Why is this “Credit Crisis” Affecting Mortgage Rates?

While TV’s talking heads are screaming about a mortgage meltdown, it’s pretty clear on closer examination that most of the problems — so far — are confined to a fairly narrow segment of the market. However, there has been a real affect on Jumbo mortgage rates. In order to understand the impact, it’s useful to understand where the money comes from that institutions lend to borrowers.

Most mortgage money comes from three places: government agencies, Wall Street investors and depositors in so-called portfolio lenders.

The first and largest pool comes from the quasi-governmental agencies known as Fannie Mae and Freddie Mac. Fannie and Freddie, along with the FHA buy or guarantee close to half the mortgages originated in the United States each year. But those agencies only buy loans that are no larger than $417,000 and conform to a strict set of underwriting guidelines governing the collateral and the borrower’s ability to repay. Consequently, these loans are called Conforming loans.

  The second big source of mortgage money comes from Wall Street, and indirectly, from individual investors like you and me, when we invest money in mutual funds, money market accounts, insurance policies or hedge funds. Those investors have a larger appetite for risk (and return) than Fannie or Freddie, and are willing to invest in securities backed by riskier mortgages. That might be a loan larger than $417,000, called a Jumbo mortgage; one made to a borrower with spotty credit, called a Sub Prime mortgage, or a loan to a credit worthy borrower that doesn’t meet traditional underwriting guidelines, called Alt/A loan.

 The third source big source of mortgage money is so-called Portfolio lenders. Portfolio lenders originate mortgages one at a time, and underwrite them for the long haul, because they intend to retain them in their own portfolio until they’re paid off.

So, back to the crunch.  What’s happening today has little to do with the Conforming market. Fannie Mae and Freddie Mac are well capitalized and have very little exposure to the type of products that is giving Wall Street heartburn. The loans they sell to investors in the form of mortgage backed securities are guaranteed or insured against foreclosure and have been underwritten to stricter standards.

Likewise, smaller, traditional portfolio lenders are in good shape. While they too make a lot of Jumbo loans, they do it one loan at a time, and generally have a very good understanding of what they own.

That leaves Wall Street, and indirectly individual investors, holding a large bag of   Jumbo, Alt/A and Subprime loans. In a functioning market, those loans are packaged, or pooled, by big Wall Street firms and resold to investors in the form of mortgage-backed bonds and other securities. In the past those pools were made up of like kind loans. In other words, the borrowers of these individual loans within the pools were all of approximately the same credit profile… say 30 year fixed rate loans with credit scores above 680. Over the past few years though, that practice has changed.

The big Wall Street firms that “pool” or package these loans began to add Subprime/Alt/A loans to the mix in order to enhance the interest rate the ultimate buyer would receive. And although in general, most pools have a very small part of the total loans as Subprime/Alt/A, foreclosures on those loans within the pool have a huge effect on the final yield the ultimate buyer will get. So what has happened?

Basically, insurance companies, banks, and hedge funds have decided to not buy these loan pools until they better assess the risk associated with the loans within the pools they already own. The end result is that the big lenders supplying these individual loans have raised rates substantially in order to curb loan production. They have also toughened up on their underwriting standards in order to bring up the credit quality of their loans. Many of these large lenders currently have massive pipelines of loans that were originally slated for pooling that they can no longer readily move off their books. To use a familiar analogy, think of this situation as a clogged drain (or maybe another familiar home fixture would better fit).

The good news is… the plumber is already here.  Markets do work, and Wall Street is well on the way to re-assessing the risk associated with these loans. I am sure companies will be designing mortgage pools with only Prime A loans as well as other types of pools related to Prime A ARM  and Subprime loans.  There will be less mixing of products w/in the pools and the Subprime loans will carry higher rate loans underwritten to tougher standards, lower LTVs, etc...

The bad news is… this will take time. How much time remains to be seen. The press has certainly played a huge roll in vamping up the problems associated with these Sub-prime loans. Rightfully, lending practices need to be monitored and revised. Consumers need to be protected. And illegal or predatory lending needs to be discovered and stopped. Certainly there are many Americans with potential problems looming in their future, but I think it is pre-mature to say that the Sub-prime market woes will affect all mortgage borrowers. To be sure, markets are driven by “expectations” despite the actual size of the underling problems which move them. Panic is never a good thing, but it is also something that doesn’t last. Why? Because, it is rarely warranted.  

The question is “What does this mean for me and my mortgage?”  Here are two examples of situations that might require a little “action” on your part. If you have an adjustable rate mortgage that is still in its “fixed” rate period, you need to know when it is going to adjust; what would the potential rate change be and how that will effect your monthly payment. If you are thinking of buying a property that will require you to get a Jumbo loan you need to look closely at the options available in the market place today.  In either case we would suggest that you contact your trusted mortgage professional. Rates are still very competitive and there are still many flexible programs available to suit a variety of needs. Don’t wait until the last minute… it is much better to be proactive in this market place and arm yourself with all pertinent information relative to your situation.