The Changing Mortgage Market and Liquidity Crunch
By Chris Crock, MBA, PFP

The saying that “any press is good press” may be true for the likes of Paris Hilton, but it hasn’t been the case for the mortgage industry as of late. HomeBanc Mortgage, one of the mortgage industry leaders here in Georgia, shut their doors last month. At their peak they originated approximately 12% of the mortgages in Georgia. HomeBanc was the 112th major US lender to shut their doors this year.

Why is this consolidation happening? Let’s start with a little background on how mortgages work…

In years passed a borrower would visit their local savings and loan to obtain a mortgage. The Loan Officer at the bank would approve the mortgage and fund it with cash reserves from the vault. This system worked well until the bank ran out of money to lend. Borrowers came to the S&L looking for a loan and were told to come back when a current mortgage paid off. What the bank needed was a way to sell the loans they made freeing up the capital to lend to new borrowers. This way they could lend the “same” money over and over, earning an income from servicing the loans and assisting the community by offering a near limitless pool of money.

To address this issue, Fannie Mae (FNMA) and Ginnie Mae (GNMA) were established. The goal was to provide cheap mortgage money to prospective homeowners and a high quality bond for the investment community. The bond or Mortgage Backed Security (MBS) takes mortgages with similar risk characteristics and pools them together. Investors in the MBS’s know ahead of time the return they are going to receive, much like a Certificate of Deposit. To ensure the performance of the bond, each mortgage is underwritten to specific guidelines. By ensuring the borrower is both capable (Verification of Employment), willing to repay (credit report) the debt, has the cash to close (Verification of Deposit), and the value is in the property (appraisal), the loans and thus the bond will perform as expected.

During the recent real estate boom underwriting guidelines were relaxed giving way to a whole new menu of products such as the 100% investment property loans with credit scores below 600. In addition, to streamline the influx of applications, income and asset verification took a back seat to a borrower with strong credit. With housing prices rising rapidly, the basis for the mortgage, the property, could be sold to cover the note and foreclosure costs if this occurred. This cycle worked well until the price of houses moderated in 2006.

Once the housing market began to cool and prices moderated, foreclosed homes were being sold for less than the note. To add insult to injury, the loans underwritten to the looser guidelines are not performing as hoped. With the value of the collateral in question (falling home prices) and the future performance of the borrowers unknown, investors’ appetites for this risk has waned. To attract investors in this environment, rates had to increase substantially.

Loans sold to FNMA or GNMA remain largely untouched in the recent credit crunch because the investment qualities of the loans are well known. The current conforming loan limit remains at $417,000. The foreclosure and delinquency rates are well within acceptable standards lending support to these products as their interest rates have fallen in the recent weeks.

The recent rapid rise in rates not directly tied to FNMA/GNMA is an example of the pendulum swinging too wide. The fact remains that a qualified borrower is a good investment from a bondholder perspective. In a typical interest rate market, jumbo loans (loans in excess of the conforming limit) with proper documentation carry a yield about 1/4 higher than similar conforming products. Sanity will eventually return to the markets and non-conforming pricing will come in line with their risk characteristics. The depth and breadth of the current subprime issue will determine when that change occurs.

Our hearts go out to everybody touched by this unfortunate issue. Investors have closed, companies have closed, and borrowers have been left with un-funded loans. Unfortunately the damage is widespread. On the bright side, there are still a large number of lenders that are navigating through this market. All lenders are going to have tightening loan guidelines during this liquidity crunch. A good mortgage broker can still place loans with the lenders that are still viable. A little patience is going to be required as the markets sort themselves out. At the end of the day…people are still going to buy homes and there will still be lenders willing to finance them.