I have written extensively about bubble-era jumbo mortgages and have discussed in detail why they are a disaster waiting to happen. With origination of jumbos heating up again, this is a good time to revisit the jumbo mortgage market and see if the outlook has improved.
The Insane Go-Go Years
To begin, let’s briefly review the essentials of what jumbo mortgage lending was like during the speculative madness of 2004 – 2007.
You must understand that the housing bubble in much of the country would have been impossible without the total collapse of traditional lending standards.
Let me give you an example. Prior to the utter craziness of 2004 – 2007, a mortgage which required little or no down payment mortgage was exceptionally rare. By 2006, they comprised 17% of all mortgages underwritten that year.
A second factor facilitating the speculation was the rise of the interest-only mortgage. These mortgages propelled home prices in the hottest California and Florida markets because the buyer’s monthly payment was much less than with a fully-amortizing mortgage.
Without the interest-only mortgage, most first-time homebuyers in the high-cost metro areas would not have been able to afford to purchase a house even with only a small down payment. By 2005, over 60% of California mortgages were interest-only.
The final piece which was needed to create the speculative frenzy of 2004 - 2007 was the abandonment of traditional debt-to-income ratios (DTI). For many years, prudent underwriting insisted that the ratio of a borrower’s mortgage payment to monthly income not exceed 30%. Furthermore, the ratio of total debt payments to monthly income could not exceed 33-35%.
By 2005, however, DTIs of 50-55% were increasingly common. That opened up the housing market to millions of owner-occupant buyers and speculators who would not have qualified in the early years of the decade. Even looser DTI standards prevailed in 2006 and early 2007.
Impact of the Liar Loan
Perhaps the one underwriting change which was the greatest impetus for speculative madness was the stated income loan. Also known as the no-income-verification loan, it was originally used for self-employed individuals who could not easily document their income. When its use soared in 2005 – 2007 in the non-conforming mortgage market, speculation skyrocketed.
Picture this insanity. Borrowers simply stated their income, assets and employment on the application. Neither the broker nor the lender verified the stated income by examining pay stubs, W-2 forms, or income tax returns. Obviously, the temptation for the applicant to lie became almost irresistible. For good reason, the stated income loan became known as the “liar loan.”
As the bubble heated up in 2004 - 2005, origination of stated income loans skyrocketed. A rate sheet I have seen which was distributed by notorious sub-prime lender New Century to its affiliated brokers in June 2005 revealed the total collapse in lending standards. Brokers were authorized to offer a stated income loan for up to 80% of the appraised value (which would usually be accompanied by a 15-20% piggyback second mortgage) to anyone with a debt-to-income ratio of 50% or less, a FICO score of at least 525, and who had not defaulted on a previous mortgage in the preceding two years.
In 2009, a Liar Loan study reported that between the first half of 2004 and the second half of 2006, the volume of monthly loans made by the mortgage banking firm whose portfolio was examined in the study had increased more than seven-fold. By the end of 2006, nearly 80% of all their mortgages were stated income loans originated through mortgage brokers.
A report on the non-prime mortgage market sent by the U.S. General Accountability Office (GAO) to Congress in July 2009 found that almost 80% of all interest-only adjustable-rate mortgages (ARM) and Option ARMs nationwide were stated income in 2006. This may have been a recipe for disaster, yet hardly anyone seemed to care.
Why the Role of Fraud is So Important to Understand
Mortgage applicants are required to declare whether or not they intend to occupy the home they are purchasing. This is important to underwriters because investor-owned properties had traditionally defaulted at a much higher rate than true owner-occupants. Hence more stringent borrowing terms had always been given to investors.
Speculators out to make a killing in the housing market saw the stated income mortgage as their meal ticket. The temptation for stated income applicants to lie was almost irresistible. And they did in huge numbers. Until American Securitization Forum (ASF) apparently ceased publishing it last year, they had put out an excellent monthly review of the non-Agency mortgage-backed security (RMBS) market. Because there is nothing like it, take a close look at this table from the April 2013 report.
The table provides key data for mortgages still housed in non-Agency RMBS as of spring 2013. Look at the heading called “Non Owner Occupied.” The first column – “Reported at Orig” – shows the percentage of the outstanding mortgages in which the applicant did not declare an intention to live in the home. The total for all these mortgages was 11%.
The next column – “Current Inferred” – is the crucial one. It shows the percentage which the analyst who developed these statistics provides as his best estimate of the true percentage of those investors not actually living in the property. His figure is a much higher 26%.
