Credit Market and Liquidity Crunch

[jon miller]

Subprime Credit Liquidity Crisis — http://www.chicagomortgagefinance.com/

From Borrower to Mortgage To Secondary Market — The REAL Problem.
By Jon Miller, Senior Mortgage Banker
Chicago Bancorp

The Borrower

Chicago, IL — Consumers interested in purchasing or refinancing a home will pay a given interest rate based on their personal financials, current market conditions and product/debt strategy chosen. Risk assessment is based upon the borrower’s income and debt ratios, credit scoring and history, liquidity and asset base, leverage scenario and level of approval obtained which, criteria for the aforementioned is tightening significantly by the day. If the borrower’s credit will not permit A+ levels of qualification – or if income and assets cannot be sufficiently documented – an alternate course of lending is needed. Unfortunately, this course of subprime and Alt A lending has not been utilized in the way it was intended by the borrower and in some cases, the lender as well. Now we have issues. Starting from scratch, let’s take subprime for example –

Scenario — John and Jane Doe decide to purchase a home. In fact, they went home shopping first and negotiated a purchase agreement which is now fully executed and earnest money is on the line. Both borrowers had not yet retained a professional mortgage advisor and have been shopping around by telephone and the internet, which always incurs unreliability and inefficiency in the transaction (but that is another story). John and Jane find me and agree to move forward. Upon a credit and financial analysis, I discover that both John and Jane have credit deficiencies that will not permit a higher level approval (hence, lower cost) and also cannot document income due to tax return complexities. John and Jane also are just barely able to afford the home as 50% of their gross annual income is being utilized for the housing payment and personal debt. They also have very little liquid assets (1 month housing payment) in reserve. They will need to utilize subprime or Alt A (alternate lending) loan programs in this case as it is the only viable solution. Due to my discovery, it would be advised that they get their earnest money back during the attorney review period, put the contract on hold and wait until a better formal plan of action is determined by their mortgage professional (me) and hard numbers can be provided. Most likely, a credit repair plan would be issued. By following the plan, the borrowers would potentially have the ability to qualify for A+ level paper within a 45 day time frame — which equates to a lower cost of funds (interest rate, etc.), more affordable payments and better terms all around. Rather, John and Jane want to move forward with the purchase instead of going through the credit repair plan (they may not have the time, $$ or some other reason). Now it becomes my job to utilize the best financing option out of the very limited options available to get them into the home on time and STILL prepare them to utilize a credit cleanup action plan after closing – which absolutely needs to be followed over the next 12-18 months. The only product for which John and Jane qualify is a 2 year subprime ARM (assume so for this example). Remember, this is a 2 year subprime ARM loan. We only have 24 months to get everything in order for better financing.

We close. From there forward on a quarterly basis, John and Jane are followed up with to determine how much progress has been made on the credit repair. They respond with “no progress made.” Further advice is reiterated as to what to do, how to do it and another set of instructions and email are sent to the clients to be certain they are on top of things. Another quarter goes by. Still no action. Another, and another and … all of a sudden John and Jane are a month away from the ARM adjusting.

Well, we have arrived. Due to 1) the housing market being in a slump (mostly, a state of stagnancy with some areas substantially in decline during the last 2 years) and 2) higher default rates on precisely these types of loan products from the previous two years, investors are no longer willing to extend credit loosely to this type of mortgage financing situation. Now, we have two borrowers who failed to follow a course of action to improve their credit over time; a housing market providing no rate of return (appreciation) on the home they purchased; no equity in the home due to the lack of appreciation; no loan products available for highly leveraged property with little equity (John and Jane’s situation) due to the housing and default rates over the last year and subsequent guideline tightening from investors — And a housing payment for John and Jane that will adjust the full 3% when the time comes, increasing their payment by $600 per month with no opportunity to refinance due to the previous conditions mentioned. Now the default cycle continues. You can see where this is going.

The most frustrating aspect of a mortgage planner’s profession is the inability to do anything for a client to rectify a potentially hazardous financial pitfall. A situation such as this, which is based around several absolutely true situations, is completely out of our control. The media and hype discuss fraud and predatory lending being the issue for problematic mortgage defaults. I have to tell you, this is absolutely not the case except in a very small percentage of mortgage loan fundings.

