Everywhere you look today, someone is talking about the subprime crisis. The stock market has been bouncing, the media have been jabbering, and the politicians have been posturing—all due to the instability of credit as it relates to home ownership.
If you are looking to buy, sell or build a log home, you will be impacted by the changes with the lenders. The changes have been fast and furious and will likely continue for several months to come. It’s probable that the media, by focusing on exciting the public first and informing them after, will continue to fan the flames of panic, causing legislators and industry executives to further instigate rumor and cast blame on everyone except themselves. Here is a calm explanation of the current mortgage market and tips for borrowing in this dynamic environment.
In the beginning, local banks and savings & loan associations made all home loans. Local community bankers would evaluate your credit and assets and base their subjective decision on your character in deciding whether you would pay back the loan. In the 1940s and 50s, the federal government focused on making home ownership affordable to a larger number of Americans. It accomplished this goal by creating two government-sponsored enterprises (GSEs): the Federal National Mortgage Association (FNMA), called Fannie Mae, and the Federal Home Loan Mortgage Corporation (FHLMC), commonly referred to as Freddie Mac.
These two GSEs are publicly held and traded institutions, chartered with the purpose of buying loans from banks in order to replenish available funds for home loans into the marketplace. They buy loans that meet a set underwriting standard and pool the loans in order to sell securities to Wall Street investors based upon the loans. These are called mortgage-backed securities.
The GSEs brought standardization to the decision-making process for all loans by establishing specific lending criteria. The banks made loans to conform to these criteria so they could be assured of selling their loans to Fannie Mae and Freddie Mac, taking a small piece of the interest along the way for profit. All loans that were made to GSE specifications were either conforming or, if they didn’t meet GSE criteria, nonconforming.
Nonconforming loans include loan amounts bigger than the GSE limit, which today is $417,000 for a single-family residence in all states other than Alaska and Hawaii. These bigger loans are often referred to as jumbo loans. They also include loans where the income and asset documentation is less restrictive, as well as loans to borrowers with lower credit scores then Fannie and Freddie will allow. Nonconforming loans were originally made mostly by banks and S&Ls that could hold on to these loans in their portfolios and charge a higher rate to account for the increase in risk.
In the last few decades, Wall Street investors desiring high-yielding, lower-risk returns poured money into securities backed by nonconforming mortgage loans. Entrepreneurs created mortgage-banking companies for the sole purpose of making loans and selling them either to the GSEs or to institutional investors on the secondary market.
The mortgage bankers are not banks. They fund their loans on giant warehouse lines of credit from banks and Wall Street institutions.
The low-interest rate environment of the last decade, coupled with advances in industry technology, greatly increased the volume of nonconforming loans bought and sold on the secondary market. Credit scoring and computer modeling provided greater insight into consumer payment patterns, and the rise in real-estate values helped to create a greater confidence in the risk for mortgage-related investment.
Wall Street investors provided extremely low interest rates to mortgage bankers for higher-risk borrowers with low credit scores and poor payment histories, known as subprime borrowers. They also did the same for borrowers with better scores who needed to finance with little equity or verification. These were known as Alt-A. Often the investors factored in a low short-term rate to qualify with a higher rate two years down the line in order to make the risk-yield factors work on paper. The secondary market and origination volume swelled to epic proportions.
Many subprime loans were unhealthy for the borrowers and investors, but a decade of euphoria while traveling in uncharted territory can create overconfidence, allowing greed and desire to overtake solid asset management. With Wall Street providing the money, banks and bankers were obligated to fund loans meeting the desired criteria. Loan officers trusted Wall Street analysts’ risk assessment and provided products their customers wanted. Unscrupulous loan officers working for banks, mortgage bankers and brokers took advantage of the situation, but mostly the industry simply followed the laws of supply and demand while the government stood by and watched.
In 2007, the time came to pay the piper. As in the past, the real-estate market eventually slowed down, and interest rates rose moderately. The change in market dynamics made it harder for subprime borrowers to refinance. Many began to default. Many had no equity and no choice. Subprime loans became difficult to sell on Wall Street, and subprime lenders began to shut their doors.
