Mortgage Banking
December 2007
Mortgage lenders have moved quickly to adjust their product offerings and business strategies in the wake of the liquidity crisis. The shutdown of major funding sources, combined with mounting defaults for certain products, has prompted quick adjustments in business models. There's at least one silver lining: The exit of many competitors is bringing new pricing strength for surviving lenders.
By Robert Stowe England
Business lore usually associates being nimble and quick with being small. Well, that conventional wisdom has just been shaken.
Several smaller, nimbler independents in the mortgage banking industry are gone-many wiped out in the blink of an eye when mortgage asset values fell, financing warehouse lines were called and investors in private-label mortgage-backed securities (MBS) fled the market like a pack of scared rabbits.
It turns out that some of the biggest players are the ones now showing they can be quick and nimble and turn on a dime in order to survive and prosper.
This is especially true of the lenders that up until recently became dependent on the capital markets for a large segment or a majority of their funding, whether for warehouse loans or for securitized non-agency mortgages. However, for major lenders that both avoided non-agency securitizations and subprime lending, this has been a time for gaining market share.
The surviving big players can be more nimble, in part, because they have more wiggle room in the mortgage marketplace due to the exit of so many other players. But for a lot of traditional mortgage banking companies, the mortgage meltdown has descended like medieval plague. The carnage is everywhere. The demise of smaller mortgage companies now frequently goes beyond just making local headlines. In fact, there are Web sites, such as MortgageDaily.com's The Mortgage Graveyard (www.mortgagedaily.com/mortgagegraveyard.asp?spcode+google), that track the names of mortgage banking companies that have been shuttered.
According to The Mortgage Graveyard's tally, 127 mortgage banking companies had failed by mid-November, with another 40 being acquired (sometimes with bleak prospects after being acquired). This compares with 18 mortgage bankers that went under in 2006 and eight that were closed in 2005.
Subprime is not the common denominator among the list of failed companies, although, obviously, the names of subprime lenders are numerous on the list. The true common thread among the host of failed mortgage banking companies is they depended on the capital markets to fund their operations and had no other reliable source of capital, according to Paul Miller Jr., managing director and co-head of financial institutions at Friedman, Billings, Ramsey & Co. Inc., Arlington, Virginia. There were, in fact, mortgage firms that specialized in prime jumbo lending among the casualties, such as American Home Mortgage Investment Corporation, Melville, New York.
In the wake of the mortgage meltdown, some mortgage banking business models are now history, says Bose George, senior vice president of research at Keefe, Bruyette Woods Inc., New York.
"One of the most radical changes is that one part of the market [the sector made up of monoline subprime and alternativeA businesses] has basically been eliminated," he says.
Even monoline companies that originate or hold primarily prime-rated assets, like Santa Fe, New Mexico-based Thornburg Mortgage Inc., became vulnerable, George adds. Only the mortgage real estate investment trusts (REITs) that mainly purchase agency MBS were able to survive the meltdown unscathed, he says, as the liquidity squeeze last summer demonstrated the vulnerability of companies like Thornburg, which had invested in only AAA securities.
The lesson? "If you are reliant on funding from the private market, your asset class has to be agency MBS. It has to be securities guaranteed by the GSEs [government-sponsored enterprises]," George says.
"If something like August happens again . . .," George says, the surviving monoline mortgage banking companies and REITs are still vulnerable because they depend on the capital markets for short-term financing.
"If the value of securities goes down, they will once again need to sell or access capital some other way," he adds. The companies that can avoid this are the banks and thrifts, which can rely on deposits to fund their operations. "If you aren't reliant on the market to get money to fund your assets, you'll get through" if another liquidity crunch hits, he adds.
"The big winners in this whole thing are the depository institutions," says Miller. "It's the institutions that can put this stuff on their portfolio and keep it. The depository institutions are in a sweet spot now as demand for non-agency products that can be held in portfolio is rising in the wake of the collapse of the non-agency market," he adds.
This marks a big turnaround for some depositories, according to Miller. "What was happening is that the non-agency market was absorbing so much production that the depository institutions were losing market share because they were unwilling to underwrite to their own book, so they had to step away," he says. "As the non-agency market absorbed it all, they had a huge demand for this stuff, which lowered the overall underwriting standards across the country," he adds.
Meanwhile, depository institutions such as Washington Federal Inc., Seattle, and Downey Financial Corporation, Newport Beach, California-two thrifts advised by Friedman, Billings, Ramsey & Co.-shrank their balance sheets by from 10 percent to 15 percent over the last 18 months, "just letting their current book run off because they were unwilling to put the new stuff . . . onto their books," Miller says.
Lenders turn to agency funding
Reliance on deposits, however, has not been the biggest source of funding for companies that were heavily reliant on the non-agency markets. Examples of such companies include Calabasas, California-based Countrywide Financial Corporation and Pasadena, California-based Indymac Bank, as well as others, including large banks that relied heavily on the non-agency market. But now the new fountain of financial strength for the mortgage banking industry is Fannie Mae and Freddie Mac. Lenders that formerly focused primarily on non-agency financing have now switched gears completely and are focusing primarily on agency funding.
"I think what we're seeing is ... a sea change in the relationship with our lenders," says Paul Mullings, senior vice president, single family sourcing, for Freddie Mac. "We're seeing... lenders across the spectrum of size retooling their origination platforms to focus primarily on originating loans that are saleable to the GSEs [ Freddie Mac and Fannie Mae]," he adds.
