What really happened to the mortgage market?
They didn't properly price loans for the risk they assumed. While we are crying about the "poor borrowers" what about the poor lenders who got caught in the middle of this mess? Borrowers said "We'll buy it if you give it to us the funding!" Wall Street said "We'll take the extra yield!" and we all said "This time it's different!" Extrapolations proved that a five bedroom mansion in Jamaica Estates would sell for at least $5 million in this new economy, fueled by leverage.
Did any sub-prime borrowers REALLY lose anything in the sub-prime mortgage explosion?
Who were the REAL winners in the sub-prime mortgage explosion?
HINT: It ain't the lenders.
In the early 2000s, the economy was healthy, interest rates were low and consumers felt a bit flush – all of which helped push real-estate values up across the country. With values escalating, lenders felt more confident about making mortgages to customers whose poor credit histories had prevented them from buying homes in the past. (When values are rising, borrowers are less likely to default, because they can take money out of their homes if they run into trouble.)
That put more potential homebuyers in the market, helping to raise home-ownership rates to a record 69 percent in 2004 – which pushed housing prices up more. Skyrocketing prices (double-digit growth year over year was common in some areas) lured real-estate speculators, creating even more demand — and driving the cycle further.
To attract this growing pool of borrowers, lenders repurposed "creative financing" products that had previously been marketed to high-income borrowers seeking flexibility with their money. Among the most popular were variations on the adjustable-rate mortgage, or ARM.
ARMs are loans whose interest rates adjust up or down periodically. The initial rate is typically fixed for a period of two or three years. The benefit is that the starter rates are lower for ARMs than for traditional, fixed-rate mortgages. That means lower monthly payments, making homeownership more affordable and allowing borrowers to qualify for a bigger loan.
Some of the creative ARM products that flourished of late included interest-only and payment-option loans. With the former, a borrower only pays the interest on the loan — not the principal balance — during the introductory period. With payment-option ARMs, borrowers get to choose how much they pay each month: enough to cover the interest plus the principal, the interest only... or less than the interest. In that last scenario, the unpaid interest is tacked on to the principal, leaving borrowers owing more than the amount of the original loan.
How prevalent were these loans? Nearly 23 percent of all mortgages taken out in 2005 were interest-only ARMs, and more than 8 percent were payment-option ARMs. In certain once-sizzling markets, the numbers were much higher: For example, 34 percent of all new mortgages in New York in 2005 were interest-only.
These products made sense to borrowers who thought they'd live in their homes for a few years, then sell at a profit or refinance. But now that housing sales have stalled and prices are softening, borrowers can't do either very easily.
And many borrowers are facing painful payment hikes, one-third of ARMs taken out between 2004 and 2006 began with "teaser" rates below 4 percent. Payments on these loans will double on average – if they haven't already done so.
Subprime Lending Skyrocketed
And then there were the loans to borrowers with poor credit. Subprime loans expanded to 20 percent of the mortgage market in 2006, from 9 percent a decade earlier. These loans carry higher interest rates to compensate for the risk posed by borrowers. They can be traditional fixed-rate loans, but most are ARMs.
Recent subprime loans were rife with risky terms — interest-only payment options, penalties for paying off the loan early (which makes it costly to refinance into a better loan), and low documentation requirements, meaning borrowers needed little paperwork to verify that they could, in fact, afford the loans. (These so-called "liar loans" accounted for about 58 percent of all loans in 2006.
The pairing of these new loan types and new pool of borrowers was dangerous.
They took the riskiest of products and sold them to the weakest borrowers to compound risk,
New loan products allowed more Americans to own their own homes than ever before. But regulators exercised little oversight over the booming mortgage market. The Federal Reserve and four other federal regulators did not issue guidance for nontraditional mortgages until last year. They recommended that lending institutions consider the borrowers' ability to make payments over the life of the loan before underwriting, and that they improve disclosure to consumers.
Yet many, including Federal Reserve executive Roger T. Cole, say it was too little, too late. "Given what we know now, yes, we could have done more, sooner," Cole told Congress in March.
But the loans are already out there; all that's left is to wait for the fallout. This year and next, about $260 billion in prime ARMs and $376 billion in subprime ARMs will begin to reset.
What's happening today?
My borrowers have one less option today. Capital One- owned, Greenpoint Mortgage shut it's wholesale lending operation today. I didn't use them that much. They had some really cool products for investors but otherwise were cumbersome. I think I closed 3-4 loans with them these past 24 months.
Countrywide is laying off originators in their Full Spectrum lending unit. That could trim their sales force by some 25%.
Appraisal values in New York are reset back to 2003.
Beyond this episode, New York home buyers can take a breather. Our advice to lock rates at application these past two weeks was sound. Although Treasury bond yields dropped, mortgage-backed securities yields rose in fear of more defaults. It understood this conundrum that prompted our lock advice.
Today, we think it is safe for a New York mortgage applicant to float their mortgage rate; there may be some room for improvement this week.
The liquidity crisis extends past our borders: A large British insurance company may have been forced to borrow from the Bank of England and a potential German banking crisis abounds
Senator Dodd just met with Fed Chairman Bernanke. He queried whether the Fed was willing to use any and all available resources to avert a mortgage liquidity crisis and seemed satisfied with the Fed Chairman's response. That may have averted Congressional interference (we hope). Senator Dodd is continuing to petition the President to raise the statutory limits of conforming loans as an emergency measure. Some states would benefit from this prospect because conforming loans offer lower rates and more loan options than jumbo loans.
Market movement
To date, over 120 mortgage companies and counting have closed their doors due to reduced liquidity. The result: Borrowers who want to take out non-conforming loans have fewer, more expensive options.
Many media outlets have incorrectly added fuel to the fire by stating that mortgage lending has stopped altogether and that borrowers can't get a loan without a 20% down-payment. This is not true.
Conforming interest rates and loan programs, those backed by Fannie Mae and Freddie Mac, have not been significantly impacted by recent events. Even better, interest rates have come down from recent highs. While this is good news, the market is experiencing unprecedented volatility and changes could come at any time. Borrowers need to act swiftly and decisively in today's climate.
What did the Fed do?
The Fed's decision to cut this rate provides stability in the financial markets and this can be good for all of us.
How exactly does this provide stability? Here's an example: Imagine you just wrecked your car and it requires $5,000 worth of repairs. You have a short-term need for cash to pay your mechanic. Even though you know you will eventually be reimbursed by your insurance company, you still need the cash now. So do you sell off stocks to get the cash, or tap into an equity line of credit? Most likely, you draw from that line of credit rather than liquidating a long-term investment.
This is what the banks are facing in today's liquidity crisis. And Bernanke's move helps them avoid long-term damage by supplying access to short-term cash.
What should you do now?
Several lenders are taking steps to curtail the rising tide of foreclosures. Tropical Funding and their affiliates are working with an advocacy group which plans to refinance up to a billion in subprime loans at below-market rates. Freddie Mac is fueling the market with a commitment to buy up to $20 billion in subprime loans.
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