The Housing Market Index (HMI) is a monthly survey of 300 homebuilders to gauge demand for new home construction, and their corresponding confidence. New home construction has historically contributed roughly five percent to gross domestic product (GDP) and is therefore a strong proxy for economic growth.

Notwithstanding the impacts of sequestration, or the collateral damage resulting from a default by the United States on its financial obligations - favorable demographics trends, compelling affordability rates, and depressed inventory levels of both existing and new homes bode well for continued overall strength in builder confidence.

Household formation rates are breaking out of their nearly five-year slump and are expected to exceed 1.2 million new households next year (demand side of the household equation). Juxtapose that number with the 800,000+ rate in which new homes are being constructed (supply side of the equation) and you have a very positive correlation.

The availability of credit across the credit and income spectrum will have a large impact on whether households decide to rent or buy.

Case in point, the December HMI saw strong sustained growth, but cited the tight credit market as the largest obstacle to a robust housing market recovery. With the new regulation from the Consumer Financial Protection Bureau (CFPB) released last week, along with the anticipated tightening of Federal Housing Administration (FHA) underwriting standards, it is very likely that the problem of the shrinking credit box and the unyielding regulatory burden for originators will have a distinctively negative impact on the HMI and other housing indicators.

General:

Builder confidence, as measured by the HMI, may break from its eight-month increase this month. In December, the HMI boasted three consecutive quarters of improvement. The index, calculated by the National Association of Home Builders (NAHB), measures current sales expectations, sales expectations for six months in the future, and prospective buyer traffic. NAHB noted in their December release that tight credit remains the largest obstacle to growth in the housing market, saying that the “one thing that is still holding back potential home sales is the difficulty that many families are encountering in getting qualified for a mortgage due to today’s overly stringent lending standards.”

Unfortunately, the new regulation issued by the CFPB just last week may have further raised the bar for prospective homebuyers.

On January 10, 2013, the CFPB issued the much-anticipated final Ability-to-Repay/Qualified Mortgage (QM) rule. The final rule, scheduled to be effective January 2014, codifies eight requirements for lenders to verify a borrower’s ability to repay. The rule also establishes two QM constructs with more legal protection for lenders.  For the safest, highest credit quality borrowers, the rule creates a safe harbor, and for higher-cost or less prime borrowers the rule establishes a rebuttable presumption of compliance.

FHA also tightened underwriting standards required for FHA insurance earlier this month. FHA increased the upfront fees charged to borrowers from 1.75 percent to 2.25 percent.  FHA will also begin to require borrowers with a credit score of less than 580 to pay a ten percent down payment. These changes will be effective this spring.

In today’s housing market, with government entities as the primary purchasers of mortgages, it is likely that if and when the private market returns, investors will gravitate toward loans meeting the QM safe harbor standards and other stringent standards such as the FHA changes. This ‘race to the top’ in mortgage lending will only further contribute to the credit problem in the short run.

Although the rule is not yet effective, it will likely begin to impact market expectations soon. We can expect these changes to manifest themselves in forward-looking housing indicators.