Market Disarray, August 2007
August 10, 2007
Recently I have been getting a lot of mail from mortgage brokers and small lenders complaining that they are no longer able to get funding for loans that previously were never questioned. One of them described it as a market meltdown.
The focal point of any such meltdown has to be the wholesale market, where mortgage brokers and smaller (“correspondent”) lenders, who account for three quarters or more of all new loans, get their funding. Wholesale lenders are the transmission belt between the retail market, where borrowers get their loans, and the secondary market where investors buy securities that are issued against pools of home loans.
Wholesale lenders are mostly large firms who may hold some of the loans they write, but most are sold. They sell to Fannie Mae and Freddie Mac if the loans are no larger than $417,000 and meet the other requirements of the agencies. Loans that don’t meet these requirements are sold to investment banks or others who convert them into securities that are sold to investors.
The non-agency part of the wholesale market currently is claimed to be in a state of disarray. Investors have backed off from purchasing mortgage-backed securities that do not have a direct guarantee of the Federal Government, or the indirect guarantee of Fannie Mae and Freddie Mac, which is viewed as almost as good. If wholesale lenders have difficulty finding buyers, this will be reflected in the prices and other terms they quote to mortgage brokers and small lenders. And that is what I decided to look at.
Fortunately, I have been developing a data base on wholesale mortgage prices that lets me peer into the heart of the problem. Wholesale prices are those quoted to mortgage brokers and small lenders. My data base covers 12 of the very largest wholesale lenders. They are the dominant players in this market.
Ordinarily, the wholesale market is so competitive that price differences between wholesale lenders on the same transaction are very small. (In contrast, retail prices have much more statistical “noise” because they include markups, which can vary widely from one transaction to another). But that is the “normal” state of affairs. An increase in price dispersion among different wholesalers would be one important indicator of market disarray.
The transaction characteristics underlying the wholesale price data are well defined. I know the loan amount, property value, type of property, state location, purpose of loan, use of property, borrower’s FICO score, type of documentation, whether borrower escrows taxes and insurance, and lock period. None of the available series on retail prices contain this amount of detail on factors that affect mortgage prices.
The data are available for each of 14 separate loan programs, of which 6 are fixed-rate and 8 are adjustable rate. Sub-prime mortgages are not covered, though alt-A and other intermediate credit categories are included.
Because this is a work in progress, I don’t yet have the daily series that will permit day-to-day monitoring of the market. However, I did do a test run on May 4 covering California, and will use that as a benchmark for assessing the state of the market three months later, on August 3. To simplify price comparisons, I adjust all rates to zero points and fees. The interest rate is the only price used.
On cream-puff loans, interest rates rose by about .40% between May 4 and August 3. On some programs it was a little more, on others a little less, but the dispersion was small.
A cream-puff loan is one with 20% down payment on a $500,000 single-family home purchased as a permanent residence, by a borrower with a credit score of 720 or more, who fully documents income and assets, and escrows taxes and insurance. The concern, however, is not with cream-puff loans but with the riskier niches.
The evidence indicates that the price of risk has gone up. One of the tables I ran on May 4 showed the rate at different FICO scores. On scores ranging down to 680, rates on August 3 were about .40% higher, but at 660 the increase was .56% and at 620 it was 1.40%. Below 620, there were no quotes on either date, that’s sub-prime territory.
I also looked at rates on loans of different sizes on May 4: the sizes were $75,000, $417, 000, $418,000, and $2 million. The two middle sizes distinguish loans that can and loans that cannot be purchased by the two Federal agencies, Fannie Mae and Freddie Mac. The rate increases, starting with the $75,000 loans, were .41%, .45%, .74% and .80%.
The only other risky niche I priced on May 4 was a cash-out refinance for investment on a 4-family property, though it had a 20% down payment, 720 FICO and full documentation. On August 3, the rate on this loan was 1.24% higher.
On August 7, I looked at price dispersion in the wholesale market, as well as any tendencies for lenders to stop quoting prices in riskier niches.
