May 19, 2024

Archives for October 2008

Some Borrowers Will Need Very Large Loan Modifications

As discussed in a previous post, Bank of America agreed with the state attorneys general to offer  concessions to 390,000 sub prime and pay option arm borrowers by reducing both the principal owed and/or the interest rate to a level that allows these borrowers to have a an “affordable and sustainable” monthly mortgage payment.   An affordable and sustainable payment was determined to be a mortgage payment (including taxes and insurance) that would not exceed 34% of gross monthly income.   With this agreement apparently setting a standard for future concessions to homeowners, consider some recent mortgage transactions/applications that I have seen.

  • Woman wants to refinance her Connecticut home which she bought in early 2006.  The home today would probably sell for no more than $260,000.  Home was purchased for $305,000 with 95% financing; the current interest rate is at 11.625% and she owes $285,000.  The negative equity is only $25,000.  Borrower has a gross monthly income of $3780 per month and her current monthly payment of principal, interest, taxes and insurance is $3682 giving her a debt ratio of 97%.   She is currently in arrears on the mortgage and obviously not capable of making the payment.   In order for her payment to become “affordable and sustainable”  with a 34% debt to income ratio, the lender would have to reduce her loan balance to $158,000 with an interest rate of 1%.

If the home owner gets this deal, not only would her payment become affordable, she could also sell the house and reap a gain of $102,000.  The applicant’s income is about the same today as it was when she purchased the home, so there was no drastic decline in income.  Obviously, this woman should have never been approved for a mortgage in the first place; both the bank and borrower knew this.

  • A self employed carpenter applied for a mortgage to purchase a home for $185,000.  Applicant has no credit score since he pays for everything “in cash”.  The yearly income reported on his tax return for the past two years averaged $5500.  When I told the applicant that he did not qualify he became indignant and arrogantly proclaimed that his bank told him they would approve him; I wished him good luck.  This guy hasn’t been reading the papers lately but the days of borrowing based on what you say your income is are over.   The applicant understood his situation; his income averages $458 gross per month according to his tax return and the monthly mortgage payment with taxes and insurance would have been at least $1650 per month which he insisted he could afford.  I would say that the IRS should conduct more audits of self employed individuals.
  • Borrower with very good credit and working two jobs has a sub prime mortgage and applies for a lower rate under the FHA mortgage program.   Borrower gets approved with with a debt to income ratio of 56%.  At this point, instead of bringing his lunch to work everyday, he might be better off to stop paying on his mortgage and  ask his bank for a loan modification once he is delinquent.  The interest rate would need to be reduced  from 6.25% to 1% which would put him at the recommended 34% DTI.  Although most loan modifications are currently being offered only to sub prime and pay option arm customers, I am certain that in the name of equitable treatment, the offer will expand to include the multitudes of other borrowers with a debt ratio over 34% .  Why discriminate against better credit borrowers?
  • Borrower with fair credit purchases a home with 100% FHA financing with the help of a down payment assistance program.   Borrowers debt ratio at time of approval was 48%, which is extremely high and not affordable or sustainable for very long.  Why is the FHA approving loans at this ridiculous debt ratio when the state attorneys general are forcing Countrywide to modify loans to a debt ratio of 34%?  I suggest that a state attorney general be named Head Underwriter for the FHA.

I could go on and on, but one thing is for certain; there are millions of home owners currently in a stressed income situation with negative home equity who would like to refinance but can’t due to low credit scores/lack of home equity or both.   As word spreads of the great deal that Countrywide borrowers got from the recent Bank Of America settlement, there will be many indignant and angry home owners demanding the same treatment.   Can the banking system, already insolvent, handle huge new write downs?

World Economies Burn, Politicians Debate

As the world economies implode the presidential candidates debate who is the angrier man; doesn’t seem to be inspiring very much confidence in the marketplace.

