Sub-prime credit liquidity crisisJon Miller, CMPSmortgage market, secondary market, risk assessment, credit score, mortgage planner
From borrower to mortgage to secondary market--the real
problem
The borrower
Consumers interested in purchasing or refinancing a home will pay a
given interest rate based on their personal financials, current
market conditions and product/debt strategy chosen. Risk assessment
is based upon the borrower's income and debt ratios, credit scoring
and history, liquidity and asset base, leverage scenario and level
of approval obtained, criteria for the aforementioned is tightening
significantly by the day. If the borrower's credit will not permit
A+ levels of qualification--or if income and assets cannot be
sufficiently documented--an alternate course of lending is needed.
Unfortunately, this course of sub-prime and Alt-A lending has not
been utilized in the way it was intended by the borrower and, in
some cases, the lender as well. Now we have issues. Starting from
scratch, let's take sub-prime for example.
Scenario
John and Jane Doe decide to purchase a home. In fact, they went
home shopping first and negotiated a purchase agreement which is
now fully executed and earnest money is on the line. Both borrowers
had not yet retained a professional mortgage advisor and have been
shopping around by telephone and the Internet, which always incurs
unreliability and inefficiency in the transaction (but that is
another story). John and Jane find me and agree to move forward.
Upon a credit and financial analysis, I discover that both John and
Jane have credit deficiencies that will not permit a higher-level
approval (hence, lower cost) and also cannot document income due to
tax return complexities. John and Jane are also just barely able to
afford the home, as 50 percent of their gross annual income is
being utilized for the housing payment and personal debt. They also
have very little liquid assets (one month housing payment) in
reserve. They will need to utilize sub-prime or Alt-A (alternate
lending) loan programs in this case, as it is the only viable
solution. Due to my discovery, it would be advised that they get
their earnest money back during the attorney review period, put the
contract on hold and wait until a better formal plan of action is
determined by their mortgage professional (me) and hard numbers can
be provided. Most likely, a credit repair plan would be issued. By
following the plan, the borrowers would potentially have the
ability to qualify for A+ level paper within a 45-day time frame,
which equates to a lower cost of funds (interest rate, etc.), more
affordable payments and better terms all around. Rather, John and
Jane want to move forward with the purchase instead of going
through the credit repair plan (they may not have the time, money
or some other reason). Now it becomes my job to utilize the best
financing option out of the very limited options available to get
them into the home on time and still prepare them to utilize a
credit clean-up action plan after closing--which absolutely needs
to be followed over the next 12 to 18 months. Let's assume, for
this example, that the only product for which John and Jane qualify
is a two-year sub-prime adjustable-rate mortgage. Remember, this is
a two-year sub-prime adjustable-rate mortgage (ARM) loan. We only
have 24 months to get everything in order for better
financing.
We close. From there forward on a quarterly basis, John and Jane
are followed up with to determine how much progress has been made
on the credit repair. They respond with "no progress made." Further
advice is reiterated as to what to do, how to do it and another set
of instructions and e-mails are sent to the clients to be certain
they are on top of things. Another quarter goes by and still no
action. Another, and another, and ... all of a sudden John and Jane
are a month away from the ARM adjusting.
Well, we have arrived. Due to the housing market being in a slump
(mostly, a state of stagnancy with some areas substantially in
decline during the last two years) and higher default rates on
precisely these types of loan products from the previous two years,
investors are no longer willing to extend credit loosely to this
type of mortgage financing situation. Now, we have two borrowers
who failed to follow a course of action to improve their credit
over time, a housing market providing no rate of return
(appreciation) on the home they purchased, no equity in the home
due to the lack of appreciation, no loan products available for
highly leveraged property with little equity due to the housing and
default rates over the last year and subsequent guideline
tightening from investors, and a housing payment for John and Jane
that will adjust the full three percent when the time
comes--increasing their payment by $600 per month with no
opportunity to refinance due to the previous conditions mentioned.
Now the default cycle continues. You can see where this is
going.