All 12 lenders quoted prices on the creampuff (see the definition above) at various rates, and the price dispersions were small. For example, at 6%, the lowest price was $4039 and the highest was $6589, with other quotes in-between. This spread of only $2550 on a $400,000 loan is small, which is exactly what one expects to find in a well-functioning competitive market.
In my second pass, I upped the loan amount to $418,000, leaving all the other features of the loan unchanged. It remains a creampuff loan in all respects other than size – it is now a jumbo loan ineligible for purchase by the agencies.
At the same price, jumbo rates were .625-.75% higher. I do not have a comparable figure for the period just prior to the recent market upheavals, but I have looked at the spread on many occasions over the years, and it was always .25-.375%. To my knowledge, the current spread is larger than it has ever been.
The price dispersion was also higher on the jumbos. For example, on a 6.625% loan, the best jumbo price was $4494 but the highest was $11,639, a spread of $7145. On 7.5% loans, the best price was a rebate of $5059 while the highest was $14,987, a spread of $20,046. Two of the 12 lenders did not provide any price quotes on the jumbo, which is highly unusual.
With my third pass, I changed the jumbo loan from a purchase loan to a cash-out refinance, and from full documentation to no documentation. Everything else remained the same. This moved the loan into a much riskier niche.
Only 4 of the 12 lenders quoted prices for this loan, and one of the four was way off the mark. At 8%, the best quote was $3253, next best was $10,623 and the worst $13,218. The best quote by the fourth lender was $14,091 for a 9% loan.
It is clear that the price of risk has risen substantially, the higher the risk category, the larger the increase in price. Some at least of the very highest risk niches are no longer being offered. The lowest risk niches, what I called creampuff loans, have not been affected at all and may even have benefited. My data don’t cover sub-prime loans, but the plausible surmise is that these loans have been affected most of all because they are the riskiest of all.
This is not a market meltdown, far from it. In a meltdown, lenders jettison their capacity to assess risk altogether, and flee into assets insured by the Government. We haven’t seen that since the 1930s, and we won’t be seeing it now. But the situation is bad enough.
Borrowers are hit with a double-whammy. Some are being cut from the market as lenders withdraw from the riskier niches in which loans previously had been available. In those niches in which lender continue to offer loans, furthermore, the wide dispersion of price quotes increases the difficulty of shopping retail sources – as if shopping for a mortgage was not difficult enough already! It is no longer the case that brokers and small lenders have access to pretty much the same wholesale prices.
This market is correcting a previous tendency to under-price risk, a tendency arising from a prolonged period of house price appreciation. Steady price appreciation virtually eliminates the difference in performance between the least-risky and the most risky loans. Lenders with short time horizons and/or poor memories, who were willing to price on the assumption that price appreciation would continue forever, forced other lenders to do the same to remain competitive.
The fantasy that home prices only rise led to a housing bubble in many areas, before it inevitably collapsed. See my article on Housing Bubbles, written in late 2004. It is no longer rational to price loans on the assumption that rising prices will convert most bad loans into good loans. The market is now reacting to that realization.
An industry that had become conditioned to rules that allowed most anyone to get a loan, now must turn customers away. This is painful, just as denying a heroin addict the fix to which he had become accustomed, is painful. But we try to be compassionate with addicts and help them make the transition to a normal life as easy as possible. Is there something that can be done to make the market’s transition less painful?
Some are proposing that the Federal Reserve step in to lower interest rates. There isn’t a lot of scope for that because mortgage rates today are only about 1% above their lowest point reached in mid-2003. Further, the Fed has many more things to consider in setting its policy targets than the transitional pain of the home loan market.
But even if the Fed viewed pain relief in the home loan market as a priority, lowering the general level of rates would mainly help the mortgage borrowers who don’t need help. Lowering rates will not affect the investor guidelines that have made some borrowers ineligible. Those who have become ineligible under the new rules would remain ineligible. Rates in the high-risk niches that are still being priced probably would fall a little, but nothing to match the previous price increases.
In short, there would not a lot of benefit to set against the costs of changing Fed policy to one that is more liberal than the Fed would have selected otherwise.
