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Yesterday the federal banking regulators and the Conference of State Bank Supervisors gave a nudge to subprime loan servicers to explore ways to be more flexible in providing solutions for borrowers who are facing interest rate resets in the coming months. No doubt the banking regulators have seen the graphs showing that there are a huge number of subprime ARMs adjusting in February and March of 2008. Those two months will have roughly three times the dollar amount of mortgages resetting compared to average months during the last half of this year. No doubt there is a great deal of nervousness at the regulatory agencies and among investors about what the impact will be of that pig working its way through the python.  Over the jump I have the agency statement and my take on it.

Federal Financial Regulatory Agencies and CSBS Issue Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages

The federal financial regulatory agencies and the Conference of State Bank Supervisors (CSBS) on Tuesday issued a statement encouraging federally regulated financial institutions and state-supervised entities that service securitized residential mortgages to review to determine the full extent of their authority under pooling and servicing agreements to identify borrowers at risk of default and pursue appropriate loss mitigation strategies designed to preserve homeownership.

Significant numbers of hybrid adjustable-rate mortgages will reset throughout the remainder of this year and next.  Many subprime and other mortgage loans have been transferred into securitization trusts that are governed by pooling and servicing agreements.  These agreements may allow servicers to contact borrowers at risk of default, assess whether default is reasonably foreseeable, and, if so, apply loss mitigation strategies designed to achieve sustainable mortgage obligations.  Servicers may have the flexibility to contact borrowers in advance of loan resets.

Appropriate loss mitigation strategies may include, for example, loan modifications, deferral of payments, or a reduction of principal.  In addition, institutions should consider referring appropriate borrowers to qualified homeownership counseling services that may be able to work with all parties to avoid unnecessary foreclosures.  

The statement, which was issued by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the National Credit Union Administration, and CSBS, is attached.

Most mortgage-backed securities have an agreement spelled out between the servicers and the investors allowing the servicer to rework a certain percentage of the loans in a pool if they are in danger of imminent default. This works to everyone's advantage since neither the servicers or the investors really want a bunch of loans in a pool defaulting. If the number of loans that need to be restructured gets to be too large, however, the investors start losing money and they don't like that. One of the problems with this formulation is that once borrowers are in "danger of imminent default" it is usually very difficult to help them prevent foreclosure, whereas borrowers who are just starting to get behind can often be helped with good counselling and a little bit of loan restructuring.

Some background:

According to the Federal Deposit Insurance Corporation (FDIC) 11% of all mortgage loans originated in the United States in 2003 were subprime while this number jumped to 33% in 2005. (This is by number, not by dollar amount of loans, and of course the total percentage of mortgage loans outstanding that are subprime would be much lower) It’s also important to know that in this definition subprime refers to the interest rates and other features of the loan, not necessarily the credit profile of the borrower. Most news reports frame this story almost entirely in term of "high risk borrowers", but it defies belief that the credit profile of people seeking mortgages in the United States changed so dramatically in two short years in a time of relatively normal (albeit on the weak side) economic growth and moderate unemployment. What did happen during that time period was that a group of subprime loan products, that were seen as being very profitable, were unleashed on the market and sold heavily, and they were sold especially heavily to African Americans, but also to Latinos and other minority groups. And they were sold with little concern for whether the borrower actually had a low credit score.

In 2005 54% of home purchase conventional loans originated by African American borrowers had subprime characteristics while only 21% of the loans to white borrowers did. Among Hispanic borrowers 45% of the home purchase loans had subprime characteristics. For conventional mortgage refinance loans in 2005 those percentages were 49%, 22% and 33% respectively. These numbers are based on Home Mortgage Disclosure data which has required pricing information since 2004.

The new loan products that swamped the market in 2003 included interest only loans, which according to the FDIC jumped from being 3% of non-prime securitized loans to 30% during this time period. Low documentation/no documentation loans jumped from 25% to 40% of non-prime securitized loans during this time period. In many cases this wasn't because the borrower was demanding a no doc/low doc loan, but rather the result of a mortgage broker talking the borrower into that product, because they knew that they would not be able to get a loan past the lender's underwriting department based on actual income. Pay option ARMs (negative amortization loans) became popular in some markets and piggy-back loans (loans in which the down payment necessary to avoid having to pay private mortgage insurance was replaced by a second lien loan or a home equity line of credit) also were used widely. Loans referred to by the short hand terms of “2/28s” and “3/27s” rose to prominence during this time period. These risky loan products were sold by brokers who were given more financial incentives to sell these products than to sell good quality fixed rate prime products, and they found that marketing them to demographic groups who traditionally had been denied access to credit or who found mainstream financial institutions unwelcoming was easier than selling them to those who were more comfortable and had a longer history with mainstream financial institutions.

