The Sub-Prime Mortgage Fiasco - Part XII

While last month’s message focused on the government takeover of Fannie Mae and Freddie Mac, the intervening month has provided us with the government take over of AIG, the bankruptcy of Lehman Bros., a controversial government bail out plan, a deepening and broadening systematic credit crisis that has spread worldwide, the loss of untold wealth in equity markets, and governments intervention throughout the world to prop up banks and financial institutions.

Although I have views on all of the above, the goal of my updates is to provide opinions and information on the mortgage and housing markets, so I will primarily focus on these areas.

Falling home prices, which initiated the credit crisis, are still at the heart of the financial crisis. The continuation of a negative feedback loop - tighter underwriting guidelines creating less qualified buyers which in turn creates less demand for purchases which leads to lower home values and more foreclosures and lower values and further tightening of guidelines…continues to take its toll. How do we stop this loop and continued slide? Market forces will solve some of the problems, as recent housing starts have reached there lowest level in almost twenty years. While this helps reduce housing inventory and aid in stabilizing pricing, it does have a negative effect on employment and the economy (but I don’t want to digress away from housing and mortgages).

Many pundits have stated that while Wall Street is being saved by the government, not enough is being done to help those with troubled loans. My thoughts are that dealing with the relatively few entities of Wall Street and finding a solution that will impact us all is a lot easier dealing directly with hundreds of thousands if not millions of individual home owners who if helped, only helps them. However, if action is taken to collectively help troubled home owners, it could help stabilize home prices, ease the credit crisis, and give us all a sense of security as to the value of one of our largest assets.

In the second presidential debate, the debates moderator Tom Brokaw asked each presidential candidate “…as president what sacrifices will you ask every American to make to help restore the American dream”? While each candidate provided their typical non-answer, it did get me thinking. The sacrifice I am willing to make is to support a plan to assist troubled home owners. This goes against every fiber of my being as I am a true believer in personnel responsibility. While a small percentage of troubled home buyers were “duped” into a mortgage that they ultimately could not afford, I believe the majority of troubled loans came as a result of borrowers obtaining a mortgage they simply could not afford, living beyond the means of their pay, or speculation on the housing market that did not bear fruit.

My plan, if I had any input, would be similar to McCain’s but with some major differences out lined as follows:
1) Purchase from Wall Street $200B - $300B of trouble mortgages at 90% of face value, not 100%.

2) Rewrite mortgages for qualified borrowers at the 30 Year Treasury Rate + 1% (currently this would be at a rate of about 5.25%) on a 30 year amortization.

3) Borrower’s note would be for the full note amount, not a discount, and I would add the closing costs and a 1.5% points for insurance to the loan balance similar to FHA Loans.

4) Mortgage interest would not be tax deductible.

5) Mandatory debt to income ratio’s not exceeding 40%.

6) If borrower could not qualify under new low rate, immediate and uncontested foreclosure.

7) Program could be administered through existing government agencies such as FHA.

I believe such a plan would have an immediate impact on both Wall Street and borrowers. It would limit the amount of further write downs of bad loans to 10%, and remove most of the loans that have already been marked down from bank balance sheets. It removes or limits the uncertainty and trepidation of further write downs by banks which is causing a reluctance to lend to one another. In many cases banks may even be able to post a profit instead of a further loss if they already wrote down the loans by more than 10%.

It would also dramatically slow the pace of foreclosures as billions of dollars of mortgages are rewritten to affordable terms. Many of these borrowers have or will adjust to mortgages at rates ranging from or increasing to 7% - 12%+.

Much of the money provided by the government (or taxpayer) would be recouped as the loans are paid off through maturity or when the property is sold. An obvious unknown is the gain from buying the notes at 90% of face value vs. losses from foreclosures on those that did not initially qualify or are foreclosed upon subsequently, as well as managing the administration of the process on only the 1% difference between borrowing costs and lending rate, plus the 1.5% in points. A second unknown is the character of the borrowers. Would they walk away from a new affordable mortgage if they still owed more on their homes than they are currently worth? An offsetting gain would be the loss of the interest deduction to these borrowers.

The only ones who do not benefit are the vast majority of us that pay our mortgages and other bills on time. Many would call this unfair, and it is. But I would support it.

With all that has transpired, there has been little impact on mortgage rates. Conforming loans (<$417,000) and jumbo conforming loans (vary by county) are still pretty decent with the rate on a 30 year fixed at 6.375% for the conforming, and about .25% higher for the conforming Jumbo. There is huge volatility, as the rates have swung from 5.875% 10 days ago, to 6.75% last week. Rates are also impacted by credit score and loan to value.

On the subject or conforming jumbo loans, if you are considering purchasing or refinancing to these new loan limits, there is a reduction in the maximum loan size allowed that will be announced in November. To take advantage of the current loan size, you must apply prior to November 1st.

Traditional Jumbo rates are horrendous 1% - 1.5% higher than conforming rates with the exception of the 5/1 Jumbo ARM - if you are a premium borrower – Credit score above 700, lower loan to value, excellent liquid assets, and strong debt to income ratios. If you fall within this category, you can still get a rate of 5.75% - 6% depending upon the day.

There is still a very large risk premium or spread built into mortgage backed securities. This spread should narrow as the credit crisis eases, and home values stabilize. There is also an unusual detachment between mortgage backed securities, the 10 year treasury, and equity markets. They have traditionally moved in a correlation to one another, but lately they have not – making anticipating mortgage rates on any particular day fairly difficult.

On a positive note, given the lackluster economy and falling commodity prices, I am no longer in fear of inflationary pressures. As many of my long time readers know, I had always viewed inflation as the greatest threat to rates.

As usual if you have any thoughts, comments, or questions, please do not hesitate to contact me.

Regards,

- Greg

Disclosure: The opinions expressed are my own and do not represent the positions, strategies or opinions of JPMorgan Chase.