Living Through Mortgage Mayhem
Kevin J. Daum

This article was originally published in a 2007 edition of Log Homes Illustrated magazine.

Everywhere you look today someone is talking about the subprime crisis.  The stock market has been bouncing, the media has been jabbering and the politicians have been posturing all due to the instability of credit as it relates to home ownership.

If you are looking to buy, sell or build a Log Home you will be impacted by the changes with the lenders.  The changes have been fast and furious and will likely continue for several months to come.   It’s probable that the media in its focus on exciting the public first and informing them after will continue to fan the flames of panic causing legislators and industry executives to further instigate rumor and cast blame on everyone except themselves.  Here is a calm explanation of the current mortgage market and tips for borrowing in this dynamic environment.

Here is what actually happened in the beginning

Originally local banks and Savings and Loans made all home loans.  Local community bankers would evaluate your credit and assets and base their subjective decision on your character deciding whether or not you would pay back the loan.  In the 1940s and 50s the US government focused on the goal of making home ownership affordable to a larger number of Americans.  They accomplished this by creating two Government Sponsored Agencies (GSE) called the Federal National Mortgage (FNMA) called Fannie Mae and The Federal Home Loan Mortgage Corporation (FHLMC) commonly referred to as Freddie Mac. 

These GSEs are publicly held and traded institutions chartered with the task of buying loans from banks in order to replenish available funds for home loans into the marketplace.  They buy loans that meet a set underwriting standard and pool the loans in order to sell securities to Wall Street investors based upon the loans.  These are called Mortgage Backed Securities.  The GSEs brought standardization to the decision making process for all loans by establishing specific lending criteria.  The banks made loans to conform to this criteria so they could be assured of selling their loans to Fannie Mae and Freddie Mac taking a small piece of the interest along the way for profit.  All loans that were made to GSE spec were either Conforming or Nonconforming if they didn’t meet GSE criteria.

Nonconforming loans include loan amounts bigger than the GSE limit which today is $417,000 for a single family residence in all states other than Alaska and Hawaii.  These bigger loans are often referred to as Jumbo Loans.   They also include loans where the income and asset documentation is less restrictive as well as loans with lower credit scores then Fannie and Freddie will allow.  Nonconforming loans were originally made mostly by banks and S & Ls who could hold on to these loans in their portfolios charging a higher rate to account for the increase in risk.

Within the last few decades Wall Street desiring high yielding lower risk returns poured money into Mortgage Backed Securities backed by nonconforming loans.  Entrepreneurs created Mortgage Banking Companies for the sole purpose of making loans and selling them either to the GSEs or to institutional investors on the Secondary Market. The mortgage bankers are not banks.  They fund their loans on giant Warehouse Lines of Credit from banks and Wall Street Institutions.

The low interest rate environment of the last decade coupled with advances in industry technology greatly increased the volume of nonconforming loans bought and sold on the secondary market. Credit scoring and computer modeling provided greater insight into consumer payment patterns and the rise in real estate values helped to create a greater confidence in the risk for mortgage related investment.

Wall Street Investors provided extremely low interest rates to mortgage bankers for higher risk borrowers with low credit scores and poor payment histories known as Subprime.  They also did the same for borrowers with better scores that needed to finance with little equity and/or little verification.  These were known as Alt-A.  Often the investors factored in a low short-term rate to qualify with a higher rate 2 years down the line in order to make the risk/yield factors work on paper.  The secondary market and origination volume swelled to epic proportions.

Many subprime loans were unhealthy for the borrowers and investors but a decade of euphoria while traveling in uncharted territory can create overconfidence allowing greed and desire to overtake solid asset management.  With Wall Street providing the funds, banks and bankers were obligated to fund loans meeting the desired criteria.  Loan Officers trusted Wall Street analysts risk assessment and provided products their customers wanted.   Unscrupulous Loan Officers working for banks, mortgage bankers and brokers took advantage of the situation but mostly the industry simply followed the laws of supply and demand while the government stood by and watched.

Paying the piper in 2007

As in the past, the real estate market slowed down and interest rates rose moderately.  The change in market dynamics made it harder for subprime borrowers to refinance and many began to default.  Many had no equity and no choice.  Subprime loans became difficult to sell on Wall Street and subprime lenders began to shut their doors.

Meanwhile changes in the Alt-A rates from their start rates coupled with devaluations in certain economically challenged parts of the country reflected in delinquencies or late payments.  Earlier this year the fear set into Wall Street when Bear Stearns closed two funds heavily invested in subprime.  Credit tightened causing more mortgage bankers to fold and investors fearing their Subprime and Alt-A Mortgage Backed securities might be devalued decided to stop buying any securities not backed by GSEs.

Within a matter of days a widespread panic ensued.  All lenders without the ability to sell to the GSEs or portfolio were in trouble.  The media fueled the fire by speculating on the health of every lending institution on an hourly basis with doomsday scenarios.  The credit tightening spread to commercial markets despite verifiable evidence of a reasonably healthy economy.  The Federal Reserve acting quickly in conjunction with several foreign central banks added money to the banking system and reduced the borrowing rate to banks.  This stabilized the panic although much damage had occurred.  Many lenders closed, jobs were lost and the mortgage lending guidelines became much stricter. 

