As we go about our daily lives in the mortgage and real estate world; dutifully performing our job functions and taking the high road of customer enlightenment via blogs such as Bloodhound; we are faced with a very large gorilla looming in the corner of our workplace. That gorilla is the amazing meltdown of the Wall Street mortgage market and its subsequent impact on the future of housing. If you’ve been following the financial news lately you’ve noticed that the indexes that track the collateralized debt obligations (CDOs) – Wall Street’s favorite securitization method for subprime and other mortgage debt – have taken a severe beating.
The reasons are many and the events of the recent weeks impact everyone tied to the mortgage industry and economy at large. Some of the major recent events that have changed the rules of the game we are playing:
- Wall Street rating agencies like Moody’s, Standard & Poors and Fitch have changed the way subprime debt is valued; essentially emasculating large portfolios of CDOs made up of subprime mortgages
- The complete under-performance of these CDOs as mortgage delinquencies continue to rise resulting in a liquidity and credit crunch at the investor securitization and investment bank levels
- The elimination of mortgage programs as securities become illiquid and unsellable to Wall Street
- The escalation of foreclosure properties and borrowers attempting short sales that are degrading mortgage pools even further
Let’s take a look at today’s events just as an example. Option One announced that they are no longer offering the 2-year fixed adjustable rate mortgage. Commonly referred to as a 2/28 mortgage this product was wildly popular during the recent credit boom. It offers a low “teaser” rate for the first two years before adjusting to a much higher “fully-indexed” payment. These loans, issued in trillions of dollars during 2000-2006 are resetting in record numbers to ever-higher interest rates. Many point to the 2/28 reset as one of the primary causes of mortgage default, foreclosure and – ultimately for Wall Street – poor security performance.
Why did Option One eliminate the 2/28? Simple. Profitability. Wall Street previously bid on large pools of subprime 2/28 mortgages with gusto. Today? Nary a bid is being placed on pools primarily consisting of 2/28 mortgages. The market is reinventing itself right in front of our eyes, with little fanfare or notice to our customers.
Home owners who are looking to refinance out of their existing mortgages will face higher interest rates due to a large variety of factors, but it will primarily be the profitability of lenders that will dictate the rates and programs available to them.
We need to talk more about this because our customers who are sitting and waiting to make a decision as to whether to buy a home or rent or refinance a mortgage are going to be in for a very rude surprise as this CDO meltdown continues to unwind. I am not an alarmist by nature but I like to believe I can read signs that point to danger for my clients. Clients who are considering 100% or high LTV financing for purchase loans or refinancing will be looking at higher interest rates and more restrictions than ever before. They will be taking on a higher debt-burden in a declining housing market that may be driven further down, exacerbated by the Wall Street restructuring.
Clients who have less-than-perfect credit will be facing much higher rates this year as either (a) their loans reset or (b) they refinance in to what’s left of subprime financing. Money is getting more expensive – and borrowers need to be fully informed that their options will continue to be limited and continue to become more expensive as we move through this rewriting of the Wall Street debt game.
There is a wide range of issues facing our industry and our market but the effects of speculative inventory build up, speculative investing and property flipping and the speculative investment in now poor-performing mortgage debt by Wall Street will continue to be the largest factors weighing on the environment we operate in. There are enough bubble blogs and mania articles out there to appease the chicken-littles but we must be wary of being ostriches ourselves. We owe it to our customers to be frank, reasoned and honest about the effects these issues will have on the decisions they make. I believe it will be the only way for us as true honest, forward-thinking professionals to fulfill our self-proclaimed client-advocate position. Otherwise we are no better than the rest.
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Jeff Brown says:
Morgan – if you HAD to bet, what would you say is the status quo by New Year’s Eve of ’08?
July 16, 2007 — 11:26 pm
Todd Carpenter says:
Morgan,
I let someone else write my market update as the longer I’m in this business, the less I seem to understand about rates. However, is it possible that Option One, and the investors who take on this debt are moving away from short term rates because the yield curve is now back to normal, motivating longer term investments?
July 17, 2007 — 8:02 am
Morgan Brown says:
Jeff – That is such a GREAT question because it forces us to synthesize everything that we see and hear with our collective gut and experience and actually play the role of advisor. I like it.
NYE ’08 is closer than we think so here is what I think for the status quo in a scant 5 months.
– Money is more expensive, especially to subprime borrowers.
– High LTV loans will not be refinanced with low credit scores (unless there is some gov’t intervention which seems unlikely at this point and in that time frame).
– Builders will continue to slow their building but not at a rate fast enough to curb the over-supply.
– Foreclosures will continue to pile up as ARMs reset with nowhere for borrower’s to go for cheap credit.
