Mortgage Fears Past Us?

Discussion and debate about the mortgage upheaval has been relatively limited the past few weeks even though the risks have not gone anywhere. Maybe since that mortgage mess is becoming more like “old news” is the reason for the slip in attention, but more likely it’s the Fed’s 50 bps rate cut that has ushered in a tide of silence. Instead, increased focus has been given to a returning of the Bull Market coupled with the opportunities in the Tech space. The resulting implication is that the market is confident that the Fed will act to resolve lingering mortgage and housing threats, as the air swirling around Wall Street suggests that the problems are past us, or at least, have been identified.

With so much origination of Alt-A and sub-prime mortgages the past two years, problems have not had enough time to fully appear. In addition, home values are now falling thus more loans will go bad due to borrowers’ inability to liquidate at a price high enough to satisfy the outstanding loan balance.

Don’t get me wrong, nobody is dismissing the crisis, but with the averages roaring back and hitting all-time highs, it does raise a question. “What was the purpose for the exacerbated volatility and nasty market declines we observed in August?” Or, “Was it because the market was afraid the Fed wouldn’t cut? And now that it did problem solved?”

I don’t, and I bet many other’s don’t either, think the mortgage and housing woes can be directly cured by monetary policy. I believe that there are still a few banks and mortgage finance players walking the planks of the gallows. Additionally, the effects of ARM resets and foreclosure possibilities hasn’t fully encumbered the consumer, a situation that will broadly affect the economy.

Credit Suisse published a terrific Mortgage Research Report which illuminates the difference in the residential market five years ago versus last year, including the evolving trend to where we are today. A glaring statistic is the mix of purchase money mortgage originations: In 2002, subprime 6% and Alt-A 5% compared to 2006, sub-prime 20% and Alt-A 20%. Remember, Alt-A is not “Almost prime” as it is sometimes referred; It’s essentially sub-prime dressed up, in my opinion. So, we have 40% of purchase originations with questionable credit quality versus 11% just 4 years earlier.

Alt-A purchase originations hovered around 5% during 2001-2003, then tripled to 15% in 2004, and rising again to 18% in 2005 up to 20% in 2006. My educated theory for the spike (educated since I am a former mortgage professional), was due to the slowdown in mortgage originations after the re-finance boom after rates bottomed in 2003. After the most credit-worthy borrowers had taken out mortgages, the primary source of new originations would have to come from more risky borrowers.

Lenders needed the origination income and investors needed the yield. Both were willing to accept the higher risk. Partially, because home values were rising at an astonishing clip, this assuaged foreclosures since periled borrowers could unload their property to satisfy mortgage obligations if needed. In essence, at the onset, foreclosures were below trend due to the strong housing market, and lenders and investors extrapolated this trend forward in support of their heighten risk-taking endeavors. Many borrowers were given mortgages that were way out of their league. Lenders grasped assurance from the underlying collateral, since home appreciation had been so robust. In reality, rising home prices were supported by the increased number of buyers able to receive financing. Lending to risky borrowers causes home values to rise, and rising home values makes the loans appear less risky, so even more lending results, followed by additional home demand and subsequent appreciation.

The problem with Alt-A mortgages is that many lack documentation of income and assets. Many will only require a credit score if there is typical 20% down payment. The problem with a credit score is that it’s calculated from a credit history, and history is no certain indication of the future. Additionally, an individual may have good credit because he/she has never a challenging debt load. The best indication of loan performance is the borrower’s income; the stability and the amount it exceeds loan payments. In order to ascertain the cash amount a borrower is capable of paying out, one must know how much cash the borrower has coming in. Without verified income, it’s very difficult to gauge the credit quality of a mortgage.

Teaser rate, Interest Only, and Payment Option ARMS provide initial affordability with low monthly payments. These low payments eventually reset to much higher amounts, many times beyond the borrower’s reach. Several years ago, borrowers who faced this dilemma could refinance into a new mortgage thus keeping their payments low. Yet, today, lenders have tightened the credit clamp eliminating this potential alternative to default.

The key issue is that many more loans populate the “probable default universe” than what we are currently seeing. We have just begun to see mortgages go bad, yet there are potentially many more loans that haven’t had enough time to appear as troubled. Falling home values will unveil the trouble that has been obscured by the creative mortgage products.

Homeowners unable to service their mortgage are confronted by a housing market with less demand due to tightened credit standards. Rising negative equity enhances the incentive to default, as opposed to exploring every possible alternative to avoid foreclosure. Lenders reaction to increased defaults only guarantees that there will be many more to come, especially since lax underwriting guidelines tempered defaults for the past few years (either via refinance or property sale).

Many banks own these risky loans in their investment portfolios. It’s tough to profit under flat and inverted yield curve conditions, and Alt-A and IO mortgages allow extra yield to mitigate high cost of funds. Banks prefer short maturity assets due to the short duration of their liabilities, thus ARMs best suit their investment objectives. 3 and 5 year ARMs are popular holdings which mean many still have yet to reset. Borrowers facing dramatic payment increases due to ARM resets have been able to refinance into another mortgage to avoid the rate increase. Now that credit has tightened, it is likely that many borrowers will be unable to escape payment resets by refinancing into another mortgage. Additionally, lenders have curtailed offerings of the “initial low-payment” mortgage products allowing borrowers to refinance out of loans scheduled to reset.

With tightened credit standards and the elimination of these creative loan products, future mortgage originations should fall drastically. Housing market will experience increased weakness due to less qualified borrowers providing the demand needed to offset the enormous home supply. Builders and other related industries are feeling the pain. Mortgage lenders have either closed their doors or made significant reductions. These woes could affect demand in other non-related industries. Homeowners witnessing the decline in their home value could decrease consumption due to a contraction in the wealth effect. Yet, according to the stock market, it appears we have nothing to worry about.