Thursday, May 04, 2006

Fed Governor Bies Jawboning Lenders

From Reuters:
US regulators to issue bank market risk rules-Bies

Bies also reiterated concerns U.S. regulators have about the proliferation of non-traditional mortgage products, such as interest-only loans, and the easing of underwriting standards.

"While the credit quality of residential mortgages generally remains strong, the Federal Reserve and other banking supervisors are concerned that current risk-management techniques may not fully address the level of risk inherent in nontraditional mortgages, a risk that would be heightened by a downturn in the housing market," she said.

She also discussed proposed guidance on commercial real estate lending, which she said should be finalized within the "next several weeks."

The transcript of this speech is available here:
Supervisory Perspective on Current Bank Capital, Market Risk, and Loan Product Issues

Over the past few years, the agencies have observed an increase in the number of residential mortgage loans that allow borrowers to defer repayment of principal and, sometimes, interest. These loans, often referred to as nontraditional mortgage loans, include "interest-only" (IO) mortgage loans, on which the borrower pays no loan principal for the first few years of the loan, and "payment-option" adjustable-rate mortgages (option ARMs), for which the borrower has flexible payment options--and which could also result in negative amortization.

IOs and option ARMs are estimated to have accounted for almost one-third of all U.S. mortgage originations in 2005, compared with less than 10 percent in 2003. Despite their recent growth, however, these products, it is estimated, still account for less than 20 percent of aggregate domestic mortgages outstanding of $8 trillion. While the credit quality of residential mortgages generally remains strong, the Federal Reserve and other banking supervisors are concerned that current risk-management techniques may not fully address the level of risk inherent in nontraditional mortgages, a risk that would be heightened by a downturn in the housing market.

Mortgages with some of the characteristics of nontraditional mortgage products have been available for many years; however, they have historically been offered to higher-income borrowers. More recently, they have been offered to a wider spectrum of consumers, including subprime borrowers, who may be less suited for these types of mortgages and may not fully recognize the embedded risks. These borrowers are more likely to experience an unmanageable payment shock during the life of the loan, meaning that they may be more likely to default on the loan. Further, nontraditional mortgage loans are becoming more prevalent in the subprime market at the same time risk tolerances in the capital markets have increased. Banks need to be prepared for the resulting impact on liquidity and pricing if and when risk spreads return to more "normal" levels and competition in the mortgage banking industry intensifies.

Supervisors have also observed that lenders are increasingly combining nontraditional mortgage loans with weaker mitigating controls on credit exposures--for example, by accepting less documentation in evaluating an applicant's creditworthiness and not evaluating the borrower's ability to meet increasing monthly payments when amortization begins or when interest rates rise. These "risk layering" practices have become more and more prevalent in mortgage originations. Thus, while some banks may have used elements of the product structure successfully in the past, the easing of traditional underwriting controls and sales of products to subprime borrowers may have unforeseen effects on losses realized in these products.

Caveat Emptor!

Hat tip goes out to Calculated Risk for this piece..


Anonymous UnRealtor said...

Does anyone know if the federal govt can dictate lending rules, or do they just provide guidelines to lenders?

5/04/2006 02:12:00 PM  
Blogger chicagofinance said...

a tool often used

5/04/2006 03:06:00 PM  
Anonymous Anonymous said...

How far the Fed has come since early 2004, when Greenspan was actually urging prospective homebuyers to take out ARMs:

That sure seems like stupid advice now, doesn't it Alan?

5/04/2006 03:57:00 PM  
Blogger grim said...

Just saw this one over at Property Grunt..

LLC: The mark of the bubble beast?

The Grunt has heard on the wire that Bank of America has ceased all lending to all real estate LLCs. This is highly signifigant since no real estate investor in their right mind would ever purchase an investment property without an LLC and it is also indication of the current mood in the lending world.

There has been some rumblings that other banks may follow suit but nothing is official as of yet.

So why would banks be reluctant to lend to a real estate LLC? It is all about cutting their losses. If the s**t hits the fan, alot of banks will be stuck with a ton of non performing assets. Banks are in the lending business not in the real estate business therfore they are ill equipped to deal with a ton of foreclosures.

The LLC is the get the out of jail free crad for real estate investment which allows investors to be able walk away without further financial injury. Banks dislike this. They do not want to lend to anyone who is legally limited in putting their skin in the game. This is also another reason that banks will not lend to residental buildings that have less than 50% owner occupancy and is known to be a investment building.

As far as they are concerned, the more of a stake a buyer has in a property, the more likely they will move hell and high water to keep it and not let it fall into dissarray.

5/04/2006 03:59:00 PM  
Anonymous Anonymous said...

Oh, so NOW the Fed's waking up and getting serious about regulating the "Bad Credit OK" market? Too little, far too late...though at least they finally seem to realize this is going to end very badly.

5/04/2006 04:08:00 PM  
Anonymous Anonymous said...

its about time a prominent figure made some kind of statement about the lax lending and risky loan standards of the banking industry.... i guess the good old "taxpayer" will be left paying the bill...

grim... The BOA news posted on property grunt is extremly significant.. Other big banks will follow.. Wonder what tomorrow has in store for us. Ameriprise job layoffs, BOA announcement...a small but inevitable snow ball has begun to roll


5/04/2006 04:13:00 PM  
Anonymous Anonymous said...

No more funny money....

Housing Bust

Ba ba ba ba ba ba ba BOYCOTT OVERPRICED $#@!BOXES



5/04/2006 04:25:00 PM  
Anonymous Anonymous said...

Ba ba ba ba ba ba BOYCOTT HOUSES!


5/04/2006 04:32:00 PM  
Blogger jhawk92 said...

