Think we're out of the mortgage mess?
Could the housing crisis happen a second time?
Are you ready to bail out the mortgage industry to the tune of $100 billion? Can you identify if you are at risk in the next crash? What can you do to protect yourself from the next downturn?
A recent report shows that Fannie/Freddie would need $100 billion in a new crisis according to stress test results released last week by their regulator. Fannie/Freddie are the largest buyers of U.S. mortgages, and after the last crisis are basically under the control of the U.S. Treasury Department which puts you and I, the taxpayers, on the hook for any losses/bailouts.
Why is this scenario likely to come to fruition?
Roughly 40 percent of all purchases during the last 12 months were low down payment loans, this encompasses over 1.5 million borrowers. Borrowers putting between 5 percent and 9 percent down grew at double the market average, according to Black Knight Analytics. Furthermore, more than 25 percent of all lending by the government sponsored entities (Fannie/Freddie) was subprime (less than 10 percent down).
What is subprime?
Subprime lending (or non-prime) – basically any loan where the borrower puts less than 20 percent down.
Why is 20 percent the magic number?
Let’s look at what happened leading up to the last recession. Remember prices can go down, and down substantially. The last recession showed that borrowers with less than 20 percent down were substantially more likely to default on their loans.
In a recession with values dropping, if you put only 5 percent down, the borrower is underwater almost immediately. In other words, the house is worth less than is owed. It doesn’t take a deep recession to see a 5 percent to 10 percent drop in values. A little hiccup in the economy could knock prices down that much, especially in higher cost areas like the Colorado Front Range, where borrowers are spending larger portions of their income on housing.
Wait, everything is different now in the mortgage market – Right?
We cannot have the same issues again with Dodd Frank, etc…!
I hear the arguments now, default rates are at the lowest since the recession, underwriting is tougher, credit scores are higher and the list goes on.
What has changed since the last crisis?
1. Credit: There are typically higher credit requirements today. The difference is that the credit score naturally is higher during better economic times. Furthermore, credit scores have trended up as the scoring methodology has changed to eliminate many negative items on a credit report (See: Ready for a summer boost to your credit score).
2. Income: Gone are the days of the “liar loans” as they were called. Income is verified more thoroughly.
3. Appraisals: In the past there was collusion among appraisers, realtors, lenders, etc… To solve this problem a new appraisal system was put in place where appraisals were ordered through a central company so that there could not be influence by the realtors/lenders. The appraiser on a residential house is basically “assigned” by the third-party company. This sounds great in theory; the problem is you might not have an appraiser that specializes in the area. For example, I did a refinance on my house with a major bank. They sent an appraiser from Longmont, who had no clue about the intricacies of the Evergreen market. His value was off by about 40 percent since he had no expertise in the unique factors that impact mountain real estate.
4. Loan to Value: During the beginning of the recovery, lenders made few if any non-conventional loans. As the recovery has progressed, we are back to the same party. As prices have risen, borrowers are unable to put down the full 20 percent, so programs have been adjusted to enable lower down payment options. This allows lenders to continue lending and keep their revenues flowing.
Of the four factors above, one factor is exponentially more important than the others. Being a hard money lender and riding through the last mortgage crisis with no bailout from the government, we learned real quick what happens in a market downturn.
The number one factor determining whether a lender will take a loss is
Loan to Value
As a private lender in the last crisis we had a unique perspective to see how our lending practices performed under stress. We lend our own funds, look at every property and service our loans. We get to see the whole cycle (as opposed to many banks that pool their loans and securitize them). As the crisis unfolded we spread out the portfolio based on credit, income, loan to value, etc… the primary indicator of whether we would take a loss or not was the leverage the borrower utilized.
For example, in Colorado in the last crisis subprime loans were less than 40 percent of all loans, but accounted for 77 percent of all the foreclosures.
In a downturn, markets fall!
A cascading effect occurs; the market falls, dampens consumer confidence, decreases consumer spending and businesses in turn cut back to accommodate the lower spending level (layoffs, fewer purchases, etc…). Borrowers that have equity in their commercial or residential property are considerably more likely to make a payment. In the last crisis, there were a number of “strategic defaults,” where the borrower could make a payment but chose not to since the house was underwater. The theory goes: “Why throw good money away when I can go rent or buy another house for less than what I currently owe?” This is a simplistic explanation of what happened in the last crisis and what will happen again. The depth of how this plays out in the next crisis is the question.
What does this have to do with Fannie/Freddie the largest purchasers of residential mortgages? With 25 percent of mortgages originated having less than 10 percent down, the probability of major defaults has been amplified. It is highly likely that there will need to be a huge bailout by U.S. taxpayers to the tune of $100 billion or more (this doesn’t include bailouts of FHA or VA which also makes subprime loans with down payments less than 5 percent).
With all this talk of subprime defaults, how does this impact you? Are there steps you can take to identify if your neighborhood is at risk?
Fortunately, the answer is yes!
What should you do? As mentioned above, areas with higher portions of subprime loans are at much great risk of default. This trend is neighborhood specific.
How can you identify the risk to your neighborhood? I did an analysis of a few suburbs in Denver about a year ago and found my neighborhood had almost 52 percent of recent sales comprised of subprime loans (I used lender tools to see the sale price and down payment on the recent sales). This was considerably higher than other areas not far from my neighborhood. I was floored at the number of subprime loans around my house. What did I do? I sold and moved to an area that was not nearly as dependent on subprime loans to protect myself in a downturn.
Is the above chart indicative of your neighborhood? Everyone should take the time to look around your neighborhood at the recent sales and see what percentage people are putting down (you can also get this information from your local assessor’s office). The lower the down payment the higher the risk your neighborhood will fall in the next downturn. You will likely be surprised at the “price riskiness” of your neighborhood. With values still moving higher, now is the time to identify if your property is at risk and take action to position yourself for the next cycle.