Housing Hot Potato, Part II

The “game” of “housing hot potato” that I presented last week was the first installment of my attempt to show that there is more risk to the mortgage and real estate market than people think. Just as no one thought there was a problem in the equity markets when stock prices were doubling every 9 months, much of the risk of the mortgage and real estate market has been hidden because of rising real estate prices.

In Housing Hot Potato, Part 1, I detailed the early stages of risk “accumulation” via massive amounts of leverage and poor underwriting. The amount of leverage for the buyer is unlimited, since they put zero down. These relaxed underwriting standards have allowed for riskier behavior by the average homebuyer over the last decade.

In Housing Hot Potato Part II, I’ll further expose lax lending standards and I’ll attempt to get a handle on the real risks involved in this unfortunate “game.”

The Lender, Part II: “Great New Programs”

I ended Housing Hot Potato Part 1 without a good description of the lender’s motivation. Many readers were probably left wondering why lenders would allow themselves to be caught holding a “hot potato” that could easily get them burned. I suggested part of the problem stemmed from automated underwriting, often influenced by the threat of losing market share. Let’s take a look at how these lenders operate:

A representative from Lender ABC contacts Broker Bob to inquire as to why his company hasn’t seen many deals lately. Bob replies that their underwriting isn’t flexible enough (rejected loans = $0 commission), and that Lender XYZ has better programs (i.e. loans that require no or limited verification of income and/or assets). Additionally, Bob continues, XYZ is more lenient on loan-to-value (LTV) ratios. The rep then goes back to management at ABC to complain that, horror of horrors, losing business to XYZ. Then, amid great fanfare, ABC announces some “great new programs” the following week.

Most responsible mortgage brokers have kept a file of these “great new programs” as a memento of the insanity of this period. The following are real-world examples, with names of lenders left out to protect the guilty. Initially, I was skeptical as to how genuine these faxes were. Were they just baiting to lure in new customers? Late night TV teasers loaded with fine print? But as I researched, I found that these offers are from reputable lenders. (One is even listed on the NYSE.) This is exactly how the faxes came, no editing. And so, with that, I present the top three award winners from my “If you can fog a mirror, you can own a home” list:

Great New Programs!

Think about what this is saying!!! – “Stated Income Program” = Make up income

BK = Bankruptcy!

Only delaying the PAIN!

Drunk at the Punchbowl

We have just gone through the largest refinancing the world has ever known. Mortgage brokers are drunk at the punchbowl from all the easy money they made refinancing existing customers. As the refinancings are slowing down, a record number of mortgage brokers are entering the business. You can expect that the fight for future business will be fierce. If little or no income documentation is needed now, think of what this race to the bottom is going to look like as volumes dry up and lenders exert pressure to do more deals.

The Deal, Part II: Grade A

In Housing Hot Potato Part 1, I outlined the anatomy of a typical marginal, subprime deal. But now let’s focus on a Grade A-1 lender, who originates and/or funds residential mortgage loans for the best applicants (loans eligible for Fannie and Freddie financing).

Fannie Mae started with the best of intentions. Until Fannie became the buyer of last resort, the mortgage market was regional. For example, let’s say a bank in Florida has a million dollars of deposits to loan out after accounting for its reserve requirement. Housing in Florida gets hot. It lends out the million dollars but there is still demand for additional home loans. The bank has to turn away potential home buyers; there is no more money to lend out. At the same time, you have a bank in Washington State with the same amount of deposits but only using half of them. The bank in Washington has two choices. It can lend money overnight to other banks, or buy U.S. Treasuries. The bank in Florida needs to tap into more credit, so Fannie Mae becomes the intermediary.

After originating loans, the bank in Florida sells the loans to Fannie Mae. The bank in Florida now has money to lend again. In this way, there is no relationship between mortgage lending and a deposit base. Demand can be filled no matter what. The local banks that originally were in the underwriting business are now basically brokers, not originators, though they might keep some of the higher-quality adjustable-rate loans for themselves.

Fannie Mae has established certain standards that allow any owner occupied mortgage to be financed if certain criteria are met. As the call from Washington (not the state) for more people to qualify for the “American Dream” has gotten louder, it is not surprising that Fannie Mae/ Freddie Mac have been concentrating on growth and lowering their lending standards.

