CHICAGO MORTGAGE MARKET - The Credit Tightening Continues 02/28/08

 

We have arrived.

It is now more important than ever for all home buyers and real estate investors to secure financing first and foremost, prior to contract... if any possibility exists of purchasing (or refinancing) a home or property. The financial markets and mortgage industry is incredibly volatile currently, with changes occuring from all sides on a weekly basis.  It really is a historic time for all of us.

Although housing and mortgage money in general is in a bit of a debacle, Chicago's housing and mortgage market is much better off than most housing and mortgage markets throughout the rest of the country.  However, there are still obstacles ahead.

Just within the last 9 months (the last 3 months dramatically), Fannie Mae, Freddie Mac, investment and retail banks and mortgage insurance companies have felt the market's pressure and substantially tightened guidelines and borrower requirements for mortgage qualification.  Loan-to-value and debt ratio standards are regressing and credit/scoring criteria is rising.  After March 3rd, nearly all mortgage insurance providers will revise credit score requirements upward to a minimum of 620 overall.  For higher leveraging situations (no money down/100% financing, 95% financing etc), 660 will be a floor for purchase and refinance transactions for most MI carriers despite what loan product guidelines indicate.  Seller concessions above 3% will reduce the allowable LTV on many first time buyer programs by the amount of credit incurred.  Reasonable terms on jumbo loans (rates/requirements etc.) are typically capped between $1 and $2 million. Stated income products designed for upper echelon, corporation owners and self-employed types of borrowers (to avoid analyzing hundreds of pages of tax returns), have amost subsided entirely.  City and county program income requirements for low to moderate income earners has recessed whereas personal income and wages have increased consecutively for 5 years running...disqualifying many due to higher salaries.

Chicago's biggest hurdle are condominium requirements.  Condo guidelines have changed to the extent of having approximately 1/3rd of  investor pool available now to choose from as was available just a few months ago.  Just for example, several retail banks and mortgage lenders completely pulled out of lending 2nd liens and HELOCs in October of 2007 and additionally ceased many types of lending on any and all new construction and new condo conversion projects altogether...unless substantial presale or down payment requirements are met or the project is already on the investor's approved list.  Even language contained within some condominium declarations and bylaws can create non-warrantable status for the condo development and disqualify it for financing altogether...unless the decs/bylaws are amended and re-recorded correctly.  Every investor will require a full project review moving forward.

So why is all of this happening?  The "market pressure" indicated in the previous paragraph is a noteworthy culmination of variables, not just "sub-prime":

Initially, the accelerating mortgage default rates were mostly tied into sub-prime and Alt A mortgage products.  Hence, investors taking billions of dollars of losses on these types of CDO's and MBS's no longer would collateralize these products, basically making them unavailable, or, initiated a much higher risk spread premium (rate) for the product to carry it - putting the product out of scope for most borrowers as the money is just too expensive.  So these products have mostly disappeared or have become useless.  These products were generally issued to sub-prime and Alt-A credit borrowers - many of whom would not have qualified for financing according to conforming triple A eligibility requirements.  This default issue was the start of the tightening of credit on the sub-prime side and should have been contained there.  However, upon last year's news of the sub prime debacle, housing started to slow in conjunction with weakening economic conditions and slowdown...and, of course, the investors were watching this.  The consumer was also watching this.  Now add to that...

1.  Some of the CDO's were triple A rated and shouldn't have been, hence, A paper CDO's start taking losses.  Now, the sub prime tightening has spread to A paper.  The A paper investors that took minimal or no losses are concerned enough to tighten anyway before any losses are incurred.  Fannie, Freddie, Banks and Investors and MI companies continue to tighten credit requirements, creating much less product availability and very restrictive product availability (comparatively speaking).

2.  Consumers who are well qualified to purchase are standing on the sidelines waiting for some kind of foreseeable "bottom" to occur...and many whom are not waiting and trying to purchase, are not closing due to unrealistic offers being presented to sellers (20% - 50% below asking). This is clearly not helping to deplete current inventory of homes on the market and adding to the housing decline in terms of price.

