Crazy Mortgages Are Back; Just 3% Down - Bezek's Daily Briefing

by: Ian Bezek


Wells Fargo has rolled out a 3% downpayment mortgage for people with FICO scores as low as 620.

It's part of a broader trend toward lower quality loans.

I remain unwilling to invest in large US banks.

Thoughts on the housing market.

Thursday was a mixed day for the markets. The Dow (NYSEARCA:DIA) and S&P 500 (NYSEARCA:SPY) closed slightly lower, while gains in the tech stocks allowed the Nasdaq (NASDAQ:QQQ) to finish in the green.

Tech and utilities (NYSEARCA:XLU) were the market's strong spots on the day, while the big financials (NYSEARCA:XLF) lagged badly. Energy stocks also suffered a setback, as oil (NYSEARCA:USO) attempted to breach $50 but fell back rather firmly.

Overall, it's been a quiet week for the market; even on the flattish days such as Thursday, volatility (NYSEARCA:VXX) (NYSEARCA:UVXY) keeps dropping. Volatility is likely to spike again at some point fairly soon, but as always, be cautious if you're thinking about going long VXX in a dull market. It can drop a lot farther than we'd expect before reversing:

VXX Chart

VXX data by YCharts

Housing Market Getting Frothy Again?

I was slightly alarmed to see the following headline on Thursday:

Click to enlarge

Housing Wire quoted from a Wells Fargo (NYSE:WFC) employee who stated that:

"With your First Mortgage, we wanted to provide access to credit and simplify the experience while maintaining responsible lending practices. We partnered with credit experts such as Fannie Mae and Self-Help, an affiliate of the Center for Responsible Lending, to develop an easy-to-understand affordable loan option that gives homebuyers the best offering in the market," said Brad Blackwell, executive vice president with Wells Fargo Home Lending.

Given what happened to Fannie Mae (OTCQB:FNMA) during the financial crisis, relying on its "expert" knowledge may not actually be that wise.

In any case, the Wells Fargo executive said that these new 3% down payment loans wouldn't be just a niche product, but rather "the best mortgage for most first-time home buyers."

There are several things we can take away from this development, and most of it isn't good. These first-time buyers that Wells Fargo is targeting with its 3% down payments are already significantly in debt - often from student loans. In my view, the last thing they need is a 30 to 1 leveraged bet on housing prices.

Regardless, the era of more responsible home lending is closing, and we're apparently heading back to lend to just about anyone with a pulse environment that dominated prior to 2008.

The combination of stagnant personal incomes and slow economic growth mean that people need to borrow more if they want to increase their personal consumption. Banks, sitting on too much excess capital, are eager to encourage that further consumption, and so you're going to see more and more such efforts to get people to commit to more debt as the memory of 2008 fades.

While this development is regrettable - 97% loans to relatively low credit score borrowers is just begging for trouble - the bigger issue is who is making these loans. Sure, some of the least reputable of America's banks - Bank of America (NYSE:BAC) for example - were already making 3% down payment loans. I already expect them to blow up whenever there's a financial crisis, so it's hardly noteworthy that they're making lousy loans again.

But even Bank of America is requiring 660 FICO scores; Wells Fargo - the formerly responsible adult in the big bank room - is racing to the bottom with this low down payment loans to 620 FICO scores program.

The US housing market is fairly strong again. The Case-Shiller 20-city composite index has shown steady increases since the low:

So neither banks nor borrowers are likely to run into trouble on these unsound new loans just yet. But make no mistake, the seeds of the next financial crisis are being planted; the longer rates remain low, the more likely that some sort of bubble and subsequent pop will ensue.

It had been hoped that low interest rates would subsidize judicious usage of capital to help the economy recover. Instead, we're back to the same games the banks were playing a decade ago.

Unfortunately, even more conservative lenders such as Wells Fargo now feel compelled to lead the race to the bottom. Given Wells has also found itself with unseemly exposure to bad energy loans, it's worth asking if their risk management department has undergone significant changes for the worse since 2008.

In any case, large US financial institutions remain uninvestable. Yes, Wells might look cheap on paper, but when your book value will consist of mortgages that only have 3% equity, you can hardly trust in the safety of the whole structure. There's one plus. The banks have gotten better at foreclosing and short selling houses; skills they'll again get to deploy frequently as they make a fresh round of terrible mortgage loans.

If you want to buy into the financials - and you probably should, they benefit from higher rates - still avoid the money center banks. I'm buying community banks; the ones run by people responsible enough to know that loaning 97% of the value of a house to a low credit score buyer is an absurd practice.

Taking a look at the housing market, things have been quite strong. The headlines say that housing is now "hot" again despite admitting that little else - wages, retail sales, and so on - would seem to support that enthusiasm. Regardless, new home sales are back to 2008 levels.

I don't see any signs that things are immediately about to turn down for housing, though the homebuilder stocks have started to struggle after a strong run in recent quarters. Until the economy tips closer to recession or the Fed hikes several more times, housing strength will probably continue. Due to the relatively unsophisticated nature of many home buyers, rising prices tend to cause prices to further rise; momentum plays a strong role in the market.

So, be cautious if you're considering the large US banks - they're back to their old games. And the housing market is setting itself up for another tumble. But none of this needs to play out of 2016. Avoid the loud voices calling for immediate crisis; the US economy is still resilient, and the housing market isn't going to slide sharply yet.

Disclosure: I am/we are short UVXY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.