Subprime and exotic loans relegated to the fringes
Every loan product has its place. Option ARMs, interest-only, reverse mortgages, adjustable rates, high LTV, subprime, all mortgage products serve some borrower’s unique financial circumstances. Contrary to popular belief, exotic loan products were not inventions of the housing bubble. The problem during the housing bubble was the proliferation of these products outside their usual niche caused by the mispricing of risk. If risk were priced properly, these exotic loan products would have been prohibitively expensive, and far fewer borrowers would have used them. Exotic loans become toxic when they escape their specialized niche and spread like a virus among borrowers who lack the qualifications to handle them. The widespread use of exotic loans inflated the housing bubble and catalyzed the catastrophic crash.
The new qualified mortgage rules only discourage exotic loans. These loans are not illegal; no lender will go to jail for underwriting one (although they may still need to answer to Jesus). However, because loans outside the qualified mortgage rules deny the underwriter any safe harbor protections, lenders avoid them, and investors shun them. Lenders confine non-qualified mortgages to the fringes where they belong. Lenders only underwrite non-qualified mortgages if they want to hold the loan in their own portfolio, which some want to do. Private money evaluates the risks of holding these loans and prices the interest rates and fees accordingly, accordingly high that is. The high cost keeps these loans out of the mainstream and prevents them from inflating future housing bubbles.
Wells Fargo, top lenders say they will lend outside the box
… Top lenders like JPMorgan Chase, Bank of America and Wells Fargo announced that they will still work to provide for high-quality borrowers, including non-conforming loans that may fall outside of qualified mortgage lending standards.
Wells Fargo Home Mortgage Executive Vice President Brad Blackwell said the bank will still ensure the borrower has the ability to repay, but they may not always meet the QM standards.
“We are not making changes to the way we lend to non-conforming borrowers, and it is not a loosening of credit. Wells Fargo is making very high quality loans today to high quality borrowers,” Blackwell said.
Wells Fargo sees opportunity to write more profitable, higher interest rate loans. The added cost of these loans assures they don’t become too common.
…Blackwell explained that under QM, Wells Fargo would have to constrict in three areas: debt ratios over 43%, interest only loans and loans that do not meet the appendix Q guidelines.These three distinct areas though fall mostly on the hands of affluent borrowers. A self-employed, but extremely successful potential homeowner could fall afoul of the new regulation.In result, Blackwell explained that they trust their loan officers are able to distinguish between who is still a high quality borrower.
Since these borrowers have few other options, many will choose to pay the higher interest rate and get the non-qualified mortgage loan. In the past bankers evaluated customers on a case-by-case basis, but in the era of automated underwriting for the GSEs, the discretion and relationship of personal banking is lost.
According to Blackwell, about 5% of the loans that Wells Fargo produces will not fall within QM standards, which is where majority of the three distinct divisions he mentioned fall into.Wells Fargo will continue to cater to this group of borrowers, but Blackwell explained that is the group of borrowers that have strong credit and a clear ability to repay. In result, the non-QM loans will stay in Wells Fargo’s portfolio.
Non-qualified mortgages will make up on 5% of Wells Fargo’s portfolio as limited-issue niche products.
Once considered toxic, subprime mortgages get rebranded as ‘smart’
Banks want nothing to do with subprime mortgages, which nearly brought down the U.S. economy. But private firms are filling that void, rebranding loans to borrowers with poor credit as “sane subprime” and “smart nonprime,” and pitching them to wealthy investors in search of yield. This time, they say, it will be different.
It will be different this time? Are your alarm bells ringing? Before you get too worried about the prospect of another subprime driven housing bubble, consider how rare this rebranded subprime will be.
The investment companies, which include private equity firms, hedge funds and alternative asset funds, say these borrowers aren’t as risky as they seem and that investors stand to make an attractive return, ranging from 7% to 12% annually, by lending to them….
Interest rates between 7% and 12% represents an enormous risk premium considering conforming loans go for 4.5%. Borrowers using these new subprime loans will enjoy limited buying power as their incomes won’t leverage into a large loan balance. Again, the cost of these loans keeps them on the fringes where they can’t do much damage.
The firms say this lending is not risky because they only work with borrowers who have large down payments, typically at least 30%. That way, even if a borrower stops paying, the investors who funded the mortgage are unlikely to incur losses when the home is resold.
Large down payments compensate for the primary flaw in the subprime business model. Subprime failed due to an endemic flaw that can’t be corrected by changes in the loan terms. The problem is rooted in the default losses associated with loan delinquencies.
Subprime works when house prices are rising because despite the high delinquency rates on subprime mortgages, the losses associated with the resulting foreclosures is generally small because rising prices bails the lenders out. Further, when subprime loans proliferate, they stimulate demand and cause the rising prices that makes the subprime mortgage industry tenable — at least until they run out of new subprime customers or they default in very large numbers.