The Market

There are no issues with conforming loans at this point. Subprime, Alt A and some non-conforming is the problem area. Upon the street’s reassessment of the mortgage market, the risk level has gone up substantially due to higher default rates and stagnant/declining housing over time…so a much higher yield is required on those loans to offset the higher risk (based on the recent valuation). Essentially the mortgage bond is discounted (price deterioration/valued less) to the net present value which ends up deteriorating the bonds below a par yield. What was going to be a mortgage sold to Wall Street at 101 now is being sold at 98 or 99 due to the devaluation. It will now cost the mortgage company XX dollars per loan to fund the loan rather than making XX dollars in premium from which it otherwise would have profited…creating a total loss and depletion of the lender’s liquid assets to cover the discount. Secondly, margin calls (due to the discounted value of the mortgages backing the assets) exorbitantly heightened this depletion scenario in which the necessary margin shortages required additional liquidation of the mortgage lender’s assets (it may or may not have had) to cover the minimum maintenance requirement or “initial margin”.

In summary, put the two together – Wall Street (the market) adjusted what it needed for compensation – demanding a higher yield on funds already locked and being delivered at a lower yield – creating a total loss on each loan funding within the next 30-60 days. Simultaneously, margin calls added to the depletion of the company’s assets already being utilized to cover the devalued (discounted) mortgage paper. Mortgage companies cannot go back to the consumer and ask for the higher yield to offset this difference. Either the company has the liquidity to weather the storm or it shuts its doors (think AHM) as the cost per day to stay open can be millions of dollars in a credit crisis such as this.

One Day of business in a normal credit market…100M in loans (in one day) going to secondary @ 6.5% => 101M sell price => 1M profit in one day.

Today’s credit market…Wall street says 8% is the return needed for the additional risk – which discounts the current loan to a net present value and COSTS the mortgage company. 100M in loans to secondary at 6.5% => value is 97M => 3 Million Dollar loss in one day…not including margin call coverage.

Two things need to happen:

1. The credit market needs to stabilize. It cannot continue a cycle needing 8% this month to offset the higher risk only to then need 9% next month and so on. Polls will identify a given stability figure and will eventually ease itself in the long term.
2. Loan pipelines need to be covered. Clients need to get closed as soon as possible. The mortgage professional needs to have a couple of backup plans just in case an overnight change occurs with an investor’s product initially selected for that client which no longer becomes available.

Although the Fed has been talking about stepping in to provide some relief to some parts of the secondary market which have essentially seized, the bid/ask spreads are just too wide for the MBS to trade; leaving lenders with large inventories and facing additional margin calls. In my opinion, if the Fed steps in to add liquidity and help stabilize the credit markets – by their own admission – this greasing of the cog wheels will be “limited” in the overall effect. If they are able to move the secondary markets a bit, it will only flush out the already fundamentally undesirable portfolios. Since most high-leveraging, alternate documentation subprime lending has ceased, a Fed move will mostly affect only market portfolios already warehoused. Those loans that that were originated at 102… and now needing to fetch 103 or 104 on the street… might be offered at 98 to 100 only narrowing the spread and limiting the lenders net losses — but not saving them entirely. Even then, only the strongest banks (with large amounts of cash on hand) will be able to weather the storm after the Fed’s assistance. Aggressive investors will still be needed to move behind the fed to uphold any momentum the fed initiates and pull through the market deterioration within a reasonable time frame.

Recommendation – CLOSE YOUR LOAN AS SOON AS POSSIBLE!

[JWM in SD]

That is pretty brave using your real name.

Oh, and that comment about fraud not being significant…maybe in Iowa but not SoCal…It was and is SOP around here.

[NotCranky]

How Many mortgage brokers just promised the exploding ARM client that they could refinance in 2 years VS. how many counseled them on credit repair and the fact that even credit repair and modest wage increases would not save them from being upside down and a liquidity crunch? Sorry Jon but it sounds like you are saying…”if they only would have listened to me my clients wouldn’t have gotten hurt”.Well maybe where you live but as JWM said, “not around here”. In too many cases the only thing that would have worked around here, for the marginal buyer, would be to tell them it was a stupid time to buy or get a loan for that matter.

