Mortgage Market Update: Impact of the Liquidity Crisis
By Brian Chappelle
October 2007
In our May article on the mortgage market, we discussed the implications of the turmoil in the subprime arena on the real estate finance industry. At that time, we raised a fundamental question:
"Will performance problems (in the subprime market) continue and possibly spill over to other products?"
Unfortunately, in late July and early August, we got the answer that none of us wanted. When several of the largest mortgage lenders announced serious delinquency problems in alt-A products (e.g. option ARMs, stated income and "piggyback" products (80/20's)) and American Home Mortgage was forced to file for bankruptcy protection, fears about the deterioration in the quality of all nonprime mortgages became a reality.
While many were not surprised by this turn of events, it is fair to say that investor reaction "shocked" the industry. With these announcements, investors lost all confidence in the performance of the private mortgage-backed securities (MBS) market (including securities with underlying assets of subprime, Alt-A and even high quality jumbo mortgages). The private capital markets literally seized up overnight and still remain that way in mid-September.
Simply put, unless a loan can be sold to Fannie Mae, Freddie Mac, Ginnie Mae (FHA or VA) or held in a financial institution's portfolio, it has been virtually impossible to originate any other type of mortgages including high quality jumbo loans and sell them as part of a private security even if the security had a AAA rating. Stated another way, there is no liquidity for mortgage products that comprised over 40 percent of the market in 2006.
As a result of these unprecedented events, several observations are appropriate.
1. Liquidity will not return quickly.
Unfortunately, there is no easy answer to how long it will take. The liquidity problem will last until investors are comfortable with the performance expectations and repricing of risk for these securities and that will take time. For some products, liquidity may not return for years if at all.
2. There will be a dramatic shift in product availability.
Once the liquidity returns, the industry will also be adhering to the tighter credit standards that have been implemented by all of the federal and state regulators. What happened in early August has only reinforced to the regulators the need for strong and comprehensive action. For example, all nontraditional (option ARMS and interest only) and subprime mortgages now must be underwritten to the fully indexed rate. Stated income and piggyback loans will be curtailed significantly in the coming months. The net effect of these changes will be to institutionalize (in effect make "permanent") the tightening implemented by investors. These underwriting changes will eliminate the use of these products as a means to qualify homebuyers for homes they could otherwise not afford.
3. The universe of potentially eligible borrowers has been reduced by the elimination of many mortgage products.
We are returning to the times when homebuyers could qualify for mortgages at 2 or 3 times their annual incomes instead of 5 or 6 times their family incomes as has been occurring the last several years.
What can be done to minimize the impact of the liquidity crunch?
First and foremost, loans are available and still being made to qualified homebuyers.
They are predominantly being made to homebuyers who meet the program requirements and underwriting standards of Fannie Mae, Freddie Mac, FHA and VA. In addition, jumbo loans and even some of the highest grade alt-A loans are being originated, but at higher prices. The non-GSE and government loans are being placed in the portfolios of financial institutions.
Importance of FHA modernization legislation becomes even more critical
NAR is working diligently to ensure that the FHA legislation with its higher mortgage limits and lower and more flexible down payment calculation is enacted as soon as possible. While FHA modernization was always important, the events of the last 60 days underscore FHA's value in a turbulent marketplace.
Fannie Mae and Freddie Mac can play a broader role
NAR is also committed to expanding the availability of credit offered by the GSEs. NAR has joined with its trade association partners (NAHB and MBA) in writing a letter to OFHEO promoting the increase in the size of their portfolios. NAR is also supporting legislation to raise the GSEs' mortgage limits to over $600,000 to ensure the flow of capital to many high cost areas throughout the country.
In conclusion, we are now clearly in uncharted waters in the real estate finance industry and it will probably take at least several months for things to settle down. However, it is also important to remember loans are being made and will be made in the future. However, we are literally going "back to the future" with respect to the types of loans that will be originated. Fannie Mae, Freddie Mac, FHA and VA are regaining their importance in the marketplace. They will be performing the roles for which they were created (i.e. ensuring homeownership opportunities for many lower and middle income homebuyers and the availability of refinancing alternatives.)
