Nervous times

With just one week to go until the annual MBA convention and expo, the largest gathering of mortgage bankers in the US, Paul Muolo says the good time for the US mortgage market could soon come to an end following the impact of Hurricane Katrina

Predicting an end to the mortgage boom in the US has been a losing proposition for the past few years. Industry production peaked in 2003 at US $3.9trillion, then fell to $2.79trillion in 2004 – a 28% decline.

You’d think that a production drop of that magnitude would send mortgage lenders stark raving mad, screaming into the night about how the business was coming to an end. But guess what? Even though loan originations fell by what looks like a large amount, hardly a complaint was heard and mortgage bankers of all stripes – non-depositories, banks, savings and loans and credit unions – earned just as much, if not more in 2004 than they did in the record year of 2003.

And what about the current year, with about two months left to go on the calendar? It appears residential loan production will weigh in at almost $3trillion, making it the second best year ever for the industry. So are US mortgage executives in a great mood about the current state of the industry and what lies ahead for next year? Will there be partying when members of the Mortgage Bankers Association – the largest and most influential of all US mortgage trade groups – gathers in POrlando’s Walt Disney World for its annual convention? Yes. But as for being in a great mood about 2006, that’s a different matter.

First, let’s talk briefly about 2004. The reason US mortgage industry profits remained high in 2004, despite overall loan volumes declining, is tied to the rise of the sub-prime sector. Even though overall mortgage production – prime, government-insured, sub-prime and so forth – fell last year the sub-prime niche soared. Not only did it soar, it took off like a rocket, accounting for one in five loans funded in the US. This is a record.

Why exactly sub-prime originations climbed to a record $608bn last year and are likely to be $724bn this year (establishing yet a new record) is open to interpretation. In the US, sub-prime lenders fund mortgages that are A- to D in quality. The reason mortgage companies take a chance on these riskier credits (riskier, that is, than loans sold to US-sponsored mortgage giants Fannie Mae and Freddie Mac) is because of the loan yield. If a conventional loan sold to Fannie or Freddie is offered at 5.5% to a consumer, an A- loan would fetch 7%, allowing the lender to make 90 basis points more in profit. In short, the worse the credit grade, the higher the yield and the profit.

With conventional refinancing trailing off in the past two years, many A paper lenders jumped into the sub-prime pool as a way to maintain and increase profits. Not only did this increase the number of funders but several Wall Street companies, including Goldman Sachs and Merrill Lynch, formed so-called conduits to buy and securitise residential sub-prime loans. Conduits buy loans from the funders, packaging the mortgages into asset or mortgage-backed securities.

Several other investment banking companies have been securitising sub-prime mortgages for years, chief among them Lehman Brothers, Bear Stearns and JP Morgan. These conduits have added liquidity to the sub-prime market very much the way Fannie and Freddie have added liquidity to the conventional loan market.

But something else is afoot. Sub-prime lenders such as New Century, Option One and First Franklin, all based in California, have expanded their menus to include exotic mortgages such as interest-only adjustable rate mortgages and payment option ARMs that allow consumers low monthly payments compared with a standard 30-year fixed rate loan.

The emergence of interest-only and payment-only loans as consumer favourites has caused alarm in some quarters. Federal Reserve chairman Alan Greenspan has publicly lambasted the loans, predicting consumers ignorant of the risks may find themselves in financial hot water once the rate on interest-only and payment-only ARMs adjust. IOs are adjustable but POs offer consumers four monthly payment options, one that allows for negative amortisation. This lowers the monthly payment by tacking on more principal which prevents a consumer creating equity in their home because their debt is always increasing.

In September Tom Wind, co-chief executive of Chase Home Finance, declared his company, a subsidiary of JP Morgan Chase, would not fund payment-only ARMs.

“I look at what our competitors are doing and I’m really concerned,” he says.

He fears rate adjustments will lead to delinquencies and credit losses. Chase is the nation’s fourth largest lender behind Countrywide, Wells Fargo and Washington Mutual, and the only one so far avoiding payment-only ARMs. To date, interest-only and payment-only ARMs have performed well but the products are so new it’s too early to say how the loans will hold up over the long term.

