Mortgage Greed Will Bite Banks Again

The foreclosure mess has served as a decoy to the real problem faced by the big banks in America. At the height of the real estate bubble banks and their mortgage origination arms were greedily issuing mortgages to just about anyone who could fog a mirror. The reason - fees. The mortgage originators collected their fees upfront which padded the pockets of shareholders and themselves through the payment of outrageous bonuses.

Now the dogs are back to bite them. The loans were mostly packaged and sold to individual investors, institutions, and even Freddie and Fannie. When the loans were sold they were warranted by the banks and investment firms to meet certain underwriting standards. They have fallen woefully short and now investors are beginning to exercise their right to 'put back' or make the banks repurchase the loans that did not meet the warranted standards.

Here is a great piece written by John Mauldin of Millinium Wave Advisors that points to the enormity of the problem. John writes " Anyone who owns stocks in banks with relatively large MBS exposure is not investing, they are gambling that the losses will not be more than management is telling them"

This is scarier than any Halloween ghost or goblin.

Housing Bill Offers Help For Many

The housing bill recently signed by President Bush offers relief for many beyond those in danger of loosing heir homes to foreclosure. In addition to helping those hurt by falling real estate prices and adjustable rate mortgages Congress included breaks for first time homeowners, reverse mortgage borrowers, and jumbo loan mortgage holders.

First Time Homeowners - If you are buying a home for the first time you may be eligible for a federal tax credit of $7,500 or 10% of the purchase price whichever is lower. To qualify for the credit you must have modifies adjusted gross income of less than $75,000 for single filers, or $150,000 for married joint filers. For single filers the credit is reduced for modified adjusted gross income above $75,000 and disappears at $95,000, for joint filers the credit disappears for modified adjusted gross income above $170,000.

Reverse Mortgage Borrowers - The bill limits origination fees on reverse mortgages to 2% on loans up to $200,000 and then 1% on amounts beyond that up to a cap of $6,000. Congress also increased the maximum loan amounts for HUD issued loans.

Jumbo Mortgage Borrowers - Jumbo mortgages often cost more than conventional mortgages. By making permanent the increased lending limits for Fannie Mae and Freddie Mac you may be able to refinance a jumbo mortgage to a lower rate conventional mortgage for loans up to 115% of local median home price up to a $625,000 ceiling.

Understanding The Credit Crunch

Everyone has heard about the problems in the credit markets today. With all the press and airtime given to this topic I was surprised by a question from a client recently asking for an explanation. Sadly, while the problem has been discussed widely, the root of the problem has gone unexplained in the popular press.

To understand the credit problem you must first understand a little about how the bond market works. Nearly all bonds are sold out of a dealers inventory, like shirts sold at a department store. The bond dealer buys bonds, marks them up, and then resells them at a profit. Unlike stocks which trade actively everyday on the various exchanges, there are hundreds of thousands of different bond issues, and very few trade on a given day. So unlike stocks where everyone can see the value because the prices are published throughout the day, bonds are valued by using computer models. If you have bonds in your portfolio the value published each month on your statement reflects an estimate of the bonds value on that particular day. If you try to sell a bond, the price you receive could be higher or lower than the estimate your custodian provided on your statement. When dealing with bonds backed by mortgages, current and projected default rates are a factor in estimating the bonds value.

Mortgage backed bonds are created when banks and mortgage brokers pool large groups of mortgages and sell off smaller pieces to institutional and individual investors around the world. Very few mortgages are kept in house by banks, as this would tie up too much of their capital. Your mortgage has probably been sold off in this manner too. Banks and mortgage bankers make their profits from fees charged to originate the mortgage, and from fees received to service those loans. Your personal mortgage is probably part of a large group or tranche of mortgages owned by many different investors.

The current credit crunch probably began on June 20 when Merrill Lynch, a lender to a couple of Bear Stearns hedge funds investing in sub prime mortgages, asked for bids on some of the holdings held as collateral for loans made to the hedge funds. Suddenly, a large block of mortgage backed bonds had to be priced to market rather than priced to (computer) model. With a background of a weak housing market, and adjustable rate mortgages that were resetting at higher rates, the bids Merrill Lynch received from other bond dealers were significantly lower than the models had estimated. Merrill Lynch had issued a margin call, and sold the bonds off in a weak market.