Lenders are turning to the agency market, Mullings notes, because it's the one market "that's really stayed very constant and remained stable and liquid." As a result, Mullings explains, sales to the GSEs are up approximately 28 percent year-overyear in the third quarter.
Gains for agency funding in the fourth quarter-which will be the first full quarter after the collapse of the nonagency market-are likely to be starkly higher than the thirdquarter gains.
Freddie Mac has also seen a shift in the type of loans lenders are selling it. "Since May of this year, [for example], we've seen approximately $15 billion in single-family mortgages that have been sold to us with FICO® [scores] less than 660, which was the cut-off that was used by the interagency guidance to describe those as effectively non-prime loans," Mullings says.
This would suggest "these loans would have been sold away from the GSEs before, and now these loans are being sold to the GSEs," he adds. Mullings identifies the borrowers as "those who might have been prime [borrowers] before, or they were previously subprime and have strengthened their credits and now are able to refinance into products salable to the GSEs," he says.
Fannie Mae reports a similar surge in demand from lenders. Since August, the GSE has seen "an overwhelming wave of refinancings into fixed-rate mortgages [FRMs]" from adjustable-rate mortgage (ARM) borrowers, particularly subprime borrowers who are moving up to prime products, says Jef Kinney, vice president for innovation development at Fannie Mae. "Close to 100 percent are choosing fixed-rate loans," he reports. The move to Fannie Mae refis began earlier in the year, but "really took off" in August during the market disruptions, he says.
"I think they've learned [to say] let's take away some uncertainty around the loan. There's been an overwhelming wave of refi into fixed-rate," Kinney says. In many cases, Kinney says, borrowers have been able to refinance from an ARM into a fixed rate that is lower than the initial adjustable rate on their mortgages because rates on fixed-rate mortgages have declined.
For the GSEs, the turnaround revalidates their important role in mortgage finance. "We were initially created to help with the flow of capital to housing and mortgages, and that's exactly what we're doing," says Kinney. "We're showing our benefit. People are appreciative that we can provide liquidity to the market," he adds.
Turning 180 degrees on a dime
Part of the driving force behind the surge in conventional, conforming loans comes from a dramatic shift in the types of products being originated by major mortgage banking firms. Countrywide, for example, reported on Oct. 11 that in September 2007 overall funding of mortgages fell a sharp 44 percent from the same month a year earlier to $21.2 billion from $38.1 billion. A month later, Countrywide reported an even sharper 48 percent drop to $22.4 billion from $42.3 billion for the same month in 2006, but the volume was up 4 percent over September, according to David Sambol, Countrywide's president and chief operating officer. The September and October numbers are important because they show the full impact of the big shift in origination patterns.
The decline in volume at Countrywide occurred mostly over the third quarter. From June 2007 to September 2007, for example, Countrywide's mortgage pipeline fell 39 percent to $42 billion while average daily applications fell 45 percent to $1.7 billion, "illustrating the significant drop in overall activity throughout the industry," said Sambol.
How was Countrywide able to keep originations from completely falling off the cliff? The company rapidly converted over to originating loans to sell to the agencies. Thanks to the quick shift, during September fully 90 percent of Countrywide's originations were for conforming, conventional loans, the company reported.
At the same time, Countrywide sharply reduced the amount of loan fundings done through its wholesale lending channel, which fell 57 percent from $7.2 billion in September 2006 to $3.1 billion in September 2007, and by cutbacks in its correspondent channel, where loan fundings fell 49 percent year-over-year from $16.5 billion to $8.6 billion. In October, wholesale channel loan fundings again fell 57 percent (from $7.5 billion to $3.2 billion), while correspondent channel loan funding fell 53 percent (from $19.4 billion to $9 billion). In October, Countrywide originated only $42 million or 0.2 percent in subprime mortgages.
The new pattern of originations at Countrywide stands in stark contrast to its product mix before the turmoil in the mortgage markets. In 2006, for example, 33 percent or $153.8 billion of Countrywide's $462 billion in originations was sold into the private-label residential mortgage-backed securities (RMBS) market, while 38 percent or $177.1 billion was for sale to the agency market, according to Inside Mortgage Finance.
During the first nine months of 2007, Countrywide was the No. 1 issuer of non-agency RMBS, with $80.2 billion in securities. Lehman Brothers Inc., New York, was a distant second, with $46.1 billion in issues of private-label MBS.
Washington Mutual Inc. ( WaMu), Seattle, ranked third with $40.5 billion; Wells Fargo Home Mortgage, Des Moines, Iowa, ranked fourth with $37.1 billion; and Bear Stearns & Co. Inc., New York, pulled in at fifth with $36.3 billion.
JPMorgan Chase & Co., New York ($33.2 billion); GMAC Residential Funding Corporation, Minneapolis ($31.3 billion); Deutsche Bank Securities Inc., New York ($28.9 billion); Merrill Lynch & Co. Inc., New York ($28.1 billion); and Morgan Stanley, New York ($24. 2 billion), round out the top 10. Indymac came in at No. 11, with $21.8 billion.