The combination of the above will put additional pressure on the housing market, driving prices lower in places that have seen the most speculative building (over-building) in the last 5 years.
Overall, my recommendation to clients would be:
– purchase only if you’re planning on holding the property for 5 to 7 years
– refinance sooner rather than later if you have “subprime” credit
– use a divorced appraiser prior to purchasing a property to get an accurate assesment of property value from someone not tied to other parts of the transaction
– do a lot of research on the neighborhood you’re planning on buying in.
Where do you see us Jeff?
July 17, 2007 — 8:46 am
Morgan Brown says:
Todd – I think the driving force is what investment banks, hedge funds, pension funds, overseas investors, etc. are willing to pay for the CDOs made up of the collateral.
They say “there isn’t any bad debt – only a bad price” meaning that any debt can be profitable, regardless of how it is performing if it is priced appropriately.
I believe the flight from these short-term products is now that the rating agencies have changed their assessment of this debt the price is way out of whack with performance. So now instead of a CDO made up of 2/28 ARMs going for 101.5 it is being bid at 85. A huge loss.
I think the yield curve going back to normal may play a smaller part in it – but I believe the number one driver here is the anticipated performance of this type of debt compared to what people are used to paying for it – and what they are willing to pay for it now that it has been re-rated.
July 17, 2007 — 8:51 am
Jeff Brown says:
Morgan – I think you may have misread the question. I’m talking 17 months from now – NYE ’08.
I’m not sure I can disagree with your shorter term comments.
That said, I’m finding lenders willing to finance investors in growth (a relative term if there ever was one 🙂 ) with 90% hybrid loans, fixed both in payment & indexed rate. (Lender pays the MI) They’ve no doubt found buyers for these loans, so I’m wondering who those buyers are, and what is fueling their confidence?
Any ideas on that one?
In all the presidential election years I’ve experienced as an agent/broker, seven of nine have produced an up-trending economy. Only ’80 & ’92 represent exceptions.
’80 was a result of Carter printing money like he was playing Monopoly and losing. 🙂 ’92 was the result of the S & L crisis, which was going to take its course no matter what anyone in gov’t tried to do about it.
So, over 70% of those presidential election years were good. ’72, ’76, ’84, and ’96 came after relatively down times. ’00 and ’04 came during relatively good times, and since nobody in gov’t had, at that point figured out how to screw the pooch, good times rolled on during the election years.
I’m guessing Wall Street will take their hits, selling their loan portfolios for losses – and turn the page. Since the sub-prime/Alt-A loans are a lot smaller as a percentage of the total loans (than the mainstream media would have us believe) made in the last several years, it’ll surely be painful, (as we’re seeing now) but will not be catastrophic as so many are predicting.
I think life will go on, and by NYE of ’08 we’ll all look back and say, “We’ve survived the period of moronic underwriting.”
The ultimate lesson here?
Maybe it’s not to believe the Wall Streeters when they say, “No Honey, I really love and respect you, really.” 🙂 They saw a chance to reap massive quick profits and took it. And since the lenders had built in buyers working on the ‘get-rich-quick-plan’ they jumped on the wagon enthusiastically.
Your thoughts?
July 17, 2007 — 10:22 am
Morgan Brown says:
Hi Jeff –
First let me say that this is the important conversation that I think we should be having. Thank you for engaging in this discussion and bringing your wealth of experience to the table.
As we know I am outmatched in terms of depth of experience and your longer-view perspective is much appreciated.
I think that as we roll in to 2009 we will be in a stable market. What stable means then is the question I have. I agree that life will go on and we’ll look at the 2005-06 loan vintages as examples of “bad underwriting” take our lumps and move on.
I think real estate invested in for the long term with a prudent financial game plan and an eye for real value in today’s environment is still a good play.
I just think that the readers of this blog deserve discourse from people like you who can help them make sense of the current instability in the market.
Are we in for a crash? I don’t think so. Are we in for some significant price devaluation and foreclosure pressure, along with losses tied to Wall Street?
Absolutely.
Thanks again Jeff for playing along!
July 17, 2007 — 11:22 am
Jeff Brown says:
Playing along with you and the rest of these guys is playing in some pretty thin air. 🙂
By the way, Ben Stein wrote something on July 5th which included his thoughts on this subject. You can find it on Yahoo! Finance.
July 17, 2007 — 12:24 pm
winjr says:
” Since the sub-prime/Alt-A loans are a lot smaller as a percentage of the total loans (than the mainstream media would have us believe) made in the last several years, ”
And what percentage is that, exactly?
July 22, 2007 — 7:48 am