Originally posted 08/30/07
In Part I of this series I explained how money flows from investors through secondary markets through lenders to borrowers to fund mortgages. As investors face the decisions of where to invest their money they calculate the risk-reward for various investments and then decide which opportunity offers them the best return for acceptable amount of risk. As a result mortgage interest rates rise and fall daily like every other investment as investors put money into or take money out of the securities and bonds used to fund mortgages. I used the secondary markets of Fannie Mae and Freddie Mac to show flow of funds, and each of these institutions funds billions of dollars of mortgages annually.
Critical to the next part in the series are that not only do Fannie and Freddie provide secondary markets through which funds flow between investors (supplying principal for mortgages) and borrowers (supplying interest payments to investors); but they also dictate what underwriting guidelines and criteria must be met by all borrowers to meet their standards. By having uniform guidelines Fannie and Freddie are telling investors the level of risk associated with the investment. Because of the outstanding performance of borrowers with Fannie and Freddie loans investors know the standards work in creating an acceptable level of risk (foreclosure or default) to the rate of return on their investment.
Guidelines and investors determine acceptable risk-reward scenarios that result in money being made available (liquidity) for mortgages. This relationship, guidelines and risk-reward, are at the heart of the current mortgage industry problems. The looser the guidelines established for borrower qualification the higher the risk of non-performance on the mortgages funded with those guidelines, the higher the risk of course the higher the return which means higher interest rates. This is the basis for the sub-prime market, looser guidelines and higher interest rates for borrowers, higher risk and higher returns for investors.
Sub-prime borrowers are those that do not meet the criteria of Fannie Mae or Freddie Mac or the other “A-paper” mortgages that use many of the same criteria. Typically they are most deficient compared to prime or A-paper borrowers in their credit history. Sub-prime lenders were established to provide mortgages to the many people who own homes or wish to purchase homes and need a mortgage but have credit histories with a significant number of late payments, bankruptcy, possibly prior-foreclosures, etc. Traditionally these mortgage products required significant down payments or equity in the property being used as collateral. More recently with the surge in real estate values post 9/11 the industry required less and less equity in properties (what is termed LTV or Loan To Value), eventually providing combination fundings of First and Second mortgages to 100% LTV—or loans to borrowers with no down payments. As you can imagine lending money to someone with no down payment and a poor credit history appears to be pretty risky—and it is. However because of the rising market values this risk was somewhat mitigated as the $400,000 home with no equity became a $500,000 home with plenty of equity in a short period of time, allowing the sub-prime borrower to refinance to better terms, or if in trouble to sell the home, pay-off the mortgages and still collect equity. For many years this segment of the industry made a lot of people a lot of money: the homeowner able to purchase a home in a very “up” market, the mortgage broker and real estate broker who made commissions on the sale, the lender who funded high interest rate mortgages, and the Wall Street investor who purchased the bundled mortgages and then sold them through mutual and hedge funds. Everyone was happy.
Then late in 2006 some housing markets around the country started to slow down and the fantastic appreciation of the several preceding years slowed, or in some cases stopped. Home builders started reporting the sales of newly constructed homes in their, as one of my clients calls them, “Target Town” communities slowed as well. Coinciding with this slow down was the expiration of many borrowers short term fixed rate notes they used to purchase their homes with no money down.
Much is being written about “higher interest rates” also occurring during this time frame, however the rates used as the basis for adjustable rate mortgages, and those turning into adjustables after being fixed for two or three years (the majority of sub-prime loans). The higher rates for these borrowers were because of the type of loans they are in, loans now tied to high short term rates with high margins. (Sidebar: and adjustable rate mortgage interest rate for payment consists of two factors. 1) The index which floats daily and is used to calculate the mortgage rate on specified anniversary dates. The index can be one of many different indexes, 1 year Treasury, LIBOR, etc. 2) A margin that is added to the index. The better the risk of the buyer, i.e. income qualification, credit score, etc, the lower the margin. For most sub-prime borrowers their margins are over 3%. So today with a borrower with a 1 year Treasury index (about 4.1%) and a 3% margin would have an interest rate of 7.1%). Because many of the borrowers currently in default were marginally qualified to purchase the property as exhibited by poor credit, no savings for down payment and often inability to show income to support the mortgage payment, it is not real surprising that faced with no equity and a higher mortgage payment that they are not making those payments.
I understand that of the many families in foreclosure now there are some cases of true hardship, changing financial conditions and several who dealt with unscrupulous loan officers who did not fully disclose before loan documents the types of loans they were getting. But believe me after twenty years in the business this is a small percentage of the homes currently in foreclosure. The majority of those in foreclosure went in knowing the type of loans they had, that they had no equity invested and they were betting that the market would go up and they would be able to either refinance to lower rates or sell the property because of large appreciation and make a nice profit with no risk.
That all said, the sub-prime collapse started because as some of these foreclosures started analysts on Wall Street started looking at their sub-prime portfolios and felt they were at risk, greater risk then they thought they would be in when they came up with the loan programs and started funding and investing in them. Finding the level of risk unacceptable to the return, especially in comparison to the double digit returns they were seeing in equities on the stock markets for the year, Wall Street investors stopped purchasing the loans from the lenders. With no money coming in for loans they have already funded New Century, and then other lenders, could not operate and had to close their doors. This is what is known as a liquidity problem.
Now with Wall Street seeing what risk they had with the sub-prime deals they started looking at other products they were invested in and it is essentially the entire non-conforming market; i.e. loans that are not under the Fannie Mae or Freddie Mac umbrella (and government loans like FHA and VA). And Wall Street being the culture that it is one investor followed another until they moved the liquidity problem from the sub-prime mortgage market that they created to then next market where they were highly invested: Jumbo and non-conforming loans. Even though the default rate on these types of loans are well within historical norms and risk/reward calculations Wall Street has stopped purchasing many of them as well.
Overall the media has blown the current foreclosure rates somewhat out of proportion. I find the comparisons of foreclosure rates in 2007 to those in 2006 as intellectually lazy and sensationalized. With 2006 being a peak year for housing prices it was unlikely most homeowners in trouble with a mortgage would have a difficult time selling their home and paying off the mortgage. Comparing 2007 to any of the prior years in terms of number of home sales, prices or foreclosures is like comparing the last year of Henry Aaron’s career—it came after many years of exemplary performance. We are in a period of record home ownership, a very small segment of that market is experiencing difficulties and much of it due to their own greed or inability to properly calculate the risk they were taking. This is what makes news because most reporters and editors either enjoy printing bad news to show how bad the country is doing, or because they are too lazy to dig into the story, learn about what and why and who, and do some real reporting on the history and it relation to today.
Once someone on Wall Street wakes up and realizes that for many, many years they enjoyed solid and dependable return on investment in mortgages for well qualified borrowers they mortgage market will settle down and return to some sense of normalcy. We will see the non-conforming rates more in line with the Fannie and Freddie rates and we will see a return of confidence to most markets. The underlying fundamentals of low unemployment, low inflation and a growing economy still exist; these fundamentals support a strong housing market.
I hope my comments on this have given you a better understanding of how mortgage markets work and hopefully dispelled some of the hysteria and poor reporting that has occurred around the mortgage and housing markets.