The Subprime Spiral

What a difference a year makes. About a year ago, subprime was merely a blip on the radar for most mainstream banks. If they werenu00e2u20acu2122t deeply involved in the subprime market, the risk of loss or regulatory complications for commercial banks seemed fairly dim. Fast-forward to today, and you canu00e2u20acu2122t open a newspaper without reading about pervasive jitters spawned by the potential collapse of the credit markets. To give this some perspective, in 2006, there were 247 stories in the news daily American Banker referencing the subprime market; at press time in December, so far 1,237 such stories had appeared in 2007.

As time has passed, the scale of the bad news has increased. Once limited to concerns about payday lenders and small-scale origination shops, recently, even behemoth lenders such as Bank of America and WaMu have made the decision to exit the wholesale mortgage market. In late 2007, Citigroup announced write-downs on tens of billions of dollars of collateralized debt obligations, owning up that the company has suffered u00e2u20acu0153reputational damageu00e2u20ac from the fallout in the credit markets.

Moreover, as the spiral continued, the Federal Reserve voiced grave concerns over this pervasive threat. In a December speech, Federal Reserve Board Chairman Ben Bernanke said, u00e2u20acu0153The fresh wave of investor concern has contributed in recent weeks to a decline in equity values, a widening of risk spreads for many credit products (not only those related to housing), and increased short-term funding pressures. These developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing and in other credit-sensitive sectors.u00e2u20ac

In the past year, Congress robustly voiced concern over what it perceived to be the tip of another S&L-like crisis. House Financial Services Committee Chairman Barney Frank led the fray, and in November, the sweeping bipartisan Mortgage Reform and Anti-Predatory Lending Act of 2007 passed both houses to become law.

Stated Frank at the time of the billu00e2u20acu2122s passage: u00e2u20acu0153We are dealing with legislation that seeks to prevent a repetition of events that caused one of the most serious financial crises in recent times.There is no debate about what is the largest single cause of that. Innovations in the mortgage industry in themselves are good and useful, but were conducted in a completely unregulated manner and led to this crisis.u00e2u20ac Added Ranking House Committee Member Spencer Bachus: u00e2u20acu0153This legislation achieves two very important goals: implementing reforms that will help protect consumers from predatory lending practices, and preserving working Americansu00e2u20acu2122 access to consumer credit.u00e2u20ac In short, this bill served as the keystone for success in preserving safety and soundness in banking, as far as Washington, D.C. was concerned.

Where do we go from here?

Despite all the drama, todayu00e2u20acu2122s radically changed mortgage environment still provides banks with a strong opportunity to develop mortgage origination as a customer-building activity. With significant changes in the regulations governing disclosure and lender liability on the horizon, U.S. commercial banks have the potential to gain market share at the expense of ever-diminishing mortgage broker competition. Brokers that are able to survive the credit crunch will see a radically tougher regulatory environment and perhaps the end of yield spread premiums.

Last year, for example, Countrywide Financial, the countryu00e2u20acu2122s largest mortgage banker, moved 90% of its mortgage pipeline to its commercial banking arm after seeing credit lines dry up overnight. Countrywide Bank will now fund mortgage production from bank deposits and loans from the FHLB, ensuring its own source of liquidity. At the same time, it will find its mortgage business more tightly regulated, which will likely help level the mortgage origination playing field for banks. For commercial banks, this also means that the formidable Countrywide will now compete for bank deposits on a large scale in addition to mortgages, home equity loans, and insurance.

Trust and reputation will become premium values. Consumers, faced with fewer loan sources due to many large mortgage bankers exiting the market, will likely be more diligent about looking for institutions they can trust. u00e2u20acu0153Mortgages now will not be as much of a commodity, as people will look to banks for credibility,u00e2u20ac predicts Jay Brew, CEO of BNK Advisory Group, Bethlehem, Pennsylvania. Jaime Peters, a bank stock analyst at Morningstar, agrees, saying, u00e2u20acu0153Banks should be able to get 50% to 60% market share, but there will be a smaller market.u00e2u20ac

For banks with smaller mortgage portfolios and whose management is more risk-averse, the conventional mortgage market holds plenty of promise. For example, says Brew, the jumbo mortgage market is presently underserved since traditional investors have withdrawn funds. u00e2u20acu0153This is an excellent market, with strong borrowers and good properties. Banks can demand strong premiums over conventional rates.u00e2u20ac Yet, Brew cautions that while pricing is attractive, underwriting standards remain the key. u00e2u20acu0153Banks need to go back to 20% down and requiring proof of income.u00e2u20ac

