Current State of the Mortgage Market

What a fascinating and tumultuous time is upon us! Both the housing and the mortgage market are convulsing wildly! There are so many facets to the "big picture" that I would never presume have all the answers, so the following disclaimer is in order: I am a mortgage broker and the following is my opinion based on my experience and my knowledge. You might agree with me, you might not. But I urge you not to jump to any conclusions based on what I or anyone else has to say about the current state of affairs. No one can predict accurately how this is all going to turn out. My point of view is incredibly cynical in some ways, yet leaves room for optimism with the famous caveat of "it depends." In other words, my cynical prognostications can all be erased if certain entities take certain actions. Last thing is that this article is written for the masses, laypersons included. If you are an industry insider, I apologize, but I will be stopping to explain some things you definitely already know. Away we go...

The Beginning

In this case, the beginning is not an exact date or marked by an exact event, but rather the confluence of two important factors: the incredible loosening of lending standards and the overly-exuberant boom in the housing market. Yes, there are other important factors, and yes, I will discuss them, but these two are the big two in my mind.

Let's start with the loosening of lending standards. People with large amounts of money (banks, etc...) put systems into place to evaluate the potential risk associated with a loan. They've been evaluating the risk on loans since well before I was born. In the mortgage industry, this is called underwriting. There are underwriters (human beings), and underwriting systems (computers) that render decisions. Be they human or machine, the underwriting systems are employed and acting on the instruction of the money source.

"Money source" is a purposely ambiguous term so I can make the following point. Where does the money for mortgage loans really come from? If Wells Fargo gives you a mortgage loan, you might guess the money for that mortgage came from Wells Fargo, and you'd partly be right. Wells did indeed have the money to fund that transaction, and they may actually hold on to your loan forever, but there is a deeper layer to the money source than that. Even big banks need LIQUIDITY in order to continue doing business. When Wells needs liquidity, they obtain their money at a certain rate based on the appetites of the bond market. Sometimes this means "selling" your mortgage. Ultimately, the actual market metric is what's known as the "mortgage-backed security."

Mortgage-backed-securities (MBS's) are bought and sold just like stocks and bonds. By the time someone buys a MBS, its underlying risk and obligation have passed hands many times. It's gone from the consumer's intention to finance a house, to a mortgage broker, to a mortgage lender's underwriting staff, to the corporate structure of that lender, to be packaged in a "pool." Then it's either sold or held. When it's sold, it can be sold multiple times. The point is that those that are buying and selling them cannot simply call up the consumer that got the loan and ask them if they are a good credit risk. They are many times removed.

So this creates the necessary and crucial task of "judging" how sound of an investment the MBS is. After all, if a bank was selling a pool of loans with an average interest rate of 8%, the effective interest rate would only be 8% if none of the loans defaulted. Just based on historical statistics, a certain percentage of loans go into default. This risk of default is factored into the value of an MBS. In determining risk of default, investors look at several aspects of the mortgages that comprise MBS's: loan amount, credit score, whether income was documented or not, liquid assets, amount borrower compared to appraised value, whether cash was taken out, and many more.

Over time, default rates on certain "standard issue" mortgages have become very predictable. While there are many different types of mortgages, in recent history, but still before the period of so-called "meltdown," a certain type of mortgage was by far the most common. This is a 30 year fixed mortgage, with documented income and assets, with a down payment of some sort (or compensating factors to offset it), and with a reasonably strong credit history. In general, these are the components of a "Conforming" loan. A conforming loan is any loan that "conforms" to the guidelines set forth by Fannie Mae or Freddie Mac, huge Government-Sponsored-Enterprises put in place to help the American public realize the dream of home-ownership while protecting investors. So life is good right? Fannie and Freddie have their conforming loan guidelines in place. Investors can anticipate a predictable default rate and people can buy houses.

Enter the Problem #1

Unfortunately, not every family's scenario fits the conforming guidelines. In the not too distant past, there were little or no financing options for these families. To make a long story very short, investors saw great potential for this untapped market demographic. Alternative loans started to emerge with different standards than conforming loans. Interest rates were raised to account for increased risk of default and investors "guessed" at what would be the best indicators of likelihood of default. They knew it would be higher, but unlike the years and years of historical data behind conforming-type loans, there was no track record for these alternative loans.

