Calming Our Markets with Technology
Economists are of different minds on the possibility of the
It was in the mid 90’s that we started using automated underwriting systems (AUS). Initially, these were hailed for their ability to more accurately analyze borrowers and open up home ownership to a much broader group of people. With more buyers, home prices naturally appreciated (the basic principles of supply and demand). Each year, the developers of these AUSes would look at all the categories of borrowers along with their credit scores (among other factors) to determine that more could qualify to buy homes. Sure, these systems were stress tested against a jump in interest rates but lacking such a jump the systems told us more people could be qualified to buy a home. Again, with more buyers entering the market home prices appreciated even more rapidly. Markets with 100% appreciation over 5 years were common. The AUSes would again look at past loan performance and see little likelihood of defaults. Thus, the underwriting standards were loosened again. The cycle continued and by 2006 almost anyone, regardless on their income and credit, could purchase a home. The AUS’s never predicted that in a period of historically low interest rates (which we still have today), defaults could dramatically increase as they are now. With this type of vicious cycle, there was no way it wouldn’t end in a bust. Many of us saw it coming (see my articles in Mortgage Banking, “Is Technology Influencing Real Estate Cycles”, April of 2005 and “Technology and Mortgage Economics”, May of 2004) but common sense has never been easily programmed into software. Others might blame consumer psychology, the hedge funds, increasing fed fund rates or one upsmanship competition among sub-prime lenders but in my view, much of the blame could be placed on over reliance on technology – primarily with the AUS’s and their designers. The AUS designers never thought to consider that hyper-home price appreciation by itself (absent large rate increases) was indicative of a bubble that would likely burst.
We’d like to call this recent bubble and bust as a natural real estate cycle but it’s much bigger than that. Thus, is the industry now influencing these cycles? Cycles will always be there, but are we the calming industry of reason or are we stoking the fire? Our constant liberalization of underwriting standards allows for rapid price appreciation until it all falls apart. Then, we work to make the cycle even worse. We quickly and decisively use the same technology to justify why all these borrowers we said were solid, no longer are. This then creates a depreciation of home values in both real terms and dramatically in inflation adjusted terms. We use technology to justify our terrible deeds and create a vicious cycle. I for one, somewhat long for the days of 20 percent down and 28/36 top and bottom ratios. Yes, these are antiquated ways to underwrite but consistent guidelines over decades would have been better than what we’ve done in the last ten years with stoking the fire. The natural real estate cycles will always come and go but it’s up to us to be a stabilizing force. We all loathe single digit PE ratios for our public stocks but if we look at how we operate, how could any investor justify anything better? I asked the CEO of a top 5 lender how we could prevent this situation from happening again and his answer was that, “we can’t… we’ll do this all over again in the next cycle”. There must be a better way.
In other financial markets curbs are a common method to control speculative buying and panic selling. For example, at the New York Stock Exchange (NYSE) curbs are implemented anytime certain indices go up or down beyond a defined percent. Once a trigger point is hit, trading limits/halts are put into place. We also see how the Fed will vary interest rates to cool or stimulate the economy. One method to control bubble housing markets would be to require lenders to increase down payments when home price appreciation rises to fast. For example, it could be based on a month to month median price increase by county. If housing values increased for a given county faster than say a government inflation index like the CPI (or perhaps an index related to consumer income), then curbs would be used. Curbs could come in when housing prices were escalating more than 3% above the index. For each percent over a given index, down payments would have to increase by an additional 5% of the homes value. In this example, if home prices rose 8% on an annualized basis and the CPI was 3% all loans in that county would require at least 10% down (8%-3%=5% or 2% over the 3% trigger and 2% * 5%=10% down requirement). If home prices rose as much as 10% year over year, down payments would then be bumped to 20%. The effect would be to cool the market and allow home appreciation to occur over a longer period. Speculative buyers would be more limited and lenders would obtain better protection from defaults (because of lower LTV’s). After some consideration, this is the best model I could conceive though greater minds might have other solutions. The point is, there are methods that our industry could consider to help our industry, the borrower and the greater economy.
The recent subprime meltdown didn’t have to happen. The pain inflicted on so many borrowers, lenders and investors was preventable. Still, it requires out of the box thinking. By no means do I propose eliminating the AUSes but we need to use this technology to better the industry and not allow it to make matters worse. The technology does have the ability to work as a calming force. Imagine a real estate market mostly absent of wild swings. Imagine that homes would appreciate each and every year fairly consistently. Imagine what that would do for our industry, employees and our stock valuations. Imagine the reaction on Capitol Hill and what it would do to their desire to regulate what we can’t do on our own.
For the first time in the history of our industry we can actually act as a calming force through the use of technology. We can micro-manage down payment percentages on a county by county basis and on a month by month basis. In previous decades, the systems were not in place to be able to read local markets and make immediate adjustments to underwriting guidelines. We know that technology is what created the nuclear energy and it’s up to people to determine if such technology is a good thing or a bad thing. The same is true in our industry. It’s my position that it’s time to step up and use our newfound technologies for the betterment of the consumer, our industry and the global economy.