Originating Mortgage Loans

Investor's Business Daily (02/23/07) P. A2
The Federal Deposit Insurance Corp. reports a 15.6-percent increase in late mortgage payments in the fourth quarter of 2006, following an increase of 5.2 percent during the previous three-month period. Non-traditional loans such as subprime mortgages account for a large number of delinquencies, with officials predicting that "their performance will get worse before it gets better."
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Wall Street Journal (02/22/07) P. C1; Lahart, Justin; Patterson, Scott
The $14.4-million loss posted by NovaStar Financial for the fourth quarter should not have surprised investors, as other subprime lenders--including ResMAE Mortgage, Accredited Home Lenders Holding and New Century Financial--have recorded losses or closed up shop in recent months due to rising subprime mortgage defaults. Observers believe investor psychology can explain their surprise, noting the possibility that some investors focused on good news and dismissed dismal reports. Others might have thought the price reflected the bad news, or they could simply be hanging on to poor-performing stocks because they are fearful of selling at a loss. Meanwhile, it is difficult to gauge the severity of the subprime fallout, as numbers put forth by experts dramatically differ. While Federal Reserve Gov. Susan Bies says only 7 percent to 8 percent of outstanding mortgages are subprime adjustable-rate loans originated less than two years ago, a report from Inside Mortgage Finance finds that they account for 13 percent.
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Charlotte Observer (NC) (02/21/07); Appelbaum, Binyamin
Wells Fargo Home Mortgage has announced that it will shutter two subprime business centers--one in Fort Mill, S.C., and one in California--due to rising subprime defaults and a drop in demand for high-rate loans. The downsizing will leave 250 people at the Fort Mill operations facility without jobs, but some will be transferred to a different division in the same city. The operations centers fund high-rate loans for mortgage brokers and also buy such loans from other lenders. In response to the climbing default rate, Wells Fargo Home Mortgage has imposed stricter lending requirements and emphasized its commitment to helping borrowers obtain the best financing terms for which they qualify.
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For further insight, refer to blog posted February 20, 2007 titled:

Sub-Prime Market Tightening - Yes There Is a Positive Side

 

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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Baltimore Sun (02/16/07)
The flawed-credit mortgage market saw delinquencies reach 12.6 percent last quarter, and subprime mortgage lenders are facing financial difficulties that have forced some companies to shut down or file for bankruptcy protection. During a recent Senate banking and housing committee hearing, Martin Eakes--CEO of the Center for Responsible Lending--estimated that 2.2 million homeowners with subprime loans could lose their properties to foreclosure, placing the blame on limited documentation, low- or no-down payment and risky loans with teaser rates that have the potential for significant payment increases. Mortgage industry officials countered that borrowers defaulting on their home loans are experiencing job loss, illness, high consumer debt loads and marital problems; and Mortgage Bankers Association chief economist Douglas Duncan challenged the idea that "delinquencies are at crisis levels" by pointing out that they surpassed 14 percent in mid-2002, declined to about 10 percent in 2004 and 2005 and are now rising again. Nonetheless, lenders are likely to tighten their lending standards. Congress will push to restrict limited documentation, low downpayments and excessively risky loans; and lenders will face more lawsuits from consumers.
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Wall Street Journal (02/14/07) P. A3; Hagerty, James R.; Simon, Ruth
An emerging trend has subprime lenders stepping back from "piggyback" loans, which finance up to 20 percent of a property's value while the borrower's primary mortgage covers the rest. An increase in delinquencies and defaults on these secondary loans among home buyers with flawed credit has made investors skittish, making the loans more difficult to sell. In response, lenders are scaling back on piggybacks by making them more costly for consumers and rejecting applicants with especially weak credit backgrounds; they also moving away from piggyback lending to low- or no-documentation and "stated-income" borrowers, who have been known to exaggerate their financial status. The U.S. housing sector could suffer another setback this year as a result of the tightening, by barring some prospective home buyers from lining up financing at a reasonable cost.
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USA Today (02/08/07); Kirchhoff, Sue
The Senate Banking Committee held a hearing on Feb. 7 to discuss predatory lending, which Chairman Christopher Dodd, D-Conn., has deemed a "crisis." Dodd called for legislative action, noting that many cash-strapped, low-income borrowers are obtaining adjustable-rate subprime loans and could see their monthly payments skyrocket by 50 percent in just a couple of years. Mortgage Bankers Association chief economist Doug Duncan said the current 1-percent mortgage foreclosure rate is normal and underscored that "specific mortgage products" play less of a role in foreclosures than unemployment. Uniform national lending standards and enhanced financial education for borrowers were recommended by Duncan to curtail predatory lending.
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