REQUIRED READING: Is There Still A Place For Jumbo Mortgages?

Mortgage-backed securities (MBS) for non-agency loans have remained locked down for the past year, as the free flow of capital to real estate is no longer available. Lending conditions that helped fuel residential real estate markets hit a wall in 2007, as panic from subprime spilled over to the prime segment of the market.

Underwriting standards and qualification requirements tightened significantly for all kinds of real estate lending, and large loans, in particular, became especially difficult to place. Loans that were the bread and butter for Wall Street and the conduits were left without a home, leaving consumers and originators in the lurch.

Two in three Americans now say it has become more difficult to obtain a mortgage, reflecting how lenders have made it harder to get credit as housing prices stumble and capital markets tighten. According to a survey commissioned by Deloitte LLP, 67% of people who applied for a home mortgage found the process more difficult than before the U.S. housing crisis began over a year ago.

Industry veterans agree that problems in the mortgage market began with significant and unexpected credit deterioration for subprime loans. Many of those subprime loans were placed into securities that received AAA scores by the rating agencies.

When those securities began to get downgraded, it was an eye-opening experience for the investment community. The crisis of confidence that began with subprime soon made its way up the credit curve to Alt-A and then to the prime jumbo mortgages – an area where delinquencies were not yet an issue.

At the same time, write-downs at Wall Street broker/dealers and money center banks put pressure on capital levels, causing them to de-lever their balance sheets and cut back on their ability not only to make loans, but also to buy loans on the secondary market. The result: a substantial decline in the demand for non-agency mortgages, along with erosion of confidence in the related mortgage securities markets.

Investors abruptly stopped buying mortgage-backed securities if the loans behind them could not be sold to Fannie Mae and Freddie Mac. Over the past year, mortgage issuance has gone from a predominantly non-agency market to an almost entirely an agency market. As recently as 2006, non-agency loans constituted 55% of residential MBS issuance. For the first five months of 2008, according to the Securities Industry and Financial Markets Association, non-agency issuance recorded a 4% share, and most analysts see the market share remaining under 10% at least until 2010.

Federal input

In February 2008, as part of Washington's $152 billion fiscal stimulus plan, the government raised the conforming loan limit to $729,750. With passage of the stimulus package, the government-sponsored enterprises (GSEs) may temporarily purchase loans (until Dec. 31) beyond the prevailing conventional loan limit in designated high-cost areas.

The companies may purchase loans up to 125% of the area's median home price in high-cost areas, not to exceed $729,750, except in areas such as Alaska and Hawaii, where higher limits may apply. Most markets eligible for the highest loan amounts are located in California, including San Diego, San Francisco and Los Angeles. The maximum loan amount for the New York metropolitan area, for example, is $688,625, and in Miami, the GSEs can purchase loans up to $433,500.

Jumbo loans were part of the Housing and Economic Recovery Act of 2008, which President Bush signed into law last July, permanently increasing to $625,000 the size of home loans that the GSEs can buy and the Federal Housing Administration can insure. The GSEs also could buy and back mortgages 15% higher than the median home price in certain areas.

Congress raised the conforming loan amount in order to inject some temporary and desperately needed confidence into the mortgage market. With the GSEs in the picture, lenders would be able to sell some of the larger mortgages on the secondary market to help generate some liquidity.Â

On Sept. 7, 2008, the Bush administration seized control of the GSEs, placing them under conservatorship of the Federal Housing Finance Agency (FHFA). In a press release, James B. Lockhart, FHFA director, said that although the GSEs had worked hard over the past few years to correct risk management deficiencies, market conditions simply overwhelmed that progress.

‘The result has been that they have been unable to provide needed stability to the market,’ said Lockhart. ‘They also find themselves unable to meet their affordable housing mission. Rather than letting these conditions fester and worsen and put our markets in jeopardy, FHFA, after painstaking review, has decided to take action now.’

