Q&A About Subprime Mortgages

You can’t pick up a newspaper or watch the TV news these days without reading/seeing a story about troubles in the land of subprime mortgages, which is, by the way, a very big place.  Big not only because of the significant portion of all real estate mortgages that are considered subprime loans, but because if the level of foreclosures and bankruptcies that some pundits anticipate actually happens, it could have a domino effect that touches, sometimes painfully, nearly everything that people care about.

I’d like to reference two good background articles about subprime mortgages. Chronicle reporter, Kathellen Pender’s March 15 article takes an informative FAQ approach that addresses questions such as these:

-What is a subprime loan?

-How big is the market?

-What went wrong?

Whereas Harry Domash in his Chronicle spot called Online Investing chooses a question and answer format that speaks to questions such as:

-Can I profit from the subprime lending fiasco…?

-Will the REIT I hold be hurt…?

One overlooked issue in the subprime mess that Kenneth Harney writes about in his Nation’s Housing article (April 1 Chronicle) is how the paucity of escrows for insurance, taxes and such will likely mean that these obligations will be unpaid by the financially overstress subprime borrowers who face them.  The result here could be liens by government entities against the properties that could ultimately result in losses for the lender.  This is an under-reported story that you can read in Mr. Harney’s article here.


Opportunities in the Subprime Implosion

Freddie Mac says that it will no longer buy high risk mortgages vulnerable to foreclosure. While there are many kinds of loans that can be deemed “high risk”, what Freddie is really referring to is “subprime loans”. Freddie Mac is developing new standards for subprime loans; in fact, half of the loans they currently own will no longer comply.

The mortgage leviathan is reacting to surging home-mortgage delinquencies and foreclosures in the subprime market. Write-offs of mortgage loans by banks have reached a three-year high in the fourth quarter last year, according to Federal Deposit Insurance Corporation (FDIC), while at the same time several large subprime lenders have been bleeding – stock shares have plummeted in price, some are teetering on bankruptcy, and others have shut their doors.

Joining noteworthy industry lions such as HSBC, Countrywide and Saxon, New Century reported earlier this week that it too has troubles which are particularly egregious. New Century admits that it’s technically in default with several lenders and is under investigation by federal regulators. Analysts caution that this company – the second largest in the subprime industry – may implode if most of its warehouse lenders do not issue waivers to New Century for being out of compliance with debt covenants.

Companies like New Century rely on warehouse lenders to help finance their operations. These lenders require that the loans they invest in perform to clearly defined standards. If they don’t, the warehouse investor can put it back to the loan’s originator (New Century). Consequently, originators are getting saddled with the non-performing loans they aggressively originated.

How did this happen?

Peter Coy in his BusinessWeek.com article “Why Subprime Lenders Are In Trouble” gives an accurate and succinct description of what went wrong.

He reports that the quality of mortgages underwritten by the industry has dramatically changed in recent years, particularly as recently as 2006. At that time there was a shift in lenders’ loan strategy. Rather than competing with one another based on price (lowering rates), the game became to compete based on easy terms (lowering lending standards). Reducing the standards enabled the most aggressive to keep volume up, and now loans that should never have been made are becoming delinquent and going into foreclosure.

When Countrywide recently announced that 19% of their subprime portfolio is in default (last year it was about 2.5%!), I asked Bill Aubrey, the Chief Investment Officer of Capital Alliance to give me his take on what’s happening to the industry. (Disclosure: I work for Capital Alliance.) Bill Aubrey:

“Despite all the recent blood letting in this industry, there’s nothing wrong with writing subprime/nonprime/non-conforming or whatever the street folks want to call it as long as it’s done correctly. That is to say, don’t let a “restaurant engineer” who also happens to be a 1st time homebuyer with $7,000 per month income stated on his unexamined loan application borrow 100% of the appraised value.

Or for that matter, lend to the quintessential sales guy who states he makes $25,000 per month, but examination of his bank statements shows he made this income 12 months ago! Since then he ran into a small glitch in paying his bills on time because he had to pay all the medical bills for his sick Mother who is 76 years old. Like the lady did not have Medicare.

Or better yet, the guy who wants to borrow $200,000 (at a 100% loan-to-value) for “investment purposes”. Great investment when the borrower is paying 12.5% for the dough!

All three of these scenarios have come across my desk in the last 6 to 8 months and everyone of those so called “deals” were purchased by the big boys on the street! Now the whole industry is getting a black eye because of this stupidity.”

My take is that despite the “black eye”, those left standing will have opportunities to underwrite more quality loans because the “big boys” will be hurting so badly that they’ll make a substantial retreat from funding non-conforming loans. Companies like Capital Alliance — which follow a strict underwriting guidelines that require substantial borrower equity in the collateral, a minimum credit rating, and affirms stated income and appraisals — may find that they have more quality business knocking at their doors than they can answer.

Those with discipline often win in the end, and in this situation, those that followed conservative underwriting policies will look better than ever relative to the subprime industry as defaults and foreclosures soar for the undisciplined.

Piggyback Fall-off + Uncle Sam Spikes Mortgage Insurance

Over the last few years with easy credit and soaring housing values, many mortgage borrowers by passed mortgage insurance in favor of so-called piggyback loans.

Mortgage insurance pays the lender should its borrower default on a loan.  Lenders like this and typically require borrowers to purchase this insurance if the borrower’s down payment is less than 20% of the purchase price.  The cost of this insurance averages between 0.6 and 0.8% of the loan and, until recently, has not been tax deductible.