Will delinquencies and foreclosures soar as Wind fears? For now, mortgage bankers in the US have other problems to worry about. Although sub-prime production is likely to set another record this year, profit margins have slipped. In the US sub-prime lenders either fund their production with deposits or borrow money, often through Wall Street or via warehouse lines from large commercial banks.

With profitability, all was well until the Federal Reserve began hiking short-term rates 18 months ago. Lenders make their profit on the difference between short-term rates and the rate they lend money out at, minus their expenses.

There are $7.98trillion in outstanding residential loans in the US. It is the largest debt market in the world. Consumers have homes valued at $15.8trillion.

A few months ago short-term rates were at 1%. Today they are 3.75%. Typically, in a perfect world, long-term rates should rise in tandem with short-term rates allowing mortgage lenders to pass on increased cost of funds to consumers. But in this mortgage cycle that hasn’t happened, at least not yet. Mortgage rates have hardly budged while short-term rates have risen, squeezing both prime and sub-prime lenders. In the US most mortgages are priced off the 10-year Treasury.

Industry executives say profits on sub-prime, home equity loans and interest-only mortgages are off considerably from their highs of last year. “We are seeing substantial price pressure in sub-prime, HELOCs and hybrid loans,” says Angelo Mozilo, chairman and chief executive of Countrywide Home Loans, the nation’s largest overall funder.

“Profits per loan are down,” he adds, noting that some banks (depositories) are funding interest-only mortgages and instead of selling them into the secondary market are portfolioing them.

The Countrywide boss says by putting the loan on its books the lender can avoid a mark-to-market writedown.

Profit margins on sub-prime and alt-A interest-only loans are still decent, executives say, but are starting to suffer. Mike Baldwin, president of Lime Financial of Oregon, which relies heavily on IOs for its production, believes margins are continuing to compress. He says part of the problem is that lenders are not raising their rates which in the words of Mozilo, allows consumers to get a “great deal”. It may be a great deal for consumers, but as Baldwin and Mozilo know, that doesn’t translate into a great deal for mortgage bankers.

Dan Perl, president of First Street Financial of southern California, says the price war in the sub-prime market has settled down a bit since the spring and summer because some large lenders that were undercutting the market have since raised their rates.

As Mortgage Strategy went to press more and more US lenders were starting to raise their rates in at attempt to thwart the profit squeeze. But executives fear that higher rates will quickly translate into lower loan volumes and dwindling profits.

Another factor driving loan production is home sales. During the past two years housing starts (construction) and existing home sales have defied gravity, leaving economists scratching their heads.

“The ongoing vigour of the housing sector is confounding,” Greenwich Capital said in a report earlier this year.

There is a concern that Baby Boomers in the US are doing to the second home market what they did to technology stocks a few years ago. A study by the National Association of Realtors says the second homes market – holiday and investment properties – is on fire with such sales accounting for 36% of all homes sold. In certain holiday markets, particularly beach and lake front properties, home prices have doubled in three years. NAR, which for the first time did extensive research on the subject, found that 23% of all second homes bought were for investment while another 13% functioned as holiday homes.

But the fear is that speculators have been driving up home prices by using IOs and payment option ARMs – at least that seems to be Greenspan’s fear. A lot of ink has been spilled writing about a US housing bubble, even a global housing bubble. So far there has been no loud pop but that doesn’t mean it couldn’t happen.

Mortgage executives are a sanguine bunch but not to the point of believing in the tooth fairy. In the past few months, a number of top executives have voiced their opinion that home prices will flatten in the months and year ahead, and may even creep down a bit. Few think they will go pop.

In October, Mozilo declared on national TV that he expects housing prices to ease, especially in markets where speculators have rushed in. Interestingly, a few months ago he told National Mortgage News he had concerns about the condo market in Orlando where the MBA is holding its annual convention.

On average, home prices have risen 53% in five years. “We’ve hit the tipping point and in many areas we’re seeing a levelling off of prices,” Mozilo says.

Slower sales and lower prices will translate into less business for mortgage lenders, prime, sub-prime or otherwise. It will affect non-depositories, banks, and credit unions. Nobody will be immune. When the correction comes many small to medium-size lenders will head for the exits and maybe even a few larger ones too. That means mergers and acquisitions, consolidation, with larger fish gobbling up smaller ones, and mid-sized companies joining forces to compete against the big boys.

