Editors note: Part three of a four-part series on the crisis in subprime mortgage lending looks at how subprime lenders, having built up the infrastructure needed to originate loans in large volumes, needed to continue making risky loans to remain profitable. (Read Part 1, Part 2 and Part 4.)
The Center for Responsible Lending predicts that one in five subprime mortgages originated in the past two years will end up in foreclosure, and that as many as 2.2 million families have already lost their homes or will end up in foreclosure in the next several years.
Although the Mortgage Bankers Association and other industry groups say such estimates are alarmist, there’s no dispute that many subprime lenders that made money hand-over-fist during the housing boom are now facing a rocky period.
Washington Mutual Inc.’s home loans unit, which turned a $1.03 billion profit in 2005, posted $48 million in losses in 2006 after the bank sold nearly all of its subprime mortgage production and scaled back subprime loan production.
Countrywide Financial recently reported that its $2.06 billion in net earnings from mortgage banking in 2006 represented a 15 percent decline from 2005 profits.
Although subprime mortgages account for just 9 percent of the lender’s $1.28 trillion servicing portfolio, the percentage of delinquent subprime loans rose to 19 percent by the end of the year, up from 15.2 percent at the end of 2005 and 11.3 percent at the end of 2004. At 3.53 percent, subprime loans pending foreclosure were also up significantly from 2.03 percent at the end of 2005 and 1.74 percent at the close of 2004, Countrywide said in its annual report to investors.
New Century Financial Corp. saw its stock plummet after the lender postponed reporting its fourth-quarter-2006 earnings and said it would restate results for the first three quarters to reflect expected losses on bad loans it was forced to repurchase.
Since December, it’s been a rare week without headlines announcing the closure, bankruptcy or acquisition of a troubled lender by a rival. More than 20 companies have been affected so far, including ResMAE Mortgage Corp., Mortgage Lenders Network USA Inc. and Ownit Mortgage Solutions Inc. — all in Chapter 11 bankruptcy. (See article sidebar for more details on affected lenders.)
"Your big lenders will be around and your mortgage brokers will be around, and a great number of people in between will go by the wayside," said Patrick F. Stone, the chairman of The Stone Group, an Austin, Texas-based commercial brokerage and development company. Stone also serves as vice chairman of the board of directors at Metrocities Mortgage LLC, but said he was not speaking on behalf of the lender.
The early payment defaults that have left many subprime lenders without a source of funding are "forcing this sort of Darwinian evolution where the excess capacity is being wrung out of the market," McCleary said. "In 2003, there were lots of mortgage originators set up by brokers, who looked at the 2 and 3 percent margins on loans, and the massive amounts of money being made, and said ‘It’s my time to do this.’ They split off and set up their own shops."
Many of those small shops are now either going out of business or being swallowed up by larger lenders. Consolidation will allow companies that remain to boost their profits, Countrywide Chief Executive Officer Angelo Mozilo told investors when the company reported its 2006 earnings.
"There is a substantial amount of consolidation (in the mortgage lending industry), either through acquisition or just going broke or bankrupt," Mozilo said, adding that much of the action is "happening below the radar screen." The problems at the smallest lenders don’t make headlines, and Mozilo estimated 40 to 50 are going out of business every day.
Countrywide, he said, "backed away from the subprime arena because of a concern over credit quality.
"The subprime business was (historically) a business of, you take inferior credit, but you require superior equity," Mozilo said. "So people had to make a substantial down payment if they had marginal credit. Well, that all disappeared in the last couple of years, and you can get a 100 percent loan with marginal credit. And that doesn’t work, particularly if you have any kind of bumps like we’ve had now in deterioration of real estate values, because people can’t get out. So I think we’ve got a ways to go on that. There’s no signs of … the pressure abating on the subprime arena, and some signs that problems are accelerating."
Early payment defaults
During the boom, with home prices appreciating at the rate of 9 percent a year, borrowers had the confidence to stretch beyond their means in order to buy a first home — or cash in by flipping properties that they never intended to live in. As long as home prices kept going up, borrowers could finance their purchases with mortgages that carried low initial payments, knowing they’d be able to refinance into another loan before their payments went up.
But when home prices began to stagnate or fall, many borrowers found themselves saddled with loans worth more than their properties, and without the equity they needed as collateral to refinance on better terms.
Some stopped making payments on loans that were just 30, 60 or 90 days old — giving Wall Street investors who’d bought securities backed by the loans the right to demand that their originators take them back.
As head of asset-backed securities trading for UBS Investment Bank, Jack McCleary has had a front row seat on the drama as it unfolds.