3.  The consumers who do want to buy right now and have marginal creditworthiness may not qualify now due to this tightening of credit. Again, this is not helping to deplete the overage of housing inventory and, again, adds to declining prices.

4.  The declining prices and increasing inventory are causing further tightening of credit. 

5.  This further tightening of credit and declining sales/prices have depleted equity positions in owner's homes.  Now, qualified borrowers who financed 95% or 100% within the last two years cannot capitalize on refinancing to lower mortgage rates is some cases (due to the tighter credit/equity requirements of loan programs).  The sub prime borrowers are subject to the same thing, however, their rates will likely increase when the fixed period ends - putting them in a position of defaulting should they not be able to make the higher payments....and they cannot refinance due to the tightened credit requirements and flat to declining value of their home....which leads to....

6.  More defaults, increasing inventory, price declines and/or lack of appreciation, owner's equity depletion, the inability for some to refinance...

7.  Furthering the slowing economic conditions due to uncertainty of everthing and less spending;

8.  Furthering potential recession, higher jobless claims, inflation at 2.7% and rising (in the short term)...

9.  Again, furthering the tightening of credit....

10.  And buyers and investors still standing on the sidelines waiting...waiting...waiting......and the cycle continues.

The Fed only reaffirmed yesterday and today what was already known by mortgage planners and loan officers in the mortgage banking industry; by indicating in their statements before congressional leaders that this excess tightening of credit will only exacerbate the problem we all face of housing markets potentially worsening before rebounding.  There is no real fix for the problem other than to let it carry through its natural course of action.  Note that the economic stimulus package has no bearing in the Chicago markets.

This is all not nearly as bad as it looks on paper.  Chances of recession are minimal and, should one occur, it is likely to be short and timid. Despite oil and food costs being very high currently, inflation through higher CPI, PPI and CPE is likely temporary and in no way representative of the 1970's crisis as some would indicate.  Jobs are reducing to reflect the current slowdown, but still relatively strong.  In all probability, the reduction in workforce will reflect the degree of recession incurred...if such "R word" comes to fruition.  Corporations are cash heavy right now and able to continue forward even in slower economic conditions.  If the housing bust were to spiral completely out of control, legislators and the Fed will likely step in to formulate the necessary solution to ease a massive crisis in housing... should a crisis occur.  FHA would likely be the solution for sub-prime and overtightened credit markets of sorts.

Guys, this is absolutely the best time to purchase real estate in 20 years.  I purchased a 4 unit foreclosure, 85% rehabbed and only mimimal work needed for 2/3rds ($100K less) of current market value.  There is an overabundance of these types of deals out there.  However, you will not find this kind of deal on new construction or new conversion on the market.  Likely, you will pay within 10% of asking and no less.  Developers for large/new projects are relatively well capitalized and not going to give away property.  Those who are not well capitalized will ride out the market and get their price or foreclose.  It would be ridiculous to think they could or would sell at cost or a loss and, in their mind, may as well hold onto the property as long as possible anyway if it were going to short sale or foreclosure.  The mortgage market is a bit bumpy but can be navigated through with minimal headaches should you retain an experienced mortgage planner.  Understand however, this is not the time to look for homes first, write a contract and go rate shopping.  There are just too many changes occurring weekly to transact in this fashion.  Retain the professional, secure the financing and the purchase or refinance transaction will ultimately carry through smoothly for everyone.

 

Mortgage Market - The Subprime Liquidity Credit Crunch 08/07

Prime vs. Subprime.pdf 

The Borrower

Chicago, IL — Consumers interested in purchasing or refinancing a home will pay a given interest rate based on their personal financials, current market conditions and product/debt strategy chosen. Risk assessment is based upon the borrower’s income and debt ratios, credit scoring and history, liquidity and asset base, leverage scenario and level of approval obtained which, criteria for the aforementioned is tightening significantly by the day. If the borrower’s credit will not permit A+ levels of qualification - or if income and assets cannot be sufficiently documented - an alternate course of lending is needed. Unfortunately, this course of subprime and Alt A lending has not been utilized in the way it was intended by the borrower and in some cases, the lender as well. Now we have issues. Starting from scratch, let’s take subprime for example -

