Originating Mortgage Loans

With the real estate market showing signs of stabilizing in 2007, will the recent jump in mortgage default rates with higher risk borrowers put a crimp in this stabilization? In a nutshell, sub-prime lending has grown substantially over the last six to seven years and can be partially credited with the real estate boom we experienced during that same time period. Will the recent tightening and demand for higher yields from investors in the sub-prime realm put a damper on the real estate market? In my humble opinion, this is a bad news-good news situation for the real estate industry.

When you talk to proponents of sub-prime lending, they will tell you:

1. Sub-prime products allow many individuals to purchase a home that in the past they may not have been able to do so.
2. Provides purchase and refinance financing alternatives to individuals that may have experienced events that prevented them from getting a traditional prime home loan.
3. Allows time for individuals to build a credit history to eventually refinance and qualify for a prime home loan while building equity in their home and realizing significant tax savings.
4. Sub-prime loan products allow credit worthy borrowers a financial vehicle to qualify for a home loan.

All four of the statements above are true and powerful justifications for sub-prime loans. However, there are also negatives to sub-prime lending, such as as:

1. Many borrowers are put into what my good friend Dennis Geist calls "Neutron Loans." Much like the Neutron Bomb, these loans leave the home intact yet destroy the homeowner putting them in foreclosure and/or bankruptcy court.
2. Borrowers put into loans they cannot afford (closely related to #1).
3. Borrowers are not put into best-fit loan products. Instead, loan originator puts borrower in a sub-prime loan product that provides them the path of least resistance and highest pay-off. 
4. Higher default rates
5. "Fogged mirror" underwriting guidelines in the pursuit and frenzy of loan volume and keeping up with competition.
6. Artificially drives real estate values upward.

Last week, serious problems cropped up due to rising defaults. Several major lenders announced tightening of sub-prime underwriting guidelines and HSBC announced its bad debt charge last year would be about $1.8 billion higher than expected as problems grew in U.S. mortgage securities it had purchased, particularly loans to borrowers of less than top credit (sub-prime mortgages).

Officials with Mortgage Bankers Association argue the impact will be limited. The trade group estimated that about 17 percent of home purchases are now made using sub-prime loans. If those buyers get squeezed out, that's bound to be felt throughout the real estate market, according to experts, although Sandler O'Neill analyst Mike McMahon  and others say it's tough to quantify by how much.

"It's not like subprime loans are going to go away completely - it won't be anything that drastic," said McHahon. "But I think there is going to be an impact on home purchases, even if it's hard to quantify at the moment. In the past few years there's been an explosion in mortgage credit. It makes sense there would be some retrenchment."

Mike Fratantoni, senior economist with the Mortgage Bankers Association, said there would be a greater risk to the housing market if defaults were rising across the board, noting that so far the rise in borrowers who are late on mortgage payments is still mostly in the subprime sector. And he said even the growing problem in the subprime sector is not a big shock for the market.

The rate of subprime borrowers who are more than a month late on a mortgage payment was 13.2 percent in the third quarter of 2006, the latest numbers available, up from a 10.5 percent delinquency rate in the third quarter of 2005.

The overall mortgage delinquency rate was 4.7 percent in the third quarter, just slightly above the 4.4 percent rate of a year earlier, when it was a historic low.

"We don't agree they (subprime home buyers) are all going to be cut off from mortgage credit," said Fratantoni. "It is going to have something of a negative effect, but that's not a big enough part of the market to be a macro concern."

Additionally, the unknown is how many high LTV sub-prime borrowers that are currently in default were placed in high rate loans when they would have qualified for a prime rate FHA loan? FHA market share has been decreasing substantially over the past decade and it is my suspicion at the benefit of sub-prime market share gain. I don't have any data from a controlled study, however over the last few years I have seen hundreds of borrowers placed into sub-prime products that would have qualified for a prime FHA loan.

Why would originators and real estate agents allow their borrowers to be placed in a sub-prime loan instead of FHA financing? Based upon my research and findings, below are a few of the major reasons:

1. Lack of knowledge of FHA underwriting guidelines
2. Broker or lender not approved to make FHA loans
3. Sub-prime loan provided path of least resistance for loan originator and real estate agent
4. Real estate agents advised sellers not to accept an FHA purchase offer

In my estimation, with the recent FHA enhancements and proposed FHA Modernization Act in Congress, loan originators and real estate agents that embrace and take the time to understand FHA loan products will be positioned to capture significant market share from those originators and realtors that don't evolve with the current market environment.

As previously stated, currently 17% of all purchase transactions are made utilizing sub-prime mortgage products.  Even if sub-prime purchase volume were to drop 25-30%, I believe a significant portion of it could be funded under alternative prime loan products. This predicted decrease in sub-prime lending falls into three categories:

1. Qualifies for alternative loan product
2. Does not qualify for alternative prime product
3. Won't qualify for mortgage that set's them up for failure (Neutron Loan)

Of the three categories listed above, one and three are positive. Number two, provides an opportunity for the financial markets to resolve.

In conclusion, I believe the impact from the recent sub-prime changes will have somewhat of a negative effect, but for reasons noted above, will not be a big enough part of the market to be of macro concern.