For the past two weeks, I have run a great article by mortgage and real estate expert Josh Lewis on just what is happening now in the mortgage market. Josh is at it again this week, with another brilliant piece on what the current liquidity crises means for your real estate holdings, your mortgage and ultimately your wealth.
If you’ve been fretting about what to make of all of the liquidity crunch talk on CNBC and elsewhere, I encourage you to read Josh’s insightful perspective. I guarantee that it will clear things up for you, and it might even keep you from making any mistakes with your mortgage or real estate.
By Josh Lewis
Two weeks ago, I wrote an overview of the mortgage market meltdown for Doug’s Alert readers. I’m following up today to explain more about what has expanded beyond the mortgage markets and become the "liquidity crisis."
The current drama unfolding in the financial markets has been referred to as a "Minsky meltdown" in honor of economist Hyman Minsky. Minsky became famous for his theory on market bubbles, which Wikipedia explains as follows:
"Minsky found that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what investors can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to those that can afford loans, and the economy subsequently contracts."
Many of the folks I talk to ask some variation of this question: "I understand subprime loans disappearing but why is it that creditworthy borrowers can’t qualify for a mortgage?"
The answer is that the period of prolonged stability and speculative euphoria has ended. We saw home prices skyrocket in the last decade. This made it almost impossible for a homeowner to lose their home to foreclosure and by extension that meant it was almost impossible to lose money lending to homebuyers and owners on nearly any terms. Zero down? No problem. Negative amortization? No problem. Can’t prove your income? No problem. After all, if you can’t make your payments you’ll sell the home, repay the lender and no harm is done.
At the same time, for reasons too numerous to list here, the global markets were awash in funds looking for an investment. For anyone who has ever taken Economics 101, you know what happens when demand greatly exceeds supply. Prices go up. When prices of bonds, such as mortgage-backed securities go up, their yields come down in the form of interest rates. This was the perfect storm for borrowers as the hurdle to cross in qualifying for a loan simultaneously dropped to the floor while the cost of borrowing plummeted as well.
To put it in perspective, a borrower in 2000 with a 580 credit score would have needed at least a 10% equity position and proven in some way that she had an income sufficient to repay the loan. IF SHE MET THOSE TWO CRITERIA, she would pay a premium interest rate 2-3% above the going "prime rates."
By 2005, that borrower could get 100% financing, stated income (no income documentation) with no more than a 1% premium to prime rates. The reason is that the long period of stability had led investors to believe there was no risk of losing their capital as home values always rise. The investors were also happy to receive a 1% premium since prime rates produced such a little return.
Over the last year, bit by bit, the markets have woken up to the actual level of risk in mortgages and we find ourselves now in a "period of hyper instability." Nobody wants to sell the mortgages they have on their books because they will have to sell at a discount. Once those loans sell at a discount, all of the loans on other investors’ books then will be "marked to market" and the losses will be realized for accounting purposes whether the loans are sold or kept on their books.
In essence, we have a standoff where the markets have frozen. Nobody owning mortgages wants to sell them because they don’t want to know how little they are worth. Absolutely nobody wants to buy mortgages for the same reason. Lenders, not having anyone to sell their closed loans to, have simply decided not to lend to anyone or to offer such high rates that they can’t lose money selling them once a market materializes for them.
The ONLY exceptions currently are loans underwritten to the standards set by the government (VA/FHA) or Government Sponsored Enterprises Fannie Mae and Freddie Mac. That means only loans under $417,000 are being offered at good terms and only for full documentation, prime credit loans.
At some point, a market for non-conforming loans will re-emerge. The guidelines will not be nearly as generous and the rates will be higher, but there will be a return to normalcy that will look much more like 1998 than 2005.
In the meantime, this is causing SERIOUS problems, especially in high-priced markets throughout the country including most of California. According to RBS Greenwich, $27 billion of subprime loans per month will be facing an interest rate reset as their fixed period ends. Since the fixed period on most of these loans was two years, most of these loans were taken out too late in the cycle to build up enough equity for the borrower to qualify under the new tighter guidelines. Even if they could qualify, they would face terms that would likely make the payment too high to manage.
This doesn’t count the Alt-A and prime loans that will be facing rate resets. These shouldn’t be in as bad of shape because most were fixed for three-to-five years and as a result have built up some equity. These loans also were made to borrowers with higher scores who "should" have some options in today’s markets.
The last group of folks facing a day of reckoning are the stubborn few who have held on to their Pick-A-Payment Option ARM’s as the rates climbed from a low in the 3% range to the low 8% level today. Why would anyone do this? Because the negatively amortizing, minimum payment was still much lower than the interest-only and fully amortizing terms available in the market. With stated income loans on the shelf for the near future, the window for getting out of these loans may have closed.
I will leave you today with the same advice I had two weeks ago. If you are in anything other than a fixed rate loan with at least 20% equity in your property, you need to be consulting with your mortgage professional to see what your true risk is and what options exist for safer financing. If you do not have a trusted mortgage advisor, I will be happy to walk you through the process and to help you build a game plan for securing your financial future.
You can reach my offices at 888-944-JOSH (5674) ext. 1 or via e-mail here.