| and Its Importance in the Bond Market |
In years passed a borrower would visit their local savings and loan to obtain a mortgage. The Loan Officer at the bank would approve the mortgage and fund it with cash reserves from the vault. This system worked well until the bank ran out of money to lend. Borrowers came to the S&L looking for a loan and were told to come back when a current mortgage paid off. What the bank needed was a way to sell the loans they made freeing up the capital to lend to new borrowers. This way they could lend the “same” money over and over, earning an income from servicing the loans and assisting the community by offering a near limitless pool of money.
To address this issue, FNMA and GNMA were established. The goal was to provide cheap mortgage money to prospective homeowners and a high quality bond for the investment community. The bond or Mortgage Backed Security (MBS) takes mortgages with similar risk characteristics and pools them together. Investors in the MBS’s know ahead of time the return they are going to receive, much like a Certificate of Deposit. To ensure the performance of the bond, each mortgage is underwritten to specific guidelines. By ensuring the borrower is both capable (VOE), willing to repay (credit report) the debt, has the cash to close (VOD), and the value is in the property (appraisal), the loans and thus the bond will perform as expected.
During the recent real estate boom underwriting guidelines were relaxed giving way to a whole new menu of products such as the 100% NOO with credit scores below 600. In addition, to streamline the influx of applications, income and asset verification took a back seat to a borrower with strong credit. With housing prices rising rapidly, the basis for the mortgage, the property, could be sold to cover the note and foreclosure costs if this occurred. This cycle worked well until the price of houses moderated in 2006.
Once the housing market began to cool and prices moderated, foreclosed homes were being sold for less than the note. To add insult to injury, the loans underwritten to the looser guidelines are not performing as hoped. With the value of the collateral in question (falling home prices) and the future performance of the borrowers unknown, investors’ appetites for this risk has waned. To attract investors in this environment, rates had to increase substantially.
Loans sold to GNMA or FNMA remain largely untouched in the recent credit rout because the investment qualities of the loans are well known. The foreclosure and delinquency rates are well within acceptable standards lending support to these products as their interest rates have fallen in the recent weeks.
The recent rapid rise in rates not directly tied to FNMA/GNMA is an example of the pendulum swinging too wide. The fact remains that a qualified borrower is a good investment from a bondholder perspective. In a typical interest rate market, jumbo loans (loans in excess of the conforming limit) with proper documentation carry a yield about 1/4 higher than similar conforming products. Sanity will eventually return to the markets and non-conforming pricing will come in line with their risk characteristics. The depth and breadth of the current subprime issue will determine when that change occurs.
Our hearts go out to everybody touched by this unfortunate issue. Investors have closed, companies have closed, and borrowers have been left with un-funded loans. Unfortunately the damage is widespread. The fact remains this is the best industry in the world and we diligently press forward as we work harder through these difficult times
Chinese Proverb
There is a Chinese proverb that states, “May you live in interesting times.” It is often argued that the word interesting is meant to be a synonym for turbulent or dangerous. This phrase hits the bull’s-eye given the current state of the financial markets.
While stocks and bonds are swinging around wildly there is good news. Interest rates for conforming and FHA/VA loans are still in the 6’s, historically low by many standards and the funds are widely available. In addition, the National Association of Realtors has projected home sales will move in a narrow range and improve throughout the year.