What followed was a cataclysmic downward spiral of overly-exuberant underwriting standards. To keep up with competition, lenders got more and more aggressive, all the while operating in a market segment with a non-existent track record. Default rates were being guessed at, and were becoming evident in real time. Also evident was the fact that "experts" underestimated the actual default rate of these new alternative loans. Ratings Agencies (wall street analyst companies), were listing these new MBS's as much better than they were (because no one really knew how they would turn out). This goes back to the point of the investor being so far removed from the consumer. Wall Street analysts were saying that MBS's from these new alternative loans were a hot buy, so investors bought more. And more demand among investors drove an increase in the aggressiveness of loan programs and underwriting standards. It was a downward spiral in which anyone with a pulse could finance a house.

If this existed in a vacuum, it might not be so devastating, but it does not. This fire happened to be ignited at the same time that a large amount of gasoline, in the form of a real estate boom was occurring. There can be numerous "chicken versus the egg" arguments about the housing boom and the loosening of the mortgage market. The fact is they occurred at relatively the same time and they fed off each other.

Problem #2

People talk about the real estate boom that began around 2001 and ended about mid 2006. People and "experts" talk about the boom as if it's something that's happened before. "There have been up times and down times" they say. "This is just another boom." Those "experts" are wrong. There has never been a period like this. We have just experienced the largest housing boom in history. Might there be another one that supersedes it in the future? Possibly, but I would argue that the current time period will serve as a sobering lesson for us in the future. I would argue, this is as big as it gets. And it's not because I have the experience to have lived through previous ups and downs. It's not because I have decades of experience tracking these issues (because I don't). It's not because I have the foresight to predict the future of the markets. It is due to a simple truth: this "boom" is so much more inflated than any previous booms that it will stand as an obvious outlier in historical home price data. That is to say, compared to other upturns and downturns, the current boom is a much much larger digression from the mean than we have ever seen.

Here is an absolutely brilliant graph by the Yale economist Robert Shiller:

As you can see, there have been ups and downs. All have been within a certain standard deviation of the mean. The highest highs and the lowest lows have not deviated more 35% from the mean. Now take a look at the last 5 years. Adjusting for inflation a house today costs twice as much as the average value of a home for the last 100 years! We're over 100% away from the mean. I don't remember a lot from my statistics class in business school, but I do remember the concept of regression, or a return to the mean. It will happen. But remember this doesn't mean a house will eventually return to the same price it was in 1940, it means it will return to the same inflation-adjusted price. Even so, we are in the middle of a housing price correction right now that will likely continue. The severity of the correction and the length of the correction are two things that no one can accurately predict. That is where opinion comes in. You will hear a lot of opinions on the news, especially the economic focused news outlets. They vary, but I don't really think the "experts" realize just how bad things are. This is where my opinion comes in. but first, we need to talk about the interconnectedness of the mortgage market and the housing market.

There are a couple of caveats to the negativity. First, the mean housing data does not necessarily take into consideration that houses are much bigger and nicer (in general) than they were in the past. This may ease some of the regression to the mean. Furthermore, it's very important to note that different real estate markets around the country have behaved very differently. Although the media is national and national home data seems to spell doom for the entire nation, there are pockets around the country where the real estate market should be staying more steady. Some have already hit past the bottom, some have leveled out, and some will actually continue to grow. It just depends where you are and what market forces at play in your local market.

Mortgages and Home Prices: How They Are Connected

In the late 90's, the demand for housing began to rise steadily. Builders rushed to meet that demand by building more homes, yet the demand continued. The mortgage market had to do it's part by making sure more people could qualify to buy homes, so lending guidelines loosened. This also coincided with a period of decreasing interest rates. All the ingredients for the meltdown were in place. The lower interest rates drove an already high demand for homes higher. The easy lending guidelines made sure everyone could get the loan they wanted. Existing homeowners tapped their home equity to finance their lifestyles. Home equity was apparently an infinite well of money. Everyone, including industry professionals, made future plans on the assumption that values would continue to increase and money would continue to be easy to obtain.

There is an obvious downward spiral here. It is now culminating with one of the most dangerous gambles the mortgage market took. Before you read the following sentence, let me say that there is nothing wrong with adjustable rate mortgages (ARMS) if used for the appropriate purpose in the appropriate market. That said, ARMS are one of the main contributors to the meltdown. Short term ARMS were created that allowed someone to have a fixed payment for 1, 2, or 3 years. The introductory rates on these were low enough to allow first time homebuyers to buy homes well beyond their means. Brokers and banks assured these borrowers not to worry because their home would increase in value and they could refinance in 2 to 3 years to a more favorable loan. It seemed like a workable plan as long as everything stayed steady.