These are the issues that make this problem devilishly complex. There were plenty of relatively well off speculators gaming the system trying to ride the real estate wave to more wealth, and no one wants to reward them, but there were also a lot of working class people just getting lied to by mortgage brokers who knew that given the current lax regulatory regime that they operate under, the chances that they would ever be charged with fraud were slim to none.

When one or two houses per neighborhood are being foreclosed on, that fact puts some temporary downward pressure on the value of their neighbor's houses, but when 20% to 50% of the houses are being foreclosed on, as is the case in some blocks in some minority neighborhoods in the cities with the worst problems, there is also an enormous cost to society as a whole, and that cost may mushroom if no way is found to mitigate the effect of the upcoming peak in ARM resets .

In his speech at Jackson Hole on August 31, Chairman Bernanke described the problem as follows:

The problems have been most severe for subprime mortgages with adjustable rates: the proportion of those loans with serious delinquencies rose to about 13-1/2 percent in June, more than double the recent low seen in mid-2005.1 The adjustable-rate subprime mortgages originated in late 2005 and in 2006 have performed the worst, in part because of slippage in underwriting standards, reflected for example in high loan-to-value ratios and incomplete documentation. With many of these borrowers facing their first interest rate resets in coming quarters, and with softness in house prices expected to continue to impede refinancing, delinquencies among this class of mortgages are likely to rise further. Apart from adjustable-rate subprime mortgages, however, the deterioration in performance has been less pronounced, at least to this point. For subprime mortgages with fixed rather than variable rates, for example, serious delinquencies have been fairly stable at about 5-1/2 percent. The rate of serious delinquencies on alt-A securitized pools rose to nearly 3 percent in June, from a low of less than 1 percent in mid-2005. Delinquency rates on prime jumbo mortgages have also risen, though they are lower than those for prime conforming loans, and both rates are below 1 percent.

With today's statement the regulatory agencies are trying to jawbone the servicers and investors into taking a hit now, by restructuring as many of these "hybrid" ARMs into affordably fixed rate loans now before they reset, in order to avoid the much bigger hit to them and to the economy in general, if huge numbers of these loans go bad pulling down the investors and whole neighborhoods with them. At this point the bank regulators are trying to stave off disaster so that the growing number of voices accusing them of responsibility for the mess, because they did not adequately regulate risky loan products at a time of weakening underwriting standards, won't be the final word on this crisis.

There is probably a decent chance that they can pull off avoiding an overall meltdown of the economy, but the effect that their regulatory failure will have on exacerbating the racial disparities in wealth will be around for years to come. Others on this site have, and I'm sure will continue to pay close attention to how the subprime mess affects the overall economy; I'd like to see more attention paid to the racial disparity aspects of it, because I think that will have a very damaging effect on our country.

Originally posted to bankbane on Wed Sep 05, 2007 at 04:01 AM PDT.

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Comment Preferences

  •  Citigroup is staying big in subprime (7+ / 0-)

    This piece of news didn't get much play, but on Friday Citigroup finalized the deal to take over the loan servicing rights of the parent comany of Ameriquest, one of the biggest failed subprime lenders.

    "The more they spoke of honor, the more I checked my wallet."

    by bankbane on Wed Sep 05, 2007 at 04:13:45 AM PDT

  •  recced comment in lieu of a tip jar (1+ / 0-)
    Recommended by:
    bronte17

    This is an excellent and very thorough analysis of a very human problem. I lived next to a Hispanic neighborhood that was undergoing revitalization because so many people had moved in and improved properties that had been on the verge of collapsing. Unfortunately, I suspect that a lot of those people were given subprime mortgages. It would be a shame if the neighborhood collapsed on account of shoddy lending practices as it was becomming an interesting and lively place.
    Thanks for writing a diary in analytical terms that is as passionate as the diary I wished to write using anecdotal evidence.

    In wine there is wisdom, in beer there is strength and in water there is bacteria.

    by northsylvania on Wed Sep 05, 2007 at 04:22:22 AM PDT

  •  Barney Frank will hold hearings today. (2+ / 0-)
    Recommended by:
    bronte17, MarketTrustee

    The chair of the House Financial Services Committee will convene hearings today at 10:30 am (EDT) on the implications of the subprime meltdown on the global markets. For those of you able to watch from your computers, you can go here.

