Separately, yesterday’s WSJ has this interesting article on the credit market — basically, the melt-down is starting to happen, we just don’t know how severe it will be.
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Mortgage Market Begins to See Cracks
As Subprime-Loan Problems Emerge
August 30, 2006; Page C1
First the housing bubble deflates. Then come the credit problems.
As homes sales have fallen and borrowing costs have edged higher, the mortgage business has slowed down. The big question is whether credit-quality deteriorates. While customers have been able to pay off loans in high numbers for years, the markets are seeing the first glimmerings of problems among customers with poor credit.
That’s to be expected. But there are signs that problems will emerge among higher-quality borrowers over the next several months.
Almost as if they are following a script, the mortgage companies that cater to those with poor credit — so-called subprime customers — see trouble first, and they’re already warning about emerging credit troubles.
Last week, H&R Block, the big tax preparer, alerted Wall Street that its Option One Mortgage unit, which focuses on the subprime market, would have to set aside about $60 million, or 19 cents a share, because borrowers were falling behind on their payments.
Customers of Countrywide Financial, which has products across the credit-quality spectrum, are paying loans off more slowly, as are those at subprime companies Impac Mortgage and Accredited Home Lenders. Mortgage companies, such as regional bank Fremont General, have begun putting money aside to account for loans going bad.
So far, late payments and defaults are relatively low. But the housing downturn is just in its early stages. In one of the first signs of concern in the market for credit-worthy customers, First Horizon National said yesterday that mortgage volume was falling so rapidly that it would miss earnings estimates for the current quarter. Less than 5% of First Horizon’s loans are to customers with poor credit.
Marty Mosby, the bank’s chief financial officer, says he’s not worried about credit problems, which have been low as a percentage of loans. “We don’t see any trends that say it’s going to swing very dramatically,” he says.
Here’s what’s been happening: Mortgage originators make loans and then sell them to investment banks, which mash them together with other loans and slice them up like sopressata for sale to institutional investors.
The worry has been that in the rush to gain customers during the housing boom, mortgage-makers lowered their lending standards. During the boom times, investment banks overlooked these concerns because they had no problem finding buyers for their mortgage and debt products.
Now, with the mortgage market slowing and the secondary market for mortgage-related securities faring modestly worse than in the past, investment banks are scrutinizing the loans that come into their sausage factories more carefully.
The investment banks have been sending mortgages back to the lenders if they find slip-ups, such as inaccurate paperwork or poor performance. The most common trigger is a so-called early payment default, where the mortgage holder has missed the deadline for the first payment.
Lenders complain that the investment banks are taking advantage of a contractual loophole to push the mortgages back. Customers often miss first payments, they say, for reasons that have nothing to do with credit worthiness. Sometimes it’s just an indication of an administrative delay.
But that’s probably wishful thinking.
If the problems spread beyond customers with poor credit, they’ll infect the world of exotic mortgages for supposedly credit-worthy customers first. Along with the companies that offered mortgages to customers who didn’t produce much documentation of their income and assets, the more vulnerable will be banks that sold huge numbers of option adjustable-rate mortgages.
Option ARMs give borrowers choices to minimize their mortgage payments, including the ability to make a minimum payment that is lower than the interest due that month. When a customer chooses that option, the mortgage balance goes up. After a certain period, often just a year, the rate can move up sharply.
Skeptics have wondered whether customers understood the full costs of these loans and whether lenders correctly estimated how likely it was they’d be paid back.
In an indication that there was reason to worry, Washington Mutual, one of the country’s biggest mortgage lenders and a big option ARM player, slipped in a rather stunning confession in its annual filing with the Securities and Exchange Commission.
In the filing, WaMu confessed it had bungled the underwriting for option ARMs, improperly measuring some of its customer’s debt-to-income ratios for 2004 and most of 2005. As short-term interest rates rose in those years, the company disclosed, the interest rate at which lenders qualified for loans “was not adjusted upward, which resulted in loans being made to borrowers who were qualified based on debt-to-income ratios calculated using an interest rate below” the prevailing interest rate.
In other words, the applicants looked more credit-worthy than they really were. Talk about violating Rule No. 1 in lending.
Of $43 billion of such loans, WaMu discloses, the unpaid balance for borrowers who were qualified at below the market rates totaled $30 billion.
The bank says it fixed the problem in October. It disclosed the problem in its annual filing this spring, but outside American Banker, few in the media or Wall Street picked it up.
A WaMu spokesman emails that the company expects that “the credit performance of these loans will not differ materially from the expected performance of option ARMs [customers] qualified” at the correct interest rates. WaMu, which says it has more than 20 years experience writing option ARMs through all economic cycles, says that the customers’ credit scores and the ratio of the size of the loan to the value of the property were high and that these measures are more important gauges of loan quality.
Option ARMs have been among the most scrutinized exotic mortgage products over the past year. That such an error could creep into WaMu’s lending should worry investors not only about the bank’s balance sheet but the industry’s lending standards as a whole.
Option ARMs didn’t go to subprime customers. That’s precisely why the coming mortgage problems may not be isolated to customers with poor credit.
