Thursday, March 08, 2007

As bad as it is...the worst is yet to come

worst is yet to comeI know, I know....it has been too long since my last post. I have been busy with other business interests yet still keeping an eye on the industry and what is going on.

NOTHING that is happening should come as a surprise, especially to regular readers of this blog. I pretty much called how this was going to play out. Lets refresh and see where we are today.

We have had rising inventories for quite some time now...but people whined and whined that prices were not coming down. No, prices did not come down immediately, that takes time. But I think it is safe to say that most areas are definitely having a softening of prices. There is a great website that tracks this information: www.thebubblebuster.com

As we have seen the inventories increase and sales volume drop 20-40% in many areas, we have seen foreclosures skyrocket to all time highs. I received an e-mail last week from foreclosure.com that said they are tracking a record 155,671 foreclosures nationwide! That might not sound like much, but if you look at the increased foreclosure activity in many areas, and the fact that it is only going to get worse, you will see that this is only going to exacerbate the supply/demand imbalance that already exists.

Do not forget there there is still a good trillion dollars or so of loans left to adjust in 2007. Falling values is going to make refinancing many of these loans very hard if not impossible. This will lead to more people walking away from homes because they can't make the payment, or they don't want to pay on a decreasing 'asset'.

To make matters worse, the lenders that used to make these great 'you can afford the American dream' loans are either out of business or headed that way. I heard some intel that New Century is going to file for Chapter 11 here in the near future. Not only that, but like most of these other 'subprime' lenders, has some pretty major accounting issues to 'account' for. BUT, even if the companies were still around to make the loans, nobody is buying them!

I have discussed the MBS (mortgage backed securities) market many times before. I have a friend that is now in the corporate offices of a major lender. He told me that the secondary market is basically paying 'par' for most 'subprime' loan pools now. What does that mean?? It means that if a lender has a 500 million dollar pool of loans and they go to sell them, the secondary market will pay them 500 million for the loans. Dare I say it is hard to make money selling widgets that cost you $10...for $10. I am not including the expenses involved in making the loans either.

The way it should work is that the lender sells the $500 million of loans for say $520 million. Then goes back and lends that money...repeat cycle. Making money each time they sell the loans, which in turn gives them more money to lend out, and in turn sell for more money. Very simplified I know...but I'm not teaching an MBA class at Harvard, just trying to get people to understand the basics of what is going on here.

The main reason the lenders have been making these loans to begin with is because the secondary market would buy them and assume the risk! Remember the reference I have made several times about 'driving forward while looking in the rear view mirror'? Everything looks good when looking backwards, but you don't see the curve in the road ahead and the cliff to one side. That is how the mortgage market and the secondary markets have operated. The secondary markets kept buying debt and taking more and more risk, because they were not seeing the defaults yet (looking in rearview mirror). So they 'put the pedal to the metal' and would buy debt that was even lower quality and higher risk...but hey, all is well! The lenders will make 'stupid loans' if they are not assuming the risk AND can make money while doing it. BUT, now that the secondary market is seeing defaults and foreclosure activity rise higher than projected, they scale way back, and stop buying the debt.

Lets not even get into the fact that China used to be one of the largest purchasers of our mortgage debt, and that if the consumption/production relationship between the USA and China falters, we could see some tough economic times ahead. Here is a good article from the China Daily from back in October 2005. Then you have this article from a bloomberg.com analysis of the Chinese market taking a dip. I like this part the best:

China's slide affected markets around the globe for the simple reason that it reintroduced the long-forgotten concept of risk into the collective consciousness. Emerging markets don't go up forever. Junk bonds are called junk for a reason. Subprime mortgage loans are made to those with less-than-first-rate credit histories.

You have news coming out that 60% of Countrywide's ARM customers wouldn't qualify for the loan if new proposed measures were put in place that made sure the borrower had to quality on what the payment could be, not the beginning teaser rate. Countrywide rationailizes that only 25% of people refi at the end of the period into another ARM loan, but from my experience and the people I am talking to today, the rate is much higher than that. Either way, if you remove 25-60% of the potential borrowers from the market, guess what, 400-500K is no longer 'starter home' pricing.

I am going to be politically incorrect here for a minute. As a general rule, who do you think are 'financially smarter' people: people with good credit (700+), or people with bad credit (500's)?? The reason I ask, is that people with good credit for the most part make good financial decisions. And people with bad credit make bad financial decisions. So, wouldn't making loans that require some financial knowledge, to people that generally don't posess this knowledge, be a recipe for disaster?? You are making high risk loans to high risk borrowers, and NOT making them pay the risk premium anywhere close to the risk being assumed.

But don't think that 'prime' borrowers are exempt. Remember me saying that there was a distinct lack of good underwriting across the board? Well, it doesn't mean much when I say it, but apparently it does when Lehman Bros does. Here is the quote:

Lehman Brothers Holdings Inc. announced yesterday it is cutting the ratings of Countrywide Financial Corp., the largest mortgage lender, and other prime lenders as defaults surge.

"Prime loans will see rising default rates as subprime has, due to increasingly weak underwriting in recent vintages," analyst Bruce Harting said. "The rapidity, breadth and depth of the subprime sector meltdown has been extraordinary, even in the context of an environment in which most industry observers felt that major problems in the subprime space were inevitable and overdue."

If you think the nonsense in the lending arena was concentrated only in the subprime markets, you are mistaken. It has permeated all aspects of lending. Risk assessment has been shoved aside for the past few years...be it mortgages, car loans, credit cards, etc. With the massive consumption by most Americans being done on credit, look for trouble up ahead...but it will require you to stop looking in your rear-view mirror to see it.

Stay tuned...

SoCalMtgGuy

4 Comments:

Anonymous Anonymous said...

Why IS it that when I read your postings I come away with the strongest sense of clear, honest Thinking?

anon-i-moose in MN

3/08/2007 1:57 PM  
Blogger powayseller said...

SoCal, I am with you: primes are as likely to default as sub-primes.

What is the DTI of the prime borrower? I spoke with an economist recently whose work shows a very low default rate on primes because he assumes they got loans at 30% DTI. So the thinking is: a high-FICO borrower at 30% DTI can easily handle a rate adjustment from 4.5% to 7.5%. That would bring him to 39% DTI, so he'd cut back on restaurant meals, but not lose his house.

Why would a prime borrower borrow within his means? Wasn't he even more likely to go above and beyond?

3/10/2007 11:08 PM  
Anonymous Anonymous said...

Where do these "matress flyer" companies come from ? I take it licensing and other regs don't prevent their entry into the lending market. Other than closing their doors, and resurfacing somewhere else, is there any penalty or consequence to them ?

3/25/2007 5:28 AM  
Blogger joshva said...

Great thoughts you got there, believe I may possibly try just some of it throughout my daily life.

business transcription

9/25/2010 12:00 AM  

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