Indymac Bank has also reported a dramatic shift from non-agency to agency production. In late August, it said that 90 percent of its originations now are for conforming, conventional mortgages that can be sold to the GSEs. In an Aug. 28 press release, Indymac Chairman and Chief Executive Officer Michael W. Perry stated: "We have rapidly shifted the mix of our mortgage production, in light of the current secondary market. Whereas in [the second quarter of 2007] 40 percent of our production was sold to the GSEs, the [single-family residential] permanent mortgage loans we are originating today are 90 percent GSE-eligible."
In addition, the company originates prime jumbo full-documentation loans and prime home-equity loans to a maximum of 90 percent combined loan-to-value (CLTV).
A return of the agency market
While it's too early for definitive numbers on originations for the fourth quarter-the first full quarter after the collapse of the private-label secondary market-the data from the third quarter show a sharp turn away from non-agency-securitized mortgage funding toward agency funding.
At large depository institutions that have significant mortgage operations, the shifts have not been as dramatic, but mostly to the extent the institutions stayed away from subprime lending and the private-label secondary market.
The broad parameters of the shift in origination patterns can be seen in the securitization data available from the third quarter, as collected by Inside Mortgage Finance.
Each quarter this year has registered a significant shift in the shares of securitization accounted for by agency versus non-agency RMBS. In the first quarter, $271.9 billion of nonagency RMBS still represented a slight 51 percent majority of the total $537.2 billion in RMBS securitizations, while agency represented $265.2 billion or 49 percent, according to Inside Mortgage Finance. The subprime meltdown began in late February, and its effect can be seen in the agency versus nonagency shares for the second quarter. Those numbers show $289.8 billion for agency-53 percent of the overall $548.3 billion in issuance-while non-agency fell to a minority 47 percent share at $258.5 billion.
In the third quarter, agency RMBS rose to $307 billion or 72 percent of a lower overall total of $423.2 billion issuance, which was down a whopping $125.1 billion. Overall numbers fell sharply because non-agency RMBS plummeted to $116.2 or 28 percent of total RMBS in the third quarter, a mere shadow of its share during the first quarter.
The collapse of the private-label secondary market, coupled with expanded portfolio lending by depositories, reshuffled the relative positions of top originators, according to Inside Mortgage Finance. In the third quarter, for example, Countrywide held its top slot even though originations fell 27.3 percent from the prior quarter ($130.2 billion to $94.6 billion), as the overall industry's originations fell 21.9 percent. Wells Fargo retained the second pole position as originations sank 14.8 percent, from $80 billion to $68.1 billion. Chase moved up from No. 4 to No. 3, while originations were down 14.3 percent ($59.6 billion to $51.1 billion). O'Fallon, Missouri-based CitiMortgage Inc. fell from No. 3 to No. 5, as originations dropped 26.3 percent ($61.26 billion to $45.2 billion). Charlotte, North Carolina-based Bank of America (and affiliates) moved from No. 5 to No. 4, while originations fell 7.5 percent ($51.9 billion to $48 billion). Fourth-quarter data are likely to show an even more dramatic reshuffling.
A bigger role for FHA
Not surprisingly, the biggest fear faced by most mortgage lenders is the ongoing performance of subprime loans and the valuation of those assets. To date, the bulk of write-offs have been in second mortgages and home-equity lending. Lenders and investors have trampled over one another as they stampede away from subprime-a term that now seems radioactive.
The volume of subprime lending has fallen more steeply than any other loan category. Lenders want to get subprime off their books, whether it's whole loans held in portfolio or even AAA-rated subprime RMBS tranches. Subprime held in portfolio is being run off, and originations kept to a minimum or zero and perhaps sold if one can find a buyer.
Subprime grew into the largest category of private-label securitization beginning in 2004, when $362.5 billion of subprime-backed securities were issued, according to Inside Mortgage Finance. During that year, there was $233.4 billion of jumbo-backed issues and $158.6 billion in alt-A. It was the first year subprime securitizations topped prime jumbos since 1997, when there was $56.92 billion in non-agency subprime issuances compared with $49.97 billion in jumbo prime and $6.5 billion in alt-A.
By 2006, non-agency subprime issuance had reached a whopping $448.6 billion, with alt-A at $365.7 billion and jumbos, by comparison, languishing at $219 billion. The current drop in subprime activity can be seen by comparing the numbers from the first to third quarters of 2007, when issuance fell from $88.55 billion to $26.22 billion-a 70 percent decline.
At deadline, there were no definitive overall (portfolio, securitized and sold) origination data on subprime portfolio lending for the third quarter, but given the high number of depository institutions that have said they are exiting subprime lending, the volume is likely to fall sharply here, too. Only lenders with a strong track record of well-documented, solidly-performing subprime loans are likely to continue in the business.
There is one ray of sunshine for subprime borrowers and that is the Federal Housing Administration (FHA). FHA insures some subprime loans that meet its qualifications. The loans are then pooled into securities guaranteed by Ginnie Mae and sold in the secondary market. This effectively takes the credit risk off the books of the lenders that originate the FHA loans.
The full faith and credit of the federal government backs the Ginnie Mae MBS, which makes most investors view them as almost as secure as Treasuries. President George Bush shone a spotlight on the role of the FHA on Aug. 31, when he announced a new program-FHASecure-for borrowers in adjustable-rate mortgages facing rate adjustments and resets they could not afford. The impact of having the White House focus on the FHA has been a boon.
