being aided by relaxed lending standards.
The Mortgage Bankers Association's refinancing index soared in March to its highest level since 2012, and remains more than 40% above its level this time a year ago despite about 13 million Americans being out of work and relying on weekly unemployment jobless benefits from the government. Refinancings have allowed homeowners to take advantage of record-low interest rates to either cut their monthly expenses or cash out some of the equity in their homes to see them through these tough times.
All this activity is being aided by a relatively new innovation called the automated appraisal waiver from Fannie Mae and Freddie Mac. As the name suggests, the waiver means a homeowner who meets certain requirements does not need to obtain an appraisal in order to take out a new mortgage.(1) The result has been nothing short of breathless. The two firms account for an estimated 80% of all conventional refinancings and 90% of all 'cash out” refinancings, according to data compiled by the American Enterprise Institute, or AEI. Refinancings between the two totaled about 618,000 in July, up from 218,000 in January. About 154,000, or 25%, were cash out refinancings, compared with 93,000 in January, or 43%.
Don’t let the declining share fool you. The jump in cash out refinancings still represents a 66% increase in the space of seven months thanks in part to automated underwriting. Readers may recall that in the years leading up to the last housing bust, Fannie Mae and Freddie Mac automated income documentation. While that sped up the loan process, which seemed essential at the time given the magnitude of application volumes, it also proved to be a system that could be gamed. There were no safeguards against submitting multiple applications until the income provided finally qualified in the automated system. In the end, “no documentation” often suited best. We know how that ended.
Appraisal waivers have been key in supercharging the latest refinancing activity, according to Edward Pinto, the director of the AEI's Housing Center and who was Fannie Mae's chief credit officer in the 1980s. He conceived one of the first automated pricing models in the early 1990’s. Here's what he says:
“I’m a big fan of automation,” Pinto said in a recent conversation. “But the one I designed was for a bank, which retained the risk of the mortgage. With Fannie and Freddie, it’s the taxpayer who assumes the risk, so their only incentive is to push volumes and share as high as possible. We saw how dangerous this was with the GSEs’ automated underwriting systems in the ’00 years. My fear is that appraisal waivers will repeat the same pro-cyclical mistake.”
The average equity extraction on a cash out refinancing these days exceeds $60,000, and more homeowners will be enticed to extract equity with every uptick in home prices. The latest data from property research firm Redfin shows median home prices have reached record highs and are up 13% over the last year. That helped propel aggregate cash withdrawal volumes to about $100 billion in the past six months based on AEI calculations. And even with refinancing volumes up more than 200% over the same period in the last year, the mortgage analytics firm Black Knight figures nearly 20 million homeowners are still eligible to refinance their mortgages.
How does it work? The automated appraisal process effectively sends a computer-generated model to search for the latest comparables around the home where the mortgage is being refinanced. That’s a potential problem at a time when housing prices are rising at a pace that many economists believe is unsustainable and at risk of a pullback. Fannie Mae and Freddie Mac say automated appraisals have eliminated the bottlenecks tied to the dearth of appraisers. Even so, the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, has raised concern about the rapidity with which refinancing activity is taking place.
As appealing as the prospect of a streamlined mortgage refinance process is to homeowners, with Federal Housing Authority delinquency rates rising above 15% and the highest in records going back to 1979, now is not the time to relax underwriting standards in the name of efficiency.
(1) In a document on its website explaining the automated appraisals, Fannie Mae says only a 'small percentage of purchase loans qualify for an appraisal waiver offer, and borrowers always have the choice to obtain an appraisal. Fannie Mae continues to require full appraisals on the vast majority of purchase money mortgages to establish market value of homes and to provide valuable input to our appraisal database.'
Danielle DiMartino Booth, a former adviser to the president of the Dallas Fed, is the author of 'Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America,' and founder of Quill Intelligence.
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