Some Straight Talk On the Mortgage Mess

Even before this mortgage mess started, one person who kept emailing me over and over saying that this is going to get real bad. He kept saying this was beyond sub-prime, beyond low FICO scores, beyond Alt-A and beyond the imagination of most pundits, politicians and the press.

When I asked him why somebody from inside the industry would be so emphatically sounding the siren, he said, “Someobody’s got to warn people.”

Since then, I’ve kept up an active dialog with Mark Hanson, a 20-year veteran of the mortgage industry, who has spent most of his career in the wholesale and correspondent residential arena — primarily on the West Coast. He lives in the Bay Area. So far he has been pretty much on target as the situation has unfolded. I should point out that, based on his knowledge of the industry, he has been short a number of mortgage-related stocks.

His current thoughts, which I urge you to read:

The Government and the market are trying to boil this down to a ’sub-prime’ thing, especially with all constant talk of ‘resets’. But sub-prime loans were only a small piece of the mortgage mess. And sub-prime loans are not the only ones with resets. What we are experiencing should be called ‘The Mortgage Meltdown’ because many different exotic loan types are imploding currently belonging to what lenders considered ‘qualified’ or ‘prime’ borrowers. This will continue to worsen over the next few of years. When ‘prime’ loans begin to explode to a degree large enough to catch national attention, the ratings agencies will jump on board and we will have ‘Round 2′. It is not that far away.

Since 2003, when lending first started becoming extremely lax, a small percentage of the loans were true sub-prime fixed or arms. But sub-prime is what is being focused upon to draw attention away from the fact the lenders and Wall Street banks made all loans too easy to attain for everyone. They can explain away the reason sub-prime loans are imploding due to the weakness of the borrower.

How will they explain foreclosures in wealthy cities across the nation involving borrowers with 750 scores when their loan adjusts higher or terms change overnight because they reached their maximum negative potential on a neg-am Pay Option ARM for instance?

Sub-prime aren’t the only kind of loans imploding. Second mortgages, hybrid intermediate-term ARMS, and the soon-to-be infamous Pay Option ARM are also feeling substantial pressure. The latter three loan types mostly were considered ‘prime’ so they are being overlooked, but will haunt the financial markets for years to come. Versions of these loans were made available to sub-prime borrowers of course, but the vast majority were considered ‘prime’ or Alt-A. The caveat is that the differentiation between Prime and ALT-A got smaller and smaller over the years until finally in late 2005/2006 there was virtually no difference in program type or rate.

The bailout we are hearing about for sub-prime borrowers will be the first of many. Sub-prime only represents about 25% of the problem loans out there. What about the second mortgages sitting behind the sub-prime first, for instance? Most have seconds. Why aren’t they bailing those out too? Those rates have risen dramatically over the past few years as the Prime jumped from 4% to 8.25% recently. seconds are primarily based upon the prime rate. One can argue that many sub-prime first mortgages on their own were not a problem for the borrowers but the added burden of the second put on the property many times after-the-fact was too much for the borrower.

Most sub-prime loans in existence are refinances not purchase-money loans. This means that more than likely they pulled cash out of their home, bought things and are now going under. Perhaps the loan they hold now is their third or forth in the past couple years. Why are bad borrowers, who cannot stop going to the home-ATM getting bailed out?

The Government says they are going to use the credit score as one of the determining factors. But we have learned over the past year that credit scores are not a good predictor of future ability to repay. This is because over the past five years you could refi your way into a great score. Every time you were going broke and did not have money to pay bills, you pulled cash out of your home by refinancing your first mortgage or upping your second. You pay all your bills, buy some new clothes, take a vacation and your score goes up!

The ’second mortgage implosion’, ‘Pay-Option implosion’ and ‘Hybrid Intermediate-term ARM implosion’ are all happening simultaneously and about to heat up drastically. Second mortgage liens were done by nearly every large bank in the nation and really heated up in 2005, as first mortgage rates started rising and nobody could benefit from refinancing. This was a way to keep the mortgage money flowing. Second mortgages to 100% of the homes value with no income or asset documentation were among the best sellers at CITI (C), Wells (WFC), WAMU (WM), Chase (JPM), National City (NCC) and Countrywide (CFC). We now know these are worthless especially since values have indeed dropped and those who maxed out their liens with a 100% purchase or refi of a second now owe much more than their property is worth.

How are the banks going to get this junk second mortgage paper off their books? Moody’s is expecting a 15% default rate among ‘prime’ second mortgages. Just think the default rate in lower quality such as sub-prime. These assets will need to be sold for pennies on the dollar to free up capacity for new vintage paper or borrowers allowed to pay 50 cents on the dollar, for instance, to buy back their note.