"We're back in the game again," says Meg Burns, director, office of single-family development at FHA.
Burns reports that interest in FHA programs had been growing, but the president's announcement "tipped the balance for us" by getting borrowers interested enough that they asked lenders and brokers about how they could participate. Since then, FHA has seen a surge in the number of applications and the number of lenders that are approved.
During September alone, for example, the FHA added 127 new lenders, raising the number of new lenders approved in the past year from 870 to 997. New-lender approvals rose steadily throughout the prior 12 months, with the number of new lenders added rising each month. In fiscal year 2006 (October 2005 to September 2006), by contrast, there were only 692 new lenders added. On Sept. 30, FHA had 9,605 approved lenders.
Burns now says that the potential for FHASecure is likely to be significantly higher than the 82,000 borrowers estimated when the program was announced.
There is no cap on the number of refinancings or home-purchase loans that FHA can endorse, she explains. FHA can insure loans that meet its specifications with loan-to-value (LTV) ratios as high as 97.15 percent for loans on properties with appraised values in excess of $125,000. For homes with lower appraised values, the LTV ratios can be marginally higher, with the limit set at 98.75 percent LTV for properties with appraised values of $50,000 or less.
FHA sets payment-to-income ratios at 31 percent and debt-to-income ratios at 43 percent. Borrowers for FHASecure must show that in the six months prior to the reset, they were able to make the payment during the month due, as well as paying on time other recurring obligations.
"People forget sometimes that the United States housing finance system is probably the best system in the entire world, in part because of the role the government plays in supporting the private sector," Burns says. "And it's not just FHA. It's the GSEs as well. The balance [between the private and public sectors] we've achieved in this country is unparalleled in any other country," she says.
Before this year, FHA's market share had been in steady decline for several years, Burns says. Over the past year, however, the FHA has seen the beginnings of a turnaround in its program, both for endorsements of purchase loans as well as refinancings. Monthly FHA endorsements rose 28 percent from 35,981 in October 2006 to 44,951 in August 2007. The total value of loans endorsed during the same period rose 33 percent from $4857 billion to $6,465 billion.
Overall FHA loan dollar volumes, however, remain a fairly small share of the total mortgage origination market. For the 11 months ending in August, total FHA endorsements reached $53.9 billion.
FHA has stood by for years watching developments it found alarming for subprime borrowers. As Burns explains it, during the boom in securitized subprime lending, the FHA contended that many of those borrowers would have been better served by the FHA.
"That's why we're here to serve borrowers who have a riskier profile," she says. "Why should they pay a higher interest rate when FHA as a government mortgage insurance company is here just to provide them access to prime rate financing?" Borrowers, however, were attracted to lenders that made the whole process easier, with stated-income loans, for example, she adds. FHA, however, has been arguing that the private-MBS market loans borrowers were taking out were often not in their best interests.
The FHASecure program allows borrowers who were able to make their payments before the resets to apply for an FHA-endorsed mortgage. The reason for that policy is that "we in FHA feel very strongly the borrower must have the capacity to repay," Burns says.
"Borrowers who immediately went delinquent on those other loan products clearly were not qualified for those loans to begin with," she adds. "We cannot be an outlet for just any subprime loan. We really need to be careful and cautious. Our goal isn't just to give somebody a temporary solution and stave off the inevitable foreclosure for some period of time. Our goal is to put people into a new permanent financing arrangement, to permanently avoid foreclosure. Sustainable homeownership-that's what we say all the time these days, not a temporary solution," Burns says.
Rethinking second mortgages
While the turmoil in the capital markets has been a major determinant of the products mortgage bankers are offering, lenders have also been sharply cutting back or eliminating types of loans that are suffering the highest delinquencies and defaults.
One can see changing patterns in loan-type preferences by lenders quite clearly in the securitization data for the third quarter. (Full third-quarter data on all loan originations, including those for agency and portfolio lending, were not available at press deadline.)
When one looks at the third-quarter securitization data, it is clear that lenders were moving en masse for the exit doors on second mortgages, both closed-end and home-equity lines of credit. "The vast majority of the second mortgages made over the last two years were just piggyback loans and basically fixed-term second mortgages that were just used to avoid mortgage insurance and effectively raise the [combined] loan-to-value [CLTV] ratio," says Guy Cecala, publisher and editor at Inside Mortgage Finance.
Lenders were clearly aware of the piggyback loan problem by the third quarter, when origination volume for securitized closed-end seconds dropped like a rock to $1.24 billion from $10.7 billion in the second quarter-an 88 percent plunge, according to Inside Mortgage Finance.
Securitized closed-end seconds peaked in the fourth quarter of 2006 at $18.62 billion. Securitized home-equity lines of credit (HELOCs) also followed the same pattern, falling 87 percent in the second quarter to $620 million from $4.91 billion in the second quarter. Even subprime did not fall this hard, despite the meltdown that began in late February. Non-agency subprime securitizations fell 65 percent from $74.7 billion in the second quarter to $26.2 billion in the third quarter.
Closed-end seconds and HELOCs have turned out to be the unexpected ground zero in the current mortgage meltdown. This was not because of anything inherently problematic with these loans, but because they became the backbone of a new practice that swept the industry: 100 percent LTV lending combining 80 percent first mortgages with 20 percent second mortgages.
