Friday, September 07, 2007

Credit Crunch and the Mortgage Industry - How did this happen?

Category: Financial Planning

Courtesy of Valerie & Carolyn Messina at Millenia Mortgage (973-575-5557) an excellent summary, in plain English, about how we got to where we are in the mortgage industry today. They take us back 8 years so the lightbulb will go off about how the mortgage industry created the credit crunch of today.

The TRUTH about what’s happening in the mortgage industry today!

It seems obvious to state that much is happening within the mortgage industry of late. We get an incredible amount of emails and questions each day about the state of our industry, so we thought we would take a few minutes to try my best to break down what has occurred and focus a little on how Valerie and I are situated and going to adjust to this rapidly changing environment.

Basically, to understand what has occurred we have to go back more than 8 years. It all started in the late 90's with the crash. Following the bursting of the tech bubble, there was a filtering of funds out of stocks into other investment tools in search of higher returns. The best opportunity for a significant increase of returns was to invest in the real estate market, which remained rather stagnate since the early 90's. So, money began pouring out of the stock market to the real estate marked in record amounts. People began buying speculatively, investing in properties, holding them a few months, and selling them for a quick profit.

Then a tragic day in the history of the United States happened; after September 11th, the economy basically nose-dived into a recession. This prompted the Federal Reserve, trying to spur economic growth, to begin lowering the Fed Funds rate which ultimately leveled off at an unprecedented level of 1% in 2003. This led to the lowest rates in the mortgage industry in 40 years. What this did was further exacerbate the already rising interest in the real estate and mortgage market. Mortgage volume hit an all time high in 2003 with 3.8 trillion dollars funded, well above the original high set in 1998 of 1.8 trillion in mortgages.

We obviously know what happened next, the interest in the real estate market exploded. Mortgage rates were incredibly low, home prices were rising, and the tidal wave that was to later occur was nothing more than a ripple in the oceans current. Toward the end of the record year in 2003, spending became robust and the fear of inflation began to rise. With an overnight rate as low as 1% in 2003, an exorbitant amount of liquidity made its way to the hands of every individual and corporation who wanted to borrow money, flooding the market with dollars; the obvious risk of inflation grew.

As the fear of inflation, rose so did long term interest rates hedging themselves against the imminent possibility of the Federal Reserve increasing the Funds rate. As this fear of inflation rose, and with it interest rates, the record volume of 2003 declined. As the worries of declining volume spread throughout the mortgage industry, another problem began to emerge. An unprecedented pricing war began in 2004 and would eventually last almost 30 months. Amidst it the Federal Reserve, fearing an overheated economy, would begin increasing the Fed Funds rate in what would amount to be 17 times ending in mid 2006 at 5.25%.

Despite their attempt to raise long-term rates to offset the over-stimulated sector, rates remained historically low. This may have been due to an incredible surge of foreign investment in our long term treasuries helping to keep yields lower; but what really affected mortgage rates on the street was the battle of price occurring between lenders. To fight for the declining mortgage volume, lenders cut their margins, narrowed their credit spreads, and simply began losing money. There were record losses now coming from most lenders.

However, midway through 2005, an uprising began. Shareholders of publicly traded banks and owners of private institutions decided they could no longer accept this dismal level of return on investment. Mortgage prices needed to rise to sustain growth, especially as volume continued to decline. This adjustment to price was the
first step toward the eventual collapse we are currently seeing today.

As banks and mortgage companies raised their price to gain profitability, they sought a way to stay competitive. Without price to drive growth, they leaned towards credit. So what began as a price war, now became a credit war. Every bank and mortgage institution began relaxing their credit standards, some worse than others. Stated Income, No Documentation, No Money Down, Lower FICO requirements, No Reserve Requirements… the list goes on and on. Instead of gaining market share by aggressively pricing their mortgage products, they made a ludicrous, but conscious, decision to ease their guidelines. This led to the worst lending practices ever seen in the mortgage industry. All universal laws of mortgage lending were broken.

To think that our industry was going to lend a 1st time home buyer with 520 credit score 100% of the value of their home and ask for stated or no documentation regarding their income or assets was insane. To expect this borrower not to default was ridiculous. Now here we are 2 years after the credit war began. 145 mortgage lenders have disappeared since 2006, 11 hedge funds have imploded in the last several months as well as two European Banks. There are 1.7 million foreclosures expected just this year compared to 300,000 to 500,000 usually seen in a normal market.

The expectations are that the peak in foreclosures will not occur until early 2008. So the record number of defaults has led to the ominous amount of foreclosures, which has led to increased underwriting standards, a rapid change to guidelines, tightening of liquidity and on and on and on and on.


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