Harry L. Jensen's

Subprime Opinion

Shattered Lives, Shattered Dreams

Subprime market collapse was inevitable. Subprime underwriting was thin going in and left a lot to be desired. Fault rest with the borrower, funding lender and financial markets.

The Subprime solution is solely in the hands of the beneficiary.

Since the first imigrant set foot on the American continent, land ownership has been a priority for all american. Over the centuries, the dream of home ownership has gained momentum and more Americans own homes today than at any other time in American history. Real estate ownership is not restricted to the rich and famous, but available to all Americans that can afford the monthly payment.

Affordability is the question that plagues the Subprime lender’s decision of yesterday. To lend or not to lend wasn't even asked. Sign here, sign there, fund the loan, record the deed, transfer the risk to the investor, book the profit, close the next deal was the Subprime lender’s method of operation. Underwriting standards were marginalized at the expense of sound business practices.

Greed fosters poor decision making.

The drive by financial media, that takes great exhortation in the demise of the Subprime mortgage industry, is doing a great disservice to those who are losing their piece of Americana. In reporting the demise of certain subprime lenders and potential losses to investors, the sad story of homeowners, that may lose their home, is poorly reported. “Can’t make the payment - it’s not my problem, unless it affects my pocket book.” This philosophy breeds a harsh investor response and very little compassion for the delinquent homeowner.

Foreclosure is the unhappy ending to home financing that was doomed from the beginning of the loan process. Who is at fault? Ultimately, it's the investor that purchased the risk.

Since 1972, I've been originating and closing mortgage loans. I've participated in thousands of loan closings. Over four decades of interest rate volatility, I found a way to survive.

In the turbulent times of the ‘80s, sellers and buyers used an "All Inclusive Deed of Trust" (AITD), also referred to as a "Wrap", to make the deal work. The AITD is technically a second mortgage and used by a seller to finance the deal when interest rates are high. The AITD is used to hide the transfer of ownership and avoid lender note acceleration.

The 80's saw many sellers finance a portion of the sale price via a 2nd mortgage along with the buyer assuming the existing 1st mortgage. Mutual Guarantee Insurance Corporation (MGIC) saw a way to make a profit and insured questionable second mortgages. Many insured second mortgages ended up being foreclosed and MGIC took losses.

The 80s experience taught me a valuable lesson. If yield generates investor demand, there is a good chance the deal will close.

Financing is the key to a majority of real estate sales.

Mortgage Backed Security (MBS) Subprime investors over the last 13 years based their decisions on a risk/reward investment model and not on sound underwriting standards. High yield means high risk. In the 90s, Subprime lenders introduced a MBS secured by a new 125% loan. The 125% loan was based on the Fair Market Value (appraisal) plus 25%. The maximum 125% loan amount was determined by the MBS secondary mortgage market, but limited to $250,000 or lower. Subprime interest rates were 3% to 6.5% above FNMA/FHLMC yields and the note contained a prepayment penalty provision.

As property values stabilized and property inflation began creeping back into the real estate structure, the risk associated with the 125% loan was mitigated by improving economic conditions. To create consumer demand for the 125% loan, the Subprime lending industry needed a 125% lending program that eased the consumer's concerns about the Adjustable Rate Mortgage (ARM). The answer was an ARM mortgage that contained a fixed rate for the 1st two years of the 30 year loan and commonly referred to as the 2/28 ARM loan program. Subprime lenders offered the 2/28 alternative to credit challenged borrowers that were denied financing by traditional lenders.

Lenient 125% underwriting standards, based on the initial fixed rate, property inflation and investor demand for yield, reduced the investor's due diligence review of the 125% risk. By the very structure of the 2/28 ARM Subprime note, rising ARM indices and extremely high “margins” caused the monthly house payment to increase after the two year fixed rate period. The fully indexed ARM monthly payment beginning the 3rd year caused an immediate strain on the family’s net income.

The fully indexed rate beginning the 3rd year is the reason for the current Subprime crises. Borrowers could afford a 6.75% rate, but had no prayer in making a 10% loan payment.

The mortgage origination industry had a plan to help the 2/28 borrower at the end of the 2nd year. To avoid fear of any monthly payment increase after 24 months, the mortgage origination industry pushed the refinance option. The 2/28 borrower was convinced, via 2/28 marketing, that refinancing would be available at the end of the 2nd year. The refinancing of the 2/28 loan was subject to property inflation, higher income, an improved credit score and lower lender mortgage interest rates. If perfect is needed for a satisfactory outcome, you can always count on an imperfect result.

Subprime lender programs helped builders, realtors and consumers close real estate transactions that main stream lenders declined. The 2/28 and 3/27 ARM programs were intended as an interim step that helped the credit challenged buyer. A tri-merged credit report, with three credit scores, allowed the funding lender to grade the credit risk and determine an interest rate acceptable to the secondary mortgage market in relation to the risk.

