What's Going On in Mortgage Financing?

It's all over the news, but what does it mean???

Sub-prime mortgage woes, including American Home Mortgage (the nation's #10 lender) going out of business, bad news with Countrywide, Novastar stock going down to junk status... could mean something... or nothing to you. It depends on where you are.

Let's take a brief random walk around some definitions and details, so that you will be able to understand what is really going on, and can differentiate truth from hype, and gauge the screaming headlines without the filter of fear.

Over the past several years, many loans were made to homeowners with what is euphamisticly called 'non-traditional' or 'non-conforming' situations. These borrowers had a poor credit history, an inability to document income, or any number of factors that made them less than prime candidates for a loan. There is a reason these types of loans are called 'Sub-Prime' and their slightly more credit worthy cousin, 'Alt-A'. They are risky loans and not up to the standards of A credit, prime, or traditional loans. The low interest and lots of money floating around, there were a lot of loans made to people who should not have been able to get the loans, but the loans were made because after holding the loan for some short period of time (called seasoning), the loan could be sold off to the secondary market for these loans, which were then bundled into what is called tranches, assigned a risk rating, and sold to investors both here in the US and around the world. In fact, over 1/3 of these bundled tranches were sold in the European and Chinese markets.

Another type of non-conforming loan is the jumbo loan, which has a loan amount higher than $417,000, which is the current maximum loan amount that can be done from government-backed mortgage giants Fannie Mae (FNMA) and Freddie Mac (FHLMC). Loan amounts higher than this maximum come from private institutions.

In the last week, most non-conforming loan product rate rocketed significantly higher.

Default and foreclosure rates are on the rise, and the rising rates are a natural re-pricing of risk. In fact on Friday Wells Fargo announced jumbo loans would have an interest rate of 8%. That's not a typo. Yes, 8%. Other major lenders raised rates, not to that level, but as much as 1% over the course of the week. What is happening is lenders are not able to sell these loans on the secondary market unless there is a much higher interest rate attached to them. In Wells Fargo's case, I think that they just shut the jumbo loan window until the market settles out and incorporates a revised risk structure into rates. Of course there are numerous other details and implications involved here, but I am trying to outline the basics so my readers know what is going on. To continue...

The end investor for sub-prime and Alt-A loans have charged a premium for taking on a pool of these loans because they knew that they have a higher rate of default and delinquent payments. But the rating agencies (those rating the risk of these loans) may have substantially underestimated the risk of default. This is the crus of the credit crunch. These private investors, not having accurate assessments of the risks of the tranches or packages of loans that they were buying, now aren't so eager to buy. So this paper is discounted, so instead of paying $101K for a $100K loan that will bear interest, they may be willing to pay $95K for that mortgage to account for that risk. Or lower. Substantially lower in some cases. In fact, the pool of buyers for these tranches has dried up, and discounts of up to 30% or more are not unheard of. To say that this has hit the financial and housing markets hard would be to sugar-coat it.

When you have thousands and thousands of these loans, you have millions and billions of dollars in loss for the company trying to sell the pool at a much lower price than they were expecting. This is called a 'liquidity crisis', and is exactly what happened to American Home Mortgage. They were holding too many of these loans when the music stopped, and were forced to sell at massive losses, and eventually they had to make the decision to close the doors and stop the bleeding. Novastar is following suit, with their stock price dropping from over $42 per share in January, to a little more than $6 on Friday, and today, dropping down around $4 per share before rebounding back up to $6 on news that it will continue making loans.

To take it one step further in detail...

Even when a lender is able to take some losses, they may be subject to a 'margin call'. This means that as their losses and risk premiums increase, the value of their loan portfolio decreases. [start thinking about the value of Countrywide]. As the value decreases, the credit lines that are secured by those portfolios begin to issue margin calls as the value of the asset they are secured on is now diminished. This is exactly like margin calls in the stock market. If you have a loan against a stock that is losing value, you will get a 'margin call' and need to pay down the loan, as the underlying stock is losing too much value to be considered adequate collateral any longer. So for the big lenders, as their portfolio is losing value due to increased risk premiums and losses... the margin calls start coming in, and they are required to pay down their balances. In turn, this means that they have less availability to fund their new loans, and they themselves have decreased ability to obtain money on the market that they can then loan out. It all spirals down to a credit crisis, which is how the current situation is described.

In response to seeing this situation play out in the fall of American Home Mortgage, lenders of other non-conforming loan products increased their interest rates dramatically almost overnight to be better prepared for increased risk premiums in the future.

What's Next?

This is not a problem that is going to settle out overnight. There are too many bad loans out there that should not have been made as a result of an easy credit mania that went on for too long. Easy money with low interest rates, too many lenders giving money to too many people with little or no documentation and bad credit history, led to the too-fast rise in home prices. In Southern California and in our local area of Santa Clarita, home price appreciation was over 20% per year for what, four years running? That's insane, and totally not sustainable.

The credit market is tightening. Loans to people with bad credit are disappearing, 100% financing is disappearing, qualification is being made on the adjusted rate, not the initial rate, on adjustable rate mortgages. Negative amortization loans, where the loan balance goes up every month, don't make any sense in a depreciating environment. But all of these things will tend to dry up the pool of potential buyers, thus slowing down an already slowing housing market.

The Federal government threatens to bail out people and companies affected by what is essentially, a re-evaluation of risk. This is exactly the wrong thing to do. An accurate evaluation of risk in an orderly and transparent market is how this whole ball of wax works! To have the Fed step in is to distort the market, rewarding those who have made bad decisions, and penalizing the American taxpayer, who if the government does take action, will end up footing the bill.

What should you do now?

First, even if you are not presently in the market for a home loan of any type, work to perfect your credit.

If you are in the midst of getting a home loan, work on the credit, and now is not the time to be nickel and diming out the costs. Get the loan. Get it funded. Get it done.

My Team and I are available for counseling with a limited number of people. The real estate market is great, just not for everyone at the same time. If you think you will be making a move in the next year in the Santa Clarita area, give me a call today at 661-287-9164.