Is a 'Credit Crunch' Coming to the Mortgage Market?

This article was originally released in February 2007, and has been updated as conditions have changed (last: 09/07).

Part I: History Lessons

Like many of you, we've been following the issues of mortgage risks and housing bubbles for an extended period, as well as the ongoing liquidity crunch. Of late, certain of those concerns seem to have become reality, and we've left to wonder: Is a 'credit crunch' the next leg of the housing boom-and-bust cycle? The swirl of issues and speculation about them has prompted this discussion piece, which -- we hasten to add -- isn't intended as any kind of authoritative examination, but rather an outline.

Let's look at certain of the facts first. Over a period of time, we saw a strong stock market rally which ended in a substantial correction. This was followed by a very robust real estate market characterized by "risky" loans, including negatively-amortizing short-term ARMs and low- and no-documentation loans at increasingly competitive interest rates. That mortgage-fueled demand kept home prices rising strongly over a number of years, and it seems that speculative building projects cropped up everywhere. Good times were booming.

Sound familiar? We're actually describing the period from about 1985 to roughly 1989 or so. While there are differences between then and now, there seems to be more than a passing similarity.

Sometime around 1988, lenders began to notice that certain of the loans they had made were starting to, in industry parlance, 'underperform.' In the ensuing years, "risky" (see footnote) lending, concentrated primarily among thrifts, was the impetus for FIRREA, the second coming of the thrift bailout-and-closure plan. (If we recall correctly, the first was the "Southwest Plan").

At the time, delinquencies and foreclosures spiked, REO and workout specialists were born, home prices suffered in many markets, and the term 'cramdown' entered the mortgage lexicon.

Investors in all kinds of assets, especially real estate and mortgage paper, looked at their books, found credit- and asset- quality problems everywhere, and turned a cold shoulder. Credit conditions tightened swiftly and significantly. Loan losses were the undoing of a number of lenders, and nearly toppled two of the largest in the market at that time.

The recession which followed was ultimately deemed to have been caused by a "credit crunch"; while brief, it was a sharp and painful recession nonetheless.

Forward in Time

Now some 15-plus years later, lenders have learned a few things, but apparently not all of the lessons have stuck. Driven by hopes of fat returns, a competitive rush into subprime lending in the mid-late 1990s drove yields way down for the riskiest borrowers... until lenders discovered that regardless of the price of the loan, the reason that these borrowers were 'subprime' in the first place is because they fail to pay their bills, regardless of the interest rate being charged to them. Worse, those borrowers that did pay yielded less, so profitability suffered, and many subprime concerns folded.

Where are we now?

One lesson that seems to have been retained is to utilize better risk management. While portfolios of loans are sizable, mortgage loans are no longer specifically concentrated on the books of thrifts, which are truly few in number. Mortgages, and the risks they represent, are now theoretically spread among thrifts, banks, REITs, and institutional and individual investors both here and across the globe as portions of CDO and CMO packages. Concentrations of loans made in a specific geographic region are probably less dense, as lenders now either operate in many markets or are active in buying loans on a broader basis. Even where a lender makes many kinds of loans, not all are retained; instead, many are offloaded though other, more diverse channels to investors here and abroad. Those which are retained are likely subject to better and different scoring and hedging tools, which may serve to ameliorate any losses which may occur. However, there still is no clear picture of where any accumulations of risk may exist.

Part II: Where It All Falls Over

Despite all the technology, all the management tools, hedging strategies, and all the new risk-spreading conduits, one thing will never change: The ability -- and/or desire -- of the individual lone borrower to make the payment on his or her mortgage loan.

Essentially, it all begins and ends there, and any change in actual borrower behavior can (in the right conditions) render all that hedging, scoring, planning and modeling moot, or at least distort them all to a considerable degree. Should those lines of defense against loss fail to protect the lender's assets, it's a pretty fair bet that they simply won't buy any more loans, or loan of a specific type or with given features. If they do, they will demand much greater diligence in underwriting them, not to mention higher yields.