    "The more they spoke of honor, the more I checked my wallet."

    by bankbane on Wed Sep 05, 2007 at 04:24:36 AM PDT

  •  modifications (4+ / 0-)

    Servicers have a load of options in servicing these loans from modifications of the interest rates to buying back loans (from pools if securitized, probably the worst option for a lender) to refinancing... There are a lot of options, the problem is that all of these options will still require more out of pocket from homeowners.

    I have been a credit underwriter in the mortgage industry for a government agency for 10 years now. I know first hand what kinds of options servicers and lenders have when making and servicing loans.  What's frustrating with these issues isn't just the high ratios and low credit scores, but how many homebuyers go from buying a home with a 40 to 50% ratio and then turn around and buy a new car or they decide to divorce and for some reason, the borrowers can't figure out why they can no longer afford the place.  What's most frustrating are the high credit score folks with good jobs who walk away from the property.  These are all common problems, but when you add the usual common problems which might amount to 3 to 5% default rates and add in the subprimes then increase your rates to 8 or 10% default, well, this is wherein the problem really lies.

    One other note, Mortgage loans are not profitable to a lender if you refi or sell in the first 36 to 60 months, depending on your original terms.  If you have a loan about to reset, PLEASE, contact your current lender and request a MODIFICATION.  It's worth their bottom line to keep you as a customer for the long term, especially if you pay consistantly.  

    •  High quality home buyer counselling (0+ / 0-)

      There is no doubt, that we'd all be better off if there was a lot more high quality home buyer counselling going on. The question of course is always, who is going to pay for it.

      "The more they spoke of honor, the more I checked my wallet."

      by bankbane on Wed Sep 05, 2007 at 04:53:06 AM PDT

      [ Parent ]

      •  we all end up paying for it one way or another (0+ / 0-)

        Start by teaching home buyer councilling in high school, have "free clinics" for those beyond school age, have it a requirement of getting a home loan- we need drivers' licenses to drive a car, why not require councilling before taking out a loan?

        We have no future because our present is too volatile. We only have risk management. The spinning of the given moments scenario. Pattern Recognition. ~W. Gibson

        by Silent Lurker on Wed Sep 05, 2007 at 08:06:40 AM PDT

        [ Parent ]

        •  HUD (2+ / 0-)
          Recommended by:
          Silent Lurker, MarketTrustee

          has a list of homebuyer counselors and most of the courses are very good.  DoD provides financial fundementals courses which I've taken at the members first duty station.  The training is out there, but you also have to have a lender or real estate willing to point you in that direction.  All too often, it's the Real Estate agent who's the first contact point and they aren't forcing this issue at all.

  •  should they be helped at all? (1+ / 0-)
    Recommended by:
    debedb

    these borrowers jumped into very expensive loans without reading the fineprint and now they're finding out they can't meet the monthly payments.   Because of their folly the average home price skyrocketed and the prime borrowers that can document their income and do read the fineprint are outpriced in todays market.     Considering that wages have stagnated for the last 7 or 8 years, why would a prime borrower contract themselves into an inflated housing market?  doesn't make any sense..  rent for a few years, let prices drop

    It's not a popular opinion but I don't think these borrowers should be rescued (and neither should the lenders.)   Let the RE market correct itself so prime borrowers can buy into realistic mortgages.  

    •  I think you miss the point (0+ / 0-)

      We have more real protections for toy buyers in this country than we do for people who buy a mortgage. If it's a dangerous toy it gets recalled, but with dangerous mortgage products the "market" is expected to sort it out. That's what needs to be fixed.

      A very small percentage of prime or subprime borrowers actually read the whole pile of documents that they are called on to sign at closing, because they presume that the broker or the realtor is representing their interests, when in fact in most states, no one is legally required to even tell them that they are not being represented by the people who are selling them the single biggest investment that most of them will make in their life.

      The mortgage interest deduction (even for second homes) has put a more long term upward pressure on home prices, and it primarily benefits upper middle and upper income people. For all the people who want to be all libertarian on this issue, why are you always so silent on that one?

      "The more they spoke of honor, the more I checked my wallet."

      by bankbane on Thu Sep 06, 2007 at 05:01:09 AM PDT

      [ Parent ]

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