Smaller countries world wide are collapsing – Bulgaria, Estonia, Romania, Turkey – we will find out how interlinked the world really is.  Iceland couldn’t have set itself up better for bankruptcy than if they had deliberately planned it.

The GAP sales plunge 25% – expect to see massive layoffs as companies dramatically cut costs starting with labor.  Very few businesses can sustain a 25% sales drop without either closing the doors or slashing costs.

AIG burns through the original $85 billion in Fed funds in a week and comes back for $38 billion more; does anyone believe that they won’t need more?  We may find out what the US Treasury lending limits are before this is over.

Where is the mighty (mythical?) plunge protection team when you really need them?

A 20% plunge in stock values over 7 days is a crash.  These types of declines usually do not stop until one day we are lock limit down and the selling burns itself out.

On the bright side, if you have any spending money left after the Crash of 2008, a vacation to the Caribbean is getting cheaper by the day: A Silver Lining for Vacationers in the Caribbean

World’s worst borrowers given astonishing concessions

Bank of America agreed with the state attorneys general to offer astonishing concessions to 390,000 subprime and pay option arm borrowers that will cost upwards of $9 billion, as reported on by the Wall Street Journal.

Summary terms of the settlement with borrowers for loans made by Countrywide Financial include the following:

Mandatory loan modifications are required due to “unfair and deceptive” practices.

Supposedly this action will keep borrowers in their homes, support local communities and the general economy.  Some background here: loan modifications, still off the mainstream press, have over the past year grown into a sizable cottage industry, manned mostly by ex loan officers and former lenders, who for a fee, will negotiate with the borrowers bank to try and obtain a reduction in either or both the interest rate and the principal balance.

Many lenders are now and have been proactively contacting borrowers and offering them a loan modification where it was obvious that the borrower was in over his head.  The biggest impetus to loan mods was by Indy Mac after being taken over by the FDIC where 38,000 borrowers were sent letters offering to reduce their payments by either rate and/or principal reductions.

Loan mod results to date have been uneven, and each lender has been individually offering concessions where they see it to be in their best interest.  To date, most of the loan mods have been an interest rate reduction since the mortgage investors are hoping that eventually property values recover and their write downs will be limited.  In cases where only an interest rate reduction was offered, initial stats suggest that only 20% of borrowers are still current six months later  thus necessitating either a foreclosure, recovery, or another loan mod.

I recently spoke to a woman in Massachusetts who had a subprime mortgage with Chase at 12%; after months of phone calls and sending paperwork to Chase, she was given a fixed rate of 1% for 5 years, with the rate to rise in steps to 6.25% at the end of 10 years.   The lender did not, however, adjust the loan principal and she has negative equity of around $80,000.  Whether or not this loan mod works out for both parties is subject to debate.

In an excellent post by Mr Mortgage, a very compelling argument is made that negative equity is one of the prime motivators for payment default by the borrower, regardless of the rate.  Apparently the attorney generals read Mr Mortgage, since the loan mod mandate settlement requires that changes be made to the borrowers loan so the that loan payment is “affordable and sustainable”; thereby necessitating in most cases both a rate and principal reduction.

A Credit Suisse study of subprime loan mods, however,  indicated that over 20% of subprime mortgages in which a principal reduction was granted were 60 days delinquent on their mortgages within eight months of the loan mod, so the success rate is not much different were only a rate reduction was granted.  Keep in mind that all the statistics on loan mods are preliminary and based on small sample numbers over short periods of time since there have not been a great number of loan mods done to date.

Borrowers’ monthly PITI (principal, interest, insurance and property taxes) should not exceed a 34% front end debt ratio.

This means the PITI should not exceed 34% of the borrowers’ monthly gross income.  See my post on Mortgages still being approved for unqualified borrowers) and Unsound lending policy.

For borrowers who took out pay option ARMs, Bofa will reduce the loan amount so that borrowers have as much equity, if not more, than when they took out the loan.

Borrowers will not be charged for the loan mod and any prepayment penalties will be waived.