Peters agrees that jumbo loans could be a good niche for banks. u00e2u20acu0153Banks that make jumbo prime mortgages and keep them on the books can charge a good premium. Over the long run, it is an excellent business to be in.u00e2u20ac Peters also notes that the entire mortgage market is shrinking. u00e2u20acu0153You wonu00e2u20acu2122t see a 70% home ownership rate in the future.u00e2u20ac

Bank boards today, therefore, should be giving consideration to how to capitalize on the supply gaps in this new marketplaceu00e2u20ac”especially where savvy yet conservative loan and credit operations can offer the security consumers yearn for. Last year, in the midst of much shakeout in the market, JPMorgan Chase increased its mortgage staff to over 5,000 loan officers to concentrate on two niches where loan funds were least available: jumbo loans and subprime mortgages. It boosted production by more than 40% in the second quarter and 35% in the third quarter of 2007, while most others were running for cover. The bank attributed the increase in mortgage origination volume in part to its ability to rely on in-house cash to fund loans. Likewise, U.S. Bancorp also reported an upswing in its 2007 mortgage loan production, which helped increase net-interest income by 19% year-over-year.

Subprime risk can be managed

Despite the current fear and loathing associated with the sector, subprime loans can still be an attractive area for banks to consideru00e2u20ac”albeit with the proper underwriting and pricing. u00e2u20acu0153There will always be a place for subprime lending as long as pricing advantages are available,u00e2u20ac affirms Peters.

u00e2u20acu0153Banks have important roles to play in extending credit to all parts of the market,u00e2u20ac says University of Connecticut law professor Patricia McCoy, coauthor of numerous articles about subprime loans and the need for reform. u00e2u20acu0153At the same time, there is the need for bank lenders to assure that customers eligible for cheaper loans are not steered to more expensive loans.u00e2u20ac

She sees the need for bank lenders to redesign loan features that put borrowers at risk. For example, she says, during the last several years, mortgage brokers were offering loans that were underwritten at the initial rate, which is the biggest problem with delinquencies today. u00e2u20acu0153Bank regulations now require that loans be underwritten at the fully indexed rate,u00e2u20ac McCoy says.

But this, too, offers a window of opportunity for well-run banks. u00e2u20acu0153Large numbers of homeowners facing rate resets can be refinanced through the banks,u00e2u20ac continues McCoy. u00e2u20acu0153Banks have the credibility and the knowledge to help many of these borrowers fit into more conventional financing. It is good business for banks and they will also be doing [society] good.u00e2u20ac

While interest rate risk is always a consideration in portfolio lending, BNK Advisoryu00e2u20acu2122s Brew maintains that 15-year mortgages are a good choice because they closely track changes in a banku00e2u20acu2122s cost of funds. Thus, as rates change, the bank is able to invest the cash flow from these shorter-term loans and effectively manage the interest rate risk.

Once the loans are originated and on the books, there are several dependable sources where banks can sell what they might consider subprime or near-prime loans. Fannie Mae, Freddie Mac, and the Federal Home Loan banks offer special programs for first-time homebuyers with no down payment funds and for other customers who might have credit challenges. As long as they are properly documented, loans sold to these agencies through their automated underwriting systems do not have a buyback clause.

The Federal Home Loan Bank Community Investment Program (CIP), for example, directed at those whose income is less than 115% of the area median, has made over $47 billion in mortgage loans during the past 16 years. Its First-Time Homebuyer Program (FHP) can target much of the new borrower demographic and even offers matching down payment funds up to $10,000.

And traditional government loans such as FHA and VA are still available to serve those who donu00e2u20acu2122t qualify for traditional mortgages. These loans were supplanted over the past few years by subprime lenders but are likely to make a comeback.

A brave new market

With the emphasis among U.S. housing and mortgage groups in the last decade on the benefits and need for widespread homeownership, much of banksu00e2u20acu2122 recent market share has come from targeting first-time homebuyers, which has resulted in banks originating the lionu00e2u20acu2122s share of high-cost loans. (Federal regulators define high-cost loans as those with interest rates three percentage points higher than a benchmark rate for first mortgages, and five percentage points higher for second mortgages.) The Federal Reserve reports insured depository institutions originated 25% of that market, and their subsidiaries, another 25%.