Now, not surprisingly, "the one loan product that's really disappeared is 100 percent financing-that's really gone," Friedman, Billings' Miller says.
Home-equity loans of any type are a big problem because they aggravated the credit woes of the subprime sector and spread those woes into the alt-A and prime markets. "People were underwriting to FICO scores" to give some borrowers 100 percent financing, Miller says. "What they're finding is FICO scores are not at all a good predictor of losses."
The reliable predictor, it turns out, is combined loan-to-value. "The loans having trouble today are those 100 percent LTV loans," Miller says. "Not only are lenders getting hit hard on severity of losses, but the frequency is much higher than anticipated."
"The problem, too, was that everybody was slow to recognize the problem on these closed-end seconds, these piggyback loans," says Cecala. securitizations, for example, fell from $18 billion in the first quarter to $12 billion in the second quarter. It was not until late July that the problem openly presented itself, when Countrywide announced huge markdowns in prime home-equity loans.
The company took an impairment charge of $417 million for its investments in credit-sensitive retained interest, including $388 million in impairment on residual securities collateralized by prime home-equity loans. Countrywide also set aside $293 million for held-for-investment loans, including a loan-loss provision of $181 million on prime home-equity loans in the banking segment of the company. Thus, the total impairment tied to prime home-equity loans was $569 million.
"It's a misnomer to call it home equity," says Cecala. "The traditional home-equity lines of credit are doing well. Very little of that product is securitized. It's held by banks because it's a good investment," he says.
While lenders have cut back on subprime and various second mortgages and home-equity mortgages, the data so far at least show much less of a cutback in some types of alt-A loans that have been the source of rising delinquencies. "There were clearly problems with stated-income and no-documentation loans," Cecala says. "Yet, the prevalence of them has not changed since 2006."
Stated-income and/or no-documentation loans were 54.6 percent of the non-agency market in 2006, according to Inside Mortgage Finance. For the first nine months of 2007, they still represented 53.7 percent of originations.
"Prepayment penalties, IO [interest-only] features, layering-all these things that have been identified as high risk-they were still prevalent in the marketplace," he says. More complete data that include portfolio lending in the third quarter can yield a more complete picture of the direction of these trends.
Citigroup's rising loan-loss provisions
As banks with large mortgage operations announced their third-quarter earnings, the charge-offs for closed-end seconds and home-equity lines began to rise far above the $569 million charge-off at Countrywide in the prior quarter. Rising loan-loss provisions from deteriorating second mortgages led the parade of third-quarter reports from many major lenders.
For example, Citigroup Inc., New York, reported in the third quarter that delinquencies for all second mortgages rose to an "all-time high," according to Gary Crittenden, chief financial officer for Citigroup, during the Oct. 15 investor conference call.
Crittenden told investors and analysts that delinquency rates for second mortgages had risen to 1.1 percent in the third quarter from 0.58 percent in the second quarter. "In part, our reserve action for our mortgage portfolio reflects this significant deterioration," Crittenden said. Delinquencies for first mortgages had also risen during the third quarter to 2.09 percent, the highest levels since the third quarter of 2003 and near the peak of 2.81 percent in the first quarter of 2003.
The loan-loss reserves for mortgages were not separately stated, and were part of an increase of $854 million for Citigroup's U.S. consumer lending business, which is made up of mortgage lending, auto loans and student loans. The bank's press release did, however, indicate that mortgages represented a big piece of the provisioning, with the following statement: "Higher credit costs were primarily driven by a weakening of leading credit indicators, including higher delinquencies in first and second mortgages, as well as trends in the macro-economic environment, and a change in estimate of loan losses."
On Nov. 4, Citigroup predicted it would take an $8 billion to $11 billion hit from marking to market its $43 billion portfolio of what Crittenden called "super-senior investment-grade CDO [collateralized debt obligation] tranches backed by subprime loans." At the same time, Chairman and Chief Executive Officer Charles Prince "retired" and the board announced a new chairman, Robert E. Rubin, former U.S. Treasury secretary, and a new acting president, Win Bischoff, who had headed Citigroup's European operations.
Crittenden denied that Citigroup might be forced to cancel its dividend in the fourth quarter in response to a report several days earlier from equity analyst Meredith Whitney of CIBC World Market, who suggested that Citigroup would have to raise $30 billion in capital to rebuild its capital base. CIBC downgraded Citigroup's shares to "sector underperform" from "sector perform."
Citigroup also reported in a statement on Nov. 4 that it had $11.7 billion of subprime-related exposures in "the lending and structuring business" as of Sept. 30. Citigroup had been reducing its subprime exposure since the beginning of the year, when the exposure was $24 billion. The $11.7 billion of subprime-related exposure was broken down as follows: $4.2 billion in actively managed subprime loans "purchase or resale or securitization" at their discounted value, $4.8 billion of financing transactions with customers secured by subprime collateral, and $2.7 billion in CDO warehouse inventory and unsold tranches.
CitiMortgage curtailing some products
Crittenden reported on Oct. 15 that Citigroup was lowering the origination volume of second mortgages from third-party correspondents, and had taken steps to strengthen the underwriting of both first and second mortgages.