That is a huge difference. The reason for this is simple to account for. There were enormous numbers of purchasers who lied on their mortgage application and were really investors/speculators. Anyone who invested in non-Agency RMBS (including mortgage REITs) or is considering doing that needs to understand the significance of this discrepancy.
It is essential for me to also explain the research upon which the analyst based his conclusions. His firm reviewed loan level data from CoreLogic and linked it to Equifax’s enormous credit database. With this approach, they were able to determine rather accurately whether a borrower who had claimed to be moving into the house he/she purchased actually did so.
What they found was quite shocking – yet not at all surprising to me. For the loans they reviewed – including jumbos, sub-prime, Alt A and second liens – they could confirm only about 45% of those who said they were living in the house. The other 55% were either “mis-reported,” “unknown” or had moved out of the house. For loans still outstanding as of October 2010 (when the research ended), the percentage of confirmed owner-occupants was even lower.
This widespread lying is essential for an investor to know because, as I explained, investor-owned properties have always defaulted at a much higher rate than true owner-occupants.
What does this mean for you and your clients? Any information from the SEC or anywhere else which shows owner-occupancy based on application data is totally inaccurate. You need to use the ASF figures to get any sense of the large percentage of investor-owned properties in almost any non-guaranteed RMBS.
Jumbo Mortgage Lending During the Bubble
Jumbo mortgages are those whose amounts exceed the Fannie Mae/Freddie Mac limits for purchase by them. It is now $417,000 in most areas. Higher cost areas such as the East and West coasts are permitted loans up to $625,000.
The number of jumbo mortgage originations during the madness years of 2004 – 2006 is mind-blowing. Take a look at this table from the mortgage statistics provider -- mortgagedataweb.com.
Out of the ten metros which originated the largest number of jumbo mortgages for home purchase in 2005 - 2006, seven were in California. Notice that for several California metros, half of all the first liens originated were jumbos.
Refinancing Insanity During the Bubble
As I have explained in several articles, it is the refinancing madness which is so important yet so little understood by investors. Take a good look at this table showing the top 25 metros for refinancing with jumbo mortgages.
Jumbo Mortgages for Purchasing Homes (2005 – 2006)
Refinancing with jumbo mortgages was clearly dominated by major California metros. In Los Angeles County, it was just incredible.
You can also see that it was not only California. If you simply combine the jumbo lending for three counties in the NYC metro – Kings County, Queens County and Bergen County in New Jersey – that would place them at number six on this list. You also need to understand that the vast majority of refinancing in the entire NYC metro was to tap their rising equity with a cash-out mortgage. Take a look at this chart.
These loans were actually the refinancing of mortgages which had been taken out only a few years earlier. This was occurring throughout the nation.
Keep this key point in mind. Because the peak in cash-out refinancing was during the three bubble years of 2005 – 2007, the overwhelming majority of properties whose owner refinanced with a jumbo mortgage in these years are still underwater.
California was the epicenter of the jumbo refinancing madness in the four bubble years 2004 – 2007. An incredible 1.1 million jumbo refinancings were originated in California just during 2004 – 2006.
The serious delinquency rate on these jumbos shown in ASF’s last Non-Agency RMBS report in April 2013 was bad -- 13-19%. The mortgage servicers have modified another 15% of these jumbos. Had they not done this, the delinquency rate would have been much higher.
Interest-Only Jumbo Mortgage Resets Are Coming
In an article published last December, I examined in detail why the reset of home equity lines of credit (HELOC) to fully-amortizing loans over the next four years will be a major calamity.
A very similar problem is beginning to appear with interest-only jumbo mortgages. According to Inside Mortgage Finance, roughly $840 billion in interest-only jumbos were originated during the bubble years of 2004 – 2007.
Take a good look at the adjacent chart showing the annual amount of interest-only jumbos.
Let me explain the disaster looming just over the horizon. Many of the interest-only jumbo loans had 10-year initial periods after which they would reset to fully-amortizing mortgages. For most of them, this amortizing period is the remaining 20 years on the loan. You can imagine the huge hike in monthly payments which the borrower will face when the loan resets.
The resets on these bubble era loans have started this year and will peak in 2015 - 2016. What will the lenders do? Since the majority of these properties are still underwater, are they prepared to cancel the reset and continue the interest-only terms for the borrower? Will they place a time limit or do it for an indefinite period? In either case, they are placing an enormous bet that they will be bailed out by a continuing rise in home prices. That is a very big gamble.