The most frustrating aspect of a mortgage planner's profession is
the inability to do anything for a client to rectify a potentially
hazardous financial pitfall. A situation such as this, which is
based around several absolutely true situations, is completely out
of our control. The media and hype discuss fraud and predatory
lending being the issue for problematic mortgage defaults. I have
to tell you, this is absolutely not the case except in a very small
percentage of mortgage loan fundings.
The market
There are no issues with conforming loans at this point. Sub-prime,
Alt-A and some non-conforming loans are the problem areas. Upon
Wall Street's reassessment of the mortgage market, the risk level
has gone up substantially due to higher default rates and
stagnant/declining housing over time; therefore, a much higher
yield is required on those loans to offset the higher risk (based
on the recent valuation). Essentially, the mortgage bond is
discounted (price deterioration/valued less) to the net present
value, which ends up deteriorating the bonds below a par yield.
What was going to be a mortgage sold to Wall Street at 101 is now
being sold at 98 or 99 due to the devaluation. It will now cost the
mortgage company XX dollars per loan to fund the loan rather than
making XX dollars in premium, from which it otherwise would have
profited, creating a total loss and depletion of the lender's
liquid assets to cover the discount. Secondly, margin calls (due to
the discounted value of the mortgages backing the assets)
exorbitantly heightened this depletion scenario in which the
necessary margin shortages required additional liquidation of the
mortgage lender's assets (it may or may not have had) to cover the
minimum maintenance requirement or initial margin.
In summary, put the two together. Wall Street (the market)
adjusted what it needed for compensation, demanding a higher yield
on funds already locked and being delivered at a lower yield as
well as creating a total loss on each loan funding within the next
30 to 60 days. Simultaneously, margin calls added to the depletion
of the company's assets already being utilized to cover the
devalued (discounted) mortgage paper. Mortgage companies cannot go
back to the consumer and ask for the higher yield to offset this
difference. Either the company has the liquidity to weather the
storm or it shuts its doors (think American Home Mortgage), as the
cost per day to stay open can be millions of dollars in a credit
crisis such as this.
-One day of business in a normal credit market = $100 million in
loans (in one day)
-Going to secondary at 6.5 percent = $101 million sell price = $1
million profit in one day
In today's credit market, Wall Street says eight percent is the
return needed for the additional risk, which discounts the current
loan to a net present value and costs the mortgage company.
-$100 million in loans to secondary at 6.5 percent = value is
$97 million = $3 million loss in one day--not including margin call
coverage
Two things need to happen:
1. The credit market needs to stabilize. It cannot continue a
cycle needing eight percent this month to offset the higher risk
only to then need nine percent next month and so on. Polls will
identify a given stability figure and will eventually ease itself
in the long term.
2. Loan pipelines need to be covered. Clients need to get closed
as soon as possible. The mortgage professional needs to have a
couple of back-up plans just in case an overnight change occurs
with an investor's product initially selected for that client which
no longer becomes available.
Although the Fed has been talking about stepping in to provide
some relief to some parts of the secondary market which have
essentially seized, the bid/ask spreads are just too wide for the
mortgage-backed securities to trade, leaving lenders with large
inventories and facing additional margin calls. In my opinion, if
the Fed steps in to add liquidity and help stabilize the credit
markets, by their own admission, this greasing of the cog wheels
will be limited in the overall effect. If they are able to move the
secondary markets a bit, it will only flush out the already
fundamentally undesirable portfolios. Since most high-leveraging,
alternate documentation sub-prime lending has ceased, a Fed move
will mostly affect only market portfolios already warehoused. Those
loans that were originated at 102, and now needing to fetch 103 or
104 on the street, might be offered at 98 to 100--only narrowing
the spread and limiting the lenders net losses, but not saving them
entirely. Even then, only the strongest banks (with large amounts
of cash on hand) will be able to weather the storm after the Fed's
assistance. Aggressive investors will still be needed to move
behind the Fed to uphold any momentum the Fed initiates and pull
through the market deterioration within a reasonable time
frame.
My recommendation: Close your loan as soon as possible!
Jon Miller, CMPS is a senior mortgage banker for Chicago Bancorp. He may be
reached at (312) 491-5383 or through his company's Web site at www.chicagomortgagefinance.com.
