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Pinnacle e-Letter

Mortgage Lending in Turbulent Times
By John Ward, Mortgage Advisor, Pinnacle Financial Partners

The recent calamity in “sub-prime” mortgages underscores the need for objective advice driven by the client’s best interest. The housing boom, liberal underwriting, demand and liquidity opened the door to unprofessional, and sometimes unethical, business practices that adversely affected the mortgage market and caused financial tremors to spill over into the wider economy. This article explores what caused the mess and how it may impact you.

Mortgage 101
Understanding how mortgages work is essential to understanding the current high-risk mortgage meltdown.

Mortgage lenders typically sell mortgages to another party, known as the secondary market, to free up liquidity to lend to another borrower. The servicing of loans is retained in the secondary market. This is what you and I see when we make our monthly payments.

Larger mortgage companies bundle mortgage loans and sell them as Mortgage Backed Securities (bonds), which are rated -- A, AA, BBB, etc. -- based on how risky they are. Higher risk means higher yield; lower risk means lower yield. Almost all loans are eventually sold as Mortgage Backed Securities regardless of who services the loan long term. This is done because of capacity, liquidity, market demand and fee income.

What's Behind the Sub-Prime Debacle
Most mortgage loans today are originated by largely unregulated mortgage companies with little of their own capital at risk. Because most are not banks, they circumvent the strict standards of the government’s banking regulation system.

These mortgage companies, thinking they could turn a profit by selling off the loans, confused and deceived borrowers using flashy rate sheets and complicated, far-fetched mortgage products. Advice from unqualified product pushers and rate sellers put many borrowers in a product they can’t afford -- a position that may ultimately destroy the financial futures of these borrowers.

Over the last five years, large hedge funds and money managers advanced credit to these offending mortgage companies because the yields were very good when the rates were low. When higher-than-expected rates hit, these investors stopped advancing credit to these mortgage companies. As a result, many mortgage companies are now either going bankrupt or are under stress.

After Wall Street watched hedge funds and money managers take huge losses on their portfolios, its investors lost interest in securities (bonds) with real estate as collateral. Over the last five years, while real estate appreciation soared and the stock market slumbered along, most of Wall Street’s investments in the U.S. were pointed directly toward real estate and buying performing mortgage debt. Therefore, there was a great deal of liquidity (or money available to lend).

Now that Wall Street has stopped investing in mortgage backed securities, liquidity is lost. This means there is less money to lend for mortgages and product rates are higher to offset the risk and availability of products that are not Fannie Mae or Freddie Mac ("secondary market" agencies that purchase closed loans from mortgage lenders).

Of the $7 trillion in sub-prime loans, most were adjustable-rate mortgages that have or will reset to higher rates. As a result, the number of foreclosures and delinquencies will increase even more. Borrowers will have a hard time making their payments when they adjust, combined with the depreciation of the lender’s collateral and houses sitting longer due to the slowing housing market. Defaults and delinquencies in sub-prime mortgages are beginning and will continue to soar.

What to Expect
Overall, even credit-worthy borrowers will have fewer options and will have to work harder.

• Fewer mortgage companies. We will continue to see mortgage companies fail, not because of defaults, but because of liquidity problems.
• More limited product offerings. Expect the choices available to prospective homeowners and those seeking loans or refinancing to narrow. With less credit available, many lenders are offering fewer mortgage products, eliminating no-down payment programs and interest-only mortgages.
• Tougher underwriting criteria. Loan-to-value (LTV) ratio, credit scores and verification of income will have a much larger influence. Appraisals will be scrutinized more heavily to make sure pricing is correct. Underwriting may take longer than it once did, so be sure to allow enough time to get the transaction closed.

The Best Thing You Can Do
The current mortgage mess illustrates the value of having a financial advisor you can trust. Be sure you know the mortgage lender involved in the transaction. A good lender will be honest and upfront and will spot problems long before the closing.

Pinnacle has always had very high credit standards and is diligent in ensuring that borrowers are using the right mortgage loan product for their personal situation. We are not and do not anticipate experiencing the problems being faced by others who are either under investigation or getting out of the mortgage business. We are continuing to make the same quality mortgage loans we always have.

John can be reached at (615) 849-3373 or john.ward@pnfp.com.

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