Current State of Mortgage Financing...What's Going On?

Anyone watching or reading the financial news over the last few weeks has seen a lot of angst and consternation over the state of the mortgage industry. In fact, one of the larger lenders in the US, American Home Mortgage, was forced to shut down operations recently. But why? What is happening, what does all this mean to you and most importantly... what should you be doing do right now to make sure you are protected?

Here's the scoop.

Over the past several years, many loans were made to homeowners with somewhat non-traditional or "non-conforming" situations, be it a poor credit history, inability to document income, or any number of factors that do not fit within the traditional "box" for home loans. These loans are often called "Sub-Prime", or "Alt-A", meaning that they were somewhat riskier in nature than A credit, prime, or traditional loans. Another type of "non-conforming" home loan is one where the credit and income might be perfectly fine, but the loan amount is higher than $417K, which is the current maximum loan that can be done using pools of money from mortgage giants Fannie Mae (FNMA) and Freddie Mac (FHLMC). If the loan amount is higher, it can certainly be done - it's called a "jumbo loan" - but the end money comes from private institutions, not from the large government sponsored entities of Fannie and Freddie.

Most non-conforming loan product rates popped significantly higher recently. Here's what happened.

The end investor for Sub-prime or Alt-A loans will charge a premium for taking on a pool of these loans, because they know that traditionally, they might have a higher rate of default and delinquent payments within that risky pool. But lately, default and foreclosure has been on the rise - partly due to the fact that with credit tightening and a soft real estate market, many troubled homeowners are unable to refinance or sell in order to get out of trouble. So now, these end institutions are demanding a much higher "risk premium" for taking on these pools of loans, as they see the rates of default are climbing higher.

But since these institutions are purchasing these pools of loans sometimes months after the borrower has actually closed at a given rate, this increase to the risk premium means that instead of paying $101K for a $100K loan that will bear interest, they may only be willing to pay $95K for that $100K mortgage to account for the risk. Multiply that times thousands upon thousands of loans...and you have millions upon millions of dollars in loss for the company trying to sell the pool at a much lower price than they were expecting. This is called a "liquidity crisis", and is exactly what happened to American Home Mortgage - there was no mismanagement, but they simply got caught holding too many "hot potato" loans, forced to sell them at massive losses...and eventually they had to make the decision to close the doors and stop the bleeding.

Further, even when a lender is able to take some losses, they may be subject to a "margin call". This means that as their losses and risk premiums increase, the value of their loan portfolio decreases. As the value decreases, the credit lines that are secured by those portfolios begin to issue margin calls as the value of the asset that they are secured on is now diminished. This is exactly like margin calls in the Stock market. If you have a loan against a Stock that is losing value, you will get a "margin call" and need to pay down the loan, as the underlying Stock is losing too much value to be considered adequate collateral any longer. So for the big lenders, as their portfolio is losing value due to increased risk premiums and losses...the margin calls start coming in, and they are required to pay down their balances. In turn, this means that they have less availability to fund their new loans, which then exacerbates the problem.

In response to seeing this situation play out in the demise of American Home Mortgage, lenders of other non-conforming loan products increased their interest rates dramatically almost overnight to be better prepared - and likely over-prepared - for increased risk premiums down the road. Even though loans above $417K are not presently suffering from increased delinquencies like the Sub-prime and Alt-A loans are, these rates popped higher as well, because they are being purchased by smaller private entities that can't afford to take on any margin of risk.

What happens next?  The major damage is probably already done, and the present situation will likely settle out over the coming year.  Lenders will stop pulling products off the shelf, and the rates on products that have moved so significantly higher now should trend lower down the road as delinquency rates stabilize.  

But here are a few important things YOU should do right now:

ONE:  Even if your clients are not presently in the market for a home loan of any type, make sure that their credit standing is as solid as possible. Many people in the market for a home loan didn't expect they would have a need, and didn't plan in advance to ensure their credit would qualify them for the best possible financing. With no immediate need for a home loan, time is on their side... If any of your clients need assistance in this area, I would be happy to assist them.

Excellent post!  Good explanation with some great advice.

Quick follow-up on this post. 

I saw a statistic last week in a Denver newspaper that said foreclosures in California were up 300% over last year.  This statistic in my opinion is completely worthless and is designed to generate a reaction.  There is no doubt that foreclosures are up, and there is no  doubt in my mind that it will get much worse.  The question of course is how bad and only time will tell on that one. 

However, when analyzing statistics, we have to remember that the last few years have seen some of the most incredible results in the real estate markets, including some of the lowest foreclosure rates around.  So, when you are comparing foreclosures this year to last year, a 300% increase is not really that much.  In addition, there are substantially more mortgage loans generated each year, so I would be more interested to see a statistic that addresses the number of foreclosures as a percentage of total overall mortgage loans year over year.  It would be much more meaningful.

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