Many on Wall Street argued that a takeover was unnecessary, as the GSEs could take other measures to bring capital in line. Bradley Ball, analyst with Citigroup Global Markets, argued that the GSEs, by shrinking their balance sheet through normal runoff, would reduce capital requirements by $1 billion per quarter. Under federal control, most expect the GSEs to sharply grow their portfolios in the near term, which bodes well for the jumbo market.

‘The Fannie and Freddie conservatorships,’ according to James Jones, president of First Wellesley Consulting Group of Wellesley, Mass., ‘favor small and mid-sized banks that make local market portfolio jumbo loans. Banks can apply sound, commonsense underwriting and incremental, risk-based pricing to originate jumbo loans in their markets. I do not believe that the GSEs will be able to match the banks in jumbo-loan pricing and underwriting guidelines given their current challenges. These conditions may provide well-capitalized banks with an opportunity.’

The National Association of Realtors predicted in 2007 that the GSEs would buy over $150 billion of jumbo loans in 2008, while Wall Street analysts peg the number at half that amount. Freddie Mac said it would purchase $10 billion to $15 billion in jumbo loans in 2008, while Fannie Mae hasn't made any public comments about its intentions. Through June, some press reports indicated the GSEs had purchased about $250 million worth of jumbo loans.

Early on, the plan didn't yield the anticipated results, as lenders and investors remained cautious, unsure if the lack of a market precedent for purchasing these loans in the secondary market would leave them holding the bag. The interest rate declines that were hoped for never occurred, and the spread between the old conforming loans and the new conforming loans remained high, reaching as high as 1.36%, according HSH Associates. Prior to mid-2007, the spread was as little as 0.25%.

Daniel M. Shlufman, president of FCMC Mortgage Corp. in Clifton, N.J, says the program got off to a slow start, as the GSEs didn't have a handle on how to price risk properly. Other lenders complained that they took no applications for the new conforming-jumbo loans at first.

In May 2008, Rep. Barney Frank, D-Mass., the chairman of the House Financial Services Committee, voiced his concern over why conforming-jumbo rates were not coming down. Shortly thereafter, Fannie Mae indicated it would purchase the new conforming loans at a more reasonable spread, so lenders could price these loans at lower rates. Fannie Mae also announced plans to enhance its programs for conforming-jumbo loans.

In a press release dated May 16, 2008, Fannie Mae announced additional eligibility and product expansion for conforming-jumbo mortgages, including the following transactions and products:

For all occupancy types

  • fixed-rate, interest-only mortgages with a 10-year interest-only period, 30-year term;
  • 7/1 and 10/1 fully amortizing adjustable-rate mortgages (ARMs), LIBOR index, 5/2/5 caps, 30-year term; and
  • 7/1 and 10/1 interest-only ARMs with a 10-year interest-only period, LIBOR index, and 5/2/5 caps, 30-year term.

For principal residence transactions only

  • cash-out refinances with loan-to-value (LTV), combined LTV (CLTV) and home equity CLTV (HCLTV) ratios up to 75% (maximum $100,000 cash-back to the borrower),n increased ARM LTV, CLTV and HCLTV ratios for purchase money transactions up to 90%, and
  • increased LTV ratios for limited cash-out refinances to 90% (and reduced CLTV and HCLTV from 95% to 90%).

According to Shlufman, the political pressure worked, as pricing fell in line with levels legislators originally envisioned. ‘Mortgage rates for conforming-jumbo loans have fallen over the past few months and are much closer to market,’ he says. ‘The difference between a traditional conforming loan and a conforming-jumbo loan is now down to about 0.25%.’

Jose Lemus, president of Brymus Capital, a mortgage broker in Santa Ana, Calif., agrees pricing has improved, and that has allowed him to close more loans. ‘We had a few borrowers who weren't able to qualify, given the rates that prevailed in April,’ says Lemus. ‘When conforming-jumbo rates began to fall, it really helped a lot of people. I have another stack of borrowers who need rates closer to 5.5 percent.’