The mandate that no fee be imposed on the borrower for modifying the loan will make it very questionable from an ethics and business standpoint for the nascent loan mod industry to try and attempt to charge a Countrywide mortgagor a fee to modify their loan, since Bofa will be contacting all the Countrywide customers with no cost offers to modify their loans.

In those cases where the loan is serviced by Countrywide but owned by an investor, Bofa will work with the loan servicer to get the necessary approval for a loan mod.

BofA will send offers of a loan mod to qualified borrowers by December 1 and stay any foreclosure action until a borrower’s eligibility has been determined.

Bofa will provide $150 million to refund some closing cost on the original loan if the borrower is in foreclosure and also provide $70 million of “key money”, cash payouts to help with moving costs.

It is only logical to conclude that since one of the largest banks in the country has agreed to this type of settlement that virtually every other lender and loan servicer will also be required to participate, either by invitation or legislative decree.  Indeed, banking regulators are now calling on every subprime loan servicer “in the strongest possible terms” to adopt a similar loan mod program as possible.

In the rush to “do something”  to address the foreclosure problem, it appears that there is a collective rush to judgment that loan mods are the best manner in which to address the problem.   Superficially, it appears to be a compelling solution to the problem; make the payments low enough so that the homeowners can easily make their mortgage payments.  Every easy solution, however, seems to create unanticipated adverse consequences.

Specifically, the following issues may cause adverse consequences that outweigh the presumed advantages:

1. Moral hazard may be a significant factor.  I talk to many people who would like to refinance but cannot due to insufficient or negative equity in their homes.  Most of these people have good credit and sufficient income to pay their mortgage but many of them (especially with negative equity) bring up the question of whether or not they should stop paying their mortgage and mail the keys back to the bank and to what extent this would impact their credit.

As publicity about the loan mods programs grow, the flood gates could open here especially since there are around 12 million households that now owe more than their house is worth according to Moody’s  Modifying a loan may sound like an easy solution, but the reduction of a loan amount equates to a loss for someone else – a bank, pension fund, insurance company etc.   A reduction of only $25,000 on 12 million homes means another bailout of $300 billion – someone gets burned by this loss and our government does not have an unlimited ability to borrow money.

2. The social backlash and resentment from the 40 million households who have a mortgage but still have equity, as well as from the 24 million households that have no mortgage is going to be tremendous; the consequences will not be positive.

3. Every borrower who has a subprime or pay option arm loan was not a victim; I am sure some did not understand the terms of their loans and there were abuses, not to mention that many of these borrowers should never have been granted a mortgage approval in the first place.  However, most people of reasonable intelligence normally ask about the terms and details of their mortgage and are given numerous disclosures during the loan process and at the closing table.

Why should someone else pay for another’s carelessness with their financial affairs and failure to properly evaluate their actions?   There is plenty of blame to go around here, both on the borrowers part and certainly on the part of the lenders who knowingly made loans that they knew could not be repaid.

4. For a nation that has a tremendous debt burden on every level, loan mods could encourage debt repudiation on a massive level which will cause a further destruction of asset values on a scale too large to contain, which is what is already happening.   Every loan represents an asset to someone else; debt destruction and asset price destruction reinforce each other; the evaporation of wealth (assets) on a massive scale will not help anyone.

5. Many of the buyers of properties in the past 4 years purchased with 100% financing.  To the extent that they now have negative equity, what have they really lost?  They received a free call option on future price appreciation of the property that they bought. Now that the property didn’t go up in value, they are entitled to walk away from their loan obligation or simply default and then be given huge concessions?   I have seen many people that purchased a home with 100% financing come back a year or two later and then take out as much cash as possible with a new first or  second mortgage. My math puts these people way ahead of the game.

