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The Banking Implosion
By Aaron Parker
I’m sure by now you all have noticed the ongoing meltdown in the mortgage industry. The cause of this whole mess is a little bit complicated, rooted in both the structure of the mortgage industry, and human nature. I’ll try to explain both factors here in layman’s terms.
How does the mortgage industry work?
Most of you have seen the ever present ads for mortgages, promising low payments, and low interest rates and no income checks required. Seems a little fishy and too good to be true, right? Well, for the most part it is. Let’s go through the whole loan process, from start to finish. In a perfect world, this is how it works.
First, a loan is originated. This is the part the consumer sees. You deal with a loan officer and a bank or broker who takes your application, and presents the loan programs available to you. You pick the program you want, and then your file is submitted to underwriting. The underwriter approves the loans subject to a list of conditions which you will work with the processor and the loan officer to meet. You need to get an appraisal, document your income and credit history, and perhaps show some assets. When all the conditions are met, you are allowed to close, and you either get the house of your dreams, or are able to refinance your previous mortgage.
This is as far as most people have ever seen, but it’s only the beginning of the fun.
Where did the bank get the money to lend you?
Most mortgage banks work with something called a warehouse line of credit. They actually borrow the money they lend you. Then, the bank will take your loan, lump it together with a bunch of other loans and sell it to investors. This is called securitization. Your mortgage has now become part of someone’s investment portfolio somewhere. The bank takes the money it got from selling your mortgage and pays back the warehouse line of credit, and ideally has something left over for profit. If a bank makes a $100,000 loan to you, it would like to turn around and sell it to investors for $103,000 or more. This is why banks like to charge higher rates, because an investor may decide that the $100,000 is worth $101,000 if it returns 6.5%, but is worth $105,000 if it returns 7%. The higher the rate they charge you, the more the bank can sell your loan for. There’s a lot more to it then this, but this is a good enough understanding for now.
How do investors decide how much to pay?
They analyze the risk of the loans and require higher returns for riskier loans. They know there will be defaults, but they will make up the difference on the loans that do perform at higher rates. If you have an 800 credit score and make a ton of money and have half a million in the bank, an investor will consider you very safe and not require a high rate of return. If you have a 510 credit score, can’t document your income and have a history of missing mortgage payments, how will a bank get someone to by your mortgage? Easy, they will charge you a rate so high that even though it is risky, someone will be willing to take the risk. That is called sub-prime lending. Most subprime loans started with fixed rates for the first 2 or 3 years, and then adjust upwards by 3 or more points. Payments can jump by hundreds of dollars.
I have read that the mortgage institutions Fannie Mae and Freddie Mac guarantee loan up to $417,000, so loans past that amount are deemed jumbo loans. The interest rates on these loans have risen dramatically affecting especially areas such as New York City. This issue has jumped interest rates for higher income households with good credit scores.
These factors create a recipe for recession since generally people who can't borrow don't buy or remodel and will even foreclose. A lot of foreclosures entering the market then depresses housing prices further exacerbating the situation.
I am not sure that there is any solution outside of federal interventions -- other than moving into teepees made from old clothing in someplace like Death Valley.
I actually think that the most likely forms of federal intervention will only serve to prolong the problem. Bailouts to borrowers won't solve the problem of people living in homes that they couldn't really afford, and bailouts to banks will only reward behavior that needs to not be encouraged. I think things are at the point where we really need to see some sort of shakeout to get back to a sustainable level.
The conforming loans that you mentioned (the under 417k, FANNIE MAEs are one the two areas of loans that are doing well. Rates on those have actually dropped since this whole mess started as the perception is that these are much safer then the others.
Another problem that the jumbo loans are currently having is the way they are bundled for resale. They have been mixing income verified loans with non-income verified loans when they are re-sold. Investors don't really know what they are getting. The rates on the income check jumbos will start to come down when they change the way the loans are bundled for resale. I have no idea where the stated income and no doc jumbos will end up.
I definitely agree that this mess will cause major downward pressure on home prices, particularly the over 500k segment of the market. The next 12-24 months will probably be a bloodbath for borrower's, but next year will be a great time to buy if you aren't currently a home owner. For the people that are in fixed rates that they can afford, I say just ride it out, as things will definitely stabilize eventually after things settle down.
I'm actually working with a borrower right now that had a loan disappear out from under them. They are a decent credit score, but what was originally going to be a no doc loan for under 7% has turned into a struggle to document every penny they earn so we can qualify for an expanded ratio income check loan.
And subprime has virtually disappeared. The only places still doing those are only doing fixed rates, and those are all above 10% interest if you have a below 600 credit score.
Things are going to over correct for a while. If you have any plans to buy a home or refi any time soon, be very aware of what's on your credit report, and take steps well in advance to position yourself as well as possible. The days of throwing money at anyone with a pulse are definitely gone.
AP
does this mean i'll be able to buy a cheap apartment next year? :-)
Where you live...? I doubt it. ;)
"With all my faith
And all my heart
And all those simple things you are"
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