Reportedly, Fannie Mae and Freddie Mac have proposed that they be allowed to help by making loans they are not now authorized to make, specifically “jumbo” loans larger than their current limit of $417,000. The agencies would dearly love to get out from under that limit, which is going to run through 2008 and maybe even beyond if housing prices don’t recover.
But there is no shortage of money for jumbo loans, the shortage is in the higher-risk niches, some jumbo but many not. A credible offer by the agencies would be to make loans in high-risk niches that the private market has now placed out of bounds, and/or to offer better prices in high-risk niches that the agencies believe are being over-priced. In either case, the agencies should define these niches exactly as they would appear in their underwriting manuals, and provide credible evidence that the niches are closed or over-priced.
I’m not sure that, even if the agencies provided an explicit and valuable quid pro quo, the deal would be a good one. Fannie and Freddie are already far too big. If it were my call, I would freeze their loan limit forever so that their market share (and political clout) gradually declined. If the limit was raised instead, there should be an attached sunset clause that automatically terminates the authority after a specified period, such as 12 months.
In a normal market, borrowers can assume that all loan providers have access to pretty much the same wholesale prices. This means that it is safe to focus on the loan provider’s markup. But when wholesale prices for the same deal vary all over the lot, this strategy no longer works. Borrowers need to consider the range of wholesale sources to which a loan provider has access, and that information is very hard to come by.
Hopefully, the situation will not last long, but meanwhile, what is a borrower to do? Give yourself enough time to consider more loan providers. Shop the 4 Upfront Mortgage Lenders listed on my web site, where you can find an on-line quote, or the absence of one, very quickly.
In the past, I have recommended interviewing Upfront Mortgage Broker about their markups, in addition to other factors. In today’s market, if the UMB (or any other broker) has a wholesale source for your loan, your interview should include information about his range of wholesale sources in general, and about how many other wholesale price quotes the broker had for your loan in particular.
Just remember that this is sensitive information to brokers. You have a right to ask for it, the broker has a right not to provide it, and you have a right to walk out the door.
Recently I have been getting a lot of mail from mortgage brokers and small lenders complaining that they are no longer able to get funding for loans that previously were never questioned. One of them described it as a market meltdown.
The Wholesale Market
The focal point of any such meltdown has to be the wholesale market, where mortgage brokers and smaller (“correspondent”) lenders, who account for three quarters or more of all new loans, get their funding. Wholesale lenders are the transmission belt between the retail market, where borrowers get their loans, and the secondary market where investors buy securities that are issued against pools of home loans.
Wholesale lenders are mostly large firms who may hold some of the loans they write, but most are sold. They sell to Fannie Mae and Freddie Mac if the loans are no larger than $417,000 and meet the other requirements of the agencies. Loans that don’t meet these requirements are sold to investment banks or others who convert them into securities that are sold to investors.
The non-agency part of the wholesale market currently is claimed to be in a state of disarray. Investors have backed off from purchasing mortgage-backed securities that do not have a direct guarantee of the Federal Government, or the indirect guarantee of Fannie Mae and Freddie Mac, which is viewed as almost as good. If wholesale lenders have difficulty finding buyers, this will be reflected in the prices and other terms they quote to mortgage brokers and small lenders. And that is what I decided to look at.
Wholesale Price Data
Fortunately, I have been developing a data base on wholesale mortgage prices that lets me peer into the heart of the problem. Wholesale prices are those quoted to mortgage brokers and small lenders. My data base covers 12 of the very largest wholesale lenders. They are the dominant players in this market.
Ordinarily, the wholesale market is so competitive that price differences between wholesale lenders on the same transaction are very small. (In contrast, retail prices have much more statistical “noise” because they include markups, which can vary widely from one transaction to another). But that is the “normal” state of affairs. An increase in price dispersion among different wholesalers would be one important indicator of market disarray.
The transaction characteristics underlying the wholesale price data are well defined. I know the loan amount, property value, type of property, state location, purpose of loan, use of property, borrower’s FICO score, type of documentation, whether borrower escrows taxes and insurance, and lock period. None of the available series on retail prices contain this amount of detail on factors that affect mortgage prices.