The latter is probably where the ’second mortgage implosion’ will end up going. Why sell the loan for 10 cents on the dollar when you can get 25 to 50 cents from the borrower and lower their total outstanding liens on the property at the same time, getting them ‘right’ in the home again? Wells Fargo recently said they owned $84 billion of this worthless paper. That is a lot of seconds at an average of $100,000 a piece. Already, many lenders are locking up the second lines of credit and not allowing borrowers to pull the remaining open available credit to stop the bleeding. Second mortgages are defaulting at an amazing pace and it is picking up every month.

The ‘Pay-Option ARM implosion’ will carry on for a couple of years. In my opinion, this implosion will dwarf the ’sub-prime implosion’ because it cuts across all borrower types and all home values. Some of the most affluent areas in California contain the most Option ARMs due to the ability to buy a $1 million home with payments of a few thousand dollars per month. Wamu, Countrywide, Wachovia (WB), IndyMac (IMB), Downey (DSL) and Bear Stearns (BSC) were/are among the largest Option ARM lenders. Option ARMs are literally worthless with no bids found for many months for these assets. These assets are almost guaranteed to blow up. 75% of Option ARM borrowers make the minimum monthly payment. Eighty percent-plus are stated income/asset. Average combined loan-to-value are at or above 90%. The majority done in the past few years have second mortgages behind them.

The clue to who will blow up first is each lenders ‘max neg potential’ allowance, which differs. The higher the allowance, the longer until the borrower gets the letter saying ‘you have reached your 110%, 115%, 125% etc maximum negative of your original loans balance so you cannot accrue any more negative and must pay a minimum of the interest only (or fully indexed payment in some cases). This payment rate could be as much as three times greater. They cannot refinance, of course, because the programs do not exist any longer to any great degree, the borrowers cannot qualify for other more conventional financing or values have dropped too much.

Also, the vast majority have second mortgages behind them putting them in a seriously upside down position in their home. If the first mortgage is at 115%, the second mortgage in many cases is at 100% at the time of origination — and values have dropped 10%-15% in states like California — many home owners could be upside down 20% minimum. This is a prime example of why these loans remain ‘no bid’ and will never have a bid. These also will require a workout. The big difference between these and sub-prime loans is at least with sub-prime loans, outstanding principal balances do not grow at a rate of up to 7% per year. Not considering every Option ARM a sub-prime loan is a mistake.

The 3/1, 5/1, 7/1 and 10/1 hybrid interest-only ARMS will reset in droves beginning now. These are loans that are fixed at a low introductory interest only rate for three, five, seven or 10 years — then turn into a fully indexed payment rate that adjusts annually thereafter. They first got really popular in 2003. Wells Fargo led the pack in these but many people have them. The resets first began with the 3/1 last year.

The 5/1 was the most popular by far, so those start to reset heavily in 2008. These were considered ‘prime’ but Wells and many others would do 95%-100% to $1 million at a 620 score with nearly as low of a rate as if you had a 750 score. No income or asset versions of this loan were available at a negligible bump in fee. This does not sound too ‘prime’ to me. These loans were mostly Jumbo in higher priced states such as California.

Values are down and these are interest only loans, therefore, many are severely underwater even without negative-amortization on this loan type. They were qualified at a 50% debt-to-income ratio, leaving only 50% of a borrower’s income to pay taxes, all other bills and live their lives. These loans put the borrower in the grave the day they signed their loan docs especially without major appreciation. These loans will not perform as poorly overall as sub-prime, seconds or Option ARMs but they are a perfect example of what is still considered ‘prime’ that is at risk. Eighty-eight percent of Thornburg’s portfolio is this very loan type for example.

One final thought. How can any of this get repaired unless home values stabilize? And how will that happen? In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.

Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And, inventories are up 500%. So, in a nutshell we have 90% fewer qualified buyers for five-times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise or home prices have to fall 50%. None, except the last sound remotely possible.

What I am telling you is not speculation. I sold BILLIONs of these very loans over the past five years. I saw the borrowers we considered ‘prime’. I always wondered ‘what WILL happen when these things adjust is values don’t go up 10% per year’.

Now we’re finding out. If you made it all the way to the bottom, you can see why I decided to run this. Feel free to post comments on my blog. Mark will likely be personally responding to any comments there.

Comments

[Who Qualifies]

It seems that hardly anyone will qualify for a rate freeze:

I watched the presentation today and found it interesting that the plan details were not really discussed on camera. After everyone spoke in generalities, they seemed to take a break before going somewhere else for a technical discussion. It seems the details were buried.

After looking all over the place on the Internet, I found a link to the details of the plan here:

www.smartmoney.com/consumer/index.cfm?st...

Among the specific details are the 97% OR HIGHER LTV limit (no more than 3% equity) which didn't seem to be mentioned by anyone that I heard:

The much-talked-about five-year rate freeze, on the other hand, will be available to anyone who doesn't qualify for a refinance, particularly folks with low credit scores and little or no equity in their homes.

