Mortgage Banking
October 2007
A leading mortgage insurance executive talks about the factors behind the current mortgage market troubles, some necessary cures and a timetable for recovery.
By Robert Stowe England
Q : What do you make of the current turmoil in the mortgage industry?
A : First point-and I'm sure you've heard this from everyone-is that the residential housing and mortgage industries are paying the price for the excesses of the past few years. Clearly, the housing and mortgage industries were in an overheated cycle. The resulting defaults and losses that are occurring are not just in the subprime segment of the mortgage market, but it's spreading across all credit segments. The magnitudes of the losses will vary by segment, but it's having a negative impact on all segments of the mortgage market.
Q : What is driving the losses in mortgages?
A : HPA-home-price appreciation-is driving the losses across all credit types, but it's being exacerbated by the aggressive lending that took place over the last few years. So, you've got the confluence of those two coming together. HPA, or the lack thereof, is unmasking the deterioration in credit standards that occurred over the last couple of years.
Q : What was new in this cycle that made things worse?
A : Importantly, the mortgage industry has been adversely impacted by parties with little or no financial stake in a mortgage transaction, such as mortgage brokers and Wall Street. The amount of fraud in some loan products is astounding. Not outstanding-it's astounding.
Q : What mortgage products are responsible for most of the fraud?
A : Third-party originated products in combination with a no-documentation or stated-income type of application has produced a recipe for fraud.
Q : Is this occurring in all the markets? Or are the problems concentrated in heated markets?
A : In terms of geography, it's everywhere. That's been our experience. Well, let me say it is everywhere, but it's more pronounced in the overheated markets where affordability became an issue and therefore the need to inflate someone's income to qualify for the loan.
Q: How did it come to be such a big part of the industry?
A : In some sectors of the country and some regions of the country, affordability became a big challenge. And this was a means by which to keep origination volumes going.
Let me say something I feel needs to be included: We believe clearly there is a need for stronger regulation of mortgage brokers and some form of regulatory authority allowing for the free exchange of information regarding brokers who commit fraud.
Q : How could that be done?
A : It needs to be implemented at the federal level, so we have consistency in the application of that regulation and everyone understands the rules of the game. So, as a result of all the points I have just stated, credit is tightening, and appropriately so. It's putting a governor on some of the frenzy that has taken place over the last few years. And it's bringing the residential housing and mortgage industry back to reality, and that's fine. It's bringing the industry back to more responsible lending.
Q : Some people seem to be overreacting, though, restricting loan availability and tightening underwriting criteria unnecessarily-partly, I think, because they want to curtail their exposure to subprime loans in volume, regardless of quality.
A : Yes, it's obvious that tightening in underwriting has taken place, with underwriting guidelines returning to more appropriate credit standards. And there has been an overreaction by the investor community, reducing availability of mortgage funds in all segments of the business, not just subprime. As an example, subprime was originally designed for a low LTV [loan-to-value ratio] mortgage. And it was a full-documentation loan. When the industry began to riskstack no-documentation or stated-income [loans] with third-party origination channels and high-LTV levels, once again, that's when the industry became overly aggressive.
Q : And this was driven apparently by the desire to Keep up volume, relying on third-party originators even if relaxing the underwriting standards?
A : That's correct-but you also had Wall Street, which had an insatiable appetite for the product.
Q : There was not good risk assessment going on there.
A : That's correct.
Q : One thing that has happened is the change in the spread between different types of mortgage-backed securities [MBS], with wide spreads for a lot of these tranches.
A : The observation in our company is that all the segments in the credit-risk spectrum in the residential mortgage market jump-shifted left. You know what I mean? In other words, [take] A-paper loans. If you were to examine a group of loans – what we would classify as A-paper loans today – they don't look like A-paper loans that were originated five years ago. There were other variables that were introduced in the A-credit segment that made those loans riskier loans, such as third-party originations, higher LTVs, limited or no documentation. A lot of these different loan programs and product types have introduced variables into all the different credit segments that have changed the profile of those loans. You blend all of this, and everything has shifted to a more risky loan profile.
Q : Now, wasn't the idea that this was going to be compensated for by other factors, such as higher FICO® scores?
A : Yes, but there's been an over-reliance on just FICO scores alone. You can't just take a high FICO score and change many other aspects or add many other risky variables and still have a high-credit-quality loan. You've still got a riskier loan profile. It may be higher credit quality simply from a FICO standpoint, but you've got a riskier loan when you introduce these other variables.
Q : Could you elaborate?
A : OK. I think one of the things we said is that this is a home-price appreciation issue and not just a subprime issue, and it's exacerbated by criteria creep, [which is the] introduction of riskier variables in the loan and utilizing more aggressive credit criteria. HPA masked a lot of credit problems, [and now] we're seeing the credit problems emerge.
Q : How is AIG United Guaranty dealing with all this?
A : We recognize this is a cyclical business. We have been seeing this correction coming for some time. We could not pinpoint exactly when the correction would occur. But we knew these aggressive lending standards could not continue forever, nor was the rapid rise in home values going to continue. So, we see this as a necessary cleansing in the residential housing and mortgage industries. We think that the business fundamentals are improving for the future as we return to more responsible lending, and if there is some type of regulatory authority that is put in place to qualify and monitor mortgage brokers.
Q : In terms of regulating mortgage brokers, would this involve licensing?
A : I think there needs to be more rigorous licensing and qualifications for mortgage brokers.
Q : On the federal level?
A : Preferably at the federal level. And I'm not usually an advocate of regulation, but free-market dynamics. However, in this instance, I think there needs to be some federal regulation.
