26 March 2008

Convergence On Mortgage Insurance and Underwriting

Mortgage lending standards and private mortgage insurance underwriting standards are converging on agreement over what kind of down payments, income and asset documentation, credit histories and loan terms must be present in order to reduce the risk of default on loan to tolerable levels. The near complete demise of the subprime mortgage industry, in turn, makes deviation from these minimum standards very difficult.

Mortgage Insurance Taxation

Most lenders offering mortgages which are not conventional (i.e. 20% down payment) require borrowers to pay for mortgage insurance.

Congress has intervened by temporarily allowing mortgage insurance payments to come within the mortgage interest deduction, subject to certain limitations (a change which should be made permanent).

This change in the tax law, which previously allowed only interest payments and points to be deducted, normalizes and subsidizes non-conventional loans, opening up the house market on a level playing field taxwise to first time home buyers who can't afford a 20% down payment.

Mortgage Insurance Underwriting Tightens

Meanwhile, mortgage insurers are tightening their underwriting standards in some markets, a change that I suspect will soon sweep the nation.

One mortgage insurer "won't insure mortgages where the borrower has had a short sale, foreclosure or bankruptcy in the past two years." Another insures loans of borrowers with as little as a 5% down payment if they have reasonably good credit (a FICO score of 620 or better), but insist on a 10% down payment for other borrowers.

Many mortgage insurers almost all now require at least a 5% or 10% downpayment, depending upon the company, the location of the home and the borrower's credit. Mortgage insurers are also steering clear of interest only and other exotic loans. For example, one major mortgage insurance company Nor will it insure loans lacking full documentation of income, loans for investors and negative amortization mortgages."

This is a major change. In 2006, about 40% of subprime loans lacked full income documentation.

The evolving standards are similar to the standards that Fannie Mae imposes to meet its prime borrower standards:

Prime borrowers have a credit score above 620 (credit scores are between 350 and 850 with a median in the U.S. of 678 and a mean of 723), a debt-to-income ratio (DTI) no greater than 75% (meaning that no more than 55% of net income pays for housing and other debt), and a combined loan to value ratio of 90%, meaning that the borrower is paying a 10% downpayment.

While borrower's with good credit can get a 5% down payment loan, mortgages with 0% or 3% downpayments have virtually vanished, and no documentation loans are now largely limited to loans where no private mortgage insurance is required. Borrower's with seriously bad credit can likewise forget about trying to get a mortgage unless they can put together the 20% downpayment that shifts almost all of the risk in the loan to the borrower.

Private mortgage insurance premiums are also increasing.

The Demise of the Subprime Market

"The share of subprime mortgages to total originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006." This rise in lending was accompanying by a rising number of lenders: "By 2005, a list of subprime-lending specialists compiled by the Department of Housing and Urban Development had grown to 210 lenders, from 141 in 1996. Their combined loan volume grew tenfold during the same period."

But subprime lending is collapsing as subprime lenders go bankrupt and the collateralized mortgage pools that financed their lending have become poison on Wall Street. According to an analyst at Washington Mutual Bank quoted on June 6, 2007: "Total subprime loan volume will probably drop to about $350 billion this year from $640 billion last year due to improved underwriting and other changes, he said." Nine months later, that forecast looks optimistic.

My own guestimate, based upon the data below, is that total industrywide U.S. subprime loan value will probably drop to about $35 billion or less in 2008: absolute numbers not seen since 1994 and market share numbers that are even smaller, of under 4%. Total industrywide U.S. Alt-A loan value may drop to $150 billion or less in 2008. The combined subprime and Alt-A market in 2008 is likely to be about a quarter of the size of the subprime market alone in 2006.

For example, at Countywide Financial, once one of the nation's largest providers of subprime loans, according to report from the company released in November of 2007:

Volume of loans considered to be riskier fell significantly. Adjustable-rate lending totaled $3.1 billion, down 81 percent from a year earlier and 19 percent from September.

