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.