Turmoil: agitation, ailment, anxiety, bedlam, chaos, confusion, commotion, distress, disturbance, turbulence, etc.
The "current" state of the mortgage industry:
With the year half over, it is
time to reflect on the economic pressures in the mortgage industry for the
past six months and, using this data, forecast where interest rates and
housing prices are heading.
The US Consumer: Consumer spending, which accounts for roughly two-thirds of the US economy, continues but at a lower pace. The consumer remains confident despite elevated gas and food prices. Supporting consumer spending is a solid economy with a strong demand for labor. Unemployment remains historically low at 4.5% supporting consumer sentiment. An employed consumer is much more confident than one looking for a job.
Interest rates rose sharply in June based on the FEAR AND PANIC (no actual data) of foreign money pulling out of the bond market and concern over rising inflation SHOULD the economy continue to improve. While the movement was swift and painful, rates still remain very attractive. The biggest risk to rates in the near term would be a major oil supply disruption that would drive the price per barrel to all time highs igniting inflation fears.
In years past a borrower would visit their local savings and loan to obtain a mortgage. The Loan Officer at the bank would approve the mortgage and fund it with cash reserves from the vault. This system worked well until the bank ran out of money to lend. Borrowers came to the S&L looking for a loan and were told to come back when a current mortgage paid off. What the bank needed was a way to sell the loans they made freeing up the capital to lend to new borrowers. This way they could lend the “same” money over and over, earning an income from servicing the loans and assisting the community by offering a near limitless pool of money.
To address this issue, FNMA and GNMA were established. The goal was to provide cheap mortgage money to prospective homeowners and a high quality bond for the investment community. The bond or Mortgage Backed Security (MBS) takes mortgages with similar risk characteristics and pools them together. Investors in the MBS’s know ahead of time the return they are going to receive, much like a Certificate of Deposit. To ensure the performance of the bond, each mortgage is underwritten to specific guidelines. By ensuring the borrower is both capable (VOE), willing to repay (credit report) the debt, has the cash to close (VOD), and the value is in the property (appraisal), the loans and thus the bond will perform as expected.
During the recent real estate boom underwriting guidelines were relaxed giving way to a whole new menu of products such as the 100% NOO with credit scores below 600. In addition, to streamline the influx of applications, income and asset verification took a back seat to a borrower with strong credit. With housing prices rising rapidly, the basis for the mortgage, the property, could be sold to cover the note and foreclosure costs if this occurred. This cycle worked well until the price of houses moderated in 2006.
Once the housing market began to cool and prices moderated, foreclosed homes were being sold for less than the note. To add insult to injury, the loans underwritten to the looser guidelines are not performing as hoped. With the value of the collateral in question (falling home prices) and the future performance of the borrowers unknown, investors’ appetites for this risk has waned. To attract investors in this environment, rates had to increase substantially.
Loans sold to GNMA or FNMA remain largely untouched in the recent credit rout because the investment qualities of the loans are well known. The foreclosure and delinquency rates are well within acceptable standards lending support to these products as their interest rates have fallen in the recent weeks.
The recent rapid rise in rates not directly tied to FNMA/GNMA is an example of the pendulum swinging too wide. The fact remains that a qualified borrower is a good investment from a bondholder perspective. In a typical interest rate market, jumbo loans (loans in excess of the conforming limit) with proper documentation carry a yield about 1/4 higher than similar conforming products. Sanity will eventually return to the markets and non-conforming pricing will come in line with their risk characteristics. The depth and breadth of the current sub-prime issue will determine when that change occurs.
The Sub-prime Market
In the old days, financial institutions that refused to lend to people with low incomes or imperfect credit were accused of victimizing the needy. Today, financial institutions that make many loans to those same people are found guilty of the same crime.
Back in the 1960’s and 1970’s, lenders who refused to lend to people with risky financial portfolios were accused of “redlining” — which was the supposed practice of refusing to lend to anyone within certain geographic areas, usually areas dominated by minorities — or of outright racism in their lending practices. In reality, what lenders were usually doing was responding in a rational way to both the prospective borrowers in question, and the rules and regulations they were forced to deal with.