Scenario — John and Jane Doe decide to purchase a home. In fact, they went home shopping first and negotiated a purchase agreement which is now fully executed and earnest money is on the line. Both borrowers had not yet retained a professional mortgage advisor and have been shopping around by telephone and the internet, which always incurs unreliability and inefficiency in the transaction (but that is another story). John and Jane find me and agree to move forward. Upon a credit and financial analysis, I discover that both John and Jane have credit deficiencies that will not permit a higher level approval (hence, lower cost) and also cannot document income due to tax return complexities. John and Jane also are just barely able to afford the home as 50% of their gross annual income is being utilized for the housing payment and personal debt. They also have very little liquid assets (1 month housing payment) in reserve. They will need to utilize subprime or Alt A (alternate lending) loan programs in this case as it is the only viable solution. Due to my discovery, it would be advised that they get their earnest money back during the attorney review period, put the contract on hold and wait until a better formal plan of action is determined by their mortgage professional (me) and hard numbers can be provided. Most likely, a credit repair plan would be issued. By following the plan, the borrowers would potentially have the ability to qualify for A+ level paper within a 45 day time frame — which equates to a lower cost of funds (interest rate, etc.), more affordable payments and better terms all around. Rather, John and Jane want to move forward with the purchase instead of going through the credit repair plan (they may not have the time, $$ or some other reason). Now it becomes my job to utilize the best financing option out of the very limited options available to get them into the home on time and STILL prepare them to utilize a credit cleanup action plan after closing - which absolutely needs to be followed over the next 12-18 months. The only product for which John and Jane qualify is a 2 year subprime ARM (assume so for this example). Remember, this is a 2 year subprime ARM loan. We only have 24 months to get everything in order for better financing.

We close. From there forward on a quarterly basis, John and Jane are followed up with to determine how much progress has been made on the credit repair. They respond with "no progress made." Further advice is reiterated as to what to do, how to do it and another set of instructions and email are sent to the clients to be certain they are on top of things. Another quarter goes by. Still no action. Another, and another and … all of a sudden John and Jane are a month away from the ARM adjusting.

Well, we have arrived. Due to 1) the housing market being in a slump (mostly, a state of stagnancy with some areas substantially in decline during the last 2 years) and 2) higher default rates on precisely these types of loan products from the previous two years, investors are no longer willing to extend credit loosely to this type of mortgage financing situation. Now, we have two borrowers who failed to follow a course of action to improve their credit over time; a housing market providing no rate of return (appreciation) on the home they purchased; no equity in the home due to the lack of appreciation; no loan products available for highly leveraged property with little equity (John and Jane’s situation) due to the housing and default rates over the last year and subsequent guideline tightening from investors — And a housing payment for John and Jane that will adjust the full 3% when the time comes, increasing their payment by $600 per month with no opportunity to refinance due to the previous conditions mentioned. Now the default cycle continues. You can see where this is going.

The most frustrating aspect of a mortgage planner’s profession is the inability to do anything for a client to rectify a potentially hazardous financial pitfall. A situation such as this, which is based around several absolutely true situations, is completely out of our control. The media and hype discuss fraud and predatory lending being the issue for problematic mortgage defaults. I have to tell you, this is absolutely not the case except in a very small percentage of mortgage loan fundings.

The Market

There are no issues with conforming loans at this point. Subprime, Alt A and some non-conforming is the problem area. Upon the street’s reassessment of the mortgage market, the risk level has gone up substantially due to higher default rates and stagnant/declining housing over time…so a much higher yield is required on those loans to offset the higher risk (based on the recent valuation). Essentially the mortgage bond is discounted (price deterioration/valued less) to the net present value which ends up deteriorating the bonds below a par yield. What was going to be a mortgage sold to Wall Street at 101 now is being sold at 98 or 99 due to the devaluation. It will now cost the mortgage company XX dollars per loan to fund the loan rather than making XX dollars in premium from which it otherwise would have profited…creating a total loss and depletion of the lender’s liquid assets to cover the discount. Secondly, margin calls (due to the discounted value of the mortgages backing the assets) exorbitantly heightened this depletion scenario in which the necessary margin shortages required additional liquidation of the mortgage lender’s assets (it may or may not have had) to cover the minimum maintenance requirement or "initial margin".