The data are available for each of 14 separate loan programs, of which 6 are fixed-rate and 8 are adjustable rate. Sub-prime mortgages are not covered, though alt-A and other intermediate credit categories are included.
Market Changes, May 4-August 3
Because this is a work in progress, I don’t yet have the daily series that will permit day-to-day monitoring of the market. However, I did do a test run on May 4 covering California, and will use that as a benchmark for assessing the state of the market three months later, on August 3. To simplify price comparisons, I adjust all rates to zero points and fees. The interest rate is the only price used.
On cream-puff loans, interest rates rose by about .40% between May 4 and August 3. On some programs it was a little more, on others a little less, but the dispersion was small.
A cream-puff loan is one with 20% down payment on a $500,000 single-family home purchased as a permanent residence, by a borrower with a credit score of 720 or more, who fully documents income and assets, and escrows taxes and insurance. The concern, however, is not with cream-puff loans but with the riskier niches.
The evidence indicates that the price of risk has gone up. One of the tables I ran on May 4 showed the rate at different FICO scores. On scores ranging down to 680, rates on August 3 were about .40% higher, but at 660 the increase was .56% and at 620 it was 1.40%. Below 620, there were no quotes on either date, that’s sub-prime territory.
I also looked at rates on loans of different sizes on May 4: the sizes were $75,000, $417, 000, $418,000, and $2 million. The two middle sizes distinguish loans that can and loans that cannot be purchased by the two Federal agencies, Fannie Mae and Freddie Mac. The rate increases, starting with the $75,000 loans, were .41%, .45%, .74% and .80%.
The only other risky niche I priced on May 4 was a cash-out refinance for investment on a 4-family property, though it had a 20% down payment, 720 FICO and full documentation. On August 3, the rate on this loan was 1.24% higher.
Price Dispersion on August 7
On August 7, I looked at price dispersion in the wholesale market, as well as any tendencies for lenders to stop quoting prices in riskier niches.
All 12 lenders quoted prices on the creampuff (see the definition above) at various rates, and the price dispersions were small. For example, at 6%, the lowest price was $4039 and the highest was $6589, with other quotes in-between. This spread of only $2550 on a $400,000 loan is small, which is exactly what one expects to find in a well-functioning competitive market.
In my second pass, I upped the loan amount to $418,000, leaving all the other features of the loan unchanged. It remains a creampuff loan in all respects other than size – it is now a jumbo loan ineligible for purchase by the agencies.
At the same price, jumbo rates were .625-.75% higher. I do not have a comparable figure for the period just prior to the recent market upheavals, but I have looked at the spread on many occasions over the years, and it was always .25-.375%. To my knowledge, the current spread is larger than it has ever been.
The price dispersion was also higher on the jumbos. For example, on a 6.625% loan, the best jumbo price was $4494 but the highest was $11,639, a spread of $7145. On 7.5% loans, the best price was a rebate of $5059 while the highest was $14,987, a spread of $20,046. Two of the 12 lenders did not provide any price quotes on the jumbo, which is highly unusual.
With my third pass, I changed the jumbo loan from a purchase loan to a cash-out refinance, and from full documentation to no documentation. Everything else remained the same. This moved the loan into a much riskier niche.
Only 4 of the 12 lenders quoted prices for this loan, and one of the four was way off the mark. At 8%, the best quote was $3253, next best was $10,623 and the worst $13,218. The best quote by the fourth lender was $14,091 for a 9% loan.
Disarray Versus Meltdown
It is clear that the price of risk has risen substantially, the higher the risk category, the larger the increase in price. Some at least of the very highest risk niches are no longer being offered. The lowest risk niches, what I called creampuff loans, have not been affected at all and may even have benefited. My data don’t cover sub-prime loans, but the plausible surmise is that these loans have been affected most of all because they are the riskiest of all.
This is not a market meltdown, far from it. In a meltdown, lenders jettison their capacity to assess risk altogether, and flee into assets insured by the Government. We haven’t seen that since the 1930s, and we won’t be seeing it now. But the situation is bad enough.