To qualify for a rate freeze, the loan-to-value ratio on your home must be 97% or higher, which means you must have no more than 3% equity in your home. (This is the loan-to-value ratio during the origination of the loan, so the recent decline in housing values doesn't come into play here.) Then, mortgage servicers will apply a newly-created FICO test. Basically, if your FICO score is 660 or below (scores range between 300 and 850), and it hasn't increased by at least 10% or more since your score at the time you took out the mortgage, you pass the test and qualify for a five-year freeze.

If your score is above 660, or has improved by 10% or more since loan origination, the servicer will look into your financial situation more closely to determine if you qualify. They might consider your income, current debt levels, and any other factors the servicer may deem necessary. This, of course, will take time since such cases will need to be reviewed individually.


What's even stranger is in this report that gives a great amount of detail of composition of the subprime market (as of December 2006):

www.responsiblelending.org/pdfs/foreclos...


On page 47 of the PDF file, Appendix 3 it shows for 1998 - 2004 how much of each type of subprime loan was made. So using the latest year, 2004 as the guide:

-Only 5% of subprime had an LTV greater than 97%.

So for the 5% who pass that hurdle, I would have to imagine these were not likely to be the under 660 FICO's.

But suppose they were just as likely to be.

Then:
-About 60% had a FICO less than 660.

So, we're down to about 3% who might qualify (5% x .6).

And then, 3/4 of those who were not fixed rate:
-About 75% were not fixed rate.

So we're down to about 2%.

Someone check my math on this, but it sounds like best case we're looking at 2% who qualify based on the info in this report. And maybe even less if you assume only the higher FICO's could get 97%+ LTV.

[H2O]

World of Fools - Told To Look-up - Look-Down.

You buy I sell - Just keep Covering my Shorts.

I told the world - I have a Interest rate cut
- Everybody ran out and bought - I covered my short.

I told the world - I have a 1/4 cut on Interest rate's
- Everybody ran out and bought - I covered my short.

That worked so good - I again told the world - I have a
1/4 cut on Interest rate's - Everybody ran out and bought
- I covered my short.

I then told the world - WE have worked it out - People can stay
and have a brain feeze on there Teeser-Interest rates -
Everybody ran out and bought - I covered my short.

Now what to do - what to do - after all I have too keep covering
my short's - Come one come all - My Elixir for all.

You buy I sell - Just keep Covering my Shorts.

[tkap]

Herb...........thanks for telling it like it is! I would add that this mess has been dropped on the doorstep of America, not by Wall Street, but rather by a handful of rating agencies in competition for transaction fees from Wall Street, these the same rating agencies that once upon a time relied upon investor clients for their revenue.

[thedoctor]

Comments stimulated by Herb Greenberg/Mark Hanson article and Sec. Paulson's WSJ 12/07/07 editorial section article:

Seems to me there are two basic problems underlying the mortgage mess. 1) people, such as mortgage brokers, who lied when filling out the related paperwork, and 2) a combined failure of good sense and prudent banking principles.

Herb Greenberg's inclusion of Mr. Mark Hanson's descriptions gives the best yet revelation of how the banking systems failed to use both good sense and prudent banking principles, and it is the first for me at revealing how borrowers who had good money and good value in their homes may not have used good sense in the amount of money they borrowed and / or may not have used good sense in how they used that money. E.g., if they took most of that money and spent it on vacation travel or bot expensive cars or invested in securities such as CFC or IMB, (and failed to sell them when these securities did their bonanza run up) they may suffer in making good on their mortgage loans. If they invested in PG or BA back in 2003 or 04, they can sell those at a profit and pay off those loans. For those who plowed the money into home remodelings and refurnishings, (as apparently happened on Long Island) and incurred greater property tax bills, it remains to be seen what will happen there. All this i've described relates to people who had a good financial position and availed themselves of the results of the FOMC's low interest rates for several years of the 2000's. (As i see it no one in good conscience can blame any of this on the FOMC as some talking heads have done on tv.)

My reading of Sec. of Treasury's WSJ article of Dec.7/07 is that certain subprime borrowers who have managed to continue their payments (I here assume this means payment of principle and interest, as in the good old fashioned fixed rate 30yr mortgages prior to ARM's being invented by the mortagage and banking industry.) in the period of time before the ARMs kick in are to be the ones who will benefit from efforts described as "The government is uniquely positioned to help avoid unnecessary defaults."

This makes sense to me as it appears to relate to enabling certain people to remain in "their" homes, continue to pay at a rate the mortgage industry sanctioned, and develop another batch of American home owners rather than increase the number of people living in "public housing." There is societal, indeed even conservative, value here. The mortgage and banking industry 'thunked' up these tactics and marketed them; they should bear most of the 'costs;' I as i read it Sec. Paulson's article mainly doesn't relate to most of the costs.

This should be able to be done with out the U.S. Treasury bailing out Freddie Mac or FNMA.
Best wishes to all, Dr. L.K.Richards, m.d., d.l.f.a.p.a.