In a subsequent interview, a spokesman for Citigroup's mortgage arm- CitiMortgage Inc.-provided additional information about changes that have been made or are under way at Citi's mortgage businesses. In spite of the subprime meltdown, CitiMortgage, which has always had a big presence in what it calls the "near-prime" market, will continue to originate "prime and near-prime" mortgages, says Mark C. Rodgers, head of public affairs for Citi's consumer lending group. The company "has prudently steered away from high-risk products," Rodgers adds.
Reiterating CitiMortgage's product and marketing strategy, Rodgers says that " CitiMortgage aims to provide a breadth of products across a wide credit spectrum." Yet, not surprisingly, CitiMortgage has "tightened some credit standards" as a result of its efforts to "constantly benchmark with the industry and competitors," Rodgers says. Addressing the important issue of providing borrowers mortgages they will be able to repay, Rodgers adds, " CitiMortgage feels strongly about providing the right products for the right borrowers across the credit spectrum."
Despite significant dislocations in the private-label secondary market, with only a few exceptions, " CitiMortgage has continued to provide liquidity to all distribution channels-retail, wholesale and correspondent," Rodgers says. Even so, a combination of factors has led CitiMortgage to alter its line-up of product offerings.
"In response to a combination of mortgage performance trends, regulatory guidance and investor appetite, CitiMortgage has eliminated or curtailed certain products, including 2/28 and 3/27 adjustable-rate loans and stated-income and/or stated-asset loans," Rodgers says.
"Pricing on these newly originated loans is generally based on execution levels that are either observed or anticipated in the secondary/securitization market," he adds. "Investors have begun to purchase jumbo loans or highly rated securities backed by jumbo prime, while [the] appetite for alt-A and nonprime-backed bonds remains extremely limited," he says.
As in the past, CitiMortgage will continue to be largely "a conforming conventional lender with a majority of loans sold to Fannie and Freddie," Rodgers adds. CitiMortgage, despite the lack of a secondary market, will continue to offer alt-A mortgages, closed-end seconds and HELOC loans, he explains. And CitiMortgage will continue to offer piggyback mortgages.
In the third quarter, JPMorgan Chase set aside $306 million for loan losses in its home-equity business, due to sharply higher delinquencies during the quarter-especially in September-according to a presentation by Michael J. Cavanaugh, chief financial officer, at the Oct. 17 investors and analysts conference call.
Net charge-offs for home-equity loans rose from $98 million in the second quarter to $150 million in the third quarter. "We anticipate quarterly losses of $150 [million] to $160 million in this quarter," Cavanaugh said during the call. "Our quarterly losses could go as high as $250 [million] to $270 million per quarter," he added.
In response to a question from an analyst on where the problems are focused in mortgages, Cavanaugh said, "It's in high-LTV home equity." Noting that it's more common where the LTV is over 90 percent, with stated-income products "in anyplace with home prices going down," the "lion's share" of the problems come from brokers, he said. "If you go down to 80 percent LTV, or go from stated to qualified income, the problems go down dramatically."
In response to rising delinquencies, JPMorgan Chase has discontinued the origination of all subprime home-equity loans and tightened underwriting across all channels on prime home equity during the third quarter. The bank also raised prices for new home-equity loans to reflect the company's higher estimate of the risk involved in such loans. JPMorgan Chase also stepped up its loan loss-mitigation efforts, according to Cavanaugh.
Losses in subprime lending were far more modest, partly because this is a much smaller business than the homeequity business. No new loan-loss provisions were added for subprime lending. Net charge-offs rose from $26 million to $40 million for subprime during the quarter. Cavanaugh expects net chargesoffs for subprime to range from $40 million to $50 million a quarter, with continued portfolio growth.
In response to the dislocation in the private-label secondary market, JPMorgan Chase is able to continue to originate any type of loan that meets consumer needs because it has a $1.5 trillion balance sheet, giving it a huge capacity to hold loans in portfolio, according to Tom Kelly, senior vice president of public relations at JPMorgan Chase. And, indeed, Chase moved up from No. 4 to No. 3 among top mortgage originators in the third quarter, with $51.1 billion, according to Inside Mortgage Finance.
"Lots of monoline companies cannot do that," Kelly says, "because there just isn't a balance sheet to do that with." A year ago, he says, JPMorgan Chase could choose to hold loans in portfolio or sell them, and did sell a lot of them, he says. Now, the bank can hold the loans in portfolio that are originated by Chase or its retail bank branches. If the private-label market returns, JPMorgan Chase can again "choose to hold or choose to sell," Kelly says.
JPMorgan Chase has offered-and continues to offer-a full range of products, from prime jumbo to alt-A to subprime to home-equity loans to conventional, conforming loans, he adds. In response to the problems in the mortgage market, the bank has tightened underwriting in all product categories.
"In each case, we narrowed the box," says Kelly. In some products the tightening has been more substantial. For example, in alt-A, "we have eliminated a lot of the statedincome/stated-asset loans," he says.
Tightened criteria have not slowed down originations. In jumbo, for example, JPMorgan Chase is more careful about the LTV. "But because there are fewer lenders even doing jumbos, we've had plenty of demand," Kelly says. The bank is also offering fixed-rate mortgages and adjustable-rate mortgages, even though the fixed-rate mortgages are likely to be held in portfolio and mortgage lenders traditionally have sought to sell fixed-rate mortgages into the secondary market to reduce long-term interest-rate risk.