For loans above the conforming-jumbo limit, the secondary market remains mostly shut down. According to Jones, , this segment is still in trouble because funding has gone away. Wall Street, he says, is not an option anymore, as loans simply cannot be placed into securitizations.

The market for new securitizations is hampered by falling prices for non-agency prime MBS, as investors continue to flee. According to analyst John Sim with JP Morgan Securities Inc., prime MBS widened significantly through the end of July 2008, as liquidity disappeared with not enough buy-and-hold investors to absorb the inventory overhang.

Sim adds that loss expectations across all non-agency sectors have grown, and loss coverage ratios have shrunk. While it's unclear how much protection investors want, Sim says current loss coverage ratios up to three times are not being met with demand, pushing prices to roughly 12 points back from conforming securities.

‘Loss expectations continue to rise,’ Sim explains, ‘especially for the 2006 and 2007 vintages. Given the uncertainty around downgrade risk, this removes a fair amount of bank portfolio and insurance company buyers.’ While dealers are searching for clearing levels on bonds, he says there is effectively no ‘backstop bid’ for the non-agency market. Though the vast majority of the sector is ‘money-good,’ he says investors need to feel comfortable with buying bonds that will not be marked down five points by their pricing service at the end of the month.

Previously, the conduits relied on Wall Street to re-package jumbo loans into securities, says Jones. These are the same players, he notes, who purchased loans from local lenders. Now, some regional banks have stepped in to purchase loans on a limited basis, say observers, but with very strict qualification requirements. While the mortgage rates are competitive, according to Lemus, only the ‘golden’ borrowers can meet the qualification requirements.
Some portfolio lenders are taking advantage of the market dislocations to increase market share.

According to Robin Simmons, assistant vice president of real estate lending with Phoenix-based Desert Schools Federal Credit Union, ‘We developed a portfolio jumbo product that has performed well. The median price in the Phoenix market is well under the conforming limit, and when we'd get applications for borrowers over the conforming limit, they were typically high net worth individuals with strong credit.’

‘We recognized through our correspondent relationships that the pricing we were able to offer these borrowers was much worse than for higher-risk, first-time buyers with below-average credit and little money to put down,’ adds Simmons. ‘It just didn't add up and, therefore, we developed underwriting criteria we were comfortable with from a risk standpoint, and priced more appropriately. For this program, we're a little more focused on assets and reserves, with a minimum FICO.’

Simmons also notes her credit union's underwriting criteria evolved as the market has changed. ‘For example, when we first introduced our program we had two mortgage insurance (MI) companies that were willing to insure them – even up to 95 percent,’ she says. ‘When MI guidelines were tightened up, we could no longer get MI, so we reduced our maximum LTV to 80 percent. We initially offered a stated-income option, with conservative LTVs and more restrictive underwriting; however, we've recently suspended that program. This decision wasn't due to performance, because of the uncertainty in the market and declining property values.’

Jones says a number of these community-based depository institutions seized an opportunity during mid-2007, when credit market disruptions first surfaced. Now, however, many institutions have reached internal policy limits and don't have the capacity to take more jumbos into portfolio, and this has taken additional funding away from this sector.

‘When you think of the traditional jumbo,’ says Jones, ‘it's usually the $1 million to $3 million loan. Many of those borrowers are obtaining financing through private banking relationships or can afford to pay cash. The people who are getting hurt the most right now are at the lower end of the jumbo range, where the loan amounts do not qualify for sale to the GSEs.’

While the GSEs are certainly assisting the jumbo market, Jones believes it's a mistake to believe their entry to the market is a solution. ‘Lenders will tell you they can only talk to one in five borrowers,’ he says, ‘where, traditionally, they may have been able to work with anyone walking in the door. Many in this middle group of borrowers, who lack access to financing, are postponing home purchases as a result.’

Robert Segal is a freelance writer based in Boston.


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