So, given that Uncle Sam wouldn’t help pay for it and that fewer borrowers could afford a 20% down payment, the market was ripe for piggybacks which let home buyers avoid mortgage insurance by tying a second or third mortgage to the first.  These can be called 80-20 or 80-10-10 loans where the second and third mortgages come with a higher rate than the first.  All this is tax deductible.

When rates were low, the second and third mortgages were cheaper than mortgage insurance, especially with the deductibility angle.  The mortgage insurance business contracted as the mortgage business exploded.

But now Uncle Sam has aided the insurers by making their product tax deductible about at the same time that the downturn in the real estate market has made piggybacks more costly.

 Read about the details here.

Mortgages Now Less Risky — Or Not?

An index that measures mortgage risk by determining if the borrower has sufficient collateral to enable a lender to collect the balance on a delinquent loan says that mortgages are getting less risky in California.  Mortgage risk fell in California by 13.4%, according to this index after nineteen straight months of year- over-year increases, according to HomeSmartReports.com. (Check here for a list by city.)

Au contraire says Berkeley economist, Ken Rosen, a real estate specialist.  In a recent San Franciso Chronicle article, he points out that an increase of loans made with payments that rise over time (adjustable rate mortgages) in combination with price declines in housing has left the market less stable, not more stable as the index proclaims.

Well, dear reader, is your glass half-empty or half-full?

Blue State Jumbos

Kathleen Pender in her Net Worth column in the San Francisco Chronicle recently penned an article with an interesting perspective.  She examines how the change of political parties in power in D.C. might result in an increase the loan limits of “conforming loans” that qualify for purchase or guarantee by the loan behemoths Fannie Mae and Freddie Mac.  This would be good news to people seeking mortgages in areas with high priced homes like the San Francisco area where the median home sold sells for $749,000.  This is because conforming loans can be had for a lower rate than Jumbo loans which aren’t backed by Fannie and Freddie and cost one-quarter to one-half a percent more. 

What’s happened over the years is the current loan limit of $417,000 has not kept up with the vaulting values in several blue states such as California, New York and Massachusetts. Red states such as Mississippi, North and South Dakota, Montana, Iowa etc. haven’t faced such a problem – their comparatively lower average home values don’t necessitate getting into Jumbo territory.

Last year the House passed a bill that would permit Fannie and Freddie to raise their conforming loan limits in high cost areas, but the Senate didn’t approve it.  With a different composition of political parties soon to be entrenched, there may soon be a different outcome.

Boom, Bust, or Flat – It Depends

While various real estate pundits debate the appreciation levels that the California housing market may face next year, nationwide the median price for a home sold dropped to $221,000 in October, a decline of 3.5 percent from a year ago, says the National Association of Realtors, as reported by AP Economics Writer, Martin Crutsinger.

So, nationwide there’s depreciation, but in California it may be flat to a 10% increase? 

If true, this is another example of how real estate is a very local phenomenon.  And although California consists of many “local” real estate markets that behave differently, overall the state is said to have a shortfall in housing that contributes to upward pressure on prices.

According to Broderick Perkins’ article in Realty Times, the California Association of Realtors reports that, “Each year ends in California with an approximate 50,000 shortfall in housing units, based on the number of new households (250,000) and the number of new housing units constructed (an estimated 200,000 this year).”

The bottom line seems to be that different places will have a different experience of real estate values during this purported boom/bust cycle.  As has been evident over time, the primary relevant factors that come into play are the housing demand/supply ratio and the economy of a specific market/locality. 

During this forthcoming period of expected average depreciation, there will be many areas that will actually do the opposite.  Where you are makes all the difference.

California Housing Market – Three Years to Recover?

I’m glad that a Federal Reserve Bank study published last year (May 2005) presents solid evidence that the employment rate and loan-to-value are two of the most important predictors of defaults and foreclosures, otherwise yesterday’s news about dropping housing prices would cause me more concern than is warranted.

Given that my company’s business is investing in residential mortgages, primarily in California, I have a vested interest in seeing a stable housing market. So when luminaries like Berkeley economist Ken Rosen says, as reported in the S.F.Chronicle, that the California housing market my take three years to recover and is expected to decline by 4.8% next year and 2.9% the year after, I take note, and then I do some quick math.

If you’re an investor in a mortgage pool, what you want is for the borrowers to keep paying their loans. If the job market is weak, or the borrowers in the “pool” have, on average, too little equity in their properties (or inversely, the loan-to-value is too high), then if falling property values evaporate the equity, there is a substantially greater likelihood that borrowers may default, leading to foreclosures. To the extent that loans aren’t paying interest and principal, investors in the pool aren’t obtaining their yield objective, or potentially, face a risk of capital loss.

For some, the devaluation Dr. Rosen predicts hurts, but the fund my company manages, and those with similar loan underwriting policies, the average equity held by borrowers in the portfolio is large enough to withstand the single digit declines described; in fact, our fund’s average loan-to-value is 63% (or 37% equity). The Fed study predicts that at this level, we face a foreclosure rate of about 1%.

Nonetheless, as I said, stability is a good thing, so I was pleased read that various indicators are keeping housing devaluations in check, such as the Index of Leading Economic Indicators which rose 0.2% in October. Economists Ken Goldstein of the Conference Board (an industry-backed research group in New York who produces this Index) said “the economy is unlikely either to reheat or get significantly cooler. Instead, the kind of slow growth now being experienced could continue right through the winter and into the spring.”

Good if it happens, but it’s great to be protected nonetheless.