Given the losses in home equity, it is no surprise Chase has looked more closely at its underwriting for home-equity loans. Some of the tightening is occurring in specific geographical markets, according to Kelly. In Nevada, which has seen a huge spike in delinquencies across most loan types and a decline in home prices, Chase is restricting loans to 85 percent of the combined first- and second-mortgage loan-to-value, according to Kelly.
"In places where housing prices are soft, a 100 percent [LTV] loan could become a no percent [LTV] loan pretty easily," he says. Previously, the bank was offering home-equity loans up to 95 percent to 100 percent CLTV, he adds. Now, Chase offers the 100 percent HELOC in only two states: Texas and Washington state. The remaining states are limited to 85 percent, 90 percent or 95 percent, Kelly says.
Chase is gaining market share, not unexpectedly, as a huge swath of competitors have gone under. For the first nine months of 2007, originations are up 35 percent over the prior year, even though total originations in the overall market are declining. Third-party originations are also up, Kelly says, as brokers seek out companies with strong financials to be sure that loans they originate will be funded when it comes time to close. In its Oct. 17 conference call, Crittenden said JPMorgan Chase estimates its share of mortgage and home-equity originations will be 9.7 percent for the third quarter of 2007, compared with 6.1 percent a year earlier.
Wells Fargo Bank reported a third-quarter increase of $172 million in net credit losses, rising to $892 million or 1.01 percent of average loans, annualized, from $720 million or 0.87 percent in the second quarter. "Almost half the [$172 million] increase in net credit losses ... was concentrated in the homeequity portfolio, where losses accelerated in the quarter given the steeper-than-anticipated decline in national home prices," said Chief Credit Officer Mike Loughlin in an Oct. 16 conference call with investors and analysts.
Wells Fargo's first-mortgage portfolio continued to perform well, with annualized losses at 0.11 percent or $16 million of the $62.9 billion portfolio. That was actually a slight improvement over the second quarter.
In the second quarter, Wells Fargo exited the correspondent nonprime business, according to Joe Rogers, executive vice president for product development at Wells Fargo Home Mortgage. Nonprime had not been a big part of Wells Fargo, representing 8 percent of loans originated in 2006. In the third quarter, the company also exited the nonprime wholesale channel.
In the wake of the collapse of the private-label non-agency market, Wells Fargo is holding loans in portfolio that it does not sell to Fannie Mae or Freddie Mac. "As a division of [a bank] which is one of only two banks globally to have the highest credit rating from both [New York-based] Moody's Investors Services (Aaa) and [New York-based] Standard & Poor's Rating Services (AAA), we are a reliable lender that offers competitive pricing for customers," Rogers says. He reports that the volume of FHA/Department of Veterans Affairs (VA), Fannie and Freddie loans is rising-"particularly the loans accessed and funded through our broker and correspondent channels," he says.
In the first six months of 2007, for example, Wells Fargo's loan volume sold to Fannie and Freddie was $60.31 billion, up from $56.58 billion in the same period of 2006. In the third quarter, Wells Fargo had $68 billion in mortgage originations, down $19 billion from the prior quarter, "with most of the decline . . . in the nonprime correspondent and wholesale channels," according to third-quarter comments released by the company.
Wells Fargo, which remains in the nonprime business (except through wholesale and correspondent channels), cites its "fair and responsible lending principles for U.S. nonprime real estate lending-with a focus on the consumer's ability to repay" as a contributing factor in the ability of the company's nonprime to perform better than in the industry as a whole.
"These principles have served us well in turbulent times," Rogers says. Wells Fargo, for example, does not make, purchase, or service negative-amortizing mortgages, including option-ARMs. "While these decisions prevented us from capturing some share of the market, they were the right decisions to make then and have proven to be right now," he says.
Wells Fargo Bank continues to provide home-equity loans through its Consumer Credit Group, Wells Fargo Financial and Wells Fargo Home Mortgage's retail, wholesale and correspondent channels. Wells Fargo also offers no- to low-downpayment options and lender- and borrower-paid mortgage insurance (on first mortgages with LTVs above 80 percent).
Charlotte, North Carolina-based Wachovia Corporation's strong portfolio lending approach to the mortgage industry put it in a position of relative strength during the market turmoil of last summer.
"We're the fourth-largest bank in the United States. We're well-capitalized, well-positioned. Eight percent of the loans we make go on our balance sheets," says Rich Fikani, head of mortgage operations for Wachovia. "So we have a vested interested not only in protecting credit quality for our shareholders, but [in] really ensuring our long-term strategy to make home loans for consumers, and make loans that work for them, and as a result, hopefully create a customer base that results in a lot of referrals going forward and a lot of repeat business going forward," Fikani explains.
Third-quarter loan performance results for Wachovia certainly underscore these points. Net charge-offs rose only 3 basis points to an annualized 0.19 percent of average net loans. Nonperforming assets (NPAs) in residential real estate at Wachovia rose by $658 million going from $1,293 billion in the second quarter to $1,951 billion in the third, according to the company's quarterly earnings report. The gain came primarily from the nonperforming assets gained in the acquisition of Golden West Financial, according to Wachovia's earnings report. Unlike Wachovia's competitors, there was no gain in NPAs in second mortgages. In fact, NPAs fell from $43 million to $41 million.
