Newly Proposed Rules Could Raise Rates on Consumer Mortgages and Price Out Households

On balance, the residential housing market has been improving in recent months, but the pace of recovery is partly restrained by frictions in the mortgage market.

Against this backdrop, U.S. regulators have proposed comprehensive new regulatory capital requirements for U.S. banking organizations.  These newly proposed rules will serve to implement Basel III, the most recent revision to international bank regulatory capital standards, in the U.S. They also reflect the implementation of certain aspects of the Dodd-Frank Act, excluding the Dodd-Frank Act’s language addressing qualified mortgages and qualified residential mortgages, which was signed into law during the summer of 2010.

The Basel III regulations directly address single family residential loans that are made to consumers and remain on bank balance sheets.  They will also target the loans made to builders of these homes as well as off-balance sheet loans.  The analysis described below focuses on Basel III’s impact on single family residential loans that are made to consumers and remain on bank balance sheets. Future work will assess the impact of newly proposed regulations on builders of single family homes and on the residential mortgages that are moved off of a bank’s balance sheet.

If adopted as proposed by the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, the U.S. version of Basel III would require banks to increase the amount of capital used to fund the single family residential real estate loans that remain on the balance sheet of banks by assigning these loans a greater risk weighting. The risk weight identifies the amount of an asset, in percentage terms, which must be backed by at least 8.0% of capital. In addition, the FDIC would separate single family residential mortgages into two risk categories, category 1 and category 2. The proposed definition of category 1 residential mortgage exposures would generally include traditional, first-lien, prudently underwritten mortgage loans. The proposed definition of category 2 residential mortgage exposures would generally include junior-liens and non-traditional mortgage products.

Raising the risk weight as described above increases the cost of consumer loan funding by both increasing the amount of relatively more expensive capital funding required and lowering the amount of relatively less expensive deposit funding needed. As a result, by raising the total cost of funding, implementation of the newly proposed rules directly addressing on-balance sheet mortgage purchase loans for single family homes could further restrict the supply of mortgage credit. In a competitive market, higher funding costs would produce a matching increase in consumer mortgage rates and price some households out of a real estate market

Recent calculations made by the Mortgage Bankers Association (MBA) demonstrate how these new regulations will likely raise funding costs and mortgage rates for some consumers. According to the MBA, a category 1 mortgage with both a loan-to-value ratio (LTV) of 95.0 and mortgage insurance would cost 2.52% under current capital requirements. However, under the proposed Basel III risk weights, that same mortgage would cost 3.04%, an increase of 0.52 percentage points. The increase in cost, and by extension the mortgage rate faced by these consumers, reflects an increase in risk assigned to these mortgages. Under current capital requirements, these loans are assigned a risk weight of 50.0%, while under Basel III rules, the risk weight would be 100.0%.

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Research by NAHB illustrates the effect that higher mortgage rates would have on housing affordability. This research indicates that an increase in mortgage rates from 2.5% to 3.0% would leave more than 2.2 million households priced out of the market for a median-priced new home.  The decline in housing affordability that results from increased consumer mortgage rates reflects an increase in both the monthly mortgage payment and the minimum income needed to purchase a home. NAHB estimates that an increase in mortgage rates from 2.50% to 3.00% would raise monthly mortgage payments by $56 per month and raise the minimum income needed by $2,373 to $51,871.

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  1. Higher interest rates and lower affordability to meet “international banking standards”? The new home industry has had extreme difficulty recovering in an interest rate environment that has seen rates plunge to record lows. One can only guess what will happen if rates rise even moderately. This and Dodd-Frank are not conducive to getting back to normalcy. Perhaps builders should consider going back and creating a form of “builder bond” program to reduce the adverse affects of an environment of over-regulation. NAHB should take the lead in looking into this.

  2. Perhaps the NAHB should spend some time evaluating what would be the net affect of increased mortgage costs on new home selling prices or house size, and plot this on a graph comparing these two variable to the cost of these bank regulations. Then, let the market decide if they will buy a smaller home that costs less. When properly motivated, the buyer will buy.

    The next issue to consider is what will happen regarding the Flippers and the Speculators? Is it possible that those Investors will step forward and take up the slack in the market by owning and then renting to those who buyers who have been priced out? Are the Flippers, Speculators and Investors ever really priced out when the leverage possible on residential home loans is still greater than nearly any other speculations? And don’t forget that the GSAs Fannie and Freddie will never stop anyone from going over their limit of four government backed mortgages. That rule was not enforced in the past, and will not be enforced in the future.

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