Fears about defaults are slowing the gusher of investor funds going to riskier segments of the mortgage market. That means less money available for "subprime" loans to riskier borrowers, forcing lenders to focus more on borrowers who can afford down payments and have well documented finances. With fewer lower-income Americans able to buy homes, downward pressure on prices will probably increase.
These pressures have intensified in recent days. The cost of insuring mortgage-bond holders against default risk, as measured by the so-called ABX index, has soared, deepening the concerns of investors in collateralized debt obligations, among the biggest holders of riskier mortgage bonds. Managers of some CDOs are delaying new offerings to "wait for the dust to settle," a process that could take weeks or months, says Chris Flanagan, head of CDO research at J.P. Morgan Chase & Co.
"CDO managers and hedge funds still want to do CDOs, but the conditions are much, much tougher," David Liu, a mortgage analyst with UBS AG, adds.
So, lenders still want to do deals, but are actually asking for documentation and savings and being more selective.
"It's tightening up a lot," said Eddie Carmona, branch manager at Homewood Mortgage in Carrollton, Texas, a mortgage broker that handles subprime borrowers.
Carmona said down payment requirements are the biggest change he's seen.
"Before, you didn't have to bring a down payment," Carmona said.
Higher credit scores. Previously, borrowers with a FICO credit score as low as 570 (out of 850) could qualify for a single loan financing 100 percent of their home purchase, Carmona said.
"Now, across the board, it's jumped up to a 600 FICO score for an 80/20 loan," Carmona said, in which a second loan has to be taken out to finance the remaining 20 percent of the home value.
Rising interest rates. Rates on subprime mortgages have risen about a full percentage point since September, Carmona said, while regular mortgage rates have been relatively steady.
More stringent savings requirements. "They want to see borrowers have at least three months of reserves in their account in case of an emergency," Carmona said.
The 2006 vintage sub-prime loans are already defaulting at a high rate. That indicates lending standards were far too loose.
However, I think an economist can convincingly argue the increase in home ownership in 2006 and probably the latter part of 2005 was largely the result of very lax credit standards. Assuming that is true, that means the latter part of the housing boom was essentially a speculative excess rather than actual investment. That means we're going to have a prolonged shakeout period where poor credit risks have to be shaken out. This will lead to a prolonged period of correction in the housing market.