Regulators, Congressmen Chime in

It's apparently becoming fashionable to say that a certain percentage of the borrowers who got mortgages over the last few years probably shouldn't have been allowed to get one at all -- or at least not with terms and conditions which they couldn't reasonably manage. (Down this path lies a discussion of whether people should be protected from themselves and their choices, and the regulator's role in doing so, but that's a philosophical discussion for another day). New regulations covering the 'riskiest' of loans was adopted late in 2006. Ruminations about 'suitability testing' for borrowers has surfaced.

Suffice it to say that after all the above, certain loans are starting to fail in a measurable way... and all simply because borrowers are failing to make the payments they promised.

How Big is the Problem?

Estimates peg approximately 80% of the mortgage market as "A" credit, leaving about 20% of the market as "subprime" of all types, terms and credit classifications.

Where Are We Going?

Fast-forward to today, and the question remains: Is the next credit crunch beginning? If so, how wide and strong might it be? And the crux is this: would a crunch be contained to subprime-class loans, or is a wider contagion in the offing?

Certainly, the numbers are all pointing that way, as loans are falling over at an increasing rate. According to the Mortgage Bankers Association, delinquencies in the 2nd quarter of 2007 were:

Prime Loans: 2.73%, up from 2.58% in Q107, and up from 2.57% in Q406 (2.44% in Q306, 2.29% in 2Q06, but still quite comfortable).
Subprime Loans: 14.82%, up from 13.77% in Q107, and up from 13.33% in Q496 (12.66% in Q306, 11.70% in 2Q06)
FHA Loans: 12.58%, up from 12.15% in Q107, down from 13.46% in Q406 (12.80% in Q306, 12.45% in 2Q06)

While expansion of the FHA program to help subprime borrowers finance and refinance their homes has been proposed (and seems a likely course), greater access to government-backed mortgage money is no guarantee that those loans will be repaid, either, as FHA deliquencies run nearly as high as do subprime ones.

In total, on a loan-weighted seasonally-adjusted basis, 5.12% of loans were delinquent in the 2nd quarter, up from 4.84% in the fourth quarter. These levels are still fair, but generally rising back toward long-term average levels after a well-below-average period. That below-average period was spurred by loans being refinanced into historically low interest rates. Of course, new loans begin from a 'current' position, where no payment stream deficiency has yet occurred, and issues of late- or non-payment typically arise over the first three to five years of the loan.

More bleak still were estimates by the Center for Responsible Lending, which put a working number for subprime foreclosures at 20% for the 2002-2006 period.

RealtyTrac, which follows foreclosure rates, said foreclosures rose by 9% in July 2007 from June, and were some 93% higher than in August 2006.

In the MBA's survey, loans of all stripes entering foreclosure posted a record high of 1.40% in the second quarter of 2007. The survey only covers the last 37 years, and it's possible that foreclosures may have been higher at other times in history.

Where Is It Coming From?

Faltering home prices are likely to blame for more than a portion of the fallover of loans. As well, some of the troubles have been traced to second mortgages originated as a portion of 'piggybacked' originations. Borrowers with little equity (i.e., high-LTV piggybacks) who face difficult economic times or rising monthly payments have little chance to refinance their mortgages or sell their homes in hopes of making full repayment if the market hasn't produced any "instant equity" for them to utilize. There's no easy way out, but as a last resort they can mail the keys back to their lender; this will certainly damage their credit rating, but if they were already subprime borrowers, there's probably little to lose in that regard.

Of course, it's also possible that those in trouble may continue to make payments on their primary first loans but fail to repay the second mortgage portion, usually a smaller loan. It's unclear (and perhaps unlikely) whether a second mortgage lien holder would initiate foreclosure proceedings for a nonperforming but smallish loan amount, and the first lien holder -- still current -- would have to agree, too. If the property is acquired and then sold, that highly-leveraged home may not bring a price high enough to pay off both the first lien holder and the second lien holder, after acquisition (foreclosure) and disposal (sales) charges are deducted. The second lien holder may end up with nothing for all effort and expense. Without foreclosure and sale, though, recapturing the money invested in the loan won't occur unless the borrower decides to repay it.

