Friday, January 10, 2014

The New Face of Subprime--Look in the Mirror; There's a 50% Chance it's You

In the last three and a half years, since July of 2010, four thousand pages of new regulations have been written governing mortgages in the U.S. Today is D-Day for two of them; today, January 10, 2014, the qualified mortgage and ability to repay provisions of the Dodd-Frank bill will take effect. Massachusetts Senator Elizabeth Warren, who helped write the rules and served as the interim director of the CFPB prior to the confirmation of Richard Cordray, spoke from the Senate floor this week praising the new rules saying that they will, "make a real difference for millions of families who own, or who hope to own, their own home” and “show once again that government can fix problems,” according to HuffPo.

Much like the disastrous roll-out of Obamacare, what the QM's are really going to do is demonstrate once again the failure of big government. Remember that Dodd Frank was supposedly passed to end "too big to fail" bailouts and "predatory loans," just as Obamacare was supposedly passed to ensure that all Americans would have access to affordable healthcare. In October of 2013, many Americans discovered for the first time that their existing insurance policies were being cancelled and that they would no longer have access to the private insurance for which they had been paying. They also discovered that their new "free" healthcare was really, really expensive.

Much the same thing is about to happen today. Under the pretext of shielding borrowers from bad loans, the federal government has created a small but elite class of borrowers--those who meet the standards of the "qualified mortgage". These borrowers will have access to the best interest rates and financing available because only these loans can be sold to Fannie Mae and Freddie Mac. But about half of the borrowers who up until today were "prime" borrowers will not qualify under the new guidelines. Last February, Corelogic Credco completed a study of the qualified mortgage rules and found that under the government's proposed guidelines about 40-50% of borrowers who qualified to have a conforming mortgage in 2010 will no longer qualify under the new rules. This statistic was confirmed this week as Wells Fargo prepares a team to underwrite the non-qualified mortgages that it will keep and service itself. Wells estimates that 40% of its mortgages will not meet the qualified standards. If you have shopped for a mortgage loan in the last three years, you know that qualification standards were already tough, so to shut an additional 40-50% of borrowers out of a market which has already shrunk from a three trillion dollar industry to a 1 trillion dollar industry is significant.

What the government has really succeeded in doing here is creating a new class of subprime borrower out of borrowers who were previously eligible for low rate and fee mortgages. And the new rules are going to have a massive impact as consumers find themselves forced into non-prime portfolio loans.

Assuming that your credit score is above 700, what factors could keep you from getting a qualified mortgage? Below are a few:

1. You are self-employed. Even if you earn a good living and declare all of your income on your income taxes, the requirements are so strict that if your income has declined over the past two years, the underwriter may not accept part or all of your income.

2. Part of your income is bonus or commission. Let's say you have been on your job 15 years and in addition to a base salary you earn a substantial bonus or commission. You receive the bonus every year so you have always used it as income. Unlike base pay, bonuses and commissions are averaged over a two year period, so if your bonus has fluctuated you may not have a high enough average to qualify with the new 43% debt to income ratio requirements. If your bonus were less last year than the the previous year the underwriter might not let you use it at all.

3. You co-signed a loan for somebody else. Your sister just got divorced and is struggling to support herself and her three kids. She has gotten a job but she needed a car to go to work and you helped her out by co-signing for it. She makes all the payments with checks and you could prove that by getting copies of the cancelled checks. The problem is that Fannie Mae won't accept documentation that someone else is paying this bill, so you will have to qualify with her car payment, and even a small car payment could be enough to push you over the 43% DTI guidelines. (This is also true for business debt in your name under your personal credit.)

4. You are receiving child support for four children, the oldest of whom is sixteen, while you go back to school to get your nursing license. The child support covers all of your expenses and allows you to qualify, and in a year when you graduate from nursing school you will be able to go straight to work for a hospital. Unfortunately, child support can only be considered if it will continue for three years, and in the case of the sixteen year old it doesn't so even though you wanted to get that house now while the interest rates and home prices are still low, you won't qualify. You can either take the higher-priced non-qualified loan or you can wait and hope that when you get your nursing job you have not been priced out of the market.

The ultimate irony of the new rules is that it allows banks to profit from higher costs and fees to a newly created class of subprime borrowers who are actually a very good credit risk but can't meet the tight new requirements. Wells Fargo and others can create a set of products to meet this need that is greatly more profitable than the loans being sold to Fannie and Freddie and FHA and they can expect to have a large demand for them.

If you are one of the nearly fifty percent of credit worthy borrowers who can no longer qualify for a Fannie/Freddie conforming mortgage what can you expect?

1. Higher interest rates and more fees. The new rules say that a lender making a non-qualified mortgage must retain at least 5% of the balance of that mortgage for life. In reality, probably most of these loans will be "portfolio mortgages"--private label mortgages written to each lender's individual specifications which they retain for the life of the loan. By the end of 2014, mortgage rates are expected to be about 5%, so a portfolio mortgage might range anywhere from 5.5 - 7-5% or higher depending on the underwriting guidelines and level of risk. Keep in mind that they have to be more expensive because in addition to the cost of servicing the loan, the lenders have the added risk of not being able to foreclose if the loan is determined to be predatory at a later date.

2. Adjustable rate mortgages. Nobody is saying much about this yet, but the thirty year fixed rate mortgage (or the fifteen year fixed rate) is really a function of a government backed guarantee which is what Fannie, Freddie, FHA and VA provided. Portfolio loans often don't offer fixed rates. Often these loans are structured to be fixed for anywhere from 2-10 years and then the rate adjusts after that. This allows the lender to qualify the borrower at a lower initial rate and then adjust the rate upward at the end of the fixed term. Not being able to secure a fixed rate mortgage for the life of the loan is going to be a big surprise for a lot of Americans who have grown up in a world where this was standard. The irony is that the adjustable rate feature of many subprime loans was blamed for much of the mortgage crisis because as the rates adjusted homeowners could not pay the new costs, but now we can expect to see a resurgence of this product.

4. Higher down payments. The government toyed with requiring 20% downpayment as part of the qualified mortgages, but in the end they did not institute this. (If they had added a 20% downpayment requirement, according to the Corelogic Credco study, a full 60% of borrowers who qualified in 2010 would not have met the new guidelines.) Typically, though, portfolio loans require more downpayment than agency loans (agency loans are loans sold to Fannie Mae or Freddie Mac.) Lenders mitigate the risk of foreclosure by requiring more downpayment, and in a world where they have to service the loan forever that can be very helpful. Also, if a borrower does decide to take the lender to court because of a foreclosure action, the lender can argue more successfully that they followed conservative lending standards when they required more cash up front. In my experience, we should expect fifteen to twenty percent downpayments to become standard for the new class of subprime.

Elizabeth Warren says that the rules will show all Americans that the government can fix problems. In reality, these rules have not "fixed" anything. Just as Obamacare has caused millions of insured Americans to lose their coverage, so the QMs are going to force millions of Americans into subprime higher cost loans. Here's a message for Washington: Stop fixing things for us. We can't take much more of this.

When the mafia extorts money from you to allow you to live, they call it "protection money." When the government does it, they call it "consumer protection." Either way, you are paying for protection from someone who has the power to take everything you have.

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