The Result

Jumbo, non-conforming and stated income loans have not disappeared.  It is true that Wall Street firms are currently no longer able to sell securities backed by mortgages that do not conform to the GSEs.  However, there are many federal and state chartered banks who still have the ability to portfolio these loans and thanks to fast action by the Federal Reserve, these banks are being supplied with capital to continue lending outside of GSE guidelines.  Guidelines with these banks have become stricter regarding credit, Loan To Value (LTV) and cash reserves.

Interest Rates are still changing based upon risk. Much of the money removed from the mortgage backed security world has moved to Treasury Bonds actually driving down real interest rates.  However, because of market uncertainty about nonconforming loans, lenders have raised rates on these loans to mitigate losses from delinquency or sale.  In June you might have expected to pay a premium of .25 to .375 percent over conforming rates.  Today the market is demanding .75 to 1.25 percent premium for these exceptions.  The general expectation is that this premium may reduce in several months as the market concerns are settled.

Tips for coping

Don’t Panic!  While the media might have you believe this crisis will result in rampant foreclosures and real estate values dropping by 75 percent or more, the economic fundamentals are currently strong and significant devaluation has been limited to areas that have suffered from economic downturn.  Sub-prime represents a small portion of the mortgage market place.  Government statistics place sub-prime mortgages at less than 10 percent of the national market and mostly in the lowest valued areas.  Even with the delinquency rate higher than previous years it is unlikely that we are about to see mass foreclosures resulting in dramatically falling home prices nationwide anytime soon.  The Federal Reserve is carefully monitoring the situation and so far has acted swiftly and appropriately to stabilize the market.  If you are in a good loan and can make your payment, keep doing it and do it on time.  Real estate markets have always performed well over time.

Don’t  believe everything you read and hear! With a presidential election not far away, there is a lot of political posturing in the search for a scapegoat.  With Mortgage Brokers limited compared to other industry lobbying efforts they are quickly becoming the unfair target of finger pointing.  While certainly there are loan originators who’s ethics have been less than honorable, it is important to know that ethical issues and bad underwriting decisions do not belong to any one type of institution.  Some Loan Officers took advantage of consumers.  Banks and Wall Street under government oversight created, offered and approved lending products both retail and through brokers that in many cases were unwise for consumers and investors.  Investigate carefully the information you are being provided and get different viewpoints before making assumptions.

Be patient and realistic as a seller!    Buyers will need to be more qualified these days, which means there will be fewer of them.  Make sure your house shows well and that you are selling because you need to do so.  Decide on the minimum price you need to be happy or satisfy your financial needs.  This is no time to be greedy.  If your area is suffering economically do your best to rent the home and cover the payment until the market picks up.  Discussing options with a qualified real estate agent such as lease/options or carrying paper may help in your ability to sell the home sooner.

Be financially prepared to Buy and Build!  Luckily, the GSEs are Log Home supporters and are more than willing provide purchase loans on them.  Additionally banks large and small have been the traditional providers for construction loans and so far have kept those programs available.  However qualifying for a loan will be more difficult these days than simply showing up.   Lenders want to see credit scores above 660 so it’s more important then ever to make those payments on time and keep your credit card balances low.  Larger down payments and money in the bank are also big factors so hoard that cash and save, save, save! 

If you are getting ready to build a log home do not pay down your lot or spend unnecessary cash before consulting with an experienced loan officer or you may find your project coming to a grinding halt.  Keep the scope of your log home realistically in line with other homes in the area since lenders will be heavily scrutinizing appraised values.  Expect that lending rates will be higher for a time and it will be difficult to compare loan programs without help. 

Financing a Log Home in the next year requires finding an experienced, trustworthy expert that can guide you through the process.  Dynamic changes are likely still to come.  Lenders will still close and programs will change often in a moments notice.  The institutions size doesn’t matter since we saw the demise of America’s 10th largest lender this year.  An honest, knowledgeable mortgage broker may be your best bet in this environment since they lack the capital issues of the banks and mortgage bankers and have the ability to move your loan package at a moments notice without missing a step or losing time.

Ultimately, patience will help you prevail through any financing hardship.  Time will erase credit issues, help you save and  allow the market to regain it’s footing.

About the Author...
Kevin Daum is the Founder and CEO of Stratford Financial Services, a Real Estate finance and education company, founded in 1989. Stratford specializes in Purchase loans, Refinance loans and Custom Home Construction finance and has successfully financed thousands of clients. He is the author of "Building Your Own Home for Dummies" (Wiley), as well as "What the Banks Won’t Tell You." Mr. Daum was an Underwriter for Plaza Savings and Loan and Key Bank of New York. He is an INC 500 CEO and has been listed as one the 40 Most Influential People Under 40 in the San Francisco Bay Area. He is the Global Chair for the Edison Innovation Program with the Young Entrepreneurs' Organization (YEO) and is a founding Board member of the Bay Area Chapter of YEO.

Mr. Daum is a frequent contributor to numerous business publications on the subjects of Real Estate and Small Business leadership and speaks regularly on both subjects. He can be contacted at kevin@stratfordfinancial.com.