This is nothing new for veteran mortgage banking executives. They’ve seen it all before many times. But how bad will the correction be? As always that’s almost impossible to predict. Already companies are announcing lower anticipated future earnings blaming their revised forecasts on the price war as well as home damage caused by Hurricanes Katrina and Rita.

Mozilo was recently asked whether the industry would experience a soft landing following its three-year boom. His response: “I’ve never seen a soft landing.”

Based in Washington DC, Paul Muolo is executive editor of National Mortgage News and US Editor of Mortgage Strategy l
Lenders count cost of Katrina as 360,000 home loans are affected
It has been almost two months since Hurricane Katrina lashed New Orleans and the Gulf states of Alabama, Louisiana and Mississippi. Early estimates that 360,000 residential mortgages could be negatively impacted by the disaster seem to be holding up. Luckily Hurricane Rita which followed a few weeks later weakened, limiting damage to the housing stock .

Residential lenders, mortgage insurers and investors in the underlying loans all stand to lose millions from the storm damage. The big question now is – how much?

US mortgage insurance executives tell Mortgage Strategy their policies cover the mortgage and not the underlying property. The typical mortgage insurance policy covers the first 20% loss on a delinquent loan. After that the lender is on the hook for the balance.

Lenders that hold either the mortgage or the underlying servicing rights to homes damaged by the storm expect the consumer to eventually make good on the loan. For now several ‘forbearance’ policies allowing the consumer a payment holiday are in place, but for how long is anybody’s guess.

If a home has been destroyed the owner will hopefully rely on their property insurance policies.

Between 20,000 to 50,000 homes may have to be bulldozed in New Orleans. Significant damage has been inflicted on the Ninth Ward neighbourhood, a predominately low-income African American community. How many of these homes have mortgages is not yet known.

One of the stickiest issues for home owners in the affected areas is flood insurance. Though New Orleans proper is below sea level and protected by levees, many neighbourhoods are not considered to be in a federal flood plain, an important designation. Homes in federal flood plans are required to have flood insurance provided by the Federal Emergency Management Agency. The reason New Orleans homes escaped flood plain designation is tied to the levees. It may sound crazy but under federal regulations if a home is protected by a levee it doesn’t need a FEMA flood insurance policy.

According to a FEMA spokesman, a consumer can purchase a FEMA policy even if they are not living in a flood plain but in the past many lenders didn’t push the issue because it would tack on an extra $400 a year to the cost of a mortgage. FEMA has received, to date, 149,000 Federal flood insurance claims related to Katrina and has on its books 322,000 policies in the affected areas. In eight counties affected by Rita, FEMA has 318,000 flood policies in place but so far claims haven’t been high.

The average FEMA flood policy covers $250,000 in structural property damage plus $100,000 for contents.

The estimate of 360,000 mortgages being at risk comes from the Mortgage Bankers Association. It has yet to attach a dollar figure to this. However, the average size of an outstanding mortgage loan in the US is $133,000. Multiply 360,000 by $133,000 and the impact could be $47.8bn.

But keep in mind not all 360,000 loans will go bad. If a home damaged by Katrina can be repaired and insurance covers the work, everybody will benefit, the consumer and the lender not to mention the mortgage insurance company.

But Katrina did more than destroy homes, it also decimated businesses and jobs. Even if a home owner was lucky enough to be spared property damage they might find themselves without income to pay the mortgage. “With the magnitude of the destruction people might lose jobs, jobs that might not come back for a long time,” says MBA economist Doug Duncan.

The company bearing the brunt of the loss will be the holder of the loan. In some cases the mortgage is held on the balance sheet of a bank or savings and loan. But it many instances the mortgage has been sold into the secondary market – to Fannie Mae, Freddie Mac, or the Government National Mortgage Association.

As Mortgage Strategy went to press Fannie and Freddie were still assessing the impact. Freddie, which is putting an end to a two-year old accounting scandal, said it could lose up to $300m from loans made bad by Katrina and Rita. Fannie pegged its losses north of $550m. Unlike Freddie, Fannie is still working through its accounting scandal and may be forced to restate prior earnings downward by $11 billion. Another $550m won’t make a world of difference compared with $11bn. Then again, in the US there’s a saying: “Couple of billion here, couple of billion there and pretty soon you’re talking real money.”