Bankers’ Hours column: Sub-prime mortgage loans are still being sought by investors
December 23, 2018
We've heard a lot about the sub-prime mortgage loan monster raising its ugly head in the past couple of years. Like classic horror film villains — Jason, Freddie Kruger and their kin — sub-prime loans keep coming baaack.
And we all know that it isn't pretty when they make their gory return. In the world of the movement of money, investing and lending, conventional wisdom posits that capital markets embracing sub-prime paper is nothing less than a harbinger of a crash and another Great Recession. Like, "What is everybody thinking? Are we so stupid that we have to do this every 10 years?"
No, we don't, and we're probably not, at least when it comes to mortgage lending. The term "sub-prime" is probably the most misused — and misunderstood — term in the lexicon of mortgage lending. First, we need to define what "prime" really means; not as easy as it sounds. The closest that we can come is probably to explain other terms: "agency eligible" or "qualifying mortgage." They both mean pretty much the same thing, with the first a financial industry appellation, while the second comes from regulations established after the passage of the Dodd-Frank Act. They mean mortgages that Fannie Mae and Freddie Mac, the mortgage conduit behemoths that were bailed out by the federal government after 2008, will buy. These entities purchase home loans, package them into mortgage backed securities, and sell them to investors, thus keeping money available for home loans.
That is probably the best description we can come up with for "prime" mortgage loans. They have standardized underwriting and appraisal guidelines, and virtually all of these loans are collateralized by the borrowers' primary homes.
The demand for the new sub-prime product is fierce. There are far more investors, big and small, seeking the derivatives backed by these mortgages than there are loans to create the securities. That’s because the yields are 3 percent or even 4 percent above what the vanilla stuff pays.
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Every other mortgage is often swept into the "sub-prime" category. That, however, doesn't mean that such loans are bad loans. Anyone who's been around mortgage lending can cite a host of examples of loans that were not agency eligible that were far superior to the Freddie/Fannie vanilla variety.
The sub-prime paper that we're seeing today may be collateralized by properties that are outliers of some sort, possibly in construction or use, or borrowers with unusual employment or financial profiles. But the companies originating these deals, and packaging them into derivatives (securities backed by the underlying mortgages (there are a lot of people doing it)), are very meticulous when it gets to underwriting and property value analysis.
They often just do it differently than as mandated in Freddie Mac/Fannie Mae guidelines. For example, these firms have a very robust program that involves analyzing cash flow through the review of bank statements for a certain specified time frame, as opposed to the traditional income analysis protocol using employment verifications and tax returns.
The sub-prime lending executives maintain that this method provides a significantly better picture of cash flow, and the significance thereof, than tax returns and verification of employment, and they may be right.
This is not what sub-prime meant in, say, 2006-08.
There are four major elements in determining if a home loan will probably be viable: documentation — that is, getting enough of, and the right, information to make a decision; analysis — reviewing the info; valuation — determining the value of the collateral, generally through a real estate appraisal; and finally, equating the lender's exposure, as evidenced by the foregoing procedure. As to the risk: If the borrower defaults, will the property value cover the loan amount, or is some form of mortgage insurance required? And, not incidentally, what's the borrower's motivation to keep the property. If the loan is more than the value of the real estate, maybe not much.
This is being done in today's sub-prime world, although, in the aggregate, this paper is, in fact, more risky than agency paper, and yields reflect that fact.
But back in the first decade of this century, sub-prime meant programs like these: "stated, stated, stated," meaning that the borrower could state how much income they made, how much their assets were worth and how much debt they had. Or "110 percent cash outs": that is, an 80 percent first mortgage, and a 30 percent second deed of trust. So the loan was underwater from the beginning.
And then there was the "payment option" mortgage. You could start out with a very low teaser rate for, say, the first three years, and also have the option of paying on the principal, or just paying that low rate, which was due to go up much higher in the fourth year.
What really got exciting was when all of these features were combined into a Lamborghini of a home loan.
The demand for the new sub-prime product is fierce. There are far more investors, big and small, seeking the derivatives backed by these mortgages than there are loans to create the securities. That's because the yields are 3 percent or even 4 percent above what the vanilla stuff pays. Capital believes that the risk reward ratio is squarely on the reward side.
Sound familiar? That's exactly what happened between 2002 and 2008. This hunger for profit was the reason for the Great Meltdown. Not bad appraisals, or bad bankers, or smarmy lawyers, or nefarious mortgage brokers, or crooked appraisers, or underhanded Realtors, or even borrowers, who were as complicit as everybody else. All of them were only facilitators. It was just good old-fashioned human greed. The greed was infinite; the supply was finite, so the creation of the supply got, well, weird.
Hmm. Think maybe those Sybils predicting a newly minted crash are on to something?
Pat Dalrymple is a western Colorado native and has spent more than 50 years in mortgage lending and banking in the Roaring Fork Valley. He'll be happy to answer your questions or hear your comments. His e-mail is firstname.lastname@example.org.