Part III: Recourse? Of Course!

As you might expect, investors became increasingly antsy during 2006 as loans they purchased began exhibiting negative characteristics such as late- or non-payments; some borrowers reportedly never made any at all. In many mortgage funding arrangements, loans must be repurchased by the originator or lender (in industry parlance, 'recourse') if they fail to meet certain criteria ('warrants').

As loans fail, these recourse options may permit the investor to return the loan to the funding lender, who has to 'make good' on the loan. Most mortgage lenders carry some insurance coverage and/or have hedges or cash reserves to manage the occasional problem loan returned to them. Few have sufficient reserves or access to cash to manage dozens -- or even hundreds -- of loans coming home to roost at the same time, and certainly not when it happens month after month. Ultimately, a loan fails and is returned to the funder, who no longer has sufficient cash to buy it back. Unless that funder can find new sources of funding or can arrange for new reserves, they have little choice but to go out of business.

Such "repo" issues have knocked out a few significant funders or originators of subprime mortgages recently, including Ownit Mortgage Solutions, Mortgage Lenders Network, ResMAE, New Century and Fremont General. These were all reportedly ranked in the in the top 20 for originations, with Fremont New Century in the top five. Other smaller shops including Mandalay Mortgage, DeepGreen Financial, Sebring Capital, and Funding America are gone, as well. HSBC, not especially noted as a subprime originator (but the recent purchaser of both Household Finance and a portfolio of subprime loans from Champion Mortgage, who are among the oldest names in subprime), reported significant losses related to subprime and piggyback mortgages. Others may be up for sale, and many are changing strategies in hopes of remaining viable, such as Ameriquest mortgage (a noted subprime lender), which announced a complete revamping of its operations in May 2006.

Not Only The Newest Loans, Either

Investors in mortgage backed securities are starting to get pinched as well. Fitch Ratings, Standard and Poors, and other bond-rating agencies have reported concerns about the subprime bonds they rate; in certain cases, additional "credit enhancement" (insurance premiums) have been required on some of bonds already issued. Lenders may able to absorb, for a while, higher costs to secure subprime mortgages provided profits are good, but profitability is declining, and ultimately those costs will need to be passed along to consumers in the form of higher rates or fees.

So far, the biggest issues have been confined to subprime lending, and especially that niche of subprime lending where a low credit score wasn't the only underwriting stretch. Piggybacked originations are especially troublesome (loans with very high loan-to-value ratios typically are), as are loans with little or no corroborating documentation. These include such monikers as Low- or No-doc, Stated Income, Stated Asset Loans (SISA), No-Income-No-Asset check (NINA), No-Income Verification (NIVs), and others. In addition, more flexibility has been introduced into underwriting to determine how much mortgage and total debt a borrower is allowed to carry weighed against his or her income (known as 'expanded debt-to-income (DTI) ratios').

These lowered entry barriers to get a mortgage exist in the form of loans which allow for the payment of interest only (no principal payments for some time), or those which allow the borrower to make a payment so small it actually increases the balance of the loan ('negative amortization'). Borrowers have been offered tremendous leverage in the past few years, and many have taken advantage of it, including investor/speculators in certain markets.

Fuzzy Logic

Also, the lines between so-called Alt-A and 'Alt-doc' loans, and sub-prime loans, can be a little blurry. Alt-A typically refers to a loan which almost, but doesn't quite, meet "A" specifications (minor flaws such as LTV ratio, perhaps); Alt-doc usually refers to Low-, no- or Alternative documentation; and sub-prime usually refers to a credit-score situation (below perhaps FICO 620 but especially below 580). Loans have been made over the past few years with considerable blending of these characteristics as well. Into this mix come certain "credit improvement" mortgages, aka 2/28s, which theoretically help borrowers with substandard credit get a mortgage loan at a "reasonable" interest rate. As they are intended to be refinanced after the two-year fixed period ends, they can have very unfriendly terms which kick in after the 24th payment has been made, or include prepayment penalties which can make refinancing prohibitively expensive.

