Current news topics & their impact in the marketplace.

Several financial topics in in the media have been much discussed recently:

• 40-year Mortgage: Effective May 8, 2023, the Federal Housing Administration (FHA) will join other entities such as Fannie Mae and Freddie Mac in offering a 40-year loan modification option.

• Loan Level Pricing Adjustments (LLPAs) for Fannie Mae & Freddie Mac Loans: Starting May 1st, a revised mortgage structure will be implemented with a 1.75% fee discount for borrowers with lower credit scores (a FICO score of 620), while the fees for borrowers with higher credit scores will be increased.

• FedNow℠ Service: In July this year, The Federal Reserve will be releasing their controversial FedNow℠ Service. It is advertised as a new instant payment system (whose infrastructure is controlled by the central bank) that will allow “individuals and businesses to make payments in real time.”

I will outline these current trends, what impact they may have on the marketplace, and what they mean for financially responsible investors and market participants.

Risks and Foolishness of the 40-Year Mortgage: Is New Government Regulation Doing More Harm Than Good?

While various 40-year mortgage options have been available in the market for some time, they were offered by banks and lenders that specialize in non-qualified loans (i.e. loans that are not bound by strictly regulated federal guidelines). Non-qualified loans usually come with higher interest rates and are marketed to borrowers with lower credit scores and less stable income.

However, with the recent FHA ruling, the use of a 40-year mortgage is likely to rise. Their new ruling allows borrowers in financial hardship to restructure their current mortgage into a 40-year mortgage. Loan modifications are sometimes viewed as a preferable alternative to foreclosure or bankruptcy. However, the primary concern is that this new ruling may encourage already financially strapped borrowers to take on loans and products beyond their means. Borrowers, lured by a temporary reprieve, could worsen their situation in the long-run if they are not properly prepared. (For example, in the 2007/2008 mortgage crisis, many homeowners who modified their loans only delayed foreclosure, and so the modification did not provide a long-term solution.1)

A loss of momentum in the housing market is likely the motivating factor for this new product. The government is moving to provide support in this critical sector amidst recent economic troubles. Enabling a greater number of individuals to retain ownership of their homes will, in theory, minimize the number of foreclosed properties entering the market and help relieve the pressures on housing prices from the increased supply.

Ultimately, this new product will distort the housing market and spur more irresponsible financial choices. Enabling struggling consumers to increase or lengthen their debt is unlikely to solve their problems or the problems of a lackluster housing market. Sadly, those who are in financially distressed situations either due to poor choices or unfortunate circumstances will be most hurt.

Understanding the Impact of Changes to Mortgage Pricing

Starting May 1, a new pricing model (referred to as a Low Level Price Adjustment, or LLPA), will be imposed by Fannie Mae & Freddie Mac (who together, guarantee the majority of new mortgages). In the past, pricing models for mortgages were used by lenders to tailor their mortgage products to the risk profiles of individual borrowers and to ensure that the lenders are compensated appropriately for the risks they take on.

The new pricing is made with the stated aim of making mortgages more affordable for borrowers who have lower credit scores. This group of borrowers will benefit most from the changes, while those with good credit scores may have their fees increased.

The biggest criticism of this change is that it will raise mortgage payments for good credit and higher down payment homebuyers to foot the bill for high-risk mortgage borrowers with lower credit scores and lower down payments. It sounds backwards, but it’s true: homebuyers with credit scores of 680 or higher will pay an additional 0.75% in fees. (This is about an additional $40 per month on a $400,000 mortgage.)

For those who want to see the adjustments, here is a pricing table showing the changes to borrowers based on their credit and down payment:

This repricing will have the largest impact on mid- to good credit score borrowers (680-780) with a healthy down payment. In turn, this will offset the costs of lending to lower credit borrowers.

As with the 40-year mortgage, this new pricing is unlikely to benefit the marketplace and instead will likely have negative outcomes. Lenders use credit scores to determine the risk of lending money to individuals, and those with low credit scores are often seen as a greater risk. Having a lower credit score means you are more likely to fail to make timely payments and have a much higher likelihood of defaulting on a loan. (Similarly, the relaxed standards of the 1995 Community Reinvestment Act, caused lenders to reduce their lending standards, offering loans to borrowers with poor credit history and no down payment. This was not the sole cause of the housing crisis, but it certainly played a role in the growth of the subprime mortgage market, which ultimately contributed to the collapse of the housing market and the subsequent financial crisis.)

FedNow℠ Service: Understanding the Controversies and Concerns Surrounding the New Instant Payment System

While I have substantive issues with FedNow℠ Service which I discuss below, for those who are concerned that this new instant payment system is a stepping stone towards Central Bank Digital Currency (CBDC)—there is a huge gap between what is currently being attempted and what would be necessary to implement a full-scale CBDC. I think if we wait and see how the FedNow℠ Service rolls out, those concerned will realize this:

This service seeks to enter the instant payment marketplace with the intention of “provid[ing] safe and efficient payment services.2” I guess they haven’t heard of PayPal, Zelle, Venmo, Square, or any other cash transfer applications the private sector already offers.

There has been no demand for an additional central bank-controlled cash transfer service by the market, but this is not stopping the government from entering a service sector of which it has no prior history of knowledge or expertise. Previous experiments like this have not demonstrated government proficiency, as exemplified by the Obamacare and Social Security websites (or the DMV).

The Federal government has a poor track record of efficiency, competence, and fiscal responsibility with the tasks it already has. It is important for market participants to have confidence in government sponsored products, but this product is unlikely to be nearly as efficient as the cash transfer applications already on the market and may entice consumers with a false confidence because of government backing.

What These Events Mean for Responsible Citizens

These three events may be aimed at fostering a flourishing economy; however, it is not likely they will do so—particularly in the real estate sector. The government’s mismanagement of federal funds through extravagant spending, currency printing, and inadequate interest rate control calls their economic credibility into serious question.

Good market regulation (if there is such a thing) seeks to reward responsible behavior and punish bad behavior. In the past, that was seen with more favorable loan terms to those borrowers who had a better history of repayment. The regulatory environment should seek to cultivate more of what it wants—not more of irresponsible behavior through policies that encourage reckless borrowing.

In reality, we have little control over the decisions and policies of the government. But what we do have control over is our own decisions. It is most important, that regardless of how these policies impact certain sectors, we each continue to work our own financial stability by making sound choices, being responsible with our resources, and taking proactive steps towards achieving our financial goals.

As a Republic, we must remember that our government is a reflection of us—our values, decisions, and choices. Right now, it reflects a very financially irresponsible citizenry. If we want a government to lead with fiscal soundness, we have to start in our homes, and then demand the same from our leaders.