The credit conundrum
If we want to expand the national homeownership percentage, how do we do it?
Can we afford a home?
It’s harder than it looks, for two reasons: the pricing equilibrium and the credit conundrum.
Because of the pricing equilibrium, cuts in national interest rates translate immediately into higher home prices. People pay the same amount — basically, as much as they can — but the house price and the loan face amount both jump up. As dozens of commentators have observed, that’s good for existing home owners — who refinance with alacrity — but does nothing for those whose income is just below the threshold.
Enter the credit conundrum.
Like crossing all seven bridges of
In a money economy (as opposed to rural self-build on free land), home ownership depends on financing.
Financing’s foundation is the national interest rate, set by our friends at the Federal Reserve (as Mycroft Holmes would call them, the gnomes in the Money Store’s basement).
Hard at work expanding the money supply
As Mycroft Holmes explained, Treasury is the ultimate credit, because everyone else pays their bills with notes that are IOUs from the government. Therefore, every other borrower faces the risk not just that the government will collapse, but also that his or her particular venture will fail.
Hence, atop that baseline every other borrower pays a premium related to that borrower’s credit-worthiness, or said in a simplified equation:
Setting an Interest Rate (I)
+ C, Treasury’s cost of capital (set by the Federal Reserve)
+ R, Risk premium (lender judgment based on assessing the applicant and his collateral)
= I, Interest rate quoted for this loan
The interest rate every borrower pays is thus related to the loan’s riskiness. That varies by asset class (as loan collateral, homes are safer than restaurants, to take an extreme example), but within a particular asset class, the prime consideration is borrower quality.
Risk premium is applied not just to the defaulting borrower, but to everybody with similar credit characteristics. It’s a simple pooling: if I (a lender) want to make a profit of (say) 100 basis points per loan per year, I have to charge more than that to reflect the risk that some borrowers will default and when they do, I’ll lose money.
In short, I have to be compensated for the risk.
Risk, simplified
Risk = Probability x Loss Given Default
The bigger the risk, the more compensation I need.
So far, so logical — from the lender’s perspective.
From where I view things, as a lender in my office, whole planets look really, really small!
Now look at it from the other side — and in particular, from the perspective of an aspirant homeowner who’d be a good borrower if only given the chance.
If only I could get on the other side of the homeownership mirror …
Who reimburses a lender for losses it suffers on defaulting borrowers? Why, all the borrowers of that credit class who don’t default.
Risk premiums are thus a kind of unwitting insurance pool, where the good pay for the bad.
Who you look like, in credit terms, determines how much of a risk premium you pay.
Do I look like a bad credit risk, you young twerp?
As a borrower, I don’t like being lumped into a risky class of ‘those people’; I want to be lumped in with the good customers, because since the lender’s risk is lower for that class and the risk premium it will charge me will therefore be lower. Yet, as Sherlock Holmes explicated in The Five Denying Pips, there are six reasons lenders deny credit, and half of them are functions not of the credit decision itself but rather of the risk assessment made of that particular borrower:
· Lack of credit history.
· Lack of income certainty
· Too costly to evaluate and originate.
Key to the foregoing is that in credit decisioning, as in politics, appearance is reality. Who you look like determines what you pay.
And those who most need help grabbing hold of the ownership ladder’s first rung? They seek to light themselves above the unfinanceable … and hence, they are charged the highest risk premium.
You look like a dog, I charge you a bigger premium
So the market’s entirely rational actions have the effect of imposing a barrier, a barrier of cost, between the aspirant and homeownership.
There is the credit conundrum.
The Credit Conundrum
As lenders move down the income pyramid, their natural credit scoring makes it ever harder to go lower, when as a policy matter, we would like them to make it easier.
I have read from time to time that this is a market failure. It’s no such thing. The market is doing what the market must, and should, do — it is pricing risk as efficiently as possible given the information available.
The credit conundrum has two policy consequences. The first is trivial:
1. Do not expect the market to create affordability. The market recognizes affordability; creation is no part of its job.
2. Affordability advances come from government. If we want to expand affordability, government must do something un-creditworthy; government must take risks the private market would not. Government must lose some money pushing into the uncharted space.
Make new loans in uncharted waters, and the dragons will get you.
Logically, if government is interested in advancing housing affordability on the demand side (at the household level) by serving the marginally creditworthy, it must choose from among several options:
· Be a direct lender (as in FmHA Section 515 loans)
· Be a loan subsidizer either with direct payments (as in the Section 235 program), or with credit enhancement (as in VA loan guarantees).
· Risk-share with Federally favored intermediaries (like the GSEs).
· Improve credit information quality, through mandated and pooled reporting, lowering the cost of consumer access to credit history, and otherwise (as in HMDA and the Fair Credit Reporting Act).