In summary, put the two together - Wall Street (the market) adjusted what it needed for compensation - demanding a higher yield on funds already locked and being delivered at a lower yield - creating a total loss on each loan funding within the next 30-60 days. Simultaneously, margin calls added to the depletion of the company’s assets already being utilized to cover the devalued (discounted) mortgage paper. Mortgage companies cannot go back to the consumer and ask for the higher yield to offset this difference. Either the company has the liquidity to weather the storm or it shuts its doors (think AHM) as the cost per day to stay open can be millions of dollars in a credit crisis such as this.

One Day of business in a normal credit market…100M in loans (in one day) going to secondary @ 6.5% => 101M sell price => 1M profit in one day.

Today’s credit market…Wall street says 8% is the return needed for the additional risk - which discounts the current loan to a net present value and COSTS the mortgage company. 100M in loans to secondary at 6.5% => value is 97M => 3 Million Dollar loss in one day…not including margin call coverage.

Two things need to happen:

  1. The credit market needs to stabilize. It cannot continue a cycle needing 8% this month to offset the higher risk only to then need 9% next month and so on. Polls will identify a given stability figure and will eventually ease itself in the long term.
  2. Loan pipelines need to be covered. Clients need to get closed as soon as possible. The mortgage professional needs to have a couple of backup plans just in case an overnight change occurs with an investor’s product initially selected for that client which no longer becomes available.



Although the Fed has been stepping in to provide some relief to some parts of the secondary market which have essentially seized, the bid/ask spreads will likely remain too wide for the MBS to trade; leaving lenders with large inventories and facing additional margin calls. In my opinion, if the Fed steps in to add liquidity and help stabilize the credit markets - by their own admission - this greasing of the cog wheels will be "limited" in the overall effect. If they are able to move the secondary markets a bit, it will only flush out the already fundamentally undesirable portfolios. Since most high-leveraging, alternate documentation subprime lending has ceased, a Fed move will mostly affect only market portfolios already warehoused. Those loans that that were originated at 102… and now needing to fetch 103 or 104 on the street… might be offered at 98 to 100 only narrowing the spread and limiting the lenders net losses — but not saving them entirely. Even then, only the strongest banks (with large amounts of cash on hand) will be able to weather the storm after the Fed’s assistance. Aggressive investors will still be needed to move behind the fed to uphold any momentum the fed initiates and pull through the market deterioration within a reasonable time frame.

Recommendation - CLOSE YOUR LOAN AS SOON AS POSSIBLE!

 

 

Understanding the Role of the Fed in Today's Credit Crisis

With all the headlines screaming Credit Crisis! and Mortgage Meltdown!, it can be disheartening to think that the apparently smart people serving on the Federal Reserve Board think that the answer to all of this would be to lower a "largely symbolic" interest rate called the "discount rate."  After all, any reasonable person would think that if there really is a credit crisis, the Fed should do away with "symbolic" gestures and start DOING something for goodness sake!  Right?  Well... the Fed IS doing something; we just need understand WHAT they are doing.

In order to understand the current credit crisis, please reference the article above.  Assuming you have read that article, you know that we are currently facing a "run on the mortgage banks" by the Wall Street investors and warehouse lenders who provide funding for US mortgage loans.  Well, the Fed has looked at this situation and basically said, "Hmmmm, we better provide these financial institutions with a new source of short term funding so that they can continue to operate even during this liquidity crunch."

The Fed can provide funding in four ways:

  1. Open market activities – this would be where the Fed injects cash into the banking system by purchasing the Treasury securities held by various banks and financial institutions. This allows the financial institutions to use this cash to meet their liquidity needs.
  2. Lending money directly to the banks that are part of the Federal Reserve System through what is called the "discount window"
  3. Regulating the interest rates that banks charge each other
  4. Regulating the amount of reserves that banks are required to maintain in order to operate.

