A report released today in the FDIC's Regional Outlook evaluates changes in mortgage underwriting during the last expansion, and the likelihood that weakening home price growth could adversely affect home borrowers and lenders. The authors do not expect adverse mortgage performance trends to threaten the capital or earnings of the vast majority of FDIC-insured institutions. The report concludes, however, that looser lending standards during the 1990s may have heightened lenders' overall risk compared to previous business cycles, and that a few previously booming locations, such as the San Francisco Bay Area1, are exhibiting heightened home price risk.
Nonconstruction residential mortgages historically have been one of the lowest credit-risk loan types for FDIC-insured institutions. Past experience probably understates credit risks during this cycle because the mortgage lending business has changed since the last recession. Chief among the changes are robust mortgage market competition, which has contributed to narrower collateral margins (higher initial leverage); increased reliance on non-recession-tested automated underwriting; and expanded involvement in the subprime mortgage market (discussed in a prior FYI ). Credit quality indicators for insured institution mortgage loan portfolios have shown only preliminary signs of weakness thus far, although continued strong mortgage origination activity in 2001 may have masked (in the aggregate) developing credit problems for more seasoned mortgage loans.
Construction and Development Lending Risks May Be Elevated in Some MSAs
Historically, lending to finance housing construction is riskier than mortgage lending on existing structures. If markets with an oversupply of housing experience weaker economic performance, insured institutions with significant lending exposures to residential real estate development may be vulnerable to weakening credit quality. Last year, some large markets displayed signs that residential construction activity was accelerating as local economic conditions were deteriorating, especially Atlanta (see Chart 1).
The risk of significant downward corrections in home prices does not appear geographically widespread. However, a handful of MSAs that have seen several years of rapid home price appreciation and declining affordability are now experiencing a softening in economic conditions (see table 1). Home prices and insured institutions lending in these markets may be adversely affected should these weaker conditions persist.
Problems likely would be more pronounced for households that rely on multiple incomes to meet mortgage payments or those with limited financial resources. In addition, increased underwriting of high loan-to-value and subprime mortgages during the past decade could aggravate any rise in delinquencies. Foreclosure risks would be amplified in any markets that see outright declines in home prices during 2002.
As of year-end 2001, the San Francisco Bay Area appeared to demonstrate the greatest likelihood of a significant overall decline in home prices. The area's fourth-quarter, year-ago change in median home prices turned negative for the first time in more than six years, highlighting this risk. Further, a recent analysis from the UC-Berkeley Haas School of Business forecasts that prices in the Bay Area housing market will decline 15 percent overall (30 percent for luxury homes) by year-end, when, according to this analysis, the recession in the local economy is expected to end.
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