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.
Other changes:
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.
6 comments:
It is interesting that the subprime implosion hit the mainstream media this week, with a large article, for example, in Barrons. This morning Calculated Risk tells us that economists are revising their housing predictions down, (but their GDP forecasts up!), and Barry Ritholtz reports that Greenspan thinks there could be a recession (i.e., brace for the economic boom).
A reader, anonymous in Europe, on Mish's blog gives us a good scenario why that might be so:
"For as long as I have been at this game, it has taken a crisis for the Federal Reserve to move. The Fed is always reluctant to move because it needs the crisis as a cover so it doesn't look like it's soft on inflation....
... if all of the subprime lenders pull out of that market and if Merrill and Bear and Lehman - big subprime lenders via acquisition -- start saying "it's a crisis" and New Century goes belly-up or Accredited Home takes down a big part of its book value or Countrywide leaves the business -- then we'll have a crisis that can justify not one but maybe three or four cuts." (and the reader goes on to predict the DJIA up 17% this year.
It is important to note that while the Fed raises rates gradually, in the past it has cut rates precipitously -- in 2001, and in 1998 it lowered rates 1.25% in less than 75 days.
Imagine if the Fed cut rates to 4% by April 15, and I think we have a good idea for the bullishness in financial markets.
I see a major fly in the ointment, though. Given the credit and leverage in this expansion, the Fed and market must hope that cutting short rates also leads to a cut in long rates (i.e., the foreigners don't flee), and further that those long rates quickly become lower than they ever were in 2001-2006 (because easy credit has already induced those able to borrow at 4.5% long rates to do so). I consider the chance of that happening less than 50/50.
In the meantime, the overall YoY inflation rate is 2.1%, meaning the 5.25% Fed rate is 3.15% over inflation - quite restrictive; and we have a persistent inverted yield curve. Indeed, in reaction to the Fed moves (perhaps), inflation over the last 5 months has averaged 2%, way down from the 4%+ of a year ago. In the past, all of these things have indicated a recession is near.
Cheers.
I think long term rates are headed up because the American consumer cannot NOT borrow, it is a strong addiction.
When people MUST borrow and at the same time standards are getting tightened then something has to give, and imo that price will be the interest rate consumers must pay to convince lenders that the risk is offset.
Redfish, you are referring to long consumer rates (not necessarily treasury rates), right?
BTW, it has been good to read you again (I knew you from the other blog).
Yes referring to what strapped consumers must pay to finance their lifestyles.
I remember you too and your diaries about the florida housing bubble. Things are going to get nasty here.
What I don't understand is how this stays out of the A and AA tranches? -wetzel
Where ever I seem to go on the internet I come across a blog or a website regarding the situation of the economy. mortgage bonds seem to be on everybody's minds and so they should be! In a society where its nearly impossible to get a 100% mortgage, at least there is a little light at the end of the tunnel.
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