Borrowers are hit with a double-whammy. Some are being cut from the market as lenders withdraw from the riskier niches in which loans previously had been available. In those niches in which lender continue to offer loans, furthermore, the wide dispersion of price quotes increases the difficulty of shopping retail sources – as if shopping for a mortgage was not difficult enough already! It is no longer the case that brokers and small lenders have access to pretty much the same wholesale prices.
Diagnosis
This market is correcting a previous tendency to under-price risk, a tendency arising from a prolonged period of house price appreciation. Steady price appreciation virtually eliminates the difference in performance between the least-risky and the most risky loans. Lenders with short time horizons and/or poor memories, who were willing to price on the assumption that price appreciation would continue forever, forced other lenders to do the same to remain competitive.
The fantasy that home prices only rise led to a housing bubble in many areas, before it inevitably collapsed. See my article on Housing Bubbles, written in late 2004. It is no longer rational to price loans on the assumption that rising prices will convert most bad loans into good loans. The market is now reacting to that realization.
Proposed Rescues and Remedies
An industry that had become conditioned to rules that allowed most anyone to get a loan, now must turn customers away. This is painful, just as denying a heroin addict the fix to which he had become accustomed, is painful. But we try to be compassionate with addicts and help them make the transition to a normal life as easy as possible. Is there something that can be done to make the market’s transition less painful?
Some are proposing that the Federal Reserve step in to lower interest rates. There isn’t a lot of scope for that because mortgage rates today are only about 1% above their lowest point reached in mid-2003. Further, the Fed has many more things to consider in setting its policy targets than the transitional pain of the home loan market.
But even if the Fed viewed pain relief in the home loan market as a priority, lowering the general level of rates would mainly help the mortgage borrowers who don’t need help. Lowering rates will not affect the investor guidelines that have made some borrowers ineligible. Those who have become ineligible under the new rules would remain ineligible. Rates in the high-risk niches that are still being priced probably would fall a little, but nothing to match the previous price increases.
In short, there would not a lot of benefit to set against the costs of changing Fed policy to one that is more liberal than the Fed would have selected otherwise.
Reportedly, Fannie Mae and Freddie Mac have proposed that they be allowed to help by making loans they are not now authorized to make, specifically “jumbo” loans larger than their current limit of $417,000. The agencies would dearly love to get out from under that limit, which is going to run through 2008 and maybe even beyond if housing prices don’t recover.
But there is no shortage of money for jumbo loans, the shortage is in the higher-risk niches, some jumbo but many not. A credible offer by the agencies would be to make loans in high-risk niches that the private market has now placed out of bounds, and/or to offer better prices in high-risk niches that the agencies believe are being over-priced. In either case, the agencies should define these niches exactly as they would appear in their underwriting manuals, and provide credible evidence that the niches are closed or over-priced.
I’m not sure that, even if the agencies provided an explicit and valuable quid pro quo, the deal would be a good one. Fannie and Freddie are already far too big. If it were my call, I would freeze their loan limit forever so that their market share (and political clout) gradually declined. If the limit was raised instead, there should be an attached sunset clause that automatically terminates the authority after a specified period, such as 12 months.
What Is a Borrower to Do?
In a normal market, borrowers can assume that all loan providers have access to pretty much the same wholesale prices. This means that it is safe to focus on the loan provider’s markup. But when wholesale prices for the same deal vary all over the lot, this strategy no longer works. Borrowers need to consider the range of wholesale sources to which a loan provider has access, and that information is very hard to come by.
Hopefully, the situation will not last long, but meanwhile, what is a borrower to do? Give yourself enough time to consider more loan providers. Shop the 4 Upfront Mortgage Lenders listed on my web site, where you can find an on-line quote, or the absence of one, very quickly.
In the past, I have recommended interviewing Upfront Mortgage Broker about their markups, in addition to other factors. In today’s market, if the UMB (or any other broker) has a wholesale source for your loan, your interview should include information about his range of wholesale sources in general, and about how many other wholesale price quotes the broker had for your loan in particular.
Just remember that this is sensitive information to brokers. You have a right to ask for it, the broker has a right not to provide it, and you have a right to walk out the door.