[SHILOH]

You might be able to tell some people, ‘it’s a stupid time to buy or get a loan,’ but many people would still not listen. They would just get caught up in the hysteria of home buying and not understand the affordability issues, fearful that they would ‘miss their chance’ to own.

[JWM in SD]

“…but many people would still not listen. ”

Yes, and the recent posters coming here and asking about whether they should be buying right now are perfect examples of that.

Fools and their money……..

[NotCranky]

You might be able to tell some people, ‘it’s a stupid time to buy or get a loan,’

Shiloh , I am very aware of this. The only real way to avoid helping some people do stupid things was to refuse to participate. Advising credit counseling be undertaken,after signing DOCS on a nutso cuckoo loan,during bubble mania doesn’t make much sense.

[bsrsharma]

Further evidence of liquidity crunch deep inside the system. There was another news item today about Freddie Mac being unable to hawk its warez. Being GSE is no longer Slam Dunk.

————————————————————
Sense of growing crisis over interbank deals
By Gillian Tett

Published: September 4 2007 21:34 | Last updated: September 4 2007 21:34

As bankers have returned to their desks this week after the summer break, they have been searching frantically for signs that the markets are gaining a semblance of calm after the August turmoil.

However, the money markets are notably failing to offer any reassurance. While the tone of equity markets has calmed, the sense of crisis in the interbank markets actually appears to be growing – especially in London.

In particular, the cost of borrowing funds in the three-month money markets – as illustrated by measures such as sterling Libor or Euribor – is continuing to rise, suggesting a frantic scramble for liquidity among financial groups.

This trend is deeply unnerving for policymakers and investors alike, not least because it is occurring even though the European Central Bank and the US Federal Reserve have taken repeated steps in recent weeks to calm down the money markets.

“What is happening right now suggests that the moves by the Fed and ECB just haven’t worked as we hoped,” admits one senior international policymaker.

Or as UniCredit analysts say: “The interbank lending business has broken down almost completely . . . it is a global phenonema and not restricted to just the euro and dollar markets.”

If this situation continues, it could potentially have very serious implications.

One of the most important functions of the money markets is to channel liquidity in the banking system to where it is most needed.

If these markets seize up for any lengthy period, there is a risk that individual institutions may discover they no longer have access to the funds they need.

This danger has already materialised for vehicles that depend on the asset-backed commercial paper sector – short-term notes backed by collateral such as mortgages.

In recent weeks, investors have increasingly refused to re-invest in this paper.

As Axel Weber, a member of the ECB council, admitted this weekend: “The institutions most affected currently are conduits and structured investment vehicles . . . Their ability to roll these short-term commercial papers is impaired by the events in the subprime segment of the US housing market.”

This problem is affecting the wider banking system because these vehicles are now tapping other sources of finance – mainly liquidity lines from banks.

It appears that the prospect of receiving new liquidity demands has prompted banks to rush to raise funds – and, above all, hoard any liquidity they hold.

The high demand from banks to secure liquidity for the next three months, coupled with their desire not to lend out what liquidity they have, has made it virtually impossible to execute trades – even at the official prices quoted for such borrowing.

That has created some extraordinary dislocations such as the fact that the cost of borrowing three-month money in the sterling Libor markets is now higher than borrowing six-month or 12-month money. “The system has just completely frozen up – everyone is hoarding,” says one bank treasurer. “The published Libor rates are a fiction.”

This situation could become increasingly dangerous in part because many other markets, such as swaps, are priced off the three-month Libor and Euribor rates. So the interbank freeze could have knock-on effects throughout the financial system.

A more pressing problem is the large volume of asset-backed commercial paper due to expire in coming weeks, which is set to increase the scramble for cash by the banks. “Money market stability needs to return as soon as possible,” says William Sels, of Dresdner Kleinwort. Jan Loeys, of JPMorgan, notes: “The longer it lasts, the greater the risk that the current liquidity crisis will worsen.”

