Mortgages and the Home Industry, Part II
The comments on my last "Wall Street Manipulation" post have certainly come in fast and furious.
Some of them, from the Mortgage Brokers (so they say; all anonymous) are particularly amusing, and demand a response.
Let's look at how we got here guys.
Home values have appreciated at rates that dramatically exceed individual's growth in salaries.
Of course home value expansion significantly beyond the rate of inflation must eventually cause people to be unable to afford houses. The "why" on this isn't particularly difficult to figure out, but for those who were educated in Government Schools, let me lay it out for you.
Let's say that your salary goes up 3% a year. If home prices go up 6% a year, then you might think this is a great thing if you own a home.
But if you don't own a home, then it sucks, because as the price creeps up faster than your salary you find that your payment gets bigger and bigger, while your salary goes up less quickly. And what's much worse is that as your salary goes up your tax bracket does too, and this takes a bigger bite as well!
In many of the home markets values are more than quadrupled in the last ten years.
Salaries, of course, have not grown at that sort of rate - they've grown in the 3% range annually.
So what has the mortgage and homebuilding industry done with this?
Rather than hold down prices for new homes and take a "reasonable" profit, they've done what any good capitalist would do when faced with too much money chasing too few goods - they've raised prices and pocketed the money.
But there's a problem here.
In order to do that mortgage lenders have had to violate principles of good loan underwriting that have existed for more than 50 years!
That is, in order to "find a butt for the seat", they've had to change the rules.
After the 2000 tech bubble explosion this was made quite easy by near-zero money cost from the Fed. This meant that with virtually any interest rate you made money, since the (short term at least) interest rates were close to zero. This, by the way, is the same game that is being played out right now with the Yen "carry trade" - Yen are basically free to borrow, so you can borrow them there and then use the money to buy interest-earning things here - heh, "Free money" shout the traders.
Uh huh. All the way up until you realize that you sold a mortgage that has a 30 year horizon at an interest rate below where it will remain for the entire 30 years!
To control that risk, banks, which used to hold mortgages on their own, started "securitizing" these loans and putting in tricky features to control that risk.
That has allowed the banks to get away with this. See, banks have FEDERAL guidelines they must maintain in terms of loan safety. Why? Because the FDIC has to bail out banks that fail! Remember the S&L crisis? That was caused by S&Ls making risky loans that couldn't be repaid. Banks know all about this stuff, and they're very cognizant (since there was a blowup in their sector among the thrifts) of what happens when you do that.
So to keep their feet out of the frying pan, they figured out a trick - they shoved off the mortgages to the general debt market! Adding to this the mortgage folks figured out that they could take a "bucket" of mortgages, sift them into baskets that were categorized by loan-to-value and FICO score, assign those a risk premium and then sell them in the market as "tranches" of debt - essentially, converting the mortgage to a bond. By doing this the bank is (mostly) insulated from the risk that you won't repay the loan, because once any recourse written into the contract has lapsed, the risk passes to someone else - the bondholder.
And from there we got Option ARMs, 2/28 ARMs, 95% CLTVs and other tricks. We also got a "relaxing" of one of the most important lending guidelines, and one that used to be nearly inviolate just 10 years ago - the 32% mortgage debt to income, and 36% total debt service to income ratios.
This has allowed people to keep buying homes.
But unfortunately, what it has also done is made those home loans unaffordable in the "out years" - more than a year or two after origination.
Why? Because the concept that these loans would last "just a couple of years" and then people would "clean up their credit and/or improve their income and refinance into a conventional 30 year fixed" was a farce - and an act of fraud.
The mortgage bankers and real estate agents know the truth, even if they were educated in government schools. You can't shove 10lbs of crap in a 5lb bag. It doesn't fit. By artificially holding down the payments for a couple of years all you've done is shift the pain to the later years, with a totally unrealistic view of where that borrower's income will be in those years.
What every one of the folks that has sold a house or loan with other than a fixed-term conventional loan - other than a 15 or 30 year, or at the outside, a 5/1 ARM - has done is screw the buyer. Every time. They've made money by bending the buyer over the table and taking turns, because the entire basis of that borrower being able to either refinance out or pay off the loan depends on the continued asset inflation of the house - a pattern that they KNOW must, at some point, end.
This charade worked through the early years of '00 because home values rose fast enough that even with negative-amort or interest-only loans, or "fancy" CLTV ratios, the house appreciated in value enough that if you got in trouble you could roll it over and do a quick sale to some OTHER sucker, who would then repeat the process and do it all over again!