If the demand created by subprime wanes, or if there is an excessive number of foreclosures, prices stop rising. Once prices stop going up, the default losses escalate dramatically. The additional interest gained on the paying customers no longer offsets the losses from the deadbeats. This outcome is inevitable because eventually the demand stimulus will slow, or an economic recession will cause subprime borrowers to default in large numbers. Once either of these events occurs, it’s game over for subprime — and those who own subprime loans lose billions — unless they demand large down payments to cushion against a downturn.
A helping hand for borrowers?
Borrowers are about to enter the seventh year of tight lending standards. With banks reluctant to ease lending for anyone but the wealthiest borrowers, experts say subprime borrowers have few choices (outside of some government mortgages) but to get loans from private lenders. …[dfads params=’groups=165&limit=1′]
For borrowers, these loans are expensive. Interest rates generally start at around 8% and can run as high as 12%, costing borrowers thousands more over the life of the loan than what they would have paid with a regular mortgage. Some lenders only offer adjustable-rate loans whose rates could rise even further going forward, leading to larger monthly payments, which could be difficult to keep up with.
I can’t recommend these loans to anyone. Any benefit from ownership is quickly eaten up by the higher costs.
Pierre Frediere, 54, signed up for Athas’ “sane subprime” mortgage in October. Frediere—who is based in Fresno, Calif., and happens to be a loan officer for an independent mortgage broker—says his credit score fell after he shuttered two companies that he launched, a multimedia firm that created commercials and a mortgage brokerage firm, and was unable to pay off all the credit card debt he had racked up in the process. Soon after, he divorced and is required to give half his income to alimony and child support, which he says also made it hard to get a bank loan. In an attempt to do a cash-out refinance—that’s when borrowers take equity out of their home while refinancing into a new mortgage—Frediere says he came across Athas, which offered him a 30-year mortgage at a 9% rate that’s fixed for the first five years before it becomes variable and could get even higher.
He has a game plan to avoid that scenario: Over the next few years he plans to improve his score and lower his expenses so that he can refinance into a regular mortgage. Otherwise, “if catastrophe happens, I’ll just sell the home and look for an apartment,” he says.
This man learned nothing from the housing bust. As Forest Gump would say, “Stupid is as stupid does.” This guy should sell his property and rent because the cost would certainly be lower. He plans to serial refinance out of an unaffordable loan into a better one later on? Didn’t people try that once before?
As long as non-qualified mortgages including subprime remain expensive niche products, they don’t present a danger to the housing market. If competition for yield prompts lenders to lower interest rates or down payment requirements, these products may again escape their niches and proliferate to unqualified borrowers. Let’s hope we keep the lid on this Pandora’s box.
Real estate news coverage suspended for holidays
Real estate news coverage is suspended from December 21 through December 31. Regular real estate related news posts will resume on January 1, 2014. I apologize for the inconvenience. Since the end of the year is a time of family and reflection, and since it’s not a time many people focus on real estate, I decided to offer something different.
Tony Bliss was a close friend of mine who lost his heroic battle with cancer in late 2012. He wrote about his experience in a series of gripping posts that reveal a beautiful and courageous man. I was deeply moved by these posts — some of which are admittedly difficult to digest. This writing is raw. Real. Be forewarned that if you read his posts, you will never be the same. You will laugh, cry, fear, hope, and stare into the abyss of your own mortality. I am honored to share this great work with you here starting tomorrow and concluding December 31st.
Come back tomorrow and catch the entire series.
15931 ORIOLE Ln Huntington Beach, CA 92649
$595,000 …….. Asking Price
$460,000 ………. Purchase Price
8/14/2003 ………. Purchase Date
$135,000 ………. Gross Gain (Loss)
($47,600) ………… Commissions and Costs at 8%
$87,400 ………. Net Gain (Loss)
29.3% ………. Gross Percent Change
19.0% ………. Net Percent Change
2.5% ………… Annual Appreciation
Cost of Home Ownership
$595,000 …….. Asking Price
$119,000 ………… 20% Down Conventional
4.48% …………. Mortgage Interest Rate
30 ……………… Number of Years
$476,000 …….. Mortgage
$117,902 ………. Income Requirement
$2,406 ………… Monthly Mortgage Payment
$516 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$124 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$3,046 ………. Monthly Cash Outlays
($473) ………. Tax Savings
($629) ………. Principal Amortization
$197 ………….. Opportunity Cost of Down Payment
$169 ………….. Maintenance and Replacement Reserves
$2,310 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$7,450 ………… Furnishing and Move-In Costs at 1% + $1,500
$7,450 ………… Closing Costs at 1% + $1,500
$4,760 ………… Interest Points at 1%
$119,000 ………… Down Payment
$138,660 ………. Total Cash Costs
$35,400 ………. Emergency Cash Reserves
$174,060 ………. Total Savings Needed