The last 60 days have seen the defining financial crisis of our generation (even the last 12 hours). Decades from now, the mortgage meltdown will be as clearly defined as the dot com bubble of the 90’s or the S&L collapse of the 80’s. We all knew something was coming because the loans were getting too risky on the subprime side. But few people are on record as saying they knew it would happen with such breathtaking speed, or cut as deeply as it has into the A-paper side and beyond.
The DJIA lost almost 390 points today on credit jitters. After the markets closed this afternoon, Countrywide, the largest lender in the nation disclosed to the SEC that they were experiencing “unprecedented disruptions…and the impact on the company is unknown.” Apartment and condominium builder Tarragon raised doubts about its ability to remain in business citing an inability to raise new financing. Renaissance Technologies Corp., a hedge-fund company with one of the best records recently, told investors that a key fund has lost 8.7% so far in August Highbridge Capital Management is down 18% in 8 days.
So what now? After the storm passes, who will still be able to get a mortgage? What will agents and builders need to know to conduct business? How should consumers prepare? Just as importantly, what do we all need to do right this moment?
Most economists agree that 75 years ago, access to decent mortgage terms for the first time in history helped lift America out of a hopeless depression. FHA helped heal the catastrophic failure of the banking system and was the envy of the western world. Nothing creates jobs like the construction of even one house. In the intervening years, we watched the conventional side of lending further the cause and make it easier and easier to qualify for a mortgage. Less money down. Creative ways of calculating that keep payments low. More creative guidelines to accept self-employed borrowers. Of course there were some ups and downs over the decades, but they were usually caused by high interest rates.
Overwhelmingly, the general trend has been that Americans have made it easier and easier to help fellow Americans buy a home. It is called market liquidity. Our mortgage company lends you money to buy a house, then we replace the dollars we gave out by finding someone who will buy the loan we made. That way we can do it again tomorrow. The people who buy our loan get their money from people who believe the loans will perform, and they hold them as investments.
As long as people believed the loans would perform, then the velocity of dollars from us to you to them was stunning. And we have applauded this power as it has propped us up through terrorist attacks, through a stock market bloodbath, through a war in Iraq, through vicious oil prices and through the uncertainty of a globalizing economy. But the ones we applauded even as recently as last year have either stepped out of the market or collapsed altogether. To date, 51 major mortgage lenders have filed Chapter 11. Most of them were subprime, so many of us did not lament the loss. Maybe we should have. But the more than 7,000 people at American Home Mortgage were doing A-paper – yes, the part of the market that was once the fillet of the steer. Granted, it was the section of the A-paper market called Enhanced Alternatives that was most devastatingly affected by this loss, but don’t be fooled.
Our company had a borrower last quarter who bought a $1.7 million home, had $3 million in the bank, was putting 25% down, and had a credit score of 780. The only problem was, after selling his company a few years ago, he has been working on a start-up company and had no income. The only place for him was…you guessed it, a stated income verified asset program in the Enhanced Alternative world. This month, that same borrower would not have gotten a mortgage at an affordable rate – or maybe not gotten a loan at all.
This will all get a lot worse before it gets better. Things are happening on the front lines that the Wall Street Journal is not talking about yet. Here is an example from yesterday: a couple was selling a $550k house. They found a young doctor who wanted to buy it. This couple was then going to take the proceeds and buy a $900k house somewhere else. The builder who was selling them this great new house asked us to help him redo his own mortgage on his own condo once he got the money from the sale. On Friday of last week, most of the lenders dramatically increased the rates on jumbo loans, and they dramatically restricted the underwriting programs. Now the young doctor can’t get a decent loan even though she was going to put 20% down. So my client can’t sell his house. So my client can’t buy the new house. So the builder can’t refinance his condo. Three mortgages evaporated in a matter of minutes. Real Estate agents lost commissions and all of the work they had invested. Appraisers might not be paid. Title searchers have to throw away the abstracts they searched and eat the cost. The builder takes longer to pay those last few invoices to finish the house.
But there is more. Now both houses are sitting on the market longer with even fewer buyers. The price drops. Time passes. Since appraisers are only allowed to use comparable sales from the last 6 months, other houses that I don’t even know about yet will not appraise for enough money, so the loans will fall through on them in a few months. Several more loans will evaporate.
It is not an exaggeration to say that there are hundreds of people that will experience negative financial impact from the scenario above. Tens of thousands of people will lose their jobs in the mortgage industry in the coming months. Mom and Pop shops, regional lenders and large lenders will go under. These companies have been spending lots of money with web design firms, printers, advertisers and countless other vendors. It really is not over. At this moment, the bond market is still okay. Rates on the good ole 30 year fixed should be holding fine. But you had better be squeaky clean, because if not, your rate will be prohibitively high even if you can find a loan program.
So who exactly will be hurt?