But eventually all such charades must come to an end.
Now, the end is here.
Home values are actually going down in many markets, especially Florida and California. The economy in places like Michigan is in the TANK, particularly around the Detroit area, as automakers fold back their operations and people's real income goes down.
Just last night PMI, one of the big "mortgage insurance" companies, released a report saying that "92% of their portfolio was to people with FICO scores of 620 and above", in a bald-faced attempt to reassure people that their exposure to subprime was "small".
The nasty truth is that this little ditty said exactly nothing about their real risk of default, because a FICO score of 620 has a roughly 1 in 10 chance of default, a FICO of 700 has a roughly 1 in 100 risk, and a FICO score of 800 has a roughly 1 in 1200 risk. That is more than a 100:1 ratio of risk, and yet PMI's press release and presentation said NOTHING about WHERE in the range of 620 to 800+ their distribution lay!
Reassurance? Baloney! If anything that ditty was the best argument for shorting PMI I've seen in the last month!
Here is reality folks - until home values regress to the mean growth rates, this problem will not and cannot end.
What needs to be done? A few things, most notably:
Some of them, from the Mortgage Brokers (so they say; all anonymous) are particularly amusing, and demand a response.
Let's look at how we got here guys.
Home values have appreciated at rates that dramatically exceed individual's growth in salaries.
Of course home value expansion significantly beyond the rate of inflation must eventually cause people to be unable to afford houses. The "why" on this isn't particularly difficult to figure out, but for those who were educated in Government Schools, let me lay it out for you.
Let's say that your salary goes up 3% a year. If home prices go up 6% a year, then you might think this is a great thing if you own a home.
But if you don't own a home, then it sucks, because as the price creeps up faster than your salary you find that your payment gets bigger and bigger, while your salary goes up less quickly. And what's much worse is that as your salary goes up your tax bracket does too, and this takes a bigger bite as well!
In many of the home markets values are more than quadrupled in the last ten years.
Salaries, of course, have not grown at that sort of rate - they've grown in the 3% range annually.
So what has the mortgage and homebuilding industry done with this?
Rather than hold down prices for new homes and take a "reasonable" profit, they've done what any good capitalist would do when faced with too much money chasing too few goods - they've raised prices and pocketed the money.
But there's a problem here.
In order to do that mortgage lenders have had to violate principles of good loan underwriting that have existed for more than 50 years!
That is, in order to "find a butt for the seat", they've had to change the rules.
After the 2000 tech bubble explosion this was made quite easy by near-zero money cost from the Fed. This meant that with virtually any interest rate you made money, since the (short term at least) interest rates were close to zero. This, by the way, is the same game that is being played out right now with the Yen "carry trade" - Yen are basically free to borrow, so you can borrow them there and then use the money to buy interest-earning things here - heh, "Free money" shout the traders.
Uh huh. All the way up until you realize that you sold a mortgage that has a 30 year horizon at an interest rate below where it will remain for the entire 30 years!
To control that risk, banks, which used to hold mortgages on their own, started "securitizing" these loans and putting in tricky features to control that risk.
That has allowed the banks to get away with this. See, banks have FEDERAL guidelines they must maintain in terms of loan safety. Why? Because the FDIC has to bail out banks that fail! Remember the S&L crisis? That was caused by S&Ls making risky loans that couldn't be repaid. Banks know all about this stuff, and they're very cognizant (since there was a blowup in their sector among the thrifts) of what happens when you do that.
So to keep their feet out of the frying pan, they figured out a trick - they shoved off the mortgages to the general debt market! Adding to this the mortgage folks figured out that they could take a "bucket" of mortgages, sift them into baskets that were categorized by loan-to-value and FICO score, assign those a risk premium and then sell them in the market as "tranches" of debt - essentially, converting the mortgage to a bond. By doing this the bank is (mostly) insulated from the risk that you won't repay the loan, because once any recourse written into the contract has lapsed, the risk passes to someone else - the bondholder.
And from there we got Option ARMs, 2/28 ARMs, 95% CLTVs and other tricks. We also got a "relaxing" of one of the most important lending guidelines, and one that used to be nearly inviolate just 10 years ago - the 32% mortgage debt to income, and 36% total debt service to income ratios.
This has allowed people to keep buying homes.