Soft Standards = Grade Inflation

As I mentioned above, underwriting standards have softened over the years. Lenders are more willing to approve loans that just a few years ago would have been deemed unsatisfactory. For example, ten years ago the “standard” guidelines for ratios were 25% and 33%. That meant that no more than 25% of one’s gross income should be used for the entire mortgage payment (principal, interest, monthly property taxes, homeowners insurance and, if applicable, private mortgage insurance); and that all other debts in addition to the mortgage payment, such as car loans, credit cards, etc., should be no more than 33% of one’s gross income.

Today, it is not uncommon for borrowers to be approved with ratios of 40% to 50%, even with little or no downpayment. Although the statistical modeling employed by Fannie/ Freddie may “prove” that such a loan is less risky, the problem is that none of these models has ever been tested during a bear market in housing.

The shift in underwriting standards and guidelines has created a serious case of grade inflation. Borrowers who previously would have been categorized as an “A-” are now considered straight “A”; those who were “B” are now “A-”, and so on. As Fannie and Freddie continue their tenure as the Easy Professor, all the while gobbling up subprime loans at a healthy pace (one of their highest percentage growth segments), what is left for the remaining true subprime lenders?

Real Risks

The sad truth is that most of these lenders don’t use standard risk analysis in their decision-making process. Just as the bull market in equities masked all kinds of irregularities (accounting fraud, deceptive practices, etc.) rising home prices have camouflaged unsound lending practices. Most lenders will candidly admit that they are really counting on two “facts”: (1) home prices rise, and (2) even in tough times, people fight pretty hard to make their mortgage payments.

Residential mortgage lenders, both conforming (Fannie and Freddie) and subprime, have been in the process of a transformation. Automated underwriting systems have drastically changed the way risk is analyzed. In a sense, human underwriting has become a lost art. When challenged on their new, more relaxed underwriting standards, industry experts counter by showing how sophisticated statistical modeling and regression analysis enable mortgage entities to more accurately forecast future rates of default. They can predict, for instance, that if a borrower has perfect credit, he is very likely to repay the loan in a timely manner, even if his ratio of debt to income is higher than the historical norm.

Systemic risk?

Although the subprime market is small, around 10% of the mortgage market, the abuses within this market are greater than most real estate professionals realize. Most of these loans are fixed for an initial time period, and then move to adjustable rate mortgages. (Remember the terms of the 1^st mortgage for home buyers in Hot Potato 1- 6.25% fixed for two years. At the end of two years the mortgage changes to floating plus 7.0%.) There is significant default risk even if “benchmark” interest rates stay nice and low, especially if the deal has been 100% financed. If the real estate market flattens or declines, what stops the borrower from putting the keys in an envelope and walking away (remember the term “jingle mail”)? He has no incentive to continue making monthly payments since he didn’t put anything into the purchase originally. This risk is compounded by more and more good paying manufacturing and service jobs being exported to Asia. And even though lenders in the subprime market will initially look very profitable as the carry between their borrowing cost and mortgage portfolio widens, they’re playing a high-stakes game.

Fannie and Freddie have also upped their default risks due in part to the increased riskiness of their borrowers. But they are also likely to run into trouble when it comes to managing their loan portfolio.

Fannie/Freddie make money by holding mortgage portfolios and financing them by issuing agency securities. The agency securities they issue yield less than their mortgage portfolio, allowing them to enjoy a positive carry. Lever up this positive carry and, voila, they show earnings growth at a 15% compound annual rate that Wall Street has come to expect. In this way, Fannie / Freddie are like giant hedge funds using massive amounts of leverage to increase the effect of their positive carry from the mortgage portfolio.

But the duration of Fannie / Freddie’s mortgage portfolio is not equal to the bonds they have issued. Hedging the amount of 30-year paper they own is not easy. As if this weren’t hard enough, Fannie / Freddie also face prepayment risk when the borrower retires or refinances the loan early. Hedging out these duration differences can be costly. The fact that even some of the smartest people on Wall Street (including the employees of these two quasi-government companies) can’t understand their financial statements makes Fannie and Freddie disasters waiting to happen. And they won’t be the only ones hurt.

Next up: HHP Part III: the secondary mortgage market…