Last time we talked about the potential for lender guideline reform to clip off the fringe of the buying pool in real estate, and what the implications for this would be to home values, and the economy in general. In the last few days, I have heard more murmer about lenders trying to tighten up so that they don't cut their own throats in the secondary market with a reputation for selling bad paper. Colleagues of mine are seeing their entire business model taken out of the product pool. It seems that some would-be buyers are going to have to be left behind here in the cycle, and the real mystery to me is, how big of a 'fringe' we are talking about...
Often referred to in the industry as a 'liar's loan', stated income loans are facing serious scrutiny. I won't get into when and why these loans make sense and are fair and smart, but I can tell you when it looks suspicious. If an applicant has a job that typically pays a flat steady salary, but they want to 'state' their income rather than prove it, chances are they don't really have the income they are stating. "Stating" is for convenience or inability to prove income, not for concealing or misleading. Lenders historically charged higher rates to off-set the risk associated with not proving income, but as these guidelines have become more and more liberal, the 'stated income' premium has shrunk. Banks and Wall Street knew that the rising value of real estate served as a safety net against any possible default case, so the risks across the board were smaller. Stated? Who cares, the house is doing 12% a year!
But those times have changed. Underwriters know that some people fudge the numbers, and that some people lie. Wall Street, Congress, and Economists are all growing concerned that too much mortgage debt is floating around qualified on false pretenses. With values flat, or declining, borrowers who have over-stated their reach are feeling the heat. Foreclosure numbers are escalating, investors are getting burned, and congress is calling for tighter standards, more regulation, and less throwing money at people who don't qualify for it.
This trend is going to persist for a while. Lenders need to shake out their bad products, get back to basic risk management standards, and deliver quality paper to Wall Street. Risky loans can be great tools for borrowers with the apetite for risk and ample knowledge of how to manage that risk. Risky borrowers can still be homeowners with stable and conservative loan products. But when you mix risky borrowers with risky products, and put them in a flat or declining housing market, look out.
A lot of economists have seen this coming for some time. The excess global liquidity has created an environment where risk premiums have been condensed so far that nobody can evaluate risk adequately any more. Bill Gross talked about this almost a year ago, noting that junk bonds were getting A Paper prices, and concluding that investors were not being fairly compensated for the risk they were taking. In most cases, it was probably not clear how much risk there was. John Mauldin expects this to turn into a full blown scandal in the mortgage debt marketplace, as those who have been buying the subprime debt are paying A Paper prices for BBB- Paper, and have been possibly mislead by creative derivitave products.
Its complicated stuff. Markets ebb and flow. Sometimes the waves get big, and cause a little damage when they smack up against the shore. The longer it takes to correct these problems, the harder the correction hits, and the more it hurts. Ben Bernanke and the Federal Reserve have been working to clip liquidity to the tune of 17 0.25% rate hikes. The Bank of Japan recently came up to 0.50% from a long-time low of 0.00%. This makes it more expensive for banks to lend money, and for people to borrow.
Often referred to in the industry as a 'liar's loan', stated income loans are facing serious scrutiny. I won't get into when and why these loans make sense and are fair and smart, but I can tell you when it looks suspicious. If an applicant has a job that typically pays a flat steady salary, but they want to 'state' their income rather than prove it, chances are they don't really have the income they are stating. "Stating" is for convenience or inability to prove income, not for concealing or misleading. Lenders historically charged higher rates to off-set the risk associated with not proving income, but as these guidelines have become more and more liberal, the 'stated income' premium has shrunk. Banks and Wall Street knew that the rising value of real estate served as a safety net against any possible default case, so the risks across the board were smaller. Stated? Who cares, the house is doing 12% a year!
But those times have changed. Underwriters know that some people fudge the numbers, and that some people lie. Wall Street, Congress, and Economists are all growing concerned that too much mortgage debt is floating around qualified on false pretenses. With values flat, or declining, borrowers who have over-stated their reach are feeling the heat. Foreclosure numbers are escalating, investors are getting burned, and congress is calling for tighter standards, more regulation, and less throwing money at people who don't qualify for it.
This trend is going to persist for a while. Lenders need to shake out their bad products, get back to basic risk management standards, and deliver quality paper to Wall Street. Risky loans can be great tools for borrowers with the apetite for risk and ample knowledge of how to manage that risk. Risky borrowers can still be homeowners with stable and conservative loan products. But when you mix risky borrowers with risky products, and put them in a flat or declining housing market, look out.
A lot of economists have seen this coming for some time. The excess global liquidity has created an environment where risk premiums have been condensed so far that nobody can evaluate risk adequately any more. Bill Gross talked about this almost a year ago, noting that junk bonds were getting A Paper prices, and concluding that investors were not being fairly compensated for the risk they were taking. In most cases, it was probably not clear how much risk there was. John Mauldin expects this to turn into a full blown scandal in the mortgage debt marketplace, as those who have been buying the subprime debt are paying A Paper prices for BBB- Paper, and have been possibly mislead by creative derivitave products.
Its complicated stuff. Markets ebb and flow. Sometimes the waves get big, and cause a little damage when they smack up against the shore. The longer it takes to correct these problems, the harder the correction hits, and the more it hurts. Ben Bernanke and the Federal Reserve have been working to clip liquidity to the tune of 17 0.25% rate hikes. The Bank of Japan recently came up to 0.50% from a long-time low of 0.00%. This makes it more expensive for banks to lend money, and for people to borrow.
This has helped cool the housing market, but people who shouldn't be borrowing still are. Risky borrowers can still get risky loans, and they have been injecting instability into the system. Now we are going to see institutions step in and self-regulate. And we are going to see congress step in and regulate with red tape. I expect to see the 100% purchase scenario in housing become very difficult relative to the current ease. Stated Income documentation will become difficult for W-2 employees. Down payment, income and credit standards are going to inch up.
If this hits with too big of a thud, there goes the 'soft landing'. Angelo Mozillo said he has never seen a soft landing, and you have to be careful when anybody tells you "this time it's different". Let's hope this all shakes out without a lot of turbulence.
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