More Recent Revelations

As the trouble in subprime loans expanded this year, we've had occasion to discuss the role of speculator/investors in the rising delinquency and foreclosure numbers. After all, sizable numbers of homes were snapped up in recent years by folks hoping to "flip" those homes back onto the market at short while later at a profit. It's likely that many of these people weren't professional investors, but ordinary folks hoping to cash in on the real estate boom, using high-leverage, low carry-cost loans (such as PayOption ARMs). When homes stopped selling quickly or could only be sold at a loss, these borrowers faced both rising monthly payments and poor market conditions. As a result, some simply stopped making mortgage payments.

Only recently has the size of the role of these investors (not homeowners) come to light. In the 1990s, perhaps 5%-7% of the loans made were to investors, but those figures rose to 11% in 2002, 12% in 2003, 15% in 2004.

It's not surprising that the states with the highest percentages of sales of non-owner-occupied homes now have the highest levels of delinquency and foreclosure. In fact, absent the influence of those states, the MBA noted that delinquencies would have declined in the second quarter of 2007, not increased. California, Florida, Nevada and Arizona were hotbeds of investor activity during the boom, and investor purchases accounted for about 30% of home sales during 2005 in those areas. In Nevada, for example, those loans now account for about 30% of the defaults (32% of the "prime quality" defaults and 24% of the "subprime quality" defaults). With little "skin in the game" (i.e, no downpayment) and little prospect of selling without losing money, investors may simply be mailing the keys back to the lender, who has little recourse but to foreclose. As there is no desire on the part of the borrower to make payments, there's no loan workout or modification needed or desired, and in the case of a subprime investor, probably not even any additional damage to their credit rating either (after all, they were rated subprime already).

Part IV: Spreading Malaise?

Although these credit quality issue seems to have worsened considerably throughout 2006, we may see more trouble yet to come. Consider that those 'risky' loans have been made in pretty fair economic times, with high levels of employment, very reasonable interest rates, and very liquid lending conditions. Compared to loans made in 2003 and 2004, today's market interest rates are notably higher, but remain good by historic standards. Home prices have risen strongly in many markets over the past few years, and that combination means that many borrowers with piggybacks, high-LTV loans, 2/28s, 3/27s or frequently-changing ARMs subject to higher interest rates have had occasion to refinance to more suitable (perhaps less risky) products.

With home prices flattening, though, homeowners with little or no equity may find fewer chances to refinance. Any interest rates higher than those available presently (FRMs below about 6.5% at this writing) makes refinancing a less likely option. There just aren't any mortgages available at the moment with rates low enough to provide meaningful interest rate relief for many borrowers, which leaves some with little choice but to accept a loan with an 'alternative payment stream' such as interest-only, or a loan such as a PayOption product which can allow for negative amortization. With few places to turn and conditions tightening around them, certain borrowers may become trapped in their loan choices.

There is already at least some tightening of credit conditions. The most recent survey of Senior Loan Officers at banks conducted by the Fed found that in the first quarter of 2007, some 16.4% of lenders reported tightening standards for residential mortgage lending, up from just 1.6% in Q406. In January, Fremont Investment & Loan, the third-largest provider of brokered subprime mortgages announced broad revisions in its lending guidelines. Among other tightening moves, it announced an end to No-Income Check loans to borrowers who make no downpayment, and declared that it will no longer refinance loans more than 90 days late. CitiMortgage announced last week that it will require a borrower-signed affidavit that a borrower with a 'stated-income' loan actually provided that information, and that it hasn't been modified by anyone during the loan process.

