Straight Talk on the Mortgage Mess from an Insider
12:11:23 PM December 6th, 2007Even before this mortgage mess started, one person who kept emailing me over and over saying that this is going to get realbad. He kept saying this was beyond sub-prime, beyond low FICO scores,beyond Alt-A and beyond the imagination of most pundits, politiciansand the press. When I asked him why somebody from inside the industrywould be so emphatically sounding the siren, he said, “Someobody’s gotto warn people.”
Since then, I’ve kept up an active dialog with Mark Hanson,a 20-year veteran of the mortgage industry, who has spent most of hiscareer in the wholesale and correspondent residential arena — primarilyon the West Coast. He lives in the Bay Area. So far he has been prettymuch on target as the situation has unfolded. I should point out that,based on his knowledge of the industry, he has been short a number ofmortgage-related stocks.
His current thoughts, which I urge you to read:
The Government and the market are trying to boil thisdown to a ’sub-prime’ thing, especially with all constant talk of‘resets’. But sub-prime loans were only a small piece of the mortgagemess. And sub-prime loans are not the only ones with resets. What weare experiencing should be called ‘The Mortgage Meltdown’ because manydifferent exotic loan types are imploding currently belonging to whatlenders considered ‘qualified’ or ‘prime’ borrowers. This will continueto worsen over the next few of years. When ‘prime’ loans begin toexplode to a degree large enough to catch national attention, theratings agencies will jump on board and we will have ‘Round 2′. It isnot that far away.
Since 2003, when lending first started becoming extremely lax, asmall percentage of the loans were true sub-prime fixed or arms. Butsub-prime is what is being focused upon to draw attention away from thefact the lenders and Wall Street banks made all loans too easy toattain for everyone. They can explain away the reason sub-prime loans are imploding due to the weakness of the borrower.
How will they explain foreclosures in wealthy cities across thenation involving borrowers with 750 scores when their loan adjustshigher or terms change overnight because they reached their maximumnegative potential on a neg-am Pay Option ARM for instance?
Sub-prime aren’t the only kind of loans imploding.Second mortgages, hybrid intermediate-term ARMS, and the soon-to-beinfamous Pay Option ARM are also feeling substantial pressure. Thelatter three loan types mostly were considered ‘prime’ so they arebeing overlooked, but will haunt the financial markets for years tocome. Versions of these loans were made available to sub-primeborrowers of course, but the vast majority were considered ‘prime’ orAlt-A. The caveat is that the differentiation between Prime and ALT-Agot smaller and smaller over the years until finally in late 2005/2006there was virtually no difference in program type or rate.
The bailout we are hearing about for sub-prime borrowers will be thefirst of many. Sub-prime only represents about 25% of the problem loansout there. What about the second mortgages sitting behind the sub-primefirst, for instance? Most have seconds. Why aren’t they bailing thoseout too? Those rates have risen dramatically over the past few years asthe Prime jumped from 4% to 8.25% recently. seconds are primarily basedupon the prime rate. One can argue that many sub-prime firstmortgages on their own were not a problem for the borrowers but theadded burden of the second put on the property many timesafter-the-fact was too much for the borrower.
Most sub-prime loans in existence are refinances not purchase-moneyloans. This means that more than likely they pulled cash out of theirhome, bought things and are now going under. Perhaps the loan they holdnow is their third or forth in the past couple years. Why are badborrowers, who cannot stop going to the home-ATM getting bailed out?
The Government says they are going to use the credit score as one of the determining factors. Butwe have learned over the past year that credit scores are not a goodpredictor of future ability to repay. This is because over the pastfive years you could refi your way into a great score. Everytime you were going broke and did not have money to pay bills, youpulled cash out of your home by refinancing your first mortgage orupping your second. You pay all your bills, buy some new clothes, takea vacation and your score goes up!
The ’second mortgage implosion’, ‘Pay-Option implosion’ and ‘HybridIntermediate-term ARM implosion’ are all happening simultaneously andabout to heat up drastically. Second mortgage liens were done by nearlyevery large bank in the nation and really heated up in 2005, as firstmortgage rates started rising and nobody could benefit fromrefinancing. This was a way to keep the mortgage money flowing. Secondmortgages to 100% of the homes value with no income or assetdocumentation were among the best sellers at CITI, Wells, WAMU, Chase,National City and Countrywide. We now know these areworthless especially since values have indeed dropped and those whomaxed out their liens with a 100% purchase or refi of a second now owemuch more than their property is worth.
How are the banks going to get this junk second mortgage paper offtheir books? Moody’s is expecting a 15% default rate among ‘prime’second mortgages. Just think the default rate in lower quality such assub-prime. These assets will need to be sold for pennies on the dollarto free up capacity for new vintage paper or borrowers allowed to pay50 cents on the dollar, for instance, to buy back their note.