Early payment defaults — cases where borrowers stop making payments on loans less than 90 days old — have grown from 1.5 percent to 3 percent in 2005 to about double that at the end of 2006, McCleary told investors at a Jan. 19 seminar in New York City.
There was a time when early payment defaults might involve some mitigating circumstance, such as the servicing rights to a loan being sold without the borrower being told where to send payments. Nowadays, they’re likely to indicate bigger problems.
"In 2005, more of the problems had to do with servicing, and loans had a higher incidence of recovering," McCleary said. "So generally we were holding them, in the belief that the roll rate from say, a loan missing first payment to missing second payment, would be very low."
In 2006 it was the opposite, McCleary said. "What we began to do is not hold the loans on our balance sheet, hope they reperform, and then put any reperformers back into securitization. We said, ‘You know what, these are all guilty until proven innocent. If they missed the first payment, they’re going back to you,’ " the loan originator.
When an originator is forced to take loans back, they have two options: get the borrower to resume making payments, or resell the loans on the marketplace for less than their original face value.
UBS has a "scratch and dent desk" that buys nonperforming loans based on the loan-to-value ratio after a property reappraisal. On average the price is 80 percent of the original value, McCleary said, but the resale price may be discounted even more deeply if properties were subject to inflated appraisals.
If 3 percent to 5 percent of the loans in a $1 billion loan package go bad right away, that can amount to a $6 million to $10 million claim against an originator, assuming the bad loans are worth 20 percent less than what they were purchased for, McCleary said.
"If we’re hoping to make say 25 or 50 basis points, we’re talking about making $2.5 million to $5 million on one of these ($1 billion) loan packages," McCleary said. "But if we’re going to have a $6 million to $10 million claim against the originator, that becomes the focus of the business, and obviously it can wipe out your profitability."
What that means to broker dealers who "warehouse" loans, McCleary said, is that companies that securitize those loans will no longer pay full price for them, because they worry that the originators won’t be around to buy them back.
There’s a "margin call environment," McCleary said, in which investors lack confidence that small and mid-sized lenders who may be subject to early payment default claims on other loans they’ve originated will be able to fulfill their promises to take bad loans back. Investors take the view that a lender’s guarantee to take loans back "is not worth anything, so I’m going to bake (the risk of default) into the (loan) price," McCleary said.
And if broker dealers can’t get the full price they’d expected for their loans on the secondary market, they may have trouble obtaining money to fund more loans.
McCleary said 80-20 piggyback loans have proved particularly susceptible to default because speculators often used them fraudulently. A piggyback loan allows borrowers to purchase property for no money down — and also avoid FHA, VA and GSE requirements for private mortgage insurance on loans with greater than 80 percent loan-to-value ratios.
"What we’re finding is there is more occupancy fraud — people who were really investors were saying they were owner-occupied homes, and when they couldn’t flip them or rent them out, they walked away," McCleary said.
A Standard & Poor’s analysis of 640,000 first-lien mortgages in bond pools found loans with associated piggybacks were 43 percent more likely to default.
In looking back at some of the loans that went bad, UBS has also discovered many were taken out by first-time home buyers, some with thin credit files. Thin credit files can make it difficult for analysts to properly assess the risk of a pool of loans, because borrowers with little credit history may have the same FICO score as more experienced borrowers.
"In some of the work that we’ve done, in looking at the percentage of first-time home buyers in pools, it’s somewhere between 30 percent to 40 percent," McCleary said.
Loan servicers are showing little tolerance when those first-time home buyers are late making mortgage payments, which could be contributing to higher foreclosure rates.
"We’re seeing a lot of people go from 60-day delinquency right into the foreclosure bucket," McCleary recalled. "We asked, why are you putting the borrowers into foreclosure so quickly? The servicer said, basically, that the borrower has no respect for the obligation. We don’t do this unless we feel there is really no intent to repay."
Looking further at the characteristics of some delinquent borrowers, "you see people that are 21, 22, 23 years old with $600,000 loans," McCleary said. "It speaks a little bit to the disintermediation of risk in the marketplace, the need for volume, that these loans are being originated in. And not surprisingly, there was, quote unquote, ‘No respect for the obligation’ from these borrowers."
The ratings agencies that grade the soundness of mortgage-backed securities are aware of such issues, McCleary said, "but they are also aware that they are serving a large community and they are generating lots of fees from originators, from the Street, so they move slowly" to bring ratings into line with reality.
The deceleration of credit "has occurred at a much faster pace than they have been able to respond to," McCleary said. Going forward, "You’ll see announcements about adjustments to HPA (home-price appreciation), adjustments to leverage in the borrower, or DTI (debt-to-income) and things like that. But overall, I think there’s a need to move the expected losses on the current pools to the levels probably above where they currently are."