1. Self employed borrowers.
Self employed borrowers have an alternate universe of navigating the tax code. Their income looks nebulous on a tax return and they have no traditional pay stubs to provide. They are real estate agents, some attorneys, some emergency room doctors, contractors, hair stylists, truck drivers and entrepreneurs. A lot of the people you know are technically self-employed. Ten years ago, if you made 10 or 12 bucks an hour at a mill and you had been there a month, you would find it easier to get a loan than the real estate agent who made $100k in commission this year, but does not have 2 years’ worth of a track record to prove. Part of the ‘easing of guidelines’ that people scoff at with such venom these days made it easier for these self-employed folks to get a great mortgage. Considering that our economy is quite literally transforming into an entrepreneurial economy as we speak, making it tough on self employed people to borrow efficiently is like lopping the head off the golden goose.
This week, we heard the death rattle of the Enhanced Alternative market. Some of it needed to go. But some of it will be sorely missed. For therein we could find the much maligned ‘stated loan’ programs. Some were SISA (stated income, stated asset) and some were SIVA (stated income, verified asset). The example above was a SIVA. The guy had no provable income, so we ‘stated’ it at a reasonable level, but we verified all of his assets by gathering 2 months’ worth of bank statements. The stated part simply means that it is clear in the file to an underwriter that, because the credit score is high, because the debt load is low, or because the property itself will have great equity, that it is a smart loan to make.
2. Anyone needing 100% financing.
Anyone wanting to finance the whole purchase price is going to have a rough road. At the very least, it will be very expensive. In past years, we did 97% loans through FHA. The borrower needed 3% down plus closing costs (which in an FHA transaction are not cheap). This government program is still around and still hanging in there. But the mortgage insurance is expensive and makes the payment high. New laws allow people to deduct the mortgage insurance portion of the payment from their Federal income tax, but the biggest fans of the FHA world still are usually the ones who are selling them. Don’t get me wrong, I am glad they are there. But in recent years, there really have been better ways to accomplish the same goal. We called them piggy back loan structures: 80/20’s, 75/25’s. Do two mortgages and avoid PMI. But now comes the next bad news. Most lenders, certainly most investors, are avoiding second mortgages as if they had Dengue Fever. A few are left, but only those banks whose insurance premiums have not shot sky high (they will!) on the book of business.
Because the wave of delinquencies and foreclosure have an inherent lag time, this piece of the market had not yet fallen too far. Six months are likely to change all of that. First Horizon Home Loans (First Tennessee Bank) just stepped out of doing second mortgages in the 100% market altogether in the last few days. Can you blame them for a preemptive move?
3. Anyone wanting a loan on a condo or single family home above $417,000.
Fannie Mae and Freddie Mac announce each year the maximum loan size that they will consider a ‘conforming’ loan (meaning a loan that conforms to their core guidelines and one that is predictably liquid). For a single family this year it is $417,000. Above that and you are called a jumbo loan or a super jumbo loan. In the last 4 business days, those loans are either gone completely, priced really high (jumping from 6.5% to 7.875% in one afternoon, for example), or the underwriting has gotten prohibitively restrictive. In middle Tennessee, the part of the housing market that needs jumbo loans to survive has cooled considerably. In some areas nationwide, it is more than cold, it is absolute zero. This liquidity constriction will prove nothing short of catastrophic for some builders and for some consumers.
4. Anyone who has a subprime loan with a prepayment penalty.
The sub prime lenders have become the whipping post for this whole crisis. But let’s not forget that they helped thousands of people become home owners, or fix their credit by consolidating debt, or avoid some financial crisis. Many of them are great borrowers and have been paying faithfully on their loans for the last few years. Most of the loans were called 2/28’s or 3/27’s or 5/25’s. This is the subprime lingo for what the conforming side calls a 2 year ARM, 3 year ARM, or 5 year ARM. The differences are huge in two ways. First, the subprime side often has a prepayment penalty that is coterminous with the initial fixed rate period. So a 2/28 is fixed for 2 years and has a 2 year prepayment penalty, and so on. Second, the margins on them are enormous, so when they do adjust, they go nuts. In other words, when a conforming ARM adjusts, it will look at the index and add a margin of 2% or 3% to come up with the new rate. When a sub prime ARM adjusts, it will look at the index and add a margin of 5% or 7%. The bad news is that by the time these loans are ready to adjust in the coming years, the borrowers may not find a loan program left that will serve them, and the rates may not be worth having anyway. They are subsequently stuck with an exploding rate every 6 months.
What should consumers do?
1. Get out of your conforming ARM now. Don’t wait.
If you are one of the legions of people with an adjustable rate mortgage, even if you have some time before it adjusts, refinance it now. Don’t wait 2 days, or until you have time to sit down and make the call. Loan programs are disappearing faster than you can make the decision. At Finworth Mortgage, we are proactively running scenarios on millions of dollars in loans. We believe that some of them will not be able to refinance with the changes of the last few days. We anticipate more changes in the coming days, and we don’t want more people left in the cold. It may mean that you go to a higher rate, but at least it will be fixed and it will be cheaper than getting stuck when your ARM adjusts and there is no loan to refinance to in a year.