Subprime loans, which go to people with poor credit, totaled just $42 million in October, down 84 percent from September, and 99 percent from $3.3 billion a year earlier. Home equity loans totaled $1.36 billion in October, down 15 percent from September and 68 percent from a year earlier.

The top ten subprime originators made about $4.9 billion of subprime loans in the fourth quarter of 2007 compared to about $82 billion in the fourth quarter of 2006. The top ten Alt-A lenders (just above subprime) made about $23.5 billion in Alt-A loans in the fourth quarter of 2007, down from $78 billion in the fourth quarter of 2006.

The collapse was in full swing in 2007: "A recent survey of mortgage brokers found that of home purchase closings they had scheduled for August, 2007, 56% of subprime homebuyers had canceled closings. Of subprime borrowers trying to refinance adjustable rate mortgages with resetting interest rates, the survey found that 64% of the subprime homeowners were unable to do so."

One website lists the total number of imploded subprime lending operations since late 2006 at 242 (2 of which have since returned from the brink) and has 19 more on a watch list. A list of the top 25 subprime lenders as the second quarter of 2006 noting their current conditions is bleak.

In short, the entire subprime industry has withered and very near died in the face of overwhelming evidence that these loans have high default rates. According to Wikipedia (and here:

Beginning in late 2006 . . . A steep rise in the rate of subprime mortgage foreclosures has caused more than 100 subprime mortgage lenders to fail or file for bankruptcy, most prominently New Century Financial Corporation, previously the nation's second biggest subprime lender. The failure of these companies has caused prices in the $6.5 trillion mortgage backed securities market to collapse[.]

There is almost no subprime lending to be had out there in the private market. It is FHA lending or nothing for most less creditworthy buyers or buyers with only small downpayments.

There is good reason for this phenomenal collapse:

16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005. By January of 2008, the delinquency rate had risen to 21%. . . . Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007.

Subprime fixed mortgages represented 6.3% of outstanding loans and 12.0% of the foreclosures started in the same period.

The American Enterprise Institute notes that:

The June 30, 2007 National Delinquency Survey of the Mortgage Bankers Association reports a total of 1,090,300 seriously delinquent mortgages. Serious delinquency means loans 90 days or more past due plus loans in foreclosure. Of the total, 575,200 are subprime loans. Thus subprime mortgages, which represent about 14% of mortgage loans, are 53% of serious delinquencies.

The survey reports 618,900 loans in foreclosure, of which 342,500 or 55% are subprime.

The ratio of subprime loans in foreclosure peaked in 2002 at about 9%, compared to its current level of 5.5%. Seriously delinquent subprime loans peaked during 2002 at 11.9%, compared to the current 9.3%. These ratios at this point are not as bad as five years ago, but they are still rising.

A systematic regularity of mortgage finance is that adjustable rate loans have higher defaults and losses than fixed rate loans within each quality class. Thus we may array the June 30, 2007 serious delinquency ratios as follows:

Prime fixed 0.67%
Prime ARMs 2.02%
FHA fixed 4.76%
FHA ARMs 6.95%
Subprime fixed 5.84%
Subprime ARMs 12.40%

The particular problem of subprime ARMs leaps out of the numbers. Also notice that FHA and subprime serious delinquency ratios for fixed rate loans are not radically different. he FHA is predominately a fixed rate lender, whereas subprime is about 53% ARMs. The total range is remarkable: the subprime ARM serious delinquency ratio is over 18 times that of prime fixed rate loans.

A central problem is that during the boom the subprime market got very much larger than it used to be. In the years of credit overexpansion, it grew to $1.3 trillion in outstanding loans, up over 8 times from its $150 billion in 2000.

While all out war on adjustable rate mortgages has not been declared, the effect of cracking down on subprime and weak credit loans may have the same effect. According to a report from a year ago: "At the end of 2006, subprime and alt-A loans accounted for roughly 72% of ARM debt outstanding—that is roughly $2.5 trillion in debt, or 25% of the total mortgage debt outstanding."

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