There’s always something to howl about.

What Isaac Newton Knew About Mortgage Lending

I recently wrote about sub-prime loans for the first time in a long while because the sector should start taking more headlines in the papers.

I’d hate for you to be unready for it, of course. Sub-prime loans are a big part of mortgage lending.

“Sub-prime” is a broad-sweeping term for the large percentage of loans that won’t get bought by the quasi-government agencies Fannie Mae and Freddie Mac. The opposite of “sub-prime” is “conforming”, as in: these loans conform to the guidelines set forth by Fannie Mae and Freddie Mac to be eligible for purchase.

Typically, the credit profile of a sub-prime borrower includes one or more of the following characteristics:

  • Low credit scores
  • History of derogatory credit (i.e. bankruptcy, foreclosure)
  • Currently delinquent on their home loan
  • Lack of credit history or credit depth
  • Low asset levels
  • Low income levels or non-verifiable income levels
  • High loan-to-value combined with low income versus debt
  • Contains “random” circumstance that introduces risk

Just because a person exhibits one or more of these traits, however, doesn’t mean that he is automatically a sub-prime borrower. This set of guidelines is very general.

Even though “sub-prime” has negative connotation to it, sub-prime loans serve a very important purpose. Sub-prime loans provide home financing to people who otherwise would not be approved for a loan at all. Remember: they don’t conform to the government guidelines!

Recently, sub-prime lenders have fallen into a world of hurt because the default risk that is inherent in every sub-prime loan is being realized with alarming frequency. Lest you think these defaults are surprising the markets, this is a problem two years in the making and industry insiders know it.

See, the one very important difference between conforming and sub-prime loans is that conforming loans are eventually bundled and sold on Wall Street as long-term bonds called mortgage-backed securities. Sub-prime loans, by contrast, are short-term. Conforming loans are overwhelmingly of the 30-year fixed variety, but sub-prime mortgages are of the 2-year ARM variety.

To understand why this matters, it’s important to review how adjustable rate mortgages work.

With all ARMs, the lender agrees to collect interest at a fixed rate for some period of time. When that period of time is over, the rate will adjust according to a set of rules agreed upon at the time of closing.

The new rate, therefore, is not pulled out of thin air. It can actually be represented by a math formula that is easy to understand.

(New Rate) = (Current Value of Index) + (Margin)

The index is usually something like LIBOR and the margin is a constant that can range from 1.50 to 6.99 or higher. Usually, the riskier the loan, the higher the margin. For comparison purposes, conforming ARMs have margins in the 2.500% range versus a typical 6.999% margin for sub-prime.

At this point in the conversation, I’d like to take a break and remind you of Newton’s First Law of physics:

An object in motion tends to stay in motion unless acted upon by an outside force.

Applied to mortgages, Sir Isaac Netwon tells us that a person who is a sub-prime borrower today will likely be a sub-prime borrower two years from now unless a fundamental change is made to the borrower’s finances. This change usually includes a reduction of overall debt load versus income, but not always.

Author’s Note: Developing and creating accountability for a mortgage plan is the joint responsibility of the homeowner and the loan officer. This is the should be the keystone of a homeowner’s short- and long-term financial plan.

Two years ago, the short-term nature of a sub-prime loan wasn’t so relevant.

At the time, LIBOR was 1.80% and it was reasonable for the “average” sub-prime client to receive a 6.500% interest rate with a 4.999% margin. When that loan would adjust, it would move from 6.500% to 6.7999%. Not a huge impact overall.

Today, however, LIBOR is 5.26% and the average client might receive an 8.500% interest rate with the 6.999% margin.

Can you see where this story is headed…?

Courtesy WSJWhen a sub-prime borrowers accepts a 2-year fixed interest rate but the “Plan for Change” is neither implemented nor followed, inertia prevails. Two years later, the borrower typically finds himself in the proverbial position that is between a rock and a hard place. The mortgage’s fixed period is over and he is still a sub-prime borrower.

At this point, the borrower can do one of two things:

  1. Allow their loan to adjust to the current market conditions according the rules of their loan
  2. Remortgage their loan to the current market conditions

If the homeowner stays in their loan and lets it adjust(i.e. no remortgage), then the new interest rate on their mortgage will be (5.26) + (6.999) = 12.25%. This is nearly 6.000% higher that their current rate of 6.500%.

Or, the homeowner can remortgage the home loan to to 8.500% — 2.000% higher than their current rate. Naturally, this is the preferred option, but as sub-prime lenders tighten their lending guidelines, there might not be a lender that accepts this sort of risk at all!

When the borrower can’t find new financing because nobody will lend to him, the 12.25% looks suddenly sweet and painful, all at once.

Three and four years ago, short-term interest rates were very, very low and that made sub-prime mortgage money appear cheap next to its conforming counterpart. Sub-prime lenders took advantage and “relaxed” their guidelines on to whom they would lend. They looked like geniuses, too, because so few loans were defaulting.

In fact, when the 2-year period ended, it was no big deal really because a sub-borrower whose ARM reset faced a 0.000-1.000 percentage point increase. That is a manageable figure for a lot of households.

But, then came last fall.

As the Fed raised the Fed Funds Rate, short-term borrowing rates increased and that impacted sub-prime mortgages. Instead of a 1 percentage point increase on a reset, the figure ballooned into the 5.000-6.000 point range.

I blogged a lot on this at the time because some high-profile lenders were closing their doors in response to the market conditions and still other lenders tightened up their guidelines (i.e. stopped lending to the riskiest borrowers in the loan applicant pool). Those that did neither have seen their sub-prime mortgages default at a much higher clip than normal.

Example: In Q3 2006, the number of late payments on sub-prime mortgages reached 12.56% of all mortgages outstanding, it’s highest mark in three years. The sub-prime lenders that stayed in the game are getting clobbered in part for the loans they granted in 2003 and 2004 — those loans are now resetting and households on tight budgets are being pushed over the edge.

Since late-2005, the sub-prime shake-out has been slow and steady but now the walls are quickly crumbling down. As long as the Fed Funds Rate sits near its current levels, the lender carnage should continue because — just like their borrowers — Sir Isaac Newton and the principles of inertia have taken over.

Source
More Borrowers With Risky Loans Are Falling Behind
Wall Street Journal Online, Ruth Simon and James R. Hegerty
Decemeber 5, 2006
http://online.wsj.com/article/SB116528735773440781-search.html?KEYWORDS=default+mortgage&COLLECTION=wsjie/6month