Housing and Subprime: No Documents? No Problem - Until Now

by: Todd Sullivan

Okay, pork belly prices have been dropping all morning, which means that everybody is waiting for it to hit rock bottom, so they can buy low. Which means that the people who own the pork belly contracts are saying, "Hey, we're losing all our damn money, and Christmas is around the corner, and I ain't gonna have no money to buy my son the G.I. Joe with the kung-fu grip! And my wife ain't gonna make love to me if I got no money!"

So they're panicking right now, they're screaming "SELL! SELL!" to get out before the price keeps dropping. They're panicking out there right now, I can feel it." - Eddie Murphy, Trading Places

First let me apologize. In a previous post, I stated I would not comment on housing anymore. Conditions, however, force me to go back on my word. This must be done for a few reasons. First, I have received a host of emails from readers on the subject and feel obligated to address them lest they think they are being ignored.

Second, I seem to be the only person who is not in the process of packing up my family, withdrawing all our cash from the bank, gathering whatever canned goods we can scrounge up and heading to the hills incoherently stammering like Hunter Thompson in some bizarre Y2K panic induced flashback.

Are you surprised?

Housing has been on a tear for the last decade. Before the last year and a half, things became insane. It is relatively easy to spot the beginning of the end in a bubble when you are not wrapped up in it. During the tech bubble in 1999-2000 when any mammal with an opposable thumb and a mouse could make money, that moment was arrived at when novel little things like earnings were no longer important and took a back seat to revenue growth, "website hits" and "click through" metrics.

It was a time when a company could actually report quarterly numbers, have increasing losses, mounting debt, but because revenue and other internet traffic metrics grew, its stock would explode to the upside.

The inevitable happened; people realized if a company is not able to earn a profit, or even demonstrate a realistic plan of how they might, it really is not worth $144 a share and the prices of these stocks then fell off a cliff. You also had prices of stocks in companies like Home Depot (NYSE:HD) and Coke (NYSE:KO) included by the frothing hoards in this mania. These were companies that actually had earnings, but were growing them at rates in the teens who were selling at 50 times those earnings. These companies, caught up in the euphoric irrationality of the millennium, also suffered as people then realized that while these companies were actually able to earn a profit paying 50 times them for companies who make screwdrivers, and Coke had the same effect as getting married in Vegas after a weekend of drinking screwdrivers and doing coke. Both decisions in retrospect left people wondering what the hell they were thinking. The answer? They weren't.

Enter housing. With people petrified of stocks and interest rates obscenely low, they poured money into housing. Predictably, prices soared. A real example: my wife and I bought out first house in 1997 after we were married. We paid $107,000 for it and put about $20,000 of cosmetic changes into it (painting, some updated wiring and insulation). Three years later, we sold it for $285,000. Our second house was bought for $117,000 and comped out four years later for $368,000. There is no logical reason for this. When we bought both houses they "comped" out in a manner similar to other houses in the area, so we were not the recipients of an unusual bargain. When we sold them, similar "comps" applied so the buyers did not get "ripped off" compared to what other buyers were paying. The market was just clearly running as all buyers were paying these prices - the buyers and sellers were not insane, the market was. So when did the seams begin to come apart?

Two words: no documentation.

You really have to read this stuff to get an understanding of why the market ran up and why lenders are now in trouble. This is from Lending Tree.com:

There are three main categories of no-documentation mortgages:

1. NINA (no income, no asset) Mortgages

How to qualify: NINA mortgages come the closest to being truly no-documentation loans. When you apply for one, you won’t need to supply information about your income, employment or assets. All the lender will check is your credit score and the assessed value of the property.

Interest rate: Because the lender is going on so little, your credit score needs to be very high to obtain this type of mortgage. If you are approved, your score will be a big factor in setting the interest rate, which will typically be 1 to 1.5% higher than a traditional mortgage, but may be as much as 3% higher.

Who it may be right for: People with excellent credit who do not want to disclose the details of their holdings; people who rigorously guard their privacy.


2. No-ratio Mortgages

How to qualify: With a no-ratio mortgage you don’t need to declare your income, so a lender can’t calculate your debt-to-income ratio (your monthly loan payments divided by your monthly income -- a ratio lenders usually prefer to remain below 36%). Lenders will still require other documentation, however, such as assets, other debts and employment. They’ll often require that you’ve been in the same job for two years.

Interest rate: You’ll pay a higher rate than you would for a traditional loan, but not as high as with a NINA.

Who it may be right for: People who would have difficulty obtaining a traditional mortgage because of their high debt-to-income ratio; people who have income that is difficult to verify.

3. Stated-income Mortgages

How to qualify: With a stated-income mortgage, you do not need to prove your income with pay stubs or W2 forms. You must be able to document the nature of your employment (again, two years in the same job is usually required), but you can simply declare an income level that is reasonable for your line of work.

Interest rate: Because you supply other documentation and will be able to show a healthy debt-to-income ratio, this type of mortgage carries only a slightly higher rate than a traditional loan. About half a percent is typical, though it varies with other factors such as credit score, the size of the down payment and how stable your income is.

Who it may be right for: Borrowers who have a good income but find it hard to prove, such as self-employed people with a lot of tax write-offs, or people who earn much of their income in cash or tips.

What is shocking is the justifications they give for those who these loans "may be right for." You are buying a house, and you are borrowing money from a bank to do so. The expectation is that you will need to have money to put down on it and actually be able to demonstrate an ability to pay the bank back. The phrase "take my word for it" should never enter the conversation. It did, though, and that is the genesis of the current situation. When buying a $500,000 house involved less paperwork than buying a Ford Escort, red flags ought to have been going up.

In 2005 and 2006, the number of both mortgage brokers and real estate agents hit historic highs. A mortgage is a commodity; give me a price and a rate and I will choose a broker. There is very little brokers can do to distinguish themselves from others. With so many brokers and a limited number of qualified mortgage applicants, brokers had to find new applicants. The only place for them to go was the pool of people who under the current rules, not only did not qualify for a mortgage and would not receive credit from a bookie were they to ask. The new motto was "If they don't fit under the current set of rules, change the rules." So they did.

What they failed to realize was, the rules were there for a reason - they worked. We are now realizing that people who do not want to provide proof of what they do for a living, how they earn income, what that income actually is or where their down payment is coming from are not doing so out of some symbolic "privacy concern," but because what they are saying is quite frankly, bull.

Who has trouble "verifying income"? Crack dealers? Illegal immigrants working under the table and not paying taxes? Contractors who cheat on their taxes? If you want my money, prove you can pay it back or take a walk and let the next person in line step up, unless of course the line is small, the others are just like you and we really need to give you the money... thus the mortgage industry dilemma the past few years. As I have said more than a few times before, the surprise here is not that this happened, but that it did not happen sooner.

Where do we go from here? A slow decent to normalcy. That is all. Not a crash, not a recession, not a depression, just normal housing conditions with realistic lending guidelines. Bernanke will not allow a recession and to be quite honest, the overall economy is performing so well, it will resist it. We have record profits, record corporate cash levels, full employment and moderate sustainable growth.

This may end up actually benefiting stocks as all the money that chased real estate the past four to five years will now look to stocks for superior returns, since it will not be in real estate for a while. There are trillions out there looking for a home to grow in; what happens to the bottom 1% or 2% to the mortgage market will not really effect us, except to entice those trillions to look for a better home. The U.S. stock market welcomes you.

Do not let the doomsayers out there scare you, let them panic and keep your cool like Billy Ray Valentine... see the movie.