Private-label, subprime mortgage originators will have a more difficult time selling Wall Street investors risky loans in 2007, experts say, even as they face tougher underwriting and disclosure standards from regulators.
But don’t expect “exotic” loans to become extinct as the mortgage lending industry copes with slackening demand for all types of loans through layoffs, consolidation and modernization.
The Mortgage Bankers Association projects home loan originations will fall 11 percent this year, to $2.21 trillion, followed by an additional 7.4 percent decline to $2.05 trillion in 2008. By comparison, lenders funded $3.03 trillion in mortgage loans in 2005, the second-highest year on record, and an estimated $2.48 trillion in 2006.
A slowdown in home sales is likely to translate into fewer home purchase loans, while rising interest rates and slower or negative home price appreciation could also make refinancing less attractive to many borrowers.
MBA economists expect purchase originations — which reached a record high of $1.51 trillion in 2005 — to total $1.29 trillion in 2007, down 6.7 percent from last year. Refinance originations are projected to drop even more sharply, to $918 billion, a 16 percent decline from 2006.
By 2008, the MBA projects refinance loans will constitute just 37 percent of the mortgage origination market, compared to 50 percent in 2005 and 44 percent in 2006. Refi’s will make up 42 percent of loan originations this year, the MBA forecasts.
“After every good party there’s a hangover,” said Amy Crews Cutts, deputy chief economist at government-sponsored mortgage repurchaser Freddie Mac. “We’ve seen a huge boom in mortgage-related employment, including Realtors.”
Now, Crews Cutts expects to see consolidation as lenders cut capacity.
“The guys who got into being a mortgage broker because easy and money fell out of sky are going to get pushed out by the ones who really know how to earn it,” she said. “I would anticipate seeing, as banks merge, and servicing offices merge, a greater emphasis on technology. But I don’t know which credit union, or which bank, is going to do the layoffs.”
Adjustable-rate mortgages will continue to lose market share this year, accounting for just 14 percent of originations, MBA economists predict. That compares to 30 percent in 2005 and 22 percent in 2006.
With the narrow spread between fixed-rate and adjustable-rate mortgages, ARMs are already looking less appealing to borrowers. In the last week of 2006, ARM loans constituted 20.4 percent of loan applications — the lowest level since July 2003. MBA economists expect the ARM share of conforming loans, which stood at 31 percent at the beginning of the year, to remain at 15 percent or less through the end of 2007.
During the boom years, subprime and nontraditional loans such as interest-only and payment-option adjustable-rate mortgages were touted as a way to help buyers grapple with rapidly escalating home prices. As long as prices kept going up, buyers could take advantage of lower monthly payments while building equity in their homes, refinancing on better terms before their payments went up. But when home price appreciation slowed or reversed in some areas, many borrowers found their homes were worth less than they owed, making it impossible to refinance on better terms.
In the last weeks of 2006 — as several subprime lenders were closing their doors because of financial difficulties — the Center for Responsible Lending issued a report predicting that one in five subprime loans originated in the last two years will wind up in foreclosure.
The report analyzed the performance of more than 6 million subprime mortgages going back to 1998, concluding that 2.2 million families had either already lost their homes or will end up in foreclosure in the next several years.
The Mortgage Bankers Association criticized the study as alarmist, and argued against tighter restrictions on lenders. One reason for the recent up tick in delinquencies and foreclosures is that more people took out loans during the housing boom, the MBA said.
But Kenneth Rosen, of the University of California, Berkeley’s Fisher Center for Real Estate and Urban Economics, said the problem is real, and subprime loan originators and the investors who financed them are to blame.
“Subprime loans, for the last and early part of this decade, were 2 percent of the market,” he said. “Then all of a sudden it became 15 percent of the market because you could securitize them through Wall Street. People who normally wouldn’t meet the criteria were approved for loans. It was a sure thing there would be substantial delinquencies and foreclosures.”
Rosen expects delinquencies and foreclosures to continue to rise, because “as housing prices decline, people are less inclined to make payments.”
Some types of nontraditional loans are now subject to stricter underwriting and disclosure requirements, as federal and state regulators react to concerns that payment shock on interest-only and payment-option ARMs have proved too volatile for many consumers.
Federal banking regulators in September issued new guidance for such nontraditional or “exotic” loans, requiring lenders to qualify borrowers at the fully indexed rate, and disclose the risk of increasing monthly payments.
The guidelines only apply to federally chartered banks, but 22 states and the District of Columbia have since issued nearly identical edicts that will require other lenders to play by the same rules. While many states moved quickly to follow the lead of federal regulators, some of the nation’s most populous states have yet to take action — including California, New York, Florida, Illinois, and Pennsylvania.