Q : Is that because there's no way for brokers to regulate themselves?
A : No, I don't think so. I think there needs to be an ongoing system of monitoring, whether it is a centralized database allowing for the free exchange of information regarding fraudulent brokers or something similar to that. They also need to have some fiduciary responsibility in the transaction.
Q : So you think that is one of the weakest links in the whole thing?
A : They are paid a commission to originate the loans. After the loan is originated and delivered to the aggregator, they really have no financial stake in the transaction. I think that's been one of the big breakdowns in the system, particularly when you mix it with nontraditional mortgage programs.
Q : So, when are things going to get better?
A : I think this situation in the housing market is going to get worse before it gets better. We're forecasting that the next six quarters are going to be challenging for the residential mortgage business. We're projecting this is going through 2008, and it will be a slow recovery in 2009. We've still got declines in new-home sales, existing-home sales, declining property values, followed by rising foreclosures in California and Florida. All of that product has to be placed on the market and absorbed in the inventory. And although the slide in the housing market in terms of sales activity may decelerate, there's still a lot of inventory that's got to be worked through the system in order for equilibrium to be reached, and that's going to take time. And there's probably another 12-plus months for inventories to reach an equilibrium level between supply and demand.
Q : Everyone has talked a lot about resets aggravating this. How do you see it?
A : The residential mortgage industry, including the mortgage insurance industry, is already seeing the impact of this housing downturn in the alt-Á and prime markets, caused primarily by HPA, combined with some irresponsible lending. And we haven't talked about the ARM [adjustable-rate mortgage] resets, and for the most part they haven't taken place. We anticipate this will be an issue in the rest of 2007 and all of 2008. There's over $1 trillion of ARMs that will be resetting. Some of the ARMs were qualified at the initial interest rate and not at the fully indexed accrual rate. And then we have the other variable in terms of what types of credit criteria, in terms of debt-to-income ratios that were used to qualify the loans and what types of documentation programs those loans were originated under.
Q : So all these problems have yet to surface?
A : Yes, as it relates to adjustable-rate loans. That's the unknown right now.
Q: What about piggyback loans? Are they now being seen as a problem, and is there not more interest in mortgage insurance [MI] instead?
A : There's no question. MI is staging a nice comeback. New insurance written by our industry is clearly up over the first six months of 2006, and our market penetration has improved because there is a flight to quality. MI tax deductibility has also helped that.
Q : Is this a better risk-management approach?
A : It's a better risk-management tool for the lender, and it's also a better product for the borrower. It's cancelable and tax deductible.
Q : What other factors have contributed to the excesses in the last mortgage cycle?
A : You had the development of these alternative mortgage products and you had rapid home-price appreciation. But you also had a generation of mortgage brokers and mortgage underwriters who’ve never been through a housing correction. They felt that home-price appreciation would continue to bail out many of the flawed fundamentals of the business. They thought appreciation would go on forever.
Q: So they didn't live through 1990-1991?
A : They didn't live through 1990-1991 and they didn't live through 1985-1987, either. So, they've never seen the impact, the negative impact on families and lenders as a result of a housing correction.
Q: you talk about the benefits of this, the coming back to reality, but could there be some systemic risk due to things like what happened to Bear Stearnsand all the market disruptions that hit over the summer? One economist predicts $200 billion will be lost to investors.
A : There could be systemic issues. We don't know. Clearly, the excess capacity that existed in the recent past no longer exists today. We wouldn't venture to guess when investors might return to the market. But no doubt there is significant reduction in investor appetite for the riskier loan products today.
Q : What will it take to get investors back in the market?
A : We don't think investors will come back into the market until the discipline is re-instilled into the mortgage business. We do think this cleansing, although painful in the short term, will lead to a stronger long-term market where responsible lending will replace the practices of the last few years. Once the investor community is convinced of that, then they'll come back into the market. But it is going to be a more responsible market, at least until the next cycle occurs.
Q : Well, the memory of this is probably going to be a little more painful and last longer than some of the other housing downturns.
A : Well, it's amazing how short memories are.
Q : How do you go about getting more players in the mortgage industry to better appreciate the advantages of mortgage insurance?
A : The Mortgage Insurance Companies of America [MICA], our trade association, has embarked on a comprehensive marketing campaign to re-educate mortgage brokers and loan officers about the benefits of mortgage insurance, and we've also targeted real estate professionals. And we're confident these efforts will have a positive impact in supporting increased loan availability and more responsible guidelines on behalf of the industry. You know, we didn't get here overnight and we're not going to get out of it overnight.
Q : How would you rate this housing correction?
A : If I were to rate this housing correction vis-à-vis the other corrections I've been through, I think this will come down as probably one of the worst.
Q : And its negative effect has been mitigated by a good economy?
A : Yes. The economy is still relatively healthy. I do have a growing concern, and I think the probability is increasing that this housing recession will lead us into a general economic recession. And that would just prolong and exacerbate the challenges the industry faces. The longer this housing correction continues, the greater the probability it will drag us into an economic recession. If there's a systemic risk, that's where it is-a housing recession tipping us into a broader economic recession.
Copyright © Mortgage Bankers Association of America. All Rights Reserved. Reprinted with Permission, October 2007
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Q&A with William V. Nutt, President and CEO of AIG United Guaranty England, Robert Stowe 2631 words1 October 2007Mortgage BankingMTGB122Volume 68; Issue 1; ISSN: 07300212English© 2007 Mortgage Banking. Provided by ProQuest Information and Learning. All Rights Reserved.