Wachovia's product-mix strategy remains pretty much unchanged, both as a result of the shutdown of the non-agency market as well as the increase in delinquencies and foreclosures that mark the broader market. Fikani attributes Wachovia's good position to a number of factors that have been in place for years and remain in effect. For one thing, "We are not 'black-box' underwriting," Fikani says, meaning that Wachovia does not underwrite to FICO scores. "While we look at FICO scores as a factor, FICO is not a requirement in our decision-making," he says.
Wachovia also differentiates itself by having its own inhouse property appraisers. "We want to ensure that what the consumer is paying for is what he's getting," says Fikani. The use of in-house appraisers "has helped not only our borrowers, but certainly has helped us as a company when market turmoil like this exists," he adds.
Wachovia did not participate in the subprime market as an originator, and it continues to stay away from those types of products, according to Fikani. Nevertheless, the company has offered and continues to offer a wide range of products, from agency products to Wachovia's core product, which is its Pick-A-Payment^sup sm^ fixed-rate and Pick-A-Payment adjustable-rate mortgages, which are loans that give customers a range of payment choices-including an interestonly payment and a lower payment that can negatively amortize the loan.
The Pick-A-Payment products, which Wachovia has offered and held in portfolio for 20 years, were not sold into the secondary market in the past, so the meltdown of the non-agency market did not interrupt Wachovia's mortgage originations in its core product. The Pick-A-Payment mortgages have been and continue to be originated at the full note rate, Fikani says. Wachovia has typically offered a 10-year fixed rate on the Pick-A-Payment rather than the five-year fixed-rate period that has been more common in option-ARMs.
While Wachovia had at one time been in third-party-originated alt-A products in the past, "we got out of the third-party alt-A long before the implosion," Fikani says.
Wachovia has offered and continues to offer stated-income loans. With stated-income loans, however, Wachovia looks at assets and the reasonableness of the claimed income. Typically, it requires a 20 percent down payment. Wachovia continues to offer an 80-10-10 first mortgage with a piggyback second mortgage; however, the 10 percent second mortgage in this instance has to have private mortgage insurance, according to Fikani.
"It's basic 101 underwriting that has been true of the industry in every cycle but the last-that a lower-down-payment loan requires a little more scrutiny and a little more due diligence than [loans that have] a borrower's stronger commitment with a higher down payment to the property," he says. Finally, Wachovia's share of originations sold to Fannie and Freddie was and remains around 20 percent. It's pretty much "business as usual," Fikani says.
"The ability to be consistent in any market environment is what helps you grow long-term. Rather than following the herd, so to speak, [you] have to do those things that are good for the consumer and good for the company, and have longterm staying power-and that's what ultimately grows your business," Fikani says.
Despite Wachovia's avoidance of the subprime market as a mortgage originator, the company announced a significant $1.3 billion of losses in the third quarter when it marked to market collateralized debt obligations, mostly backed by subprime loans, that were held in its corporate and investment bank division. The market valuation losses also included RMBS, as well as leveraged finance. On Nov. 9, the bank announced that during October, when a new round of lower valuations hit mortgage-related debt instruments, it lost another $1.1 billion on its CDOs, which fell from $1.8 billion in value to $676 million. The announcement rocked Wall Street, as investors worried about losses at other financial companies. Wachovia also said it expects another $500 million to $600 million in loan losses during the fourth quarter.
The bottom line
The responses of mortgage lenders to the non-agency market meltdown and rising credit losses associated with falling house prices have been as diverse as the business strategies of the mortgage lenders themselves. Lenders reliant on the non-agency market have had to move the fastest and transform most dramatically into agency lending in order to remain viable.
The benefit of being a depository institution has been demonstrated with a vengeance. Yet, one needs a sufficiently large deposit base to build a solid source of funding to withstand the level of market turmoil that occurred this past summer and which may not yet be over.
Mortgage lenders as a whole lost sight of potential problems with second mortgages used as piggyback loans to buy properties, embracing such risky practices as 100 percent LTV lending. Where there were lending excesses in home equity, the availability of piggyback loans has been sharply curtailed and third-party originations scaled back sharply.
Piggyback lending appears to be a more sustainable business to the extent that lenders originate both mortgages themselves through their own retail or direct-to-consumer channels. The value of mortgage insurance has been reaffirmed, underlined, and should probably henceforth be written in boldface in underwriting manuals at mortgage loan companies.
Survivors are poised to gain market share and improve profitability, even in the agency business, where margins have risen, according to comments by Countrywide's Sambol during a conference call with investors and analysts on Oct. 26. "We expect profitability [at Countrywide] to resume in the fourth quarter," he predicted, "rising to somewhere between a range of 25 cents to 75 cents a share." He further predicted the return on equity would rise to a level between 10 percent and 15 percent in 2008.
A bit of confidence is returning to the ranks of mortgage lenders, who nevertheless remain wary, as Sambol puts it, about "significant potential volatility." Countrywide identifies several potentially volatile factors, which seem to be everywhere in abundance, including general market conditions, mortgage servicing right (MSR) valuations and hedge performance, residual valuations, credit performance and non-agency secondary market liquidity.
As always, there's plenty to worry about for all industry players, even as some are gratified at surviving the enormous challenges that have rocked the industry so far this year.
A bit of confidence is returning to the ranks of mortgage lenders, who nevertheless remain wary, as Sambol puts it, about "significant potential volatility."
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