6. I have also seen many people do 100% cash out refinances in the past four years, often times using the money for trips,  new cars, consumer goods etc.  Many of these refinances occurred at the peak of the market meaning that they effectively sold their properties at peak prices.  For those now walking away or getting their loan balance reduced, it is their gain and the banks’ loss.

7. To modify the loan so that the borrower has a 34% front end debt ratio is extremely generous.  Most of the new first time homebuyers and mortgage refinances that I see approved have debt ratios above 34%, but the borrowers work hard, struggle and pay.  How is this equitable to them??

8. To reduce the principal on a pay option arm borrower back to his original principal or lower is equally inequitable to those borrowers who borrowed in a more conservative manner with a 30 year fixed rate loan.  Many of the pay option arms had initial payment rates based on a rate of  1% or 2% for a period of years; the real rate fully indexed was typically 6 or 7%,  but the borrower was allowed to pay a very low payment based on 1% and the balance of the interest that was due was added to his loan balance.  The pay option arm borrowers reap a windfall here since they effectively were given a 1% rate compared to the conservative borrower who took out a 30 year fixed rate and paid the full payment on a 6% mortgage.  Obviously, the pay option arm customer had a lot more cash left in his pocket at the end of each month; by my math they came out way ahead.

9. Many of the loan mods proposed will probably not work out since a significant number of the subprime and pay option arm loans were done with inflated stated income (liar loans).  Many of these types of loans would have to have a massive reduction in the loan balance for the borrower to have a comfortable payment since his income was never even close to what was needed to service the loan from day one.  The result would be a ridiculous situation whereby we are rewarding those who falsified their income to qualify for a loan.  How inequitable would this be for the financially responsible borrower who bought a home for $250,000 with a $50,000 down payment next door to the guy who also buys a $250,000 home, “states” his income to receive a 100% loan and now receives a loan reduction down to $150,000??

10. The impact of loan mods on future mortgage lending in this country will be incredible negative.  The government can subsidize rates and we can all pay for this, but investors who previously bought the loans or mortgage backed securities (which support the mortgage market) will either have no interest in this type of investment going forward or require a properly risk adjusted rate which is obviously going to be very high.  No one is going to lend out money when they face a substantial risk of large losses by having their original loan amount and interest rate reduced by a loan mod every time there is a price pullback in housing.  Mortgages have become and will remain an asset class of “extremely dubious value” (see 7. above).

11. Not Everyone Should Own a Home, Wall Street Journal, Janet Albrechtsen. In an excellent article that explains why Australian banks are not bankrupt entities as in America, the author points out the weaknesses in our banking system and the lack of responsible behavior by borrowers and lenders which helped propel us into the banking, housing and credit crisis.

Instead of prolonging our property market declines with constant costly bailouts, it may be wiser to follow the RTC example in the 90’s when the market was cleared by selling foreclosed properties for whatever bid was offered.  Anything will sell quickly at the right price.

Buy on the bad news?

It was difficult to tell today if the late Monday afternoon rally that brought the Dow back almost 400 points off the lows of the day was due to program trades or real buyers “buying on the bad news”.  If the buying was from bargain hunters brave enough to commit their capital on bad news, they certainly had a lot of reasons to buy.  In fact, if there are enough investors willing to “buy on the bad news” that read the Wall Street Journal, then we should be looking at a 5,000 point rally.  Some selected Journal excerpts follow.

Stemming the Crimson Tide

The credit freeze turns into a full-blown panic; no one wants to lend to anyone including interbank lending;  over $4 trillion in banks held by uninsured (and nervous) depositors; no easy solution to a massively over leveraged global financial system; Wachovia debacle does not inspire confidence in government’s efforts.

Iceland Risks Bankruptcy, Leader Says

Island nation cut off from global financial system as government prepares to takes over nation’s banks; tiny country’s bank assets are 10 times the economic output of the nation of 300,000; krona off 40% this year against euro and inflation is 14%.