Meanwhile, changes in the Alt-A mortgages from their start rates, coupled with devaluations in certain economically challenged parts of the country, reflected in delinquencies or late payments. Earlier this year, the fear set into Wall Street when Bear Stearns closed two funds heavily invested in subprime. Credit tightened, causing more mortgage bankers to fold. Investors, fearing their subprime and Alt-A mortgage-backed securities might be devalued, decided to stop buying any securities not backed by GSEs.
Within a matter of days, widespread panic ensued. All lenders without the ability to sell to the GSEs or portfolios were in trouble. The media fueled the fire by speculating on the health of every lending institution on an hourly basis, with doomsday scenarios. The credit tightening spread to commercial markets, despite verifiable evidence of a reasonably healthy economy. The Federal Reserve Bank, acting quickly in conjunction with several foreign central banks, added money to the banking system and reduced the borrowing rate to banks. This stabilized the panic, although much damage had occurred. Many lenders closed, jobs were lost, and the mortgage-lending guidelines became much stricter.
In the aftermath, contrary to fears, jumbo, nonconforming and stated income loans have not disappeared. It is true that Wall Street firms are currently no longer able to sell securities backed by mortgages that do not conform to the GSEs. However, there are many federal and state chartered banks that still have the ability to portfolio these loans. What’s more, thanks to fast action by the Federal Reserve, these banks are being supplied with capital to continue lending outside of GSE guidelines. Guidelines with these banks have become stricter regarding credit, loan-to-value ratios (LTV) and cash reserves.
Interest rates are still changing, based upon risk. Much of the money removed from the mortgage-backed security world has moved to treasury bonds, actually driving down real interest rates. However, because of market uncertainty about nonconforming loans, lenders have raised rates on these loans to mitigate losses from delinquency or sale.
In June, you might have expected to pay a premium of .25 to .375 percent over conforming rates. Today, the market is demanding .75 to 1.25 percent premium for these exceptions. The general expectation is that this premium may reduce in several months as the market concerns are settled.
Meanwhile, here are some tips for coping. Above all, don’t panic. While the media might have you believe this crisis will result in rampant foreclosures and real-estate values dropping by 75 percent or more, the economic fundamentals are currently strong, and significant devaluation has been limited to areas that have suffered from economic downturn. Subprime represents a small portion of the mortgage marketplace. Government statistics place subprime mortgages at less than 10 percent of the national market, and most are in the lowest-valued areas.
Even with the delinquency rate higher than previous years, it is unlikely that we are about to see mass foreclosures resulting in dramatically falling home prices nationwide anytime soon. The Federal Reserve is carefully monitoring the situation and so far has acted swiftly and appropriately to stabilize the market. If you are in a good loan and can make your payment, keep doing it and do it on time. Real-estate markets have always performed well over time.
Be patient and realistic as a seller. Buyers will need to be more qualified these days, meaning there will be fewer of them. Make sure your house shows well and that you are selling because you need to do so. Decide on the minimum price you need to be happy or satisfy your financial needs. This is no time to be greedy. If your area is suffering economically, do your best to rent the home and cover the payment until the market picks up. Discussing options with a qualified real-estate agent, such as lease options or carrying paper, may help in your ability to sell the home sooner.
Be financially prepared to buy and build. Luckily, the GSEs are log-home supporters and are more than willing to provide purchase loans on them. Additionally, banks large and small have been the traditional providers for construction loans and so far have kept those programs available.
Qualifying for a loan, however, will take more these days than simply showing up. Lenders want to see credit scores above 660, so it’s more important then ever to make those payments on time and keep your credit-card balances low. Larger down payments and money in the bank are also big factors, so hoard that cash and save, save, save.
This article ran longer in the November issue of Log Homes Illustrated.
Kevin Daum is the author of the comprehensive, custom home guide Building Your Own Home For Dummies and What the Banks Won’t Tell You: How to Get the Most Out of Your Mortgage. As CEO of Stratford Financial, he has financed hundreds of dream homes. He can be reached at firstname.lastname@example.org.