August 02, 2007

The mortgage industry... what's going wrong?

Sean-Paul has a good post up about the fallout in the mortgage business. While it's not completely accurate (true defaults are no where near as high as his estimate), it's a good piece detailing the problem in the business. We first commented on this in March and honestly, not much has changed. The weaker hands have continued to shake out and some of the larger players have had to ante up with additional equity (Bear Stearns with their hedge fund, GM with the GMAC-RFC sale) which they are by and large doing because the assets are performing.

And that is the most stunning unreported fact. The loans are still performing. I asked the head of secondary marketing at my former employer point blank if he was going to cut Alt-A lending. Keep in mind, I used to work for one of the largest banks in the US and probably THE most conservative. Our Alt-A was almost as tight as conventional conforming. He told me that he foresaw no need because if the market wasn't there for a purchase, he'd hold the loans for sale and service them. Because they were performing perfectly.

The issue with companies like AHM is that they weren't nearly as conservative in their underwriting as my former employer and they didn't have anything approaching the capital level. But that only scratches the surface... what happened to AHM was nothing short of rope-a-dope.

Companies like AHM, which contrary to all the bullshit in the media was PRIMARILY a Conventional Conforming (Prime) and Alt-A lender, underwrote loans as part of a delegated correspondent relationship (with end investors who package the credits into mortgage backed securities) under the guidelines established BY the end investors. AHM used temporary money in the form of a warehouse line to fund it's loans until they are sold to one of those end investors. Those warehouse lines normally came from... wait for it... those same end investors. So, as the market tightened, and AHM was forced to repurchase some loans, they got stuck with loans that the end investors would no longer accept or would not pay as much for as they previously did. Since they were, in the opinion of management, good loans, they were held for sale. Problem is, when you are operating on a shoe string you can't do that for long. In their case, they could do it for less than 8 months. As the warehouse line filled up with unsaleable loans and the market didn't come back, the end investors whose sudden guidelines changes had caused all the problems in the first place, demanded additional equity to secure the warehouse line. When it didn't come, they pulled the plug.

Now, does this mean there will be a depression? No. Wages are finally starting to lift a little which will provide the next leg of growth to the economy. Housing is going to feel still more pain and the weaker hands will continue to fold. Which is great news for people like me.

And for those of you interested in buying a condo in downtown Austin... you'll want to wait for a bit. There hasn't been enough pain in that market and to be honest, the financing structures that sustained the market on the sale side no longer exist (try to get a nodoc option arm on a non-owner occupied condo). Fewer financing options means fewer buyers and when the market goes into into imbalance from few sellers and many buyers to the exact opposite, look out below.

At the end of the day, the real winners are going to be the hedge funds who are stepping in and buying these companies for pennies on the dollar. They will end up paying millions for loans that should be worth billions. And homeowners will keep making those payments, month after month.

There is ALWAYS a floor to the price of a given asset, a point at which buyers are plentiful.

Posted by mcblogger at August 2, 2007 10:16 AM

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