My Comment: Iceland is bankrupt already, they simply haven’t filed the papers yet. Iceland has no capacity to bail out their banks; the real question is who will bail Iceland out?  I guess no one saw any problem with a couple of banks increasing their assets to 10 times the size of Iceland’s entire economy.

Long-Term Bond Markets Dry Up

The highest credit rated companies are shut out of the long-term credit markets; “credit is all but shutdown” said William Bellamy, direct of fixed income; CDS protection on $10 million of investment grade debt now cost $185,000 vs. a $40,000 per the credit crunch

Bofa Cuts Dividend, Posts Lower Profit

Per CEO  Ken Lewis, “It’s a damn disaster…These are the most difficult times for financial institutions that I have experienced in my 39 years in banking.”

My Comment: Dividend cut saves Bofa $5.6 billion per year which is $5.6 billion less to be spent by investors (consumers) and $5.6 billion less to be taxed by the government.

Mall Vacancies Grow as Retailers Pack Up Shop

Mall vacancies see highest rate since 2001; shopping center vacancies highest since 1994; landlords are giving breaks to tenants to try and keep them from leaving.

My Comment:  Landlords have to give big concessions to keep tenants; lower rents result in lower cash flow and more defaults on commercial loans; commercial loans next big nightmare for the banks.  Despite markdowns of up to 60%, consumer keep their wallets shut (Big Discounts Fail to Lure Shoppers) as credit card companies decrease or close down credit lines in a self defeating cycle.  The consumer was tapped out before the credit crisis, living off of credit cards and home equity lines of credit; sounds like another massive government rebate program is on the way.

If further reasons are necessary to buy this “market bottom” on the “bad news”, just pick up tomorrow’s Wall Street Journal.

The line at the Treasury grows longer

It is no secret that the budget deficits of state and local governments have been growing this year and are likely to accelerate sharply as this recession deepens.  Tax revenues for most states in the previous two months have shown no growth and this situation will only darken with each passing month as job losses accelerate.  Alaska, the only state with a healthy surplus due to higher oil prices is also likely to see their fiscal fortunes darken as the price of oil collapses due to a weak global economy.

Question: given the seeming inability at any level of government to cut spending or increase taxes (see IOU’s Pile Up – Taxpayers Refuse to Pay), what outcome can we expect?

Answer:  based on the numerous recent bailout precedents by the US Government,  the state governments, one after another will line up outside the Treasury for bailouts or government guarantees of their debt issues.  Result:more bailouts until we reach the point where serious minds will have to ask “who is going to bailout the US Treasury?

This week California was the latest supplicant to the US Treasury, asking for $7 billion to tide them over until tax receipts come in.   State officials also blamed the frozen credit markets for preventing them from tapping the credit markets.   I have news for the State of California -you can’t run up never ending debts without limit; it is not “frozen credit” markets causing the problem – it is the fact that poor credit quality borrowers cannot now expect to borrow unlimited sums at low rates.  After his election, Governor Schwarzenegger attempted to cut the State’s budget by reducing the bloated state bureaucracy; after massive political protests he gave up and here we are.

If the Treasury bails out California, there will be 49 states in line right behind them also asking for loans and guarantees.  After spending  $800 billion bailing out Wall Street and providing tax breaks to special interests, it will be politically impossible for Washington to say no to California.   Is Washington going to do what President Gerald Ford did in 1975  when New York City was on the verge of bankruptcy -“Ford to New York City – Drop Dead”?   Different time and different place -California will get their loans and guarantees and continue to spend until there is no one left  foolish enough to lend them money.

Here’s a solution for Governor Schwarzenegger – fight against the financial insanity of open ended deficits; lose  the next election if necessary for the greater good of the State.  Insist on budget cuts – increasing taxes will only make things worse; take on the unions that are bankrupting the future of unborn; get your financial house in order by reducing debt, sell State assets – there is an ocean of cash waiting for the right time and price point to invest; be candid with your citizens and tell them that we cannot borrow our way to “prosperity” anymore, there will be pain but you we will be building a future based on economic growth and real prosperity instead of the false prosperity built upon leverage and debt; tell your citizens that times have changed  and we all need to spend less, expect less and save more until we can correct the insane excesses of the past; if necessary go the route of The City of Vallejo, California which filed for Chapter 9 in order to break the fiscal stranglehold of sky high municipal salaries and benefits.