But unfortunately, what it has also done is made those home loans unaffordable in the "out years" - more than a year or two after origination.
Why? Because the concept that these loans would last "just a couple of years" and then people would "clean up their credit and/or improve their income and refinance into a conventional 30 year fixed" was a farce - and an act of fraud.
The mortgage bankers and real estate agents know the truth, even if they were educated in government schools. You can't shove 10lbs of crap in a 5lb bag. It doesn't fit. By artificially holding down the payments for a couple of years all you've done is shift the pain to the later years, with a totally unrealistic view of where that borrower's income will be in those years.
What every one of the folks that has sold a house or loan with other than a fixed-term conventional loan - other than a 15 or 30 year, or at the outside, a 5/1 ARM - has done is screw the buyer. Every time. They've made money by bending the buyer over the table and taking turns, because the entire basis of that borrower being able to either refinance out or pay off the loan depends on the continued asset inflation of the house - a pattern that they KNOW must, at some point, end.
This charade worked through the early years of '00 because home values rose fast enough that even with negative-amort or interest-only loans, or "fancy" CLTV ratios, the house appreciated in value enough that if you got in trouble you could roll it over and do a quick sale to some OTHER sucker, who would then repeat the process and do it all over again!
But eventually all such charades must come to an end.
Now, the end is here.
Home values are actually going down in many markets, especially Florida and California. The economy in places like Michigan is in the TANK, particularly around the Detroit area, as automakers fold back their operations and people's real income goes down.
Just last night PMI, one of the big "mortgage insurance" companies, released a report saying that "92% of their portfolio was to people with FICO scores of 620 and above", in a bald-faced attempt to reassure people that their exposure to subprime was "small".
The nasty truth is that this little ditty said exactly nothing about their real risk of default, because a FICO score of 620 has a roughly 1 in 10 chance of default, a FICO of 700 has a roughly 1 in 100 risk, and a FICO score of 800 has a roughly 1 in 1200 risk. That is more than a 100:1 ratio of risk, and yet PMI's press release and presentation said NOTHING about WHERE in the range of 620 to 800+ their distribution lay!
Reassurance? Baloney! If anything that ditty was the best argument for shorting PMI I've seen in the last month!
Here is reality folks - until home values regress to the mean growth rates, this problem will not and cannot end.
What needs to be done? A few things, most notably:
- The policy of qualifying borrowers at "teaser" rates and under "minimum" payments for Option ARMs must end. These borowers must be qualfiied under the fully amortized and expanded P&I payment and, if they cannot qualify under those rules, their applications must be denied!
- LTV and CLTV numbers over 80% must come with a PMI requirement on the entire loan balance, irrespective of whether that 80% ratio is violated by a first, second, or HELOC, and when the violation occurs. No exceptions! This will force the PMI companies to properly quote the actual risk associated with default and cover it.
- Debt to income ratios must be restored to historical underwriting guidelines (36% maximum debt service to income) at the time of loan origination. If you can't qualify under these rules, you can't afford the house!
- No recourse securitization must end. There is no way to curtail fraud if you can pass the buck to someone else and stick them with the lack of a seat when the music stops. As a result the law must change so that if the foundation of a given loan's claims is proven false, recourse extends all the way back to the originator! This will stop the "liar loans" dead in their tracks (stated income inflation), it will stop the CLTV scam with "silent" seconds and unseasoned down payments, and it will stop appraisal inflation - all three of which are major components of the problems in the industry today.
These changes will come with a cost. They would have removed 30-40% of the last half of 2006's origination traffic if they had been in place then. That sounds nasty but the truth is that until the asset price inflation is corrected, there is no fix for this problem, and the only way to solve asset price inflation is to increase supply and decrease demand!
If you're in the real estate business, whether as a Realtor, Mortgage Banker/Broker or otherwise, you've contributed to this stupidity - you are going to have to take some of the pain. And pain it will be - perhaps extreme pain for those of you in overheated markets.
But without these structural changes and the pain that comes from them, we face the stark reality that even PRIME loans written in the last few years are not safe.
Update: Consumer sentiment numbers are now out, and they are down below expectations. What's potentially really bad is that the worst deterioration is among people with high incomes - the folks who spend money and keep the economy going. People are figuring it out guys.... the chickens are home and they're starting to squawk!
Disclosure: I'm either short or hold PUTs on several stocks in this sector at present. My money is where my mouth is.
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