Higher interest rates, but especially tighter credit conditions, can exacerbate the problem of a loan falling behind. In a strong real estate market where prices are rising and home sales are brisk, a homeowner at least has a chance of selling at a price which will satisfy the liens against the property as well as cover the sales charges and such; with luck, there might even be a little left over to keep. That's not really the situation at the moment, where prices are flat and amid a lot of available homes for sale. Tighter credit means fewer potential buyers; fewer buyers creates less demand-fueled appreciation, and a homeowner can be stuck. Add a negatively-amortizing loan, and the resulting scenario -- no viable options for repayment -- becomes a recipe for "walking away" (also known as default).

Is That a Train (Wreck) I Hear?

At the moment, the storm remains contained to the forms of mortgage lending which occupy the fringes of the market, but there are disquieting signs that it continues to widen each day. Good credit quality borrowers seeking fully-amortizing mortgages will probably not even notice any change in availability, as least not for a while, anyway. However, as much of the growth in mortgage lending has been outside those narrow top-notch channels in recent years, it's a certainty that many fringe borrowers and homeowners will face a less-friendly market in 2007 and perhaps beyond. Some fiscal sanity has already begun creeping into underwriting -- for example, it's much harder to place high-combined-LTV piggybacks, and there are now higher required credit scores for other kinds of loans, especially reduced documentation types -- but there is probably much more coming just ahead if we continue along this path. It's probably also important to recognize that, when confronted with 'challenges,' markets rarely adjust in a rational, orderly fashion.

Likely Lender Responses

Will these woes expand, and will a spate of foreclosures put people on the street? Will we see a new glut of homes for sale in already saturated markets? Our guess is probably not. Lenders don't really want to own real estate, and have powerful incentives to make things work with even seriously delinquent borrowers, so options may already be in place for borrowers who are in trouble. From a lender's (and shareholder) standpoint, a partially-performing loan is better than a non-performing loan; foreclosure proceedings, property acquisition, and disposition is a costly process, with no guarantees that even what's due can be recovered from the sale. At least as potentially damaging is putting more inventory up for sale at a time when prices are already pressured, since that could depress the values of other homes in the bank's portfolio, which would raise the risks of even good loans made to solid borrowers. Of course, bank regulators and Congress are peering over lenders' shoulders, and a response which keeps people in their homes can serve to keep onerous new laws and guidelines at bay -- not to mention the good public relations such moves can garner.

There is no current indication that the expanding sinkhole will encroach into "A"-credit mortgage lending, but it will certainly influence it. Debt-to-income ratios will likely ease back over time, and LTV ratios/down payment requirements seem ripe for change, as well, given stagnant property values. Certain products may become tougher to find and obtain, such as no-doc loans, and when available, will probably carry higher rates and fees, too.

Increasing aversion to risk exhibited by investors in mortgage-based investments caused a serious disruption in the relationship of the prices of conforming and jumbo loans in August. As of this update, the difference in cost between those products has expanded to nearly five times the normal spread. At the moment, any "non-conforming" mortgage have been tarred with the "bad credit risk" brush, and investor desire for these products has waned, and although money is available, remaining sources of funds are requiring higher returns on their capital, so the lack of investor demand has served to increase rates for jumbo mortgage borrowers, at least for the moment.

It's clear that there are and will be losses related to the spate of 'binge lending' we experienced over the past few years. How deep and how wide those losses are remains to be seen, but we'll look back as the year unfolds to update any significant developments.

As always, we welcome your comments.

"Risky" lending: In the days before FIRREA, many lenders were quite solvent even though some (even many) loans on their books may have been non- or partially-performing. Then, laws were changed which regulated the capitalization levels required of lenders to cover "bad" loans. After the change, undercapitaliztion occurred for hundreds of lenders almost instantly, leaving them insolvent. FIRREA put many lenders underwater, and their assets were consolidated and marketed by the Resolution Trust Corp. (RTC).

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