WeeklyBasis 08/06/07: Subprime Hits Mortgage Market Hard

By now, you all know that the lending market turned on a dime last week, causing rates and approval guidelines on Jumbo loans (above $417k) to tighten drastically. Rates on Conforming loans (up to $417k) are down, but since our market is mostly jumbo, below is a one paragraph summary of what’s going on – then, for those that want more detail, I am including more background since this is a serious situation. Given this, I also want to remind you that RPM Mortgage is a private mortgage bank with operational roots dating back to 1986 and we’re on pace to fund more than $3 billion this year. We are currently liquid, and supported by the four largest warehouse banks in the industry. We received renewed commitments from them over the weekend to continue funding and closing our own loans as normal. We can do this when others can’t because of our size and our clean portfolio, 95% of which is A-paper loans.

THE QUICK MARKET SUMMARY
30yr Jumbo fixed pricing is awful, 2nd mortgages are very difficult to place right now, and stated income loans now require self-employment (W2 stated is disappearing), perfect credit and 6 months’ worth of stated income verified as being in the bank for at least two months. This week is light on data so all lenders are looking to Tuesday’s Fed meeting to provide some guidance on pricing. The Fed is not expected to lower rates to re-stimulate a spooked mortgage market, but they will almost certainly recognize that inflation is no longer the problem in the economy and leave themselves some room to cut rates in the coming months if consumers can’t get good home loans.

THE DETAILED MARKET SUMMARY
This current mortgage liquidity crunch was tipped off last Wednesday when American Home Mortgage, a top 10 US lender, suddenly stopped funding loans. To understand why this happened it’s important to understand the role of warehouse banks in the lending industry. Warehouse banks, which are large global institutions, extend lines of credit to mortgage banks to fund their loans. At it’s most simple, the process works likes this: After mortgage banks use warehouse lines of credit to fund and close consumer loans, they sell them to end investors for servicing and/or securitization, then they pay back the warehouse lines and start again.

American Home had a lot of risky loans, and investors who’d normally buy those loans to service (send borrower statements, handle customer inquiries, etc.) and/or securitize stopped buying. This caused the warehouse banks who were providing liquidity for funding/closing American Home loans to pull their funds. So American Home couldn’t fund new loans because they couldn’t sell closed loans, and it all unraveled quickly. This was a high profile example but it’s been going across the industry for the past 18 months. You’ve heard about mortgage firms closing shop but you didn’t see exactly why because most news outlets don’t fully know how the machine works.

The fall of American Home just underscored problems that have been brewing, and the situation was an inflection point for two reasons:

First, it caused warehouse banks (who provide liquidity for loan funding) and investors (who provide liquidity post-funding) to suddenly stop money flows.

Second, American Home was large enough to have ripple effects and cause other lenders to have funding problems. American Home, in addition to originating loans, also served as an investor that would buy and service loans from smaller lenders. Just as American Home ran into trouble when investors stopped buying their loans, smaller lenders ran into trouble when American Home stopped buying loans from them.

ARE LOAN APPROVALS HARDER NOW?
The end result is a sudden and drastic tightening of loan guidelines. The market for second mortgages is very tight, and many lenders on first mortgages are not allowing seconds to go behind them. The easy solution is the return of higher LTV first mortgages with mortgage insurance, which by the way, became tax deductible in 2007 (subject to borrower income limits). The longer term solution remains to be seen as lenders see what happens to loan volume projections with such tight parameters.

The other huge adjustment is to stated income guidelines. Right now, there are still a couple lenders offering competitive pricing and stated guidelines. But in just a few days, this has thinned out quickly and the trend seems to be stated income for self-employed borrowers only, 700+ credit, and verification of six months’ of stated income in the bank–this money can’t just show up in the bank, it must be verified as being there by two months of bank statements. Inevitably tighter appraisal reviews won’t affect purchase loans as much because purchase contracts typically demonstrate that the open market bid commands the appraised value.

HOW LONG WILL IT STAY LIKE THIS?
At any given time, markets are ruled by one of two things: fear and greed. It’s just that simple. Right now, the mortgage market is ruled by fear and that’s why guidelines are getting tighter even as you read this. As for rates, the way bonds are trading right now suggests that rates should be dropping significantly. But this isn’t happening. The fear of having unsellable loans on the books is still too strong so lenders are pricing well above market. Eventually the market has to loosen up (aka, greed mode) because there are approximately $1.2 trillion in ARMs adjusting up by as much as 2% between now and December 2008. But until we see some guidance from the Fed (after Tuesday, next meetings are September 18 and October 31), the environment will be as is. It could take as long as 36 months to unwind this credit problem as banks become more aware pf their positions. But we just won’t know for awhile.

Conforming ($200,000 – $417,000) – NO POINTS
30 Year: 6.625% (6.765% APR)
10/1 ARM: 6.75% (6.89% APR)
5/1 ARM: 6.375% (6.525% APR)

Jumbo ($417,001 – $650,000) – NO POINTS
30 Year: 7.375% (7.515% APR)
10/1 ARM: 7.25% (7.39% APR)
5/1 ARM: 6.625% (6.775% APR)