Sarah Palin touched on the need to save and only buy what we can afford to during her last debate but I am convinced that there are few politicians out there who have the courage or verbal skills to give the voters this type of message.

Unfortunately, the local, state and federal governments face tough choices on the road to financial health since they will need to reduce the multi trillion dollar benefits promised but now impossible to pay.   An age of hard times is upon us and those who chose to believe that their “entitlements” are due no matter what are in for a rude awakening since the future has already been spent.

Say no to California for  a bailout – they need to figure things out for themselves.

“Investment Time Bomb, Mega Catastrophic Risk”

I have often noted that predictions made early eventually turn out to be the most accurate, but oft most forgotten since it is yesterday’s news.  Perhaps the real nightmare now upon us is the one predicted by Warren Buffet in March 2003, as well as in earlier interviews, in which he prophetically stated that:

“The rapidly growing trade in derivatives poses a “mega-catastrophic risk” for the economy…

Large amounts of risk have become concentrated in the hands of relatively few derivatives dealers … which can trigger serious systemic problems”

Mr Buffet explained the risks of derivatives after buying a reinsurance company with a small portfolio of derivatives. These positions were gradually sold off  for a big loss “in a leisurely way in a benign market”.

In May 2007 Mr Buffet again spoke of the extreme risks to the global financial system saying:

“that excessive borrowing by traders, investors and corporations will eventually lead to significant dislocation in the financial markets.”

Mr Buffet’s dire predictions are not to be taken lightly and,  unfortunately, now appear to be occurring.   A default chain of these insanely devised and leveraged products could cause extremely significant and long lasting damage to the world economy, probably beyond the immediate ability of the world’s central banks to contain.  The collapse of Lehman, a very big player in derivatives, has some wondering if the unwinding of their contracts is the trip point for the “mega catastrophe” and the cause of the current credit crisis.  The Federal Reserve and Treasury Department apparently did not see the risk when they let Lehman go under.

Since these derivatives (specifically the CDS) are essentially a zero sum game for the parties involved (one player’s loss is equal to another player’s gain), and given the potential catastrophe we face, the government should consider a mandated freeze on the contractual obligations involved by all the counter parties in the derivatives market and then allow them to be unwound in a controlled manner.  Hopefully, at the level of power that matters, this situation is being urgently reviewed.

Fortune – The $55 Trillion Time Bomb

General Electric’s tactics incite panic

General Electric’s plan to raise $12 billion in capital via a common stock offering and a $3 billion sale of preferred stock to Warren Buffet normally would seem to be a prudent move to raise liquidity in a very uncertain economic environment.  Instead investors reacted by treating GE to a 10% loss on the day, ranking GE as the largest loser of the 30 Dow Jones stocks.

Such is the state of panic that the market is in when one of the few companies left with a triple A credit rating is viewed with suspicion.  It was very easy, however,  to conclude that something is quite wrong with the massive $700 billion GE Capital loan portfolio if GE had to pay an almost sub prime type rate of 10% on the preferred stock sale and, in addition, sell $12 billion of stock when the stock is trading at almost a 10 year low.   Making the stock sale look even more urgent is the painful fact that GE has been buying in stock for years at considerably higher prices than they are now selling it for.   Also, if GE really had no trouble raising money in the commerical paper market at 3.5%,  why would you borrow at much higher rates??  With two recent earnings warnings, one has to wonder exactly what is in the $700 billion loan portfolio, how much of it is lent long with borrowed short term funds and what type of losses will ultimately be incurred.