Looking back at 2006, Standard & Poor’s Ratings Service said that private-label mortgage-backed securities backed by second mortgage loans climbed 22 percent, to a record $74.2 billion — even as total issuance of private-label MBS fell 2.76 percent to $1.158 trillion. Newly issued MBS backed by Alt A mortgage loans also set a new record in 2006, growing by 10 percent to $365.6 billion.
Standard & Poor’s said it issued downgrades on 400 credit classes last year — specific pools of loans with similar characteristics in a particular mortgage-backed security — a 267 percent increase from 2005. Because the number of credit classes rated by Standard & Poor’s more than doubled to 26,765 by the beginning of 2006, the increased number of downgrades was not as alarming as it might appear, the company said.
But in a recent paper, "How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?" Joseph R. Mason and Joshua Rosner concluded that MBS investors "may be surprised to find the mortgage claim they purchased is based on a pool of loans with very different statistical performance properties than previously experienced or expected."
The pressure for volume
"The question we often get asked is when will origination improve?" McCleary said. "We hear a lot of talk at the conferences, (that lenders) are changing guidelines, and committed to originating better collateral. Generally they move things fairly slowly. I would say the earliest you can expect to see substantial performance changes would be the second half of ’07."
Some lenders who invested in new servicing centers, information technology and large staffs during the housing boom had no other choice but to continue to originate loans at high volumes to justify their investments, McCleary said.
"I will tell you anecdotally that we are still seeing a number of originators that cannot change their guidelines to drop volume," McCleary said. "Basically, it means they are out of business. You are going to have originators who continue to originate the current, ’06 vintage, all over again."
Some lenders actually became more aggressive even as signs emerged that the boom was coming to an end, said Mason, an associate professor of finance at Drexel University’s LeBow College of Business, and Rosner, managing director of Graham Fisher & Co.
"The consensus view seems to be that, faced with slowing demand and shrinking profit margins, subprime lenders tried to maintain volume as the housing market was faltering in late 2005 and 2006 by making riskier loans," Mason and Rosner wrote. "Those risks are manifesting themselves in even lower profits, demonstrated by a number of exits from the industry and significantly higher loan loss provisioning for those that remain."
It was not just mortgage companies, but individual brokers who depended on maintaining high volume.
"The lifeblood of any mortgage company are the brokers," McCleary said, and their desire for loan products they can originate in volume must be balanced against the demands of ratings agencies and investors for sound underwriting practices.
Mortgage broker Steven Krystofiak, the founder of the California-based Mortgage Broker Association for Responsible Lending, said commission structures can give loan officers incentives to put borrowers into high-cost loans, regardless of their ability to repay them.
"If consumers are shopping for a neg-am (negative-amortization) loan, many salesman try to sell them on the start rate alone," Krystofiak said. "The commissions are based on the note rate, and many consumers don’t pay attention to the actual interest rate. With neg-am loans, there is a large incentive for salesmen who don’t care about the client, to get them an exorbitantly high interest rate. There are banks that advertise to originators they will give up to 3.5 points for yield spread — that’s a $17,500 commission on a $500,000 loan."
"All of this is very lightly disclosed at signing," Krystofiak said. "There is a smoke-and-mirrors effect. You’re dazzling them with this nice low monthly payment, and the real interest rate can be in the high 7s, low 8s, and that’s what the commission is based on."
Minority borrowers are more likely to take out such high-cost loans, although it’s not clear whether lenders are targeting them.
Data collected under the federal Home Mortgage Disclosure Act shows African-American borrowers took out higher-priced loans 54.7 percent of the time in 2005, compared with 17.2 percent for whites. Hispanics took out higher-priced loans 46.1 percent of the time, compared with 16.6 percent for Asians. A higher-cost loan was defined as a first-lien loan with an annual percentage rate exceeding 3 percent of the rate for Treasury securities of comparable maturity.
HMDA data doesn’t include factors used by lenders to underwrite and price loans, including loan-to-value ratios, debt-to-income ratios, and credit history scores, making it hard to determine if minorities are more likely to take out higher-cost loans because they are discriminated against or because they represent greater risk to lenders.
The California Reinvestment Coalition, which performed its own analysis of the 2005 HMDA data, found that the number of higher-cost loans issued in California more than doubled in 2005, to 573,492. About 80 percent were resold on the secondary market, and only 1 percent of the repurchased by the government-sponsored enterprises Fannie Mae and Freddie Mac.
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