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The Banking ImplosionI’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.…
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The Banking Implosion
By Aaron Parker
So what broke down?
Simply put, things went too far. Borrowers wanted more cash out or bigger homes, so they took out loans they would not be able to afford later. Banks kept writing these loans because they are very profitable and they pushed the risk off onto the investors who bought the loans. This was an unsustainable cycle.
Here’s a typical story. A gentleman named Charlie I recently talked to told me that he had been living in his home for about 20 years. Two years ago, he ran into some financial hardship and decided to take out a mortgage to pay for all his unexpected medical bills. His broker put him into a subprime mortgage, explaining that since he needed to borrow 95% of the value of his home, subprime would be best. I don’t know if that was true or not, since I didn’t see his credit and income two years ago, but it really doesn’t matter for this story. In order to get the value he needed, the broker pressured the appraiser to inflate the value. Instead of the home being valued at $170,000, the value was inflated to $190,000. This allowed Charlie to take out a mortgage for $180,500, or 95% Loan to Value (LTV). He knew he was borrowing more than his home was worth, but he figured that in 2 years, his home would be worth enough to refinance again. On top of that, he took an interest only mortgage to keep his payment lower. The initial interest rate was 7.5%, which gave him a monthly payment of about $1,128. Sounds good, right? Not so fast. Housing prices in Charlie’s area stagnated, so his home is not really worth any more now then it was two years ago. On top of that, the 2/28 adjustable rate mortgage he took out recently jumped 3 full points in rate, and the interest only period ended. Now, Charlie is stuck in a mortgage where the payment jumped from $1128, all the way up to almost $1,700. What can he do now? He can’t refinance because he owes more than his home is worth. He is quickly going through his saving because he can’t afford the mortgage payments. How long before he loses his home? This story is much more common then most people realize.
Notice the jump in the foreclosure rate?
This is what happens when people are in mortgages they can’t afford and which they should probably not have been offered in the first place.
Investors of course noticed this, and decided that the subprime market was a bit too risky for them and won’t buy those mortgages anymore. A lot of banks were stuck with the loans they made, owing the warehouse money, unable to sell the loans they made for even face value. That $100,000 loan from a few paragraphs ago is now only worth $85,000 to the investor. The bank has now LOST $15,000 on the loan. Multiply this by several hundred loans, and now we are short one bankrupt mortgage bank. Now, the warehouse lender takes a hit, and gets more conservative. They may refuse to lend to other subprime lenders to avoid taking more losses. This is part of the liquidity issue we are hearing about, and has caused a number of lenders to shut down. If a subprime lender can’t borrow the money from a warehouse line, they can’t lend it to you. I’ve actually seen a couple of loans be declined in the last 2 weeks because of this issue. Major lenders like New Century, Fremont, BNC, American Home Mortgage and many others have now stopped originating new loans.
What happens to the investors that own the defaulting mortgages?
We are already starting to see an increase in hedge funds collapsing. Additionally, a large percentage of subprime mortgages have been repackaged and sold to investors, including American, Chinese and Europeans. With some fancy financial footwork, B grade securities were repackaged, bundled and sold as A grade paper. Someone will be left holding the bag, but I’m not sure who quite yet. There are billions yet to be lost, maybe hundreds of billions.
What is the net effect of this?
Investors are running away from risky loans and rushing to safer ones. Subprime loans are almost non-existent now, and rates have shot up on jumbo and Alt-A loans, which are for good credit people who can’t document their income. Meanwhile, rates on the least risky loans, the so called prime or conventional loans, are dropping. These are the loans made to people with good credit, who can document their income to qualify, and are borrowing less than 80% of the value of their homes. Investors are rushing to safety. The other sector of the mortgage industry that is doing well is the FHA sector. These loans are insured by the Federal Housing Authority (FHA) and are considered safer. FHA is replacing subprime, since the loans are not dependent on credit score, but on documentable income and payment history. I’ve seen borrowers with credit scores well below 500 get mortgages that are 30 year fixed rates and below 7% interest. And these are the rule, not the exception.
What can the consumer do?
I haven’t gone into specifics here and I’ve glossed over a lot of details. There are many more loan programs that are risky that I haven’t covered. There are intricacies I felt would just bore most readers, and I wanted to keep this short and readable.
If you are in an adjustable rate, I urge you to look into getting into a fixed rate now. I really don’t know where things will be a year from now, and if housing prices continue to drop, next year may be too late to refinance. If you have any questions, please email me at MortgageGuide@yahoo.com. I will gladly answer any questions you may have and point you in the right direction to get yourself on a better financial footing going forward. Be proactive. Don’t wait until you are drowning to look for the shore.
If you want to keep up on what is going on inside the mortgage industry, check out www.ML-implode.com. They post news articles every day related to the ongoing mortgage industry trouble, and they even have their implode-o-meter counting the number of subprime lenders that have gone out of business. Dark humor, sure, but very informative.
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"
I think Well, you have a poor history, so you are a geaetrr risk. If your credit score is low anyway, consider negotiating to get the loans paid off at a lower rate. One way to do this is to stop paying the loans, but save as much money as you can. Then, have cash ready to negotiate a deal, say for 60% of what you owe, with the most aggressive creditor. There are companies that will do this for you, but they charge large fees.Another thing I'd suggest is take a look at this non-profit site:Although they are an approved bankruptcy education organization, you do not have to be bankrupt to use their FREE services. Start by using their first survey, with an anonymous name. Then, a report will give you ALL of your alternatives, with the pros and cons of each alternative.Borrowing money to pay off these loans will only prolong the problem. I would think it would be better to solve the problem now. You can get a forced consolidation loan from consumer credit counseling service, but the creditors will not waive interest and this non-profit organization is sponsered BY credit card companies and credit reporting agencies.
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