Mortgage Market Turmoil

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Many of my clients have been asking what all the recent turmoil in the financial markets means at a consumer's level. It's easy to see that a lot of large corporations are feeling the pain of taking on too much risk over the last few years. But how does this hit home for you and me?

In simple terms, the institutional investors that bought investments made up of residential mortgages pushed for lenders to find higher yielding mortgages. These mortgages are what are commonly known as subprime loans. As many of you know, borrowers with poor credit ("subprime" borrowers) are limited to borrowing money at a higher interest rate because they are a higher credit risk. The greater the risk, the higher the rate, and in Wall Street terms, the higher the reward. In theory the higher rates that these borrowers pay cover the losses that lenders anticipate this pool of borrowers will incur when a certain percentage of them default.

After a couple thousand years of money lending, one would think that lenders could accurately estimate the percentage of risky borrowers that would default - and hence build that financial exposure into the interest rates that these borrowers pay. This is not too different from insurance. Insurance companies know how many claims they are typically going to pay out within a certain class of the population, and they reflect that in the rates that they charge - and they still make money.

So if the risk can be built into the rate, why are we in the midst of a credit crunch? In simple terms, because these subprime, riskier loans were repackaged as highly rated securities on Wall Street. The theory is that if enough subprime loans are bundled together into one bucket, the bucket as a whole isn't as risky, provided the percentage of defaults within that bucket is within expectations. And that's where things got hairy. A higher percentage of subprime loans have been defaulting, so the overall performance of the bucket wasn't producing as expected. And as a result the investors stopped buying these buckets. And in many cases, they're selling the buckets back to the lenders - many of whom can hardly afford to buy them back.

When institutional investors stopped buying these buckets, as well as buckets containing loans from higher creditworthy borrowers, mortgage lenders ran out of funds to lend to consumers, and in turn their revenue streams dried up. As a result, many mortgage lenders have closed up shop or considerably tightened their lending practices. And that's where it starts to hit home.

Because lenders don't currently have a liquid secondary market (i.e., Wall Street has lost its appetite for buying these buckets of loans) they have to either lock up their own funds (as they used to do in the old days) and/or limit their lending to loans that Freddie Mac and Fannie Mae will buy (a.k.a. Conforming loans...non-jumbos). Which lenders are best suited to lock up their own funds? Depository banks - banks that do more than just mortgages, in other words. Most of the lenders that have gone out of business have been lenders that only did mortgages. But depository lenders have other lines of business that generate cash - in short, their liabilities are their greatest assets. That's because they borrow your money cheap (in the form of a savings account) and lend it back to you at a premium (in the form of credit cards, lines of credit, and, oh, yea, mortgages).

Within the mortgage industry we call these lenders portfolio lenders because many of the loans they offer borrowers are loans that they do not sell - they keep them in their own portfolio. And these are the lenders that are currently offering the best rates. So be sure to work with a mortgage broker (such as yours truly) who has access to portfolio lenders.

What You Should Know

For the time being, here's how the “mortgage crunch” will affect you:

- Tighter Lending Guidelines, for example...

• For home purchases, higher down payments may be required.
• Stated income loans may be unattainable at certain loan amounts and/or will require higher credit scores. This will affect the self-employed and people with undocumented income the most.

• Many lenders are publishing rates in the high 7's to low 8's for jumbo loans. Others are maintaining rates in the 6's. Higher rates could push some homebuyers out of the market for a new home if they can't afford the payments.

• This may have the unintended consequence of directing some ill-suited borrowers into adjustable rate mortgages - which has contributed to some of the trouble in the subprime market. That doesn't mean that everyone needs a 30-year fixed. Adjustables are appropriate for many homeowners.

Why you should call me