The latter is probably where the ’second mortgage implosion’ willend up going. Why sell the loan for 10 cents on the dollar when you canget 25 to 50 cents from the borrower and lower their total outstandingliens on the property at the same time, getting them ‘right’ in thehome again? Wells Fargo recently said they owned $84 billion of thisworthless paper. That is a lot of seconds at an average of $100,000 apiece. Already, many lenders are locking up the second linesof credit and not allowing borrowers to pull the remaining openavailable credit to stop the bleeding. Second mortgages are defaulting at an amazing pace and it is picking up every month.
The ‘Pay-Option ARM implosion’ will carry on for a couple of years.In my opinion, this implosion will dwarf the ’sub-prime implosion’because it cuts across all borrower types and all home values. Someof the most affluent areas in California contain the most Option ARMsdue to the ability to buy a $1 million home with payments of a fewthousand dollars per month. Wamu, Countrywide, Wachovia,IndyMac, Downey and Bear Stearns were/are among the largest Option ARMlenders. Option ARMs are literally worthless with no bids found formany months for these assets. These assets are almost guaranteed toblow up. 75% of Option ARM borrowers make the minimum monthly payment.Eighty percent-plus are stated income/asset. Average combinedloan-to-value are at or above 90%. The majority done in the past fewyears have second mortgages behind them.
The clue to who will blow up first is each lenders ‘max neg potential’ allowance, which differs. Thehigher the allowance, the longer until the borrower gets the lettersaying ‘you have reached your 110%, 115%, 125% etc maximum negative ofyour original loans balance so you cannot accrue any more negative andmust pay a minimum of the interest only (or fully indexed payment insome cases). This payment rate could be as much as three times greater.They cannot refinance, of course, because the programs do not exist anylonger to any great degree, the borrowers cannot qualify for other moreconventional financing or values have dropped too much.
Also, the vast majority have second mortgages behind them puttingthem in a seriously upside down position in their home. If the firstmortgage is at 115%, the second mortgage in many cases is at 100% atthe time of origination — and values have dropped 10%-15% in stateslike California — many home owners could be upside down 20% minimum.This is a prime example of why these loans remain ‘no bid’ and willnever have a bid. These also will require a workout. The bigdifference between these and sub-prime loans is at least with sub-primeloans, outstanding principal balances do not grow at a rate of up to 7%per year. Not considering every Option ARM a sub-prime loan is a mistake.
The 3/1, 5/1, 7/1 and 10/1 hybrid interest-only ARMS will reset indroves beginning now. These are loans that are fixed at a lowintroductory interest only rate for three, five, seven or 10 years —then turn into a fully indexed payment rate that adjusts annuallythereafter. They first got really popular in 2003. Wells Fargo led thepack in these but many people have them. The resets first began withthe 3/1 last year.
The 5/1 was the most popular by far, so those start to reset heavilyin 2008. These were considered ‘prime’ but Wells and many others woulddo 95%-100% to $1 million at a 620 score with nearly as low of a rateas if you had a 750 score. No income or asset versions of this loanwere available at a negligible bump in fee. This does not sound too‘prime’ to me. These loans were mostly Jumbo in higher priced statessuch as California.
Values are down and these are interest only loans, therefore, manyare severely underwater even without negative-amortization on this loantype. They were qualified at a 50% debt-to-income ratio, leaving only50% of a borrower’s income to pay taxes, all other bills and live theirlives. These loans put the borrower in the grave the day they signed their loan docs especially without major appreciation.These loans will not perform as poorly overall as sub-prime, seconds orOption ARMs but they are a perfect example of what is still considered‘prime’ that is at risk. Eighty-eight percent of Thornburg’s portfoliois this very loan type for example.
One final thought. How can any of this get repaired unless homevalues stabilize? And how will that happen? In Northern California, ahousehold income of $90,000 per year could legitimately pay the minimummonthly payment on an Option ARM on a million home for the past severalyears. Most Option ARMs allowed zero to 5% down. Therefore, given theaverage income of the Bay Area, most families could buy that milliondollar home. A home seller had a vast pool of available buyers.
Now, with all the exotic programs gone, a household income of$175,000 is needed to buy that same home, which is about 10% of the BayArea households. And, inventories are up 500%. So, in a nutshell we have 90% fewer qualified buyers for five-times the number of homes.To get housing moving again in Northern California, either all theexotic programs must come back, everyone must get a 100% raise or homeprices have to fall 50%. None, except the last sound remotely possible.
What I am telling you is not speculation. I sold BILLIONs of thesevery loans over the past five years. I saw the borrowers we considered‘prime’. I always wondered ‘what WILL happen when these things adjustis values don’t go up 10% per year’.