2. Evaluate your subprime ARM to see what you should do. Don’t wait.
If you have a subprime ARM (like a 2/28 or 3/27) and the prepayment penalty will expire in the next 3 or 4 months, start preparing now so you can close on your new refinance the day it expires. Make sure your credit is in good shape. Gather your documents. Call your mortgage company or bank and get things rolling now. If you are in a subprime loan where the prepayment penalty will not expire for a year or more, consider refinancing it to a conforming loan today. The pain of paying the penalty may well be less than the pain of trying to refinance to whatever the rates might be, even if the loan programs are still there, in 1 or 2 years.
3. If you are in the middle of a mortgage, nail it down quickly.
Send your documents in quickly. Demand from your mortgage company to see a copy of your rate lock confirmation. Ask to see a copy of the loan commitment if they say they are ready to close. Stay in touch with your agent, with the title company, and with your lender. Don’t be afraid to pull up your tent pegs and go to another lender if you are not getting clear answers from them today. Some lenders may only have a few wholesale outlets. If their lending sources happen to be the ones that have shut off many programs, you may have to leave them to get what you want somewhere else.
What should a real estate agent do?
1. Learn the landscape and commit to re-learning it every few weeks until things settle.
The new landscape of lending will not be established for a few months. There will be a lot of misinformation and a lot of confusing signals. One certainty is that everything we have known has changed. That great symphony of effort between the mortgage folks and the real estate agent will need to be adjusted and relearned together. The 80/20 and the 75/25? Probably gone for all but the really solid borrowers. The 100% programs with PMI? Probably very expensive so your borrowers will not be able to buy nearly as much house as before. The FHA alternative from yesteryear? Some say it is back in vogue, but be very careful. Appraisal standards are restrictive and in some cases right down irrational. It will transform your inspection process into a much tougher ordeal. It will extend the length of time you will need to get the deal done. As all the folks who once went subprime flock to the FHA universe, the government wheel will grind even more slowly than it already does. Check to make sure your favorite appraiser is even certified to do FHA inspections; many of them are not. More importantly, check the maximum allowable loan amount in the county where the property is located. A lot of times, FHA won’t even do it. The rules are changing quickly and your team will need to change along with it.
2. Learn about some alternatives.
Adding seller concessions in a transaction may not work if the comparables are not there for the appraisal. Instead, ask you lender about gift equity for transactions that are not at an arm’s length. Offer information to your customers about gift money from friends and family. Get your lender involved earlier in the process so if credit scores need to be improved, there will be enough time. A 30 point variance in the score might be the difference in success and failure. The margin for error is shrinking.
3. If you are representing a seller, get serious about the buyers’ financing.
Some associations of Realtors are starting to move towards requiring that a potential buyer has their credit pulled and loan approval in place before they even view the property. In a soft and getting softer market, it is unlikely that sellers will want to scare off buyers in that way. However, once the contract is in place, don’t be afraid to get some documents from the buyer that have some teeth. Don’t accept a Loan Approval Letter. They are now worth less than the paper on which they are printed. Take the advice of the TAR and get a full blown Commitment Letter that is signed. Read it and ask questions. Get serious about appraisal and inspection contingencies. Last year in Tennessee for example, it was not that big of a concession for a seller to make. Of course the house would appraise for at least the purchase price! Not so anymore. If you have a contract that is set to close in the next 90 days, get serious about following up with everyone on the other side. After last week, the buyer may not even know that they do not have a loan. Some of the smart builders have been calling us in the last few days to make certain all the buyers that are closing in the next 4 months have a solid mortgage.
What should a financial planner or wealth management group do?
1. An understanding of the changes in the market is critical.
Your clients are watching the news. Some of them might call you about their mortgage to seek advice, but most may not. They might call a friend or their bank branch. Don’t forget that the average tenure of the loan officer at the local bank branch would shock you. What they do not know right now really can hurt them. This is a time for strategic thinking, for taking a consultative or diagnostic approach. This is a time they need you. If they have an ARM, they need to be in action. If they have a second mortgage with a significant balance, and that second mortgage has a variable rate, they need to contemplate consolidating them to a fixed rate. At the very least, an evaluation is in order. If they are contemplating a purchase, they need a realistic picture that is updated with the news of the last few weeks.
2. A refinance in the next 30 days might avert a crisis down the road.
If monthly payments and cash flow are major issues to clients, stay away from ARM’s until we know where the market it headed. Until then, in these circumstances, run scenarios on products like the 30 year fixed with a 10 or 15 year interest only period. Make sure of course that borrowers understand the consequences of this type of mortgage. Overall, a defensive and a conservative posture is critical. Even clients who are not risk averse should be hunkering down.
Six months ago, it was fair to say that nearly all the banks and all of the mortgage companies were similar in pricing. After all, we all got our money from the same place whether we were Bank of America or Bob’s Mortgage down the street. The only thing that really defined any of us was our level of knowledge, our ability to interact honorably with a client, and our track record of delivering what we promise on time. That is changing. Now, there may be wide variances from bank to bank and lender to lender. After some months, it will settle. But the value of real experience in this dramatic time has skyrocketed.
The fringe of the market is gone, and all of us will feel some pain because of it. But the core is likely to remain intact. For at least the next few years, tell everyone you know to lock in some cheap mortgage money while they still can. Anyone who sits on the fence in the next 30 days will not have a good story to tell at the water cooler this fall.
