Most analysts will acknowledge that interest rates are historically low but what most don’t mention is that these rates are artificially low. So low in fact that a high level bank executive, who I will leave unnamed, said to me “We are not stupid enough to do loans at today’s rates, the bank knows a money-loosing proposition when it sees it. We only do loans we can sell to the government.” Before considering the circumstances that lead a bank to arrive at this conclusion, it’s important to understand the market implications.
What must be understood is that even though rates may be low, financing is difficult and expensive to obtain. Nearly every loan has to be “conforming” so it can be resold to the government. Because of this, banks have very stringent underwriting standards and few buyers meet all the qualifications necessary to obtain a loan. Once a buyer does qualify, a significant amount of cash money is needed. With FHA for example, a buyer needs to put 3.5% down but may need up to an additional 4% to cover additional fees and closing costs. In effect, a typical FHA buyer may be required to put 7.5% down to obtain a loan that is supposed to require 3.5%.
What caused banks to stop portfolio lending and keep the majority of their own loans? Conventional banks (e.g. Wells Fargo) were allowed to leverage deposits 16 to 1 while investment banks (e.g. Bear Sterns) leverage 32 to 1. This government set leverage ratio still has direct impact on interest rates. The government funded Fannie Mae & Freddie Mac, which is now the largest mortgage holder in the world with no close second, is leveraged 500 to 1, allowing it to offer much lower rates than its free market competitors. In essence, the government has driven rates so low that banks in the marketplace cannot compete. This has created an environment where most major lenders only do loans that, while closed by a bank, are immediately sold to Fannie May. The problem with rates being this low is that you can’t make any money at a 4% interest rate so there is no competition to develop customized loans to fit more buyers.
Unfortunately, the government simply cannot supply the whole market with the amount of loans needed to correct all current woes in the real estate market. Until banks find a way to make a profit in the current environment their vaults will remain locked. Without easy access to capital and more relaxed underwriting the real estate market cannot fully recover… at least not to where it was before the Great Recession.