A cloud over the economy: the mortgage meltdown is deepening, and prolonging the housing recession. A weak housing sector has ripple effects for the rest of the U.S. economy. Financial markets remain vulnerable to renewed turmoil from hidden exposures to subprime mortgages and related derivatives.

Author:England, Robert Stowe
Position:Cover report: Correspondent/Wholesale

After having several teeth pulled out in the most painful way, the mortgage industry awoke the next morning to discover there is no Tooth Fairy. More to the point, surviving players in the mortgage industry now realize they were living in a fairy tale before last summer, when they expected a soft landing for the housing market. In fact, now everyone knows there is no soft landing in store for the housing sector--and possibly none for the economy, either.



The question now is how much damage the mortgage meltdown will have on the housing sector and whether or not it will pull the whole economy into recession.

Most economists see the potential for a recession, but differ on the odds of it occurring. "I think the effect of the [mortgage] credit crisis is to vastly increase the odds of a recession in the first half of next year," says David M. Jones, chairman of Investor Security Trust Co., Fort Myers, Florida, and president and chief executive officer of DNJ Advisors LLC, Denver.

For some market watchers, the negative effect of the mortgage meltdown has already been clearly demonstrated. "Late last year, it looked as though single-family home sales were stabilizing. That led to the view expressed by me and others that perhaps the end to [the] housing decline was not too far off," says Lyle Gramley, former Fed governor and senior economic adviser at the Stanford Group, Washington, D.C.

"Then we had a meltdown of the subprime market, and single-family home sales then fell another 10 percent," Gramley adds. "Since mid-July, we've had a generalization of the problems in subprime to all other sectors of the mortgage market as well, affecting different segments of the mortgage market to varying degrees. And those other sectors comprise [the remaining] 80 percent of the total market [outside sub-prime]," he explains, referring to lending by any party. The subprime fallout effect is seen in portfolio and securitized lending, he says. It even affects conforming, conventional loans--not so much on pricing, which has remained close to where it was before the crisis, but in "a tightening of non-price terms," such as the amount of down payment required, the allowed debt-to-income ratios, required FICO[R] scores and so forth, Gramley says.

"The problems outside subprime have not been as acute, but there is simply no doubt that it is going to have a significant negative effect on the housing industry [going forward]. I think we face a situation in which the decline in housing [as measured by new-housing starts] may turn out to be the worst in the post-war period," Gramley says.

Mortgage woes

The mortgage market is facing supply constraints in the wake of the collapse of the private-label residential mortgage-backed securities (RMBS) market. While slackening demand is a factor, the lower availability of mortgage financing, along with sharply higher rates for many mortgages, is a key reason that existing-home sales fell 4.3 percent in August to a seasonally adjusted rate of 5.5 million units. That was down from the 5.75 million level in July and 12.8 percent below the 6.31 million-unit pace of August 2006, according to the National Association of Realtors[R] (NAR), Chicago. (September data were slated to come out too late to be included in this story.)

Lawrence Yun, senior economist at NAR, cited the turmoil in the mortgage market as the chief reason for the fall in home sales. "The unusual disruptions in the mortgage market, including a significant rise in jumbo loan rates, resulted in a fairly high number of postponed or cancelled sales, with many buyers having to search for other financing when loan commitments fell through," he says. "Lower sales contributed to a buildup of unsold inventory," he adds.

The "disruptions" in the mortgage market include, of course, the complete collapse of the private-label RMBS market, which had represented a majority of total RMBS originated in 2006.

The high-powered Wall Street engine that drove the housing boom and captured as much as 57 percent of the RMBS market in the second quarter of 2006, according to Inside Mortgage Finance, was dead, at least temporarily, with no clear idea when it would be revived.

In the aftermath of the summer breakdown in the private-label market, the mortgage origination landscape is radically changed.

Explains Doug Duncan, chief economist at the Mortgage Bankers Association (MBA): "Anything that's not Fannie [Mae], Freddie [Mac] or Ginnie [Mae], or [is a mortgage] somebody isn't willing to hold in portfolio, is not being done. Anything that's in the jumbo, alt-A or subprime space is only being done to the extent that a bank will put it in portfolio," he says.

Some portfolio lenders are moving to fill the gap, Duncan adds. "At the biggest banks that have well-established logos, the volume of business is way up. Even so, even the big banks have a number of limitations that restrict their ability to take on mortgage loans," according to Duncan.

Portfolio lenders face three restrictions that limit their ability to take on portfolio loans, he says. First, "Capital is limited, and every whole loan you put on your balance sheet requires more capital, for example, than an MBS," Duncan says. Portfolio lenders, then, are constrained by the amount of capital they want absorbed by whole loans. "Secondly, in the portfolio, they typically will hold [mortgages] in the category called 'loans held for sale,' and the accounting treatment of 'loans held for sale' is that they have to be marked to market continually," he adds. "If a sale takes place in the securities market shortly after they've booked it, and the valuation is lower than what they booked, they have to mark to market and take a hit to earnings," Duncan says. "Thirdly, they always have some diversification objective, and it's possible that the earnings on [mortgages held in portfolio] would alter their diversification strategy--because [even though] the payoff would be there, diversification is an issue for them to consider."

When asked how voluntary portfolio-lending limits might be imposed from diversification considerations, Duncan explained: "Banks in their portfolios hold many different kinds of assets. Some of my peers at banks will manage the asset-liability selection committee or be the chief risk officer of the company for portfolio risk," he says.

"Different assets have different levels of correlation with one another in terms of performance. So, for example, home-equity loans' performance is going to be highly correlated to first mortgages, but much less correlated to the performance of, for example, working capital loans to small business. And so, when you start to grow one section of your portfolio relative to the others, it changes the overall correlated risks in your portfolio," Duncan adds.

Is the goal to avoid having everything correlate? Not exactly, he says. "You want to understand the correlations. Sufficient compensation for the risk will lead you to change the composition of the portfolio, but you have always to be cognizant of the correlation," Duncan says.

"If you dramatically grow one portion of the portfolio, which is highly correlated to two or three others, you are not just increasing the risk held in that portfolio, but the risk in your overall portfolio or several portions of your portfolio. You may be willing to do that because the returns from taking on that risk are substantial. That's a fundamental tenet of portfolio management," he says.

"The net result of all [three constraints on lending by portfolio lenders] is that the interest rates on nonconforming [loans] have risen substantially. Risk spreads in that part of the market have widened out," Duncan says. The suddenly higher rates lenders are charging for jumbo mortgages have raised some questions from borrowers and the press, he notes. "I've had some reporters calling and asking, 'Why are you abusing jumbo borrowers?' And the answer is, 'We're not.' There are rational economic reasons why institutions are managing their risks by that pricing."

Looking for a bottom

Not surprisingly, economists differ on their estimates for when the housing market will hit bottom, as measured first by reaching a peak in inventory and, finally, by a bottom in the decline in housing prices.

Mark Zandi, chief...

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