Editors note: Part two of a four-part series on the crisis in subprime mortgage lending looks at how subprime lenders built the originating infrastructure that allowed private-label lenders to overtake government-sponsored enterprises Fannie Mae and Freddie Mac in the secondary mortgage market. (Read Part 1, Part 3 and Part 4.)
When economists and historians look back on the turn-of-the-century housing boom, they may conclude that new loan products — like interest-only loans, payment-option adjustable-rate mortgages, 2-28 hybrids and piggyback mortgages — were the fuel that stoked it.
Many of these nontraditional loans had been marketed to affluent borrowers for years. So how did they end up being marketed to subprime borrowers?
At a Jan. 19 seminar for investors in New York City that was also Web cast, Jack McCleary, head of asset-backed security trading for UBS Investment Bank, offered an insider’s perspective.
In the beginning, McCleary said, subprime mortgage lenders "basically (took) a page out of the credit card model, which was, ‘We’re going to risk-base price the consumer debt. You show us the consumer, we can put a high enough coupon on there that we’ll be able to provide credit where it didn’t exist.’ "
In other words, subprime lenders calculated that if they just charged high enough rates, it didn’t matter if some people weren’t able to repay their debt.
By 2002 to 2004, with interest rates hitting historic lows, subprime lenders began targeting homeowners with credit card and other debts for refinance and home equity loans.
"It became a debt consolidation model," McCleary said. "There was some HPA (home-price appreciation), so people had equity in their homes. Ameriquest was very good at this — most of their production for this period of time was cash-out refis."
The thinking at the time, McCleary said, was, "We’re going to take the equity out of the borrower’s home, we’re going to use that to pay down consumer debt, and transfer it into mortgage debt that’s tax deductible. We’re providing a service, we’re helping borrowers make efficient and good financial choices."
The mortgage refinance business proved lucrative — if you could generate loans at a high volume. With the emergence of a market for private-label mortgage-backed securities, the money was there to loan. It was just a matter of convincing people to borrow. Subprime lenders expanded their operations and advertising so they could make more loans.
The problem, McCleary said, was that lenders were unable to charge high enough interest rates while maintaining the loan volumes needed to generate cash flow that could justify the infrastructure they had built up.
"People had added servicing centers, they had added a lot of staff, made large investments in IT," McCleary said. "It’s a cyclical industry, but generally the mortgage originators had built this out as though it was going to be a fairly smooth ride in terms of volume."
When the refinancing boom petered out in 2004 — in part because interest rates were headed back up, but also because many who wanted to refinance had already done so — lenders were left wondering how to keep squeezing profits from their large operations.
If subprime loan originators had started out trying to solve the problems of borrowers, McCleary said, "In ’05, we’ve got originator problems to solve. How do we generate more volume? Our loan prices aren’t high enough, because the spread between the WAC (weighted average coupon, or interest rates paid by borrowers on the mortgages in a pool) and LIBOR (the London Interbank Offered Rate, or the basis of the lenders’ cost of credit), isn’t large enough."
Intense competition brought profit margins down, and the economies of scale and cost savings realized by the introduction of new technology had also benefited consumers.
"You can do tremendous volume in the mortgage business and not make money," Stone said. "Wall Street has created tremendous liquidity. Ultimately this is a good thing, but like all markets, it has to figure out what works and what doesn’t. "
Compounding the problem of reduced profit margins, "We also had an affordability problem with the borrower," McCleary said, because prices had increased so much in some markets that fewer families could afford to buy homes.
"The answer that solves everybody’s problems was 80-20s," or piggyback loans, McCleary said. "The borrower obviously can afford to buy the home now, if he doesn’t have to put any money down, and by adding seconds into the portfolio, the WACs increased. Generally the WAC on seconds is, for subprime, call it 10.5 to 11 percent. Adding 5 to 10 percent of that to any pool has a significant impact on the WAC."
Subprime originators who had been doing debt consolidation "rolled into the 80-20 program, and so the FICOs came down," McCleary said. As many as 40 percent of first liens in a pool of securitized loans might now have seconds associated with them, whether inside the pool or outside of it, he said.
"Much of what we’re seeing in terms of the ’06 poor performance … is a result of second liens defaulting early and taking early losses," McCleary said "It is substantially likely, although its hard to prove on the first side, because you can’t always match up the first and the second in the same pool, that most of the (poorly performing) firsts have seconds associated with them."
Although McCleary believes 2006 marked the first year that piggyback loans showed up in numbers in mortgage-backed securities, a Federal Reserve analysis of statistics collected from lenders under the Home Mortgage Disclosure Act shows the trend taking root in 2005.
That year, lenders reported a total of 1.37 million piggyback loans — a 74 percent increase from 2004. More than one in five owner-occupied home loans funded in 2005 involved a junior or piggyback loan by the same lender, the HMDA data showed, up from 14 percent in 2004.
The HMDA data also revealed an increase in the share of non-owner-occupied loans of the type often held by investors, speculators or owners of vacation homes. By 2005, non-owner-occupied loans, which represented between 4.5 percent and 6 percent of loan volume in the mid-1990s, accounted for 17 percent of mortgage loan volume.
The boom in subprime lending, fueled by private investors eager to buy mortgage-backed securities, coincided with a diminishing presence by GSEs Fannie Mae and Freddie Mac in the MBS market, and an inability of home buyers in high-cost areas to obtain cheaper FHA and VA-backed loans.
The rapid growth in subprime and Alt-A lending helped private-label lenders overtake the GSEs in the issuance of MBS for the first time in 2005. All told, 38 percent of private-label MBS issued by private-label lenders that year — $460 billion in total — was backed by subprime loans. The value of Alt-A loans securitized by private-label lenders in 2005 doubled from the year before, to more than $330 billion.
Meanwhile, with housing prices outstripping the conforming loan limit, FHA’s share of total mortgage debt fell from 20 percent in 2000 to 9 percent in 2004. According to a report conducted for the Mortgage Bankers Association, subprime lenders boosted their market share from 2 percent to 11 percent of total loans outstanding during the same period.
The GSEs and FHA were both hampered by the conforming loan limit, the maximum size loan eligible for repurchase by Fannie and Freddie. The limit, which is adjusted annually and currently stands at $417,000, is intended to ensure that FHA, VA and other government-backed programs provide affordable housing opportunities.
But the FHA can insure loans only up to 87 percent of the conforming loan limit, or $362,790. With the median-priced home in California at well over $500,000, the FHA insured only 5,000 mortgages in the state in 2005, compared with 109,000 in 2000.
Nationwide, FHA-backed mortgages accounted for less than 3 percent of all home loans in 2005, down from 16 percent in 2000, according to HMDA data.
A 2006 report on the GSEs’ declining market share of the MBS business concluded that the trend reflected "an increase in the number of borrowers with blemished credit seeking housing financing and lenders willing to extend credit to those borrowers."
Which is not to say that the emergence of securitization and the flow of global investment capital into the U.S. housing market caused the current subprime lending crisis. It could also be argued that the hot housing market attracted investors to mortgage-backed securities.
"You don’t loan money unless people want it," said Patrick F. Stone, chairman of Austin, Texas-based commercial brokerage, The Stone Group. "With the run-up in prices, even unqualified people were enabled to buy a home through affordability-type mortgages. That was probably not in anybody’s best interest, but not necessarily solely the fault of the secondary market making liquidity available. These people (borrowers) wanted in. It’s a chicken and the egg thing."
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