The secondary mortgage market has evolved over the last 70 years from lender to lender relationships to the current Mortgage Backed Security (MBS) secondary mortgage market where yield is king. Excessive yield makes for some questionable investment decisions. Questionable Subprime underwriting standards and lack of vision, led to the current Subprime lender crises.

Fast forward to 2002, an expanding economy, solid productivity numbers and cross the board tax breaks. Fannie Mae, Freddie Mac and supervised lenders are under pressure to provide mortgage loans to marginal income borrowers. Congress passed Predatory Lending Laws and politicians made the case for lenient mortgage lending standards relating to the least fortunate in our society. A declining “Fed Fund” rate and corresponding reduction in treasury yields and mortgage rates were responsible for an unprecedented increase in home ownership. New and existing home sales broke records. Property inflation, for a short time period, solved exposure to risk issues.

The Subprime lender was a major player in the 2002-06 housing boom.

With the 125% loan success, traditional real estate lenders developed a new financing option for the income challenged borrower. Many mortgage lenders began offering an 80% first mortgage and a 20% second mortgage referred to as an 80/20. The 80% 1st could be either a fixed or ARM loan. The 20% 2nd was usually a ARM loan whose rate changed monthly. Refinancing the 80/20 and the 125 % loan was made possible by property values sky rocketing over four years. The real estate financing industry was generating fantastic profits over a ten year period. Gold was king.

The 80/20 loan program was destine to cause problems for the borrower after loan closing. Loan amounts were excessive in relation to the borrower's ability to repay the debt in an increasing interest rate market. The ARM loan payment increases in a rising interest rate market.

This 100% combined loan to value (CLTV) loan program offered mortgage financing far in excess of the 125% financing programs, which are limited to $250 thousand or less. Million dollar homes could be bought with little or no down payment utilizing reduced or no paper work loan programs. Underwriting at all levels was swept under the carpet.

Profits soared for all participants in the real estate lending industry.

Traditional funding lenders were caught in the flurry of increasing their servicing loan portfolio profits. Up until June of 2006, property inflation bailed out the lender’s high leveraged loan programs. The mortgage origination industry saw a profit in refinancing the 80/20 into a new 80% first mortgage after twelve to eighteen months of home ownership.

In June of 2004, the fed began gradually increasing rates by a 1/4%. The last 1/4% change was June 29, 2006 and all ARM indices went sky high. Property values leveled off and refinancing the 100% loan became more difficult. The 80/20 borrowers, with fully indexed rates in the 9 to 12% range, found they could not make the monthly mortgage payments. Delinquencies shot up and foreclosures rocked the Subprime lending world.

What about the dreams of the homeowner that utilized 100 and 125% loan programs? Enticed by financial markets with an appetite for yield, a real estate industry driven by profits, commissions and greed, Subprime borrowers were offered mortgage loans that would eventually cause dramatic financial consequences. There was little attention paid to the borrower's financial risked after closing. In some cases, the monthly housing expense, beginning the third year, increased by 50% and foreclosure was just around the corner.

In the late ‘80s, government formed the Resolution Trust Corporation (RTC) to sale the seized financial assets of failed savings and loans. I'm opposed to government interfering with the private sector, but the concept of a limited private enterprise to pool troubled loans is worth exploring.

Why let homeowners with sufficient income to repay the mortgage debt, at a reasonable interest rate, go into default and subsequent foreclosure? The only winners, in a rush to limit mortgage loan losses, is the investor picking up the pieces at a heavily discounted price.

I am assuming that a substantial loss will be realized by one or more investors exposed to Subprime loan defaults. These losses could be monumental when compared to the S/L losses of the ‘80s.

Here is the idea: Create a Private Trust Corporation (PTC).

The goals of the PTC are as follows:

1. Prevent Subprime financial market collapse.

2. Stabilize Subprime loan servicing pressures.

3. Save delinquent borrowers (DB) from loosing their homes.

4. Immediately stop the DB delinquency and foreclosure process.

5. Refinance existing DB with affordable financing.

6. Assign new 1st DB mortgage to PTC.

7. Consolidate DB loans into PTC Mortgage Backed Securities.

     a)  Each beneficiary of the original DB loan would receive an equivalent percentage share
          equal to the refinance loan amount in relation to the newly issued PTC MBS.

     b)  All DB loan servicing would be retained by current loan Servicer.

The idea is to refinance all Subprime loans, delinquent or in default, into a new 1st, interest only mortgage, at a rate equivalent to the 3 year Treasury note plus 0.500% for a term of 3 years with no prepayment penalty. At the end of 3 years, if the borrower has been current and made all payments on time, the loan will be converted to a 25 year amortizing loan based on the current Fannie/Freddie 30 day price plus .375%.

This plan will require co-operation between beneficiaries and servicing entities.

Refinancing existing DB loans will take some unique underwriting skills, but my experience tells me that proper pricing, loan term, interest only payments and borrower education can rule the day. The key to the idea is the ability of the borrower to make the monthly payments over 3 years. This time period should give the borrower breathing room and the investor a reasonable expectation of repayment of principal with some rate of return on the original investment.

Harry L. Jensen

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