This news caused others to question the value of mortgage backed bonds. Like dominoes, mortgaged backed bonds fell in value as more and more were offered for sale and bond dealers, hesitant to risk their own capital, we reluctant to buy them at any price. Suddenly awash in supply, the demand shrank to nearly nothing. It became like a run on a bank, a self fulfilling prophesy. The run was not contained to the sub prime segment of the market, it cascaded quickly to include any bond backed by any type of mortgage. Even Thornburg Mortgage, a company who specialized in jumbo mortgages, with very low default rates found it impossible to to find financing for its portfolio. The financing required to keep the mortgage market liquid suddenly ground to a halt. The only jumbo loans being issued were those that banks could afford to keep in their inventory, and they came with hefty interest rates.

What has happened to cause this credit crunch began with sub-prime mortgages, but the sub prime segment is not very important to where we are now. The challenge facing the credit markets now is how to restore faith and liquidity to this huge part of our economy. Without mortgage availability the housing market will plunge, taking along with it all the appliance sales, furnishing sales, legal services, etc that are part of this important sector of our economy. Without a housing industry our economy will surely slip into a recession or worse. The cries for an interest rate cut have been loud and often, yet when the federal reserve acted it was with a cut at the discount window not the fed funds rate.

The reason for this could be two fold. The Federal Reserve does not want to be seen as bailing out Wall Street. With the beginnings of this credit crunch so closely tied to predatory lending practices and hedge funds, the public perception is that the problem is contained there and it would be inappropriate for the government to in any way bail out bad business practices. Secondly, the federal reserve may believe that lowering interest rates will not solve the problem. Lower rates can make housing more affordable and even save some unfortunate individuals from foreclosure, but until the root problem of liquidity in mortgage backed securities is solved the specter of a housing collapse is more than just a nightmare scenario.

The stock market seems to be pricing in a rate cut from the Fed. So we are set up for a major disappointment should the fed forgo a cut at its September meeting. Again, this may be what chairman Bernanke wants. He does not want to bail out Wall Street, but if a stock market decline is unavoidable, he certainly wants that decline to be orderly in nature and not a fear driven plunge like we witnessed in the weeks preceding the latest Fed action. The Fed has been injecting liquidity into the banking system on an almost daily basis. More probably should be done. Allowing Fannie Mae and Freddie Mac to purchase mortgage securities over the current $417,000 limit should be a first step. This would allow banks to begin selling jumbo loans from their in- house portfolio and provide further liquidity. Yet, so far the politicians who could make this happen have failed to grasp the true nature of the problem, instead referring to such a move as a bail out.

Update

The ABC's of Reverse Mortgages

Reverse mortgages have been around for a decade but their popularity remains low. The primary reason seems to be home owner's reluctance to take any chance when it comes to their abode. Reverse mortgages are also confusing, complex, and expensive, making them an option of last resort in the minds of homeowners.

How they work.

A reverse mortgage is like a home equity loan with no payback schedule. Instead of having a mortgage you make payments on you have a mortgage that provides income to you. You can choose to take a lump sum payment, a credit line to draw on, or set up a payout schedule much like an annuity. No payments are due as long as you live in your home, however, interest accrues as you access the funds.

Contrary to common perception, the lender doesn't take your home automatically when the loan comes due. Heirs may refinance or sell the home to pay off the balance, life insurance benefits could provide funds to pay off the balance, or the heirs could just use cash to repay the balance if they want to keep the property. If the house is worth less than the amount due, you or your heirs will only owe the lender what the house can sell for.

Costs

Reverse mortgages are expensive. You can expect to pay 6% to 8% of your homes value at the time of loan origination to cover HUD insuring the mortgage, closing costs, and lender fees. Fees are usually rolled into the mortgage so you do not see an out of pocket expense, but it does increase you borrowing costs and decrease the money available for you to access.

For more information see AARP and this item from the Federal Trade Commision.