Real Estate Investor Seeks Apprentice… (Maybe NOT!)
Commentary By: Ed Wright - 3/12/07



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Mortgage Problems Spreading (Stated Income Loans)

Commentary By: Ed Wright - 3/10/07

The first quarter of 2007 has seen changes to the mortgage industry that industry experts would not have dreamed possible only a week ago which will have impacts on the Mortgage & Real Estate Markets that may take years to fully recover from. This statement is made not to be alarmist but to bring light to the move wholesale lenders have made in response to the losses and implosion of  Fremont General(NYSE: FMT), New Century Financial (NYSE: NEW), Novastar Financial(NYSE: NFI), and numerous other similar companies.

Surprisingly under reported in the news and financial pages (at this time) is the sudden removal of all of the 100% purchase programs for stated income buyers that helped fuel mortgage loans in Southern California. We are yet to see what the fallout will be of the sudden halting of these popular programs… but few in the industry can say that they did not see this coming; changes were needed, just not to this degree. Unfortunately the damage this move creates will extend far beyond the sub-prime loan programs that created the problems. 3/09/07 was the day that all Stated Income, 100% Purchase Programs, regardless of the borrowers credit scores were halted, plus the current rewriting of the guidelines for most other “Alt-A” Loan" programs.

What needs to be pointed out is that these loan types have been the backbone of  many "Leveraged Equity Investors" and the parent to our current crop of stated income loan programs, and have become the life-blood of California's expensive Real Estate Markets where many experts estimate that less than 10% of all home owners in pricey Orange County could qualify "Full Documentation." Unfortunately due to increasing default and foreclosure rates they are also what the mortgage industry has euphemistically come to refer to as "Liar's" loans.

Why are “Stated Income Loans” referred to as “Liar Loans,” and what is the problem with “Stated Income Programs” if the borrowers make the payments many ask… but in answering this rhetorical question, please consider: Why would anyone with good credit scores and levels of income they claim legitimately need a stated income loan? Perhaps the most honest answer is that only by “pushing the income numbers” were the majority of buyers actually able to qualify to buy the homes they wanted or the refinancing they were requesting. Very importantly... ask yourself how many home buyers could afford to buy most of the homes we are seeing sold in Southern California based on current full documentation income loan programs? I would dare say not very many!

“Alt-A Loans” were originally designed for borrowers with clean credit records, but over the years have evolved into programs that often provided “Low Documentation” and even “No Documentation” programs where borrowers did not show what they earned. The lending industries profited hugely from these programs because they offered higher yields than the more traditional Full Documentation home loan, but in the case of 100% financing programs were secured only by the cleaner credit record required to qualify. Naturally, as the Alt-A business exploded in popularity and banking profits soared, more and more of these loan programs were developed and markets extended to include less credit worthy borrowers and blurred the underwriting guidelines into what the industry refers to as "Alt-B" products.

Profits from the Alt-A market once easily absorbed and disguised losses for a long time as real estate values increased, but have faltered now the markets slowed down… but during this time what evolved was an Alt-A loan product with unsustainable “Sub-Prime” default risks. Not overly surprising, recent industry studies indicate that up to 90% of all “Stated Income” borrowers in the past several years actually lied about their income on their loan applications. GEE; I’m Shocked… Imagine That!! What is laughable is that anyone in the banking industry can act surprised; They created this market knowing exactly what the risks were, but ignored the risks, and as long as the money kept rolling in the party continued. My guess is that the party is over and the bill is coming due; so now the question is more about what the total bill might be?

Presently, as these “Alt-A” loans, mostly adjustable type loans are “readjusting,” the payments are on some higher risk programs increasing by as much as 40% or more, and are causing an escalating number of borrowers to simply “walk away,” and quit making their payments. Today homes are entering into foreclosure at an alarmingly increasing rate… and now the industry is looking for someone to blame (Only my personal opinion).

The “Blame Game” escalated dramatically late last week after federal regulators proposed stricter guidelines for banks that offer “Subprime” ARMs (Adjustable-Rate Mortgages); which followed Freddie Mac's decision to increase scrutiny of the criteria used for approving the loans it would buy and started requiring  better proof of the borrower(s) income and actual finances. These are the main reasons the lending industry has suddenly dropped all such “Stated Income” programs, but nobody thought the actions would be this sudden… this has caught everyone by surprise; which makes me personally wonder if the actual default numbers that many of these companies who went out of business suffered might not be much worse than what anyone was willing to admit?

The bigger potential problems has to be with so many economic factors coming into play, we may be witnessing the makings of a “Perfect Economic Storm” scenario in Southern California if wisdom is not used in the mortgage markets... and rapidly. It is the low payments and the ability for borrowers to easily refinance equity out of homes that has allowed for property prices to rise in many markets, and it was this "Alt-A" family of loan products that is under attack which has at least partially driven the markets up in value... what will happen without them is less a guess than a simple income versus debt ratio; many will simply not qualify.

No one knows for sure what this sudden shift in the lending rules will do, or where it will end, but an educated guess is that it could easily threaten the homeownership plans, goals and even gains made by families over the past 7 years, and can only further weaken any recovery the housing market was currently experiencing in California's Inland Empire area, plus multiply the hardships our faltering economy is experiencing because of the recent pressures of higher priced fuels (Now hovering at $3.00 per gallon).

Somewhere in all of this I am personally looking for the good news, and fail to see much... other than the fact a lot of questionably qualified lenders and shaky companies are closing their doors. It will also close the doors of lower production real estate offices, but open the doors for prepared investors who always make money in up or down markets as rental property is bound to become more valuable (and rents increase).

More importantly, these knee jerk responses by the wholesale lending market need to be taken in stride, and without too much panic… as over the next couple of weeks the actual changes will evolve while reasonable minds come together and hopefully competitive market forces re-design a better “Stated Income” program. We would agree that some sanity needs to return to underwriting guidelines; but the operative word here is "Sanity!" With more than 80% of all Alt-A mortgages in 2006 originated as “Low-Documentation” or “Stated-Income,” and representing 86% of mortgages provided during the fourth quarter of 2006 in California, somehow we need to better address the default problems created by such loans before we simply cease all “Stated Income” programs (Not a good idea).

No matter what occurs, or how fast it occurs, the next year will see many of the lenders who have created these problems pushed out of business and/or re-structuring while carefully distancing themselves from the damage and repercussions general greed has helped create. There really are no simple or easy answers at this time… plus, frustratingly, we at the Mortgage Broker / Mortgage Banker levels are not in control of what is going on at Freddie Mac's and the federal regulators levels, nor once again do we see the numbers that they see. We can only hope the numbers are not much worse than what we have been hearing... which could better explain these draconian actions, because presently they make little sense.