It is statistically stupid to conclude that Warren Buffet is not making another smart investment assuming that, as in the past, this financial panic will end and those buying now will be greatly rewarded with gains in the future.   My take is that there will be greater bargains and a better time to buy for the patient investor – maybe that day will be when we see a cover story from a national news media proclaiming the “death of equities”.

Insurance Industry Meltdown Continues

Insurance company stocks again suffered major losses today, with MET down 15%, PRU down 11% and HIG down a stunning 32%.   The Wall Street Journal reported on the various reasons for the continuing sell off including the poorly timed comment by Senator Reid that “someone in the Democratic caucus had said a major insurance company, “one with a name that everyone knows,” was on the verge of bankruptcy.”  A spokesman for his office later attempted to soften the statement but the damage was done.

The market value loss today on these three major US insurance companies totaled almost $12 billion and the total market cap loss from the 52 week highs on MET, PRU and HIG total a stunning $61 billion.   The horrific asset value losses being seen on virtually every asset class will have a devastating negative wealth affect on consumer spending which will in turn lead to major job losses as virtually every industry in the country experiences lower demand; this cycle is of course self reinforcing.

The Wall Street Journal also reported all three companies stating that their business was basically sound and that capital levels were fine.

On Thursday, MetLife said it had terminated some reinsurance contracts, so it will get back by late January $600 million in premiums it had paid. The company said the move had nothing to do with capital considerations.

All three firms distanced themselves from Sen. Reid’s remark Wednesday. Hartford also said the firm’s “liquidity remains strong.” MetLife said the company “is financially sound.” A Prudential spokesman said it has “a lot of cash at the parent-company level.”

My take on this is that things are obviously not fine but at a critical stage since insurance companies, as with banks, rely on confidence and right now there is a crisis of confidence.   After the AIG debacle, which occurred despite many assurances of financial health from the company before it imploded, investors are obviously giving little credence to assurances of any kind, especially when it is not possible to know what type of exotic financial timebombs (CDS, etc) that may be lurking in the portfolios.

In the past, this type of panic sell off would have provided an incredible buying opportunity for these three great American financial institutions, and this may indeed turn out to be the case.  My advice – wait and see who survives since trying to buy any selloffs in this bear market has more often than not produced some very fast losses.

Mortgages Still Being Approved For Unqualified Borrowers

With foreclosures at record highs and the banking system in collapse, why would the banks still in business be making loans with reckless disregard to the borrower’s ability to repay? As explained in my post “Unsound Lending Policy“, any mortgage borrower with a high debt ratio (large percentage of income devoted to debt repayment) is usually a candidate for default. The borrower may be unsophisticated or simply over optimistic but it should be the responsibility of the lender to ascertain, using sound underwriting policies, that the borrower has a reasonably probability of being able to repay his mortgage debt.

I am still seeing loans being approved by automated underwriting systems for borrowers with total debt ratios in the high 50’s and just this week another loan approved with a 62% debt ratio. The odds of these loans defaulting are astronomically high since the borrower simply does not have enough income to pay his loans and living expenses. These loans are being approved by “desktop underwriting”, a system where the loan is approved by a computer based on input values. Obviously the software underlying the desktop underwriting that determines whether a loan will be approved has not been updated from several years ago when little regard was given to income, credit or loan to value, since it was assumed that the borrower would simply refinance again or sell the home in an eternally rising property market.

The loans being approved today with super high debt ratios are technically not “subprime” loans since that industry no longer exists; these are loans that will be sold to Fannie Mae in most cases, thus assuring that Fannie Mae will continue to have future foreclosures and a need for eternal government support and bailouts.

The really dark question here is, have the automated underwriting systems simply not caught up with the times or is this an effort to keep home sales up, support otherwise starving realtors and mortgage companies and hope that future rising home prices will keep the high debt ratio mortgages from defaulting? If one chooses not to accept the dark theory, the only other answer seems to be that reckless mortgage lending is still alive and well.