This year, Congress is also expected to resume debate over a H.R. 1182, a bill that would amend the Truth in Lending Act to tighten restrictions and limit fees on high-cost mortgages. The bill, sponsored by Rep. Brad Miller, D-N.C., was sidetracked last year in the Republican-controlled House Committee on Financial Services. But with Democrats regaining a majority in Congress and Rep. Barney Frank, D-Mass, chairing the committee, Miller has said he is optimistic about the bill’s chances.
In high-cost regions like California, where housing prices in many areas have held up through the slump, “I’d expect (nontraditional mortgage) products to last for a long time in the future,” Crews Cutts said.
While they can be a useful tool for more affluent buyers who are aware of their risks, exotic loans are “not going to be appropriate for first time home buyers, with 5 percent down payments,” Crews Cutts said. “We’ll see quite a fallout” in subprime industry when regulators and investors turn on such products, Crews Cutts predicted.
If lenders are forced to buy back bad loans from investors en masse, or investors start demanding higher returns for financing risky loans, a credit crunch could ensue.
“Hopefully credit will tighten in a way that’s fair and equitable,” said U.C. Berkeley’s Rosen. “We have a lot of small-scale mortgage brokers that are here today, gone tomorrow, to exploit the boom.”
Wall Street analysts like Fitch Ratings have recently been downgrading investment securities backed by residential mortgages, especially those with a preponderance of subprime loans.
So-called “private label” lenders, who often obtain funding by packaging their loans as securities and selling them to investors, have taken much of the business of traditional lenders away, including government-sponsored mortgage repurchasers Freddie Mac and Fannie Mae.
The GSEs, as the government-sponsored lenders are known, can’t compete with private lenders in some high-cost areas where homes exceed the government’s conforming loan limit (currently $417,000), and have struggled in the wake of accounting and management scandals that led to voluntary limits on their lending portfolios.
“We can’t compete unless Congress changes the loan limits, and Congress may have decided they don’t want us to compete in that market — that that market is well served,” Crews Cutts said.
But Rosen thinks Freddie and Fannie “should be leading the charge,” in providing affordable alternatives to exotic loans.
“I think they’ve been preoccupied the last few years, maximizing their growth and profits,” Rosen said. “They would be the perfect ones to lead sound underwriting in this area.”
In order to afford homes in high cost area, Fitch analysts said in a Dec. 11 report, borrowers who use private label lenders have been taking on higher loan-to-value ratios (83 percent in 2006, compared to 73 percent in 2002). Often the additional debt is taken on through the use of piggyback and second lien loans, which allow buyers to make little or no down payment.
The debt-to-income ratio of private label borrowers now averages 41 percent, the Fitch report noted, and that figure is probably understated, since the proportion relying on stated income loans shot up from 37 percent in 2002 to 60 percent in 2006.
“It’s a way some borrowers, and some mortgage lenders used to get people into homes they had no ability to afford,” Crews Cutts said of such “low doc” or “no doc” loans that require little or no proof of income. “There are some really scary products out there. We’re going to see a crackdown in non-documentation mortgages — you are going to have to show a W-2 or at least income. “
But Fannie and Freddie are unlikely to regain market share lost to private-label lenders, said Mark Dangelo, an independent management advisor to mortgage lending and financial companies.
“You may see an incremental up tick (in the GSE’s market share) depending on how many non-agency (securitized loans) end up in defaults or downgrades, but I don’t see them going back to situation where they controlled three fourths of the market, like they did,” Dangelo said.
Dangelo doesn’t see a credit crunch coming, either. Although lenders will have to tighten up underwriting and provide more disclosure to borrowers, “investor appetite is still there” to fund mortgage loans.
“The international community values our mortgage-backed securities — they buy them when they are available, whether they are agency or private label,” Dangelo said. “The mortgage industry has been so healthy … and able to adapt to chaos and change.”
Crews Cutts agreed — to a point, saying investors will continue to have confidence in “plain vanilla” loans intended for buyers with good credit.
“I think the mortgage market is going to be fine with respect to home sales,” Crews Cutts said. “We’ve lost the speculative buyers. It will be the people ready for home ownership or who are already homeowners buying and selling homes. I think the mortgage credit will be plenty available for the plain vanilla segment of the market, and we’ll start to see some pullback on some of the crazy stuff.”
Dangelo agreed that investors will turn to investing in more conservative mortgage-backed securities, and said lenders could incur additional costs to meet new regulatory requirements.
But the industry will be able to offset those costs by investing in technology that makes originating, closing and servicing loans faster and more efficient, he said.
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