It Didn't Stay Steady

The new alternative loans (remember the ones with no track record to judge risk), started to show their track record, and it was worse than expected. When a loan-type has a worse than expected track record, it leads to investors not wanting to buy it any more. As a result, the money to fund these alternative loans began drying up and lenders began to go out of business. This led to a gut-check among all alternative loans and investors preemptively pulled the plug on other less-aggressive products as well. So starting in 2007, it has become much more difficult to obtain any sort of alternative financing. For instance, in 2005, a homebuyer could finance 100% of their home's value, without proving their income, with a 620 credit score. Now, lenders don't even do stated income loans to 100% with ANY credit score! That's a major change that's happened in just a short 3-4 month period.

At the same time, builders had become so exuberant that they had (and still have) immensely over-built for current housing demand. There is far more inventory on the market in terms of new homes than demand can meet. Even if there was demand for these homes, people can't get financing any more. Also, let's not forget about the scores of families that bought homes with short term fixed loans with the hopes of their values increasing, their credit improving, and refinancing into a better loan. In general their credit has not improved. In general, their house has not appreciated, and consequently they cannot refinance into a better loan. BUT they also cannot afford their payment.

Gloom and Doom

Now we have existing homeowners forced into default or short sale scenarios. This has a direct effect on banks and investors. Guidelines are further tightened to prevent future woes and this prevents even more people from getting financed right now. So their foreclosed or short-sold homes are coming onto the market and bringing prices down. Also, let's not forget about the huge inventory of new homes on the market. Builders are languishing and they are forced to drop prices as well. About the only thing that has stayed positive are interest rates. Historically speaking they are near an all time low, but it doesn't matter because they are only low on the Conforming programs. The lending standards are returning to the mean. Home prices are returning to the mean as well.

All that is to be expected, but here is why it's so bad. The volume of adjustable rate mortgages that are "coming due," or in other words, hitting their adjustable period where the payment goes up above what the homeowner can afford, will be even higher in 2008 than it is in 2007. At the same time, loans are harder to obtain than ever. Many of these people will be forced into foreclosure or short sales. These sales hitting the market at incredibly low prices lower the comparable sales data. The builders with too much inventory on their hands also lower the comparable sales data average.

And That's Why It's Worse Than Most People Think

We have hundreds of thousands of families across the nation in homes that are worth less than what they owe. They need to refinance to get out of their ARMS, but cannot due to both lending guidelines and home values. These families default or short sell which causes the lenders to take serious damage, which in turn causes lending guidelines to be further restricted. We are only just on the way down now. The crash landing has not yet occurred. As I said, there are more ARMS coming due in 2008 than there were in 2007, coupled with a tougher financing environment. When these come due and default or short sell, it further drives down the already decreasing value of real estate. This in turn harms builders who now have to take much less profit than expected and in some cases, losses. D.R. Horton's CEO said "2007 is going to suck," and he was right.

I argue that the aspects that make 2007 "suck" are the in greater supply in 2008. "Experts" and analysts incessantly like to state that housing only comprises a small percent of the entire American economy. This may be true in terms of jobs, but these "experts," all with much more education than me and much more air time are failing to see the biggest one of several critical factors in all of this: HOME EQUITY HAS FINANCED CONSUMER SPENDING. When we talk about the housing market being a small portion of the economy, that may be true inasmuch as construction jobs, but what about all of the ancillary effects?

Where do these experts think consumers are getting the money to buy the plasma TV? Maybe it's on a credit card, but eventually consumers want to consolidate that credit card with home equity. In the past they have done this, used home equity to increase their lifestyle, run up the credit cards again, and get bailed out again by home equity. BUT this will not be available in 2008! The simple fact that housing is a small part of the economy does not take into effect the interconnectedness it has with the rest of the economy. Builders losing money hurts the economy on it's scale, but what about lenders going out of business? Less people can get financed, so more people default, so more investors lose money, and less people can pump money into our economy, both on the end consumer level and the investor level.

It's a bad, bad situation. Intervention can come from many places. There are several congressional bills that have passed or that are proposed that would re-work Fannie Mae and Freddie Macs guidelines to allow some aid to the troubled areas of the mortgage market. It's not a panacea, but it will help. One thing is for sure: home prices MUST eventually return to their mean on the inflation adjusted index. Also, lending guidelines MUST return to a sustainable and predictable level of risk assessment. These two things are in the process of happening now, but they have definitely not already happened.