Facts and statistics have proven that, poor people, whether they’re minorities or not, are unfortunately not good credit risks. They aren’t regularly employed, they don’t have significant assets, and they usually have financial obligations that make the idea of being able to meet a mortgage payment often unrealistic. Lending someone in such an economic state hundreds of thousands of dollars to buy a home would be a poor business decision, unless the loan were structured in such a way as to protect the lender from the increased risk of default.
Because of banking and lending regulations in the 1960s and 70s, lenders were often restricted in the terms they could offer to borrowers. Interest rates, typically the best way of counteracting credit risk, if not capped, were at least highly regulated, and banks were not permitted to offer anything much more than the typical 30 year fixed rate conventional loan.
When the mortgage industry was deregulated, thanks in part to the people who were complaining about so called “redlining” and discriminatory lending, lenders were able to offer non-traditional mortgages that permitted people who otherwise would have been locked out of the opportunity to purchase a home, the ability to do so. One can argue about whether some people are making the right choice when they take on the responsibility of home ownership, but they’re all adults, and, in the end, they’re the ones who accept financial responsibility.
So what happened? Why have so many Sub-Prime lenders gone out of business? Here is a basic overview that is fair to all concerned. Essentially, the high risk, high loan-to-value loans that were generated from the Sub-Prime industry depend on a stable and increasing real estate market. A borrower that accepts a 2-year fixed rate wants to be able to refinance after 24 months. However, if the property value has decreased, or even stayed the same, a refinance may be out of the question. OK, then sell it! Well, maybe not in today's market. It is likely that a typical homeowner will need to wait up to a year to sell a home. So basically, when the real estate market pulled back from a 24-month unsustainable growth spurt, the Sub-Prime market was left holding the bag. The market over-reacted swiftly and the Sub-Prime guidelines got tighter, much tighter.
The fact that some borrowers are behind on their payments is no condemnation of the system that furnished them credit. They are in the sub-prime market, after all, because their credit history or income suggests they are high risks, and it’s no surprise to find that some of these "high risk" borrowers turn out to be exactly that.
The overwhelming majority of sub-prime customers handle their obligations just fine. At last count, fewer than 14 percent of them were delinquent, meaning that 86 percent were not. Most people pay what they owe, and unfortunately those who don’t, suffer the consequences. Absent consequences, fewer people would repay, and mortgage providers would demand higher rates to lend to the remainder.
In fact, most of them know what they’re doing. A recent study for the National Bureau of Economic Research found that thanks to improvements in the mortgage market during the last 35 years, “Households are now more able to buy homes whose values are consistent with their long-term income prospects.”
America is currently experiencing the highest level of homeownership in its great history. More families own a home today then ever before. This is in no small way thanks to the Sub-Prime industry. Some ten years ago lenders and Wall Street chose to allow the creation of a more risky loan. Hence, the creation of the "Sub-Prime" or below prime industry. These new riskier loans allowed families with adverse credit or little savings to qualify for a mortgage. Prior to Sub-Prime, these same families were left out of homeownership opportunity all together.
It is said that 1 in every 70 Sub-Prime loans is in default. That number is certainly high; however, we see that number as 69 out of every 70 Sub-Prime borrowers being homeowners. These are families that previously could only rent, and who are now living the American Dream. We are certainly not suggesting that Sub-Prime did not have problems. It certainly did. The guidelines expanded nearly daily allowing riskier and riskier borrowers to qualify. Our point is simple; Sub-Prime was a key factor in this recent boom in homeownership
Our hearts go out to everybody touched by this unfortunate issue. Investors have closed, companies have closed, and borrowers have been left with un-funded loans. Unfortunately the damage is widespread. The fact remains this is the best industry in the world and we diligently press forward as we work harder through these difficult times.