The Fed has done quite a bit of open market activity in recent weeks, and that hasn't quite fixed the credit crisis problem.  So, on Friday, August 17, the Fed lowered the "Discount Rate" from 6.25% to 5.75%.  This is the interest rate that banks pay when they borrow money directly from the Fed.  Sounds simple enough!  However, why are people saying that this is largely a "symbolic" move?  Also, what affect will this really have on the current "credit crisis"?

In order to answer these questions, it is helpful to understand the four major interest rates that are affected by the Fed:

1.  Discount Rate (currently 5.75%)- the interest rate that banks pay when they borrow money directly from the Fed.  The reason this is largely symbolic is because hardly any banks take the Fed up on their offer these days!  You see, banks prefer to get short term financing by:

  • Issuing "commercial paper" – these are short term IOUs of typically one to sixty days that are sold on the open market to Wall Street investors.  Interest rates on these short term loans are often better than the discount rate offered by the Fed borrowing money from other financial institutions using the Fed Funds Rate as illustrated below.
  • Borrowing money from other financial institutions using the Fed Funds Rate as illustrated below.  In most cases, Fed Funds rate is also better than the discount rate offered by the Fed.  

2.  The Fed Funds Rate (currently 5.25%) - the interest rate that banks pay when they borrow money from each other here in the US. This rate is also determined by the Fed because banks in the US are part of the Federal Reserve System. You see, the Fed's main role is to maintain "monetary stability" by keeping a close eye on the flow of money throughout the economy. One way they do this is by regulating the interest rates that banks charge each other for short term funds.

3.  LIBOR Rate (1 month LIBOR is currently 5.6%) – the London Interbank Offered Rate (LIBOR) is the interest rate that banks pay when they borrow money from other banks anywhere in the world (primarily in the international wholesale money market based in London). There are various types of LIBOR rates including the 1 week LIBOR, 1 month LIBOR, 6 month LIBOR, and 1 year LIBOR; these are the rates banks would pay if they want to borrow funds for 1 week, 1 month, 6 months, etc. Although the LIBOR rates are determined by the financial markets at any given time, they are very closely related to the Fed in that LIBOR most often changes when the market anticipates that the Fed will change their Fed Funds Rate. LIBOR is the base rate that is used on most adjustable rate mortgages (ARMs) in the US and large corporate / commercial loans. The reason LIBOR is used most often for US adjustable rate mortgages is because LIBOR is really the most accurate measure of a bank's cost of borrowing funds since most banks do business internationally these days.

4.  The Prime Rate (currently 8.25%) – the Fed Funds Rate + 3; this is the base rate that is used for most consumer loans such as credit cards and home equity lines of credit, as well as most small business loans. Like the LIBOR, the Prime Rate is also tied to the Fed Funds Rate.

In response to the current credit crisis, the Fed has done some open market activities and they have lowered the discount rate. However, more action is probably needed.  In the coming days and weeks, the Fed is probably likely to:

  • Continue lowering the discount rate as necessary to make it more attractive for banks to take advantage of that window of opportunity (no pun intended)
  • Lower the Fed Funds Rate as long as inflation remains under control.

You see, if the Fed lowers the Fed Funds Rate, the business and consumer-based interest rates of LIBOR and Prime will also go down as illustrated above. The Fed would be reluctant to do this if they feel that businesses and consumers would start borrowing and spending so much money that inflation will go up significantly.

The Fed's main goal is to "maintain monetary stability" by keeping a close eye on the flow of funds in the US economy.  It would be reckless of them to artificially encourage too much borrowing and spending as this would only artificially drive up asset prices and cause money to lose its purchasing power.  This phenomenon is known as "inflation". The good news, however, is that in some of their most recent statements, the Fed has said that inflation is basically under control. They have seemed to indicate that they are starting to get more concerned about other threats to monetary stability – such as the current credit crisis facing the economy. In fact, according to the latest reading, the Fed's favorite measure of inflation was only running at an annual rate of 1.9% compared to over 2% in recent months. This is below the implied inflation "danger zone" and seems to indicate that the Fed may be more likely to lower the Fed Funds Rate moving forward.

CALL
JON MILLER
DIRECTLY AT:
312.738.6013 jmiller@chicagobancorp.com