Why bank stress tests are critical to mortgage markets

America's 34 largest banks are healthy and hold enough financial capital to weather a future economic crisis, the Federal Reserve said Thursday after releasing the results of its annual bank stress tests.

While the banks placed under scrutiny would experience significant losses in the event of a downturn, they'd still be able to lend to businesses and households. That means banks are doing well in stockpiling reserves to protect against future losses and seeking to restore trust in a system still scarred from the effects of the 2008 banking collapse.

The positive results are welcome news for the mortgage industry, which relies on healthy banks to ensure there's an ample supply of capital flowing through the market to fund the loans that go to borrowers. Any cracks in the big banks could ultimately create costlier mortgages.

So just what are these stress tests and why are they so important?

Let's rewind to 2007 when seeds were sown that nearly brought the country to financial ruin. Many banks and lenders issued complex and misleading loans to borrowers who didn't understand or qualify for them. Supercharging the calamity were high-risk subprime mortgages, loans made with no documented income, negative amortization mortgages where borrowers only paid interest and never principal, and loans which carried low initial interest rates that reset at higher values later on. Many borrowers found themselves stuck with mortgages they couldn't afford, provoking a series of defaults and foreclosures that crippled the housing market.

A series of financial blows would next befall the banking industry as mortgage-backed securities and other financial instruments lost their value. Banks invested in those assets faced a liquidity shortage in 2008. The stock market took a nosedive. Housing prices plummeted. Unemployment mushroomed. Consumer wealth deteriorated. Prominent financial firms, such as Lehman Brothers, went bankrupt. Bank of America bought Merrill Lynch. And the Treasury Department took over Fannie Mae and Freddie Mac.

The federal government — i.e., taxpayers — bailed out the big banks to save the market from utter collapse.

Once the economy began its slow crawl to recovery, lawmakers introduced legislation to prevent another meltdown. One such law was the 2010 Dodd-Frank Act, which sought to address the notion that banks were too big to fail by increasing the amount of capital banks must hold in reserves, creating the Consumer Financial Protection Bureau and requiring banks with more than $50 billion in assets to undergo annual stress tests by the Federal Reserve.

In the past, many banks performed their own internal stress tests to test their mettle when faced with a crisis. But, after the downturn, government regulators were vested in discerning whether big banks could survive a similar crisis.

There are two types of tests: the Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act stress testing (DFAST). The CCAR is the biggest one and examines banks' capital wherewithal and plans to make dividend payouts to shareholders or stock repurchases. DFAST tests whether companies supervised by the Federal Reserve have the capital to absorb losses and keep operating when economic conditions are severe.

If banks do well on these annual exams, it proves they hold adequate capital and may increase their payouts to investors. Banks that don't pass regulator stress tests can be slapped with sanctions and prevented from some activities, such as expanding their balance sheet or paying out dividends to investors.

Healthy banks that are lending money and paying out dividends adds capital to the mortgage market. More capital in the market leads to more efficiency and liquidity, which powers the secondary mortgage market and allows lenders, such as Movement Mortgage, to finance more homes.

Home sales on the rebound

While bank stress tests have an indirect effect on the mortgage origination market, home sales data released this week give us a more direct report on the strength of the U.S. housing market.

Existing-home sales rose 1.1 percent in May, going on the mend after a sharp decline in April when home sales fell 2.3 percent, according to the National Association of Realtors. At the same time, low inventory on the market lifted median home prices to $252,800, a new high.

NAR economist Lawrence Yun said in a statement that buyers last month continue to press through the challenging buying environment. "The job market in most of the country in healthy and the recent downward trend in mortgage rates continues to keep buyer interest at a robust level," he said. "Those able to close on a home last month are probably feeling both happy and relieved."

Meanwhile, sales of newly-constructed homes also bounced back in May, increasing 2.9 percent to 610,000 units last month. That's a measurable rebound from April when new-home sales dropped 11 percent. The median sales price for these homes also increased to $345,800, up from $310,200 a month earlier.

While the sales data is encouraging, the increase in housing prices continues to put the squeeze on borrowers. Low mortgage rates will be key to attracting would-be buyers to the market in the near-term.

Listening to the Fed

Without any major economic headlines this week, the market turned its attention to Fedspeak as it looked for Federal Reserve bank presidents in a series of public speeches to offer insight after last week's anticipated rate hike.

Some central bank presidents expressed concerns that soft inflation would make it difficult for the Fed to reach its 2 percent target, and that waiting until the end of the year to consider more hikes is the best course of actions. Others were concerned about the risks of keeping rates too low for too long.

Consider the indecisive rhetoric par for the course. Fedspeak is often carefully worded and filled with ambiguous statements that yield more questions and speculation.

What we do know is the Fed will meet again in September and has said it wants to raise rates at least one more time this year. It remains to be seen whether that will be in three months or in six when the Fed meets in December.