It usually takes a high-level, macroeconomic analysis to illustrate the impact of the post-crisis regulatory framework on income inequality.  I’ve in fact been wrestling with this anew in anticipation of a paper I’ll present in a week or so at the IMF’s spring meeting.  Sometimes, though, a simple case study says it all, and thus it is with a new study from the Federal Reserve Bank of Philadelphia.  Using data on millions of mortgages, it tracks how changing rules redefined the risk of mortgages to lenders, servicers, and guarantors such as the FHA and GSEs.  It finds that, despite the sharp rise in house prices and improving credit risk, losses when a mortgage defaults remain stubbornly close to the astonishing severities reached during the crisis.  The reason for what the paper calls a new regime for mortgage risk?  New rules that, despite the consumer protection they provide, creates so much risk that the only way now to do a mortgage for a first-time homebuyer and other higher-risk borrowers is to price it out of their ballpark or get the taxpayer to pony up a costly guarantee. 

How can this be?  In 2013, the Bureau of Consumer Financial Protection issued a 753 page rule designed not unreasonably to protect borrowers from the robo-signing, erroneous foreclosures, and other abuses rampant after the 2008 crisis found servicers wholly incapable of handling problem loans.  Congress told the CFPB to weigh in and, true to its habits, it did with both feet shod in hob-nailed boots.

As we anticipated in 2013 when the mortgage-servicing rule was finalized, borrowers were indeed well protected at considerable risk to anyone with a stake in any loan that could go delinquent.  Under the rule, months if not years must pass from a missed payment to final foreclosure if a borrower takes advantage of every loan-modification opportunity.  Inspired by a mortgage-servicing model that put more than a few deserving homeowners on the streets, even if only by accident, the CFPB rule requires servicers to advance funds to mortgage owners over so long a period of time that liquidation loss – especially in a time of economic stress – is likely to be very, very high.

How high?  Here’s where the Philadelphia Reserve Bank’s staff study comes in.  Looking at loss given default (LGD) on residential mortgages starting in 2000, LGDs spike dramatically after the crisis – unsurprising – but then stay elevated into 2015 – very surprising given the sharp rise in house prices starting in 2012.  Probability of default (PD) is relatively unchanged across the time horizon, but LGDs are found to have structurally changed starting in 2009.  After eliminating housing-market factors from its analysis, the causes are laid mostly at the CFPB’s feet, although the caution born of all the costly mortgage settlements also plays its part in elevated LGDs, as do less generous claims payments from private mortgage insurers.

In short, lots of mortgages now have moderate PDs, but abysmal LGDs.  Risk-based capital in the advanced approach is calculated by combining the impact of PDs and LGDs across a business cycle, with another new FRB-Philadelphia study concluding that the way this is done is procyclical.  This poses an additional challenge to housing-market stability, but a forty percent LGD is a game-changer all on its own.  Even if standardized capital rules fail to capture LGDs such as these, losses don’t lie.  As a result, anyone holding mortgage credit risk with an elevated PD faces potential losses well beyond those now contemplated in credit-risk pricing and the modelling for the capital standards.  What to do?  Guess what – not make high-risk mortgages – the solution the market has clearly already chosen based on all the new data about minimum credit scores, LTVs and the like. 

As earlier FedFin research found, the principal form of wealth accumulation for lower- and moderate-income Americans is home ownership.  With wealth distribution already growing wider because of FRB monetary-policy drivers for heightened financial-asset valuations, these average Americans are finding themselves farther and farther behind the proverbial curve.  If lenders and servicers can’t make money making the mortgages these entry-level buyers need, they won’t make these mortgages, these households will not take their first step to wealth accumulation, and the U.S. will get still more unequal.  A high price for foreclosure protections – surely there is a more sensible way to balance borrower protection after delinquency with borrower access to the credit needed to get into the home in the first place.