The Mortgage Market Meltdown and You

By Josh Lewis

Anyone who watches the nightly news or reads the newspaper is well aware that the "subprime mess" now has become the "mortgage market meltdown." What most people don’t know is what this means, why it happened and how it will impact them. This is a complex issue that will take time to sort out. In this short space, I will try to answer these questions and help you create an action plan to protect you and your family.

What is a "mortgage market meltdown?" What has occurred in the last 10 days is best described as a complete shutdown of the mortgage markets for all loans not guaranteed by the FHA, VA, Fannie Mae or Freddie Mac. Included in this shutdown are all subprime loans, all jumbo loans (loans greater than $417,000) and most "exotic" loans such as Option ARMs and limited documentation loans.

Why did this happen? As recently as the 1980s, getting a mortgage meant going to a bank or savings and loan, which funded your mortgage from their bank deposits. After the savings and loan crisis, the mortgage markets underwent a significant shift due to changes in the regulatory environment. In the new system when you applied for a loan, it often was through a mortgage bank. A mortgage bank is an institution established to originate and sell mortgages. Mortgage banks operate with lines of credit that allow them to borrow money to fund your loan, and then pay off the funds they borrowed by selling your loan into the mortgage market and pocketing the difference as profit.

As you can imagine, Wall Street isn’t very interested in buying mortgages that only amount to a few hundred thousand dollars. What they want is to purchase pools of hundreds of similar mortgages that total millions of dollars. Over time, this business became so lucrative that nearly two out of every three mortgages was pooled this way and sold to investors as mortgage-backed securities without the benefit of FHA, VA, Fannie or Freddie guarantees.

Over the last five years, with the global financial markets awash in money seeking any investment with a decent return, the loans that were funded and sold in these pools got riskier and riskier. This situation meant lower credit scores, higher loan-to-value ratios, interest-only and even negatively amortizing loans. At the same time, the premiums required by investors to accept this risk, in the form of higher rates and fees, got skinnier and skinnier until anyone with a pulse could qualify for a big loan with great terms and tiny payments.

That laxness all stopped last week. For the last several months, as subprime delinquencies and foreclosures grew at a far faster rate than Wall Street anticipated, the market for those loans dried up and underwriting guidelines got much tighter. The major headlines here were the near overnight bankruptcy of New Century Financial, one of the largest subprime lenders in the country, and the failure of two subprime mortgage hedge funds run by Bear Stearns. For most Americans, this fallout was a concern, but not too much of a concern. After all, most of us have good credit and never rely on subprime loans.

Which brings us again to last week. Within a matter of four days, American Home Mortgage, the 10th-largest wholesale lender in the United States, announced margin calls, had trading of its stock halted and finally filed for Chapter 11 bankruptcy-court protection to wind down its business. The big news here was that American Home Mortgage didn’t deal in subprime loans. The company primarily was an Alt-A lender. Alt-A loans fill in the grey area between prime and subprime loans, usually due to some combination of high loan-to-value and limited documentation. When the media references "exotic loans," they are generally referring to Alt-A loans.

The AHM implosion was the spark that lit the fuse of this meltdown. Within days, investors on Wall Street who were paying 101% to 102% of the value of mortgage-backed securities stopped bidding entirely. They wouldn’t buy them for 90%, 80%, or even 50% of their value. Most mid-sized mortgage banks have been forced to stop funding loans until buyers resurface for these loans. Larger lenders with the capital to hold loans in their portfolio for a period of time, most conspicuously Wells Fargo home loans, responded by raising rates on these loans by 1-1.5% overnight.

To put this situation into dollar terms for you, consider that a client of mine qualified for a $1.3 million dollar purchase loan. These are good buyers with a 25% down payment, good credit and full documentation. I initially quoted these borrowers 6.375% on an interest-only loan to give them a payment of slightly more than $6,900 per month. Within two days, the best rate on this type of loan jumped to 7.25% and the payment spiked to $7,850, an increase of $950 dollars. Even loans of half this amount would have seen a similar rate increase and a payment leap of $400 to $500 per month.

What Does This Mean to YOU? The answer to this question depends on your circumstances. For all homeowners, the rapid increase in the payments required to finance a home will likely speed the fall of home prices throughout the country, especially high priced and so-called "bubble markets."

If you have a fixed rate mortgage and plan to live in your home for an extended period of time, you probably have no need to worry. The mortgage market will correct to more normal levels and the impact on you should be minimal.

If you have an adjustable rate mortgage, especially an Option ARM loan with a negative amortization feature, or a hybrid loan with a fixed period ending in the next 18-24 months, you should consult with your mortgage professional to see what options currently exist for you, and to formulate a game plan for avoiding a rate and payment spike, or worse, in the near future.

If you have a subprime loan, run, don’t walk, to see your mortgage professional. You need to understand your situation and all of your options. The situation is just too complex to try to figure out on your own.

For anyone who does not have a relationship with a trusted mortgage advisor, or would simply like a second opinion, please call me at 888.944.JOSH (5674) or e-mail me here. I can analyze your current financing, your needs moving forward and create a game plan to give you the peace of mind you require in these uncertain times in the market.