Originating Mortgage Loans

New York Times (03/01/07) P. C5; Andrews, Edmund L.
Federal Reserve Chairman Ben Bernanke told the House Budget Committee on Wednesday that he is concerned about the problems in the subprime mortgage market but added that there is no indication that there has been a spillover effect on the overall economy. A number of subprime mortgage lenders have gone out of business recently, and several others have had to boost their reserves to cover bad home loans. Fed officials have been cautiously optimistic that the housing market is starting to improve. However, the growth in lending to subprime borrowers and the high level of unsold homes on the market remain serious concerns.
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Washington Post (02/28/07) P. D2; Trejos, Nancy
The National Association of Realtors reports a 3-percent jump in existing-home sales to a seven-month high in January from the previous month, though resales were down 4.3 percent year-over-year. Meanwhile, the median price slipped 3.1 percent to $210,600 from $217,400 in January 2006, and the trade group believes the decline helped push buyers back into the market. NAR also reports a 2.9-percent increase in resale inventory to 3.55 million, equivalent to a 6.6-month supply. Regionally, existing-home sales surged 5.6 percent in the West and a more modest 2 percent in the South.
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Additional National Association of Realtors (NAR) Full Story

Wall Street Journal (02/26/07) P. A1; Ip, Greg
Federal Reserve policy maker now consider changes in oil prices or rents to be more of a factor in affecting the movement of inflation than a change in the unemployment rate, which has been the case for decades. The new approach by the Fed can be seen in its decision to end its interest-rate raising campaign last summer when core inflation was rising, and currently it is unwilling to lower rates even though it expects inflation to decline over the next two years. Nonetheless, policy makers still believe low unemployment has the potential to set inflation in motion, after the temporary influence of energy and rents has worn off. As a result, the Fed could be forced to increase interest rates to raise unemployment and lower inflation.
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Realty Times (02/23/07)
A new survey by Citi Smith Barney says that over half of millionaires and 40 percent of affluent investors, those with $100,000 in assets excluding real estate and employer retirement plans, or approximately 25 percent of the U.S. population, surveyed believe that real estate is good investment. 

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Baltimore Sun (02/23/07)
Freddie Mac reports a decline in the 30-year fixed mortgage rate to a six-week low of 6.22 percent this week from 6.30 percent last week. Continued weakness in the housing market is believed to be responsible. Freddie Mac chief economist Frank Nothaft explains, "Market participants were concerned over how much drag the slowing housing market may have on economic growth." The 15-year fixed mortgage rate was down as well, falling to 5.97 percent from 6.03 percent. Meanwhile, the one-year adjustable rate slipped to 5.49 percent from 5.52 percent, and the five-year adjustable rate decreased to 5.96 percent from 6.01 percent.
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American Banker (02/22/07) P. 19; Kaper, Stacy
In a Feb. 16 letter to bank and thrift regulators, more than two dozen Democrats on the House Financial Services Committee requested that financial institutions be given greater leeway in approving mortgage forbearances. The legislators are concerned about a possible jump in foreclosures tied to the fact that interest rates on more than $1 trillion in adjustable-rate mortgages will reset this year. The letter states that "it is important that institutions who are willing to forbear in particular instances understand that they will not be subject to additional penalties."
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USA Today (02/22/07) P. 3B; Hagenbaugh, Barbara; Kirchhoff, Sue
The consumer price index rose 0.2 percent in January, backing up concerns about a lack of moderation in inflation that Federal Reserve policymakers expressed during their meeting at the end of last month, according to newly released minutes of the gathering. Policymakers considered changing the Fed's outlook statement, but ultimately kept the language about the inflationary threat to the economy and a partiality toward rate increases. The possibility of rising inflation and higher interest rates this year prompted some investors to sell off some of their stock. With "two or three more reports like this, the likelihood of a Fed rate hike increases," Richard Yamarone, director of economic research at Argus Research, said after the CPI report was released Wednesday.
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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.

Wall Street Journal (02/15/07) P. A4; Mollenkamp, Carrick; Hagerty, James R.; Simon, Ruth
A growing number of Wall Street banks that purchased large numbers of subprime mortgages in recent years are ordering the small lenders that originated the loans to buy ones that ended up in default. Credit Suisse analyst Rod Dubitsky expects buy-back demands to continue for another six months, causing financial troubles for originators. Brea, Calif.-based ResMae Mortgage Corp., for instance, was forced to file bankruptcy after Merrill Lynch & Co. ordered it to buy back $308 million in defaulted mortgages. Meanwhile, demands to repurchase failed loans led San Diego-based Accredited Home Lenders Holding Corp. to post a $37.8 million loss during the final quarter of 2006.
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USA Today (02/16/07); Waggoner, Jack
Despite last year's crop of bad mortgages, 2007 is so far turning out to be a pretty good year in this regard. Such institutional investors as mutual funds are buying up securities backed by large pools of mortgages, with about half of the current $13 trillion in U.S. mortgage debt being in mortgage-backed securities. The riskiest home loans are divvied up according to their degree of credit risk and are then held by such speculators as hedge funds. Vanguard GNMA fund co-portfolio manager Michael Garrett is forecasting stable rates for much of this year, adding that the best time to invest in a mortgage fund is when rates are exhibiting the kind of stability they are showing so far in 2007.
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