The crucial uncertainty is what, if anything, policymakers can do to combat the sense of panic. Some observers hope the problems in the sterling market, at least, may dissipate when the current maintenance period at the Bank of England comes to an end.

Others, such as Mr Weber, have suggested that banks themselves need to raise more funds in the capital markets to meet liquidity calls. However, many private sector bankers, for their part, say that radical steps from the central bankers are needed to remove the sense of panic.

Whether the central bankers are willing or able to really help – in the UK or anywhere else – remains the great question.

Additional reporting by Paul J Davies

Copyright The Financial Times Limited 2007

[LA_Renter]

Good article! Since we are piling on I thought I would add this to the mix. Here are some of the debates occurring a Jackson Hole this weekend.

“News from Jackson Hole: Saddle up ma, it’s a shadow banking run”

“According to Axel Weber, the German Bundesbank chief, the current financial crisis bears all the hallmarks of a bank-run. You know the kind of thing – frustrated savers scrambling to cash in their flimflam paper at the Western Union for its value in gold. Something like that anyway. Weber told an audience at Jackson Hole:
What we are seeing is basically what we see underlying all banking crises
In his analysis, markets, just as in the 19th century, are currently prey to a spiralling liquidity crisis created as investor confidence drops and everyone rushes to get their chips off the table.
The difference is that this time, it’s not a run on the banks. Instead, noted Weber, the current liquidity storm is being weathered by unregulated financial institutions – hedge funds, banking conduits, SIVs and such like. It is what Paul McCulley, managing director of Pimco, has termed a “run on the shadow banking system”.

This is problematic then, for regulators like the Fed, which were created in the 19th century to deal with liquidity crises in the actual banking sector. Whereas banking crises in the past could be cooled by – in Ben Bernanke’s subtly crafted words – “a helicopter load of money”, that avenue is closed, because central banks are prohibited from lending to the unregulated institutions behind the current storm. The liquidity central bankers have injected into the system so far has been poorly targeted and hasn’t run to where it’s actually needed.”

http://ftalphaville.ft.com/blog/2007/09/03/6996/news-from-jackson-hole-saddle-up-ma-its-a-shadow-banking-run/

So what we are experiencing is a good old fashioned 19th Century Bank Run. Great!

[JWM in SD]

“The liquidity central bankers have injected into the system so far has been poorly targeted and hasn’t run to where it’s actually needed.”

Also known as pushing on a string. It’s the reason why hard money inflation won’t work…the FED can’t control where the $ ends up at and it would have to end up in your wages to make a difference. Anyone here want to gamble that hyperinflation makes its way into your paycheck??? I don’t….

[bsrsharma]

If Freddie Mac’s problems persist (and extend to Fannie too), we are seeing another inflexion – markets are not trusting GSEs and probably governments that sponsor them. If FED lowers rates next time and $ promptly drops, we know we have reached that point. Next papers to be watched carefully may be – treasuries!

[bsrsharma]

hyperinflation makes its way into your paycheck?

I have a solution! FED should design a proprietary laser printer and sell it for a low price. Insert your paycheck and it will print out n times that much currency. n is of course carefully controlled by FED and is sent to your printer on a secure encrypted link!

[JWM in SD]

“I have a solution! FED should design a proprietary laser printer and sell it for a low price. Insert your paycheck and it will print out n times that much currency. n is of course carefully controlled by FED and is sent to your printer on a secure encrypted link!”

You’re an engineer aren’t you?

[HereWeGo]

or not pushing hard enough, depending on your P.O.V.

IMO, your article represents the real threat, bsh. Hoarding “cash” en masse is a really scary concept, given the current structure of the capital markets.

It’s not the “consumer” that could cause an economic event; it’s the creditor.

[bsrsharma]

Yes; but the idea is from an old Candid Camera show where a bank teller prints out fresh currency, (saying it is the latest technology) to a dumbstruck customer.

[JWM in SD]

“Yes; but the idea is from an old Candid Camera show where a bank teller prints out fresh currency, (saying it is the latest technology) to a dumbstruck customer.”

There is a certain amount of bitter irony in that visual considering the situation we are in with regard to inflation.

[Author]

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