Recognition of the special needs of new immigrants has also gained national attention. A recent Federal Reserve Bank study regarding credit scoring indicates that immigrant first-time homebuyers tend to be older and do not present the same credit risk as younger American first-time homebuyers. As a result, credit reporting agencies are working to redesign their scoring models to reflect these subtle differences. This market, according to many observers, is ripe for new entrants, but a few caveats apply. u00e2u20acu0153Banks would do well to go beyond the traditional credit score when evaluating certain borrowers,u00e2u20ac says McCoy.

These changes in the demographics of home-buying households also mean a change in the demographics of bank customers, and banks will have to make certain adjustments in order to continue growing. The information also indicates an opportunity to market agency-salable second home mortgages to existing bank customers. Banks can capitalize on this need by providing traditional mortgage loans that will benefit consumers and result in long-term economic stability to the housing market.

A solid business foundation

Banks that want to build lasting mortgage strategies to gain and hold market share will have to establish a solid base. Traditionally, bank strategies for mortgage lending have taken one of several approaches:

u00e2u20acu00a2 A laissez-faire philosophy, with a bank employee taking an occasional mortgage loan application to satisfy a customer.

u00e2u20acu00a2 A policy to originate mortgage loans aggressively within the bank as a way to build long-term customer relationships and as a way to provide special mortgage concessions to important clients.

u00e2u20acu00a2 An aggressive program to generate mortgage business outside the bank using commissioned sales agents in addition to providing loans for bank customers.

To build a successful mortgage lending operation, banks should leverage the work of other departments to maximize their loan operations. This might include establishing policies to assure that commercial real estate lenders are working with retail mortgage lenders to take advantage of synergistic relationships. Consider, for example, a board policy requiring commercial lenders to include a clause in loan offerings that requires first right of refusal for residential mortgage end loans within the project. Not only does this help overall bank profitability, but it also assures commercial lenders that they have a reliable takeout at the end of the project.

An important by-product of mortgage lending is loan servicing. Some banks might consider it the main reason for making mortgages. While not the sexiest business in the world, mortgage loan servicing can provide strong cash flow in times of slack mortgage production. This is a very profitable business, and one that does not go unnoticed by stock analysts, says Peters. u00e2u20acu0153I would value banks that have servicing portfolios higher than those without portfolios because of the strong and dependable cash flow. Even in times of high delinquency activity, the additional costs are more than offset by related fee income, u00e2u20ac he says.

As with other operational areas, the board must ensure that proper controls are in place to guard against credit erosion and eventual losses. Management should be accountable to directors as to whether the bank has a system that measures each loan with document checklists and that adhere to acceptable underwriting standards.

And accountability goes all the way down the line. Loan officers should be held accountable for loan quality in terms of documentation, timeliness of disclosures, and delivering the right product for the customer. Each loan should be rated and used as part of a coaching and performance review program for loan officers and their managers. The cost of this attention to detail will be repaid in the form of fewer delinquencies and loan buybacks from investors.

Beyond ensuring that the bank is engaging in good business practices, underwriting and quality control can be an issue of director liability, says McCoy, the law professor. u00e2u20acu0153I am starting to get worried that there will be an uptick in lawsuits regarding lax underwriting standards, as there was during the savings and loan crisis.u00e2u20ac

Whatu00e2u20acu2122s ahead

As liquidity returns to the credit markets, so will mortgage brokers. Although many of the major banks have recently announced their exit from the wholesale lending business, including Bank of America, Wells Fargo, and Washington Mutual, Dr. Gregory Elliehausen of George Washington University Real Estate Research Center does not think banks in general will remain on the sidelines as the market recovers. u00e2u20acu0153Mortgage brokers provide a useful service to borrowers and lenders,u00e2u20ac he says. u00e2u20acu0153Brokers can rapidly expand to meet market conditions, and it is often easier for banks to expand mortgage production by working with brokers.u00e2u20ac

Banks will have an important role to play in bringing back a healthy housing market. There will be significant regulatory and secondary marketing changes. New lending practices for new classes of borrowers will be the order of the day.

More traditional markets will also return. u00e2u20acu0153There have been periods of housing decline throughout history. This one will also run its course,u00e2u20ac says Elliehausen. He does warn, however, that there should not be an u00e2u20acu0153unrealistic expectation for housing prices to resume a rapid increase as the market returns. Banks should retain perspective; the temptation has always been to continue lending as if conditions were never going to change.u00e2u20ac

Those who approach the market in an aggressive but sound manner will be able to gain new bank customers as well as some rich rewards. Refinancing borrowers at risk, sound portfolio lending for jumbo loans, and meeting the needs of a different set of borrowers will provide both opportunities and challenges for banks and their boards in the year ahead.

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