This article was originally written in 2011 for the Houston Business Journal.

Attempting to fix the problems in the mortgage market, Congress and the Administration need to use market forces and successful state policies as their guide, while protecting market fundamentals from over-reaction.  

To protect their interests from further exposure, banks changed lending practices in the real estate markets, reducing real estate loan portfolios — even selling performing loans at a discount.  By intentionally eliminating commercial and residential real estate from their portfolios, banks are ensuring a future shortage in single-family lots that will drive up home prices and hamper any recovery.  If not addressed in new policy, this over-correction will reverse the greatest wealth producing mechanism for American families: home ownership.

Most homebuilders want to deploy their capital in constructing and selling homes. Before this can happen, another developer must buy the land and invest capital in the streets, sewer, water and other infrastructure required for a single-family lot development.

Initial bank responses to the mortgage crisis were aimed at ensuring that mortgage customers were qualified: increasing the minimum threshold for credit scores and income levels, and requiring additional escrow funds by existing mortgage holders, as security against default.  

Developers altered their plans to meet consumer demand, scaling back the number of developed lots and creating home designs with fewer rooms and amenities – adjusting to the new economic reality.  Nevertheless, lenders exited the single-family home development market.

The question now becomes: have banks unilaterally determined that the era of homeownership for American families is over?

States that instituted parameters for loan-to-equity ratios did not experience the collapse in home and mortgage markets like states allowing homeowners to take out 100 percent or more of the appreciated value in their homes. Guidelines must be instituted as an industry standard to allow for rational borrowing and more secure lending for home purchase.  

Likewise, speculative home development unconnected to market demand fueled the crisis.  With the nationwide mortgage crisis of 2008, national housing starts declined sharply. Banks stopped lending to residential real estate developers – even to those whose plans for new single-family homes were directly connected to market demand.

As banks collapsed and were re-structured by the FDIC, the initial banks’ obligations hung in limbo.  Even if developers acted in good faith, and were on-schedule with profitable projects, developers were left without the funding they had secured in loan agreements with the initial bank.  Successor banks did not assume the initial bank’s liabilities in real estate construction or there was the request from the lender to “move” the loan to another bank – a daunting task in an industry reducing real estate exposure.  Unlike banks, developers did not get a bailout.

Implications for future mortgages, developments and contracts due to the retreat from real estate markets are far-reaching and destabilizing.  What developer would seek funding if the threat of unilateral cancellation were implicit in the loan agreement? What developer would fund a project in its entirety to avoid partnering with an unreliable lender?  Two unintended consequences will result: developers will halt activity in the single-family home market, and new, higher cost lending entities will develop outside of the current regulatory system. Both possibilities will destabilize the economy, retard recovery, increase overall construction costs and sow the seeds of the next financial crisis.

Still, banks and regulators do not have to follow this path.  Market forces already are impacting the scope and quantity of the developments.  Developers can make the case for a given project, but they need willing financial partners.  Lenders can establish market-based criteria and can work together with qualified developers on specific projects to avoid this future predicament.

Rationality must be returned to the marketplace – a guiding principle that fuels sustained growth and discourages speculation and panic.  Government entities should set limits on the loan-to-value ratio and not force banks to make loans to unqualified applicants for non-economic reasons.  Congress should impose a regulatory regime on non-bank lenders who fueled the crisis by granting loans at twice the bank rate to applicants that could not repay them to purchase over-priced houses.  

While some areas the single-family home market is over-stocked, this is a market-specific phenomenon.  In fact, there are municipalities that have viable economic development plans based upon sound research and vision.  Banks should invest in new single-family developments in these markets –facilitating continued economic growth of an area.

In other words, one size does not fit all. Fear need not determine our reaction to a crisis.  It’s time for banks and regulators to stop over-reacting and bring rationality back into the conversation.  We have the opportunity to minimize the negative impact of over-reaction and support recovery by allowing developers to prepare the sites that will someday become single-family homes.  Without willing and reliable financial partners, however, our economy will continue to be stuck.