Grim, how reliable is Grunt? That is enomorous, market moving, news! For a bank that size to shut off all lending to the segment of RE investors...I can't even describe the magnitude.

I'm going to send a note to someone I know at BofA right now to see if this is true. Holy C**p!!!


5/04/2006 04:41:00 PM  
Anonymous Michelle said...

I was hoping someone could asnwer this question for me (I hope I'm phrasing it right...)

When an originating lender sells a loan to the secondary market, what do they sell it for? For the sake of the argument, how much would a $1M 30yr fixedloan at 6.5% cost on the secondary market?


5/04/2006 04:47:00 PM  
Blogger chicagofinance said...

Did you check the Boston story on the Ben Jones' site?

My lord!?!

That area has way too much in common with Jersey City/Harborside/Newport/Powerhouse.

I certainly don't think we will see those depths here, but again - wow.

5/04/2006 06:09:00 PM  
Blogger grim said...

As much as I would love to point to that story as evidence, I don't trust the stats.

The sample size might be too small, in one paragraph they talk about the number of listings doubling to 86. If their market currently has 86 active listings, I can't imagine there are enough transactions in that sample to keep the mix from shifting.

Not to say the market didn't weaken, or is in the process of declining, however the stat they are using is just a bit suspect.


5/04/2006 07:12:00 PM  
Anonymous seattle price drop said...

Yesterday all the Ameriquest offices in Seattle closed- abruptly.

Today, another major lender (Merit Financial) let most of it's staff (300 people) go.

And this is in a market that, until today anyway, everyone has been yammering about how healthy it is! It'll never happen here!

About those condos in Boston that sold for 900K last year and 550K this year. I'm taking that news as entirely possible.

There are neighborhoods in seattle that shot from 400K in 2004 to 1.2 million in 2005.

That's called a LOT of froth. A few of those houses have sold at the new price, most have been sitting on the market for months.

If they go back to 500K next year, doesn't that make more sense than just about any other scenario you can think of?

Especially if the lenders are finally getting serious, and it looks like they might be!

RAPID appreciation can lead to...well, you know...

5/04/2006 09:14:00 PM  
Blogger Richie said...

What goes up fast, comes down faster...

5/04/2006 09:26:00 PM  
Anonymous Anonymous said...

unrealtor asked about fcc dictating lending rules -

All Banks are regulated by the OCC (Office of the Comptroller of the currency). OCC audits banks every year especially focusing on the risk management practices. If OCC issues (newer) guidelines which are then adhered to during these audit, then the audit reports will reflect the issues of concern & areas of risk. This might begin the process of change. Upper management in banks are usually conscious about responding to OCC audit requests.

Michelle asked about the secondary market pricing - The short answer is - "it depends". Many factors affect the pricing (the credit score of the loan i.e whether it is a prime loan or subprime loan, whether the purchaser puts the loan in their "retained loan" portfolio, whether the loan was make by a mortgage broker or a bank directly, the market conditions at the particular time etc.

A mortgage broker typically makes a revenue of between 150 to 200 basis points of the loan amount (again it is revenue, not bottom line profit). A lender who purchases a loan from a broker, securitizes it in a portfolio and then sells the portfolio typically makes a revenue of between 150 to 300 basis points.

Again, the numbers above are reflective of a normal market. Some lenders who retain loans in their portfolio (and have a servicing & collections department) lose money on originating a loan but make it up in the stream of interest income they get from owning the portfolio (which is why loans with prepayment penalties usually cost less than loans w/o prepayment).

Finally, note that current secondary market conditions are bad - some lenders are selling portfolios of subprime loans at a loss. As an example - look at the latest earnings report of ECR. It will tell you that they are selling loans "below their cost to originate". Also, this is the reason why many subprime lenders are closing shop or cutting down (Acoustic Lending, Ameriquest, QMAR, Merit Financial).


5/04/2006 09:43:00 PM  
Blogger Rob Ryley said...


Perhaps your financial analysis skills can help me out here.

New Century just released earnings today:

The Spin:
""We achieved strong first quarter 2006 results highlighted by 21 percent growth in EPS, a 17 percent increase in REIT taxable income, and 31 percent growth in mortgage loan production compared with the same period last year,"

In spite of this, the stock sold off.

The Reality:
Looking at the data in the link above, I see the following:

Using only operating income section, NEW had made 10 million less on the sale of new mortgages this quarter vs this quarter last year.

This year "other income" was 9.7% of operating income, while last year it was only 2.5%. This
"other income" is defined as gains on derivatives, using the mark to market method.

Coincidentally, these derivative gains are roughly equal to the declines in mortgage sales, and added slightly to earnings ($533,000).

I also note that provisions for losses declined slightly from last year (by about 7.9%), which added $13,212,000 to earnings.

In my view, the quality of this report is low, and some of the data looks like some earnings magic, to borrow from the book title written by Gary Giroux.

Am I being too paranoid about this report, or are the concerns valid?

5/04/2006 09:48:00 PM  
Anonymous Michelle said...

Thanks, CNS!

5/05/2006 06:58:00 AM  
Blogger chicagofinance said...

rob reyley:

I don't have time right now to review this thoroughly, but I think that you are answering your own questions.

Poor earnings quality, resulting from one-time, unsustainable, or non-core business sources will not be given requisite credit in forward looking valautions of a company.

As you read analysis, see whether you can discern which element of the report was the key driver of the market reaction.

I kind of tied up and I won't be able to research anything until next week.


5/05/2006 10:08:00 AM  
Anonymous UnRealtor said...

Thanks for the info CNS!

5/05/2006 01:37:00 PM  
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5/18/2006 04:42:00 PM  

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