What about the borrowers? Put yourself in the shoes of a California homeowner whose bubble-era jumbo mortgage is about to reset. Since you bought close to the peak of the housing market, you think your home is still underwater. Do you accept the new mortgage terms and hope that your local housing market will strengthen enough so that eventually you will have some equity in your home? You hadn’t given that any thought when you bought the house.
However, you have noticed that the number of homes on the market in California has been rising sharply and that sales have slowed. Prices seem to be weakening also. What if that continues? You have read about how the market has been supported by all those cash buyers but that they have pulled back sharply this year. What if that continues? Who will buy your house? You have noticed that young people complain that they cannot afford to purchase a home now while others say they prefer the flexibility that renting offers them.
Then it finally hits you. All those crazy ideas about where home prices were heading when you bought (or refinanced) your house were a delusion.
The problem is that you are stuck with the aftermath of decisions you made during the go-go years. You’ve read that Wall Street believes the worst is over and that the housing market is “recovering.” But your gut tells you otherwise.
Now you ask yourself this question: If this Wall Street optimism is misplaced … again, what will happen to my financial situation? Do I really want to continue paying off this burdensome mortgage for the next twenty years?
I believe that millions of homeowners with resetting jumbo mortgages will be asking these questions over the next few years. As I indicated in my article on HELOC resets, the potential number of borrowers who might walk away from their jumbo mortgage after it resets is very high.
Why Are the Big Banks Still Loaded with Jumbo Mortgages?
In October 2011, Moody’s warned that homeowners with jumbo mortgages constituted a “greater strategic default risk” than any other type of borrower. You must keep in mind that most of the 1-4 family mortgages held on the balance sheet of the large “too big to fail” banks are whole jumbo loans. The vast majority of loans originated by them which conformed to Fannie Mae and Freddie Mac limits have been securitized and sold off.
The largest banks have embraced the idea that the housing recovery is solid and have gotten very comfortable with holding new jumbo loans on their books. In March of this year, Inside Mortgage Finance reported that roughly $270 billion in jumbo whole loans had been originated in 2013. That was up from just $118 billion only two years earlier. Very little were packaged into non-guaranteed RMBS. Most went onto the balance sheet of the too-big-to-fail banks.
Several major originators in the jumbo market are now accepting down payments of only 15% from borrowers with the highest credit. After the housing collapse began, they had required a minimum of 25-30% and sometimes more. Several of the largest banks are offering interest-only terms on jumbo mortgages to their wealthier clients. How quickly they seem to have forgotten the disaster of the post-bubble crash.
One of the “too big to fail” banks showed $230 billion in 1-4 family first liens on its balance sheet in its FDIC call report for the first quarter of 2014. The overwhelming majority of these were whole jumbo mortgages.
Of the jumbos in its portfolio, nearly $24 billion were considered “Past due 90 days or more and still accruing.” Really? Keep in mind what I said in my previous article about mortgage-backed securities. Standard and Poor’s now assumes that 100% of all mortgages which are 90+ days delinquent will end up defaulting. Yet the regulators allow this bank (and the others) to continue accruing interest on these delinquent loans. What a joke! It is not so funny for investors.
Investment advisors and clients of theirs who own shares of the largest banks need to think about this. What would the bank’s capital look like if it had to mark-to-market all their jumbo real estate loans as well as home equity second liens?
Those who are bullish on these banks will undoubtedly laugh and reassure us that 2008 – 2009 could never happen again. Really? I have read the FDIC call reports of these banks and what they reveal is ugly. How much of your clients’ hard earned assets are they prepared to risk by continuing to hold shares of these bank stocks? Do you recall what happened to them during the crash?
Jumbo mortgage lenders are now quite euphoric about the state of the housing market. The idea of another collapse like 2007 – 2010 seems inconceivable to them. However, I have provided compelling evidence for the past four years that it is not at all unlikely.
For several years, the largest banks have been extremely reluctant to foreclose on these seriously delinquent jumbo mortgages. Servicers have also been holding most of their repossessed jumbo loan properties off the market. Will this keep prices for homes financed by these jumbo loans from falling again? It seems to have worked so far, but can this avoidance game continue indefinitely?
What about the resets which I have been discussing? Remember, we are talking about hundreds of billions of dollars in underwater jumbo loans. Can the large banks come up with a realistic strategy to adequately deal with the avalanche that I believe is coming? I seriously doubt it.
My Advice to Investors: Stay far away from any RMBS loaded with bubble-era jumbo mortgages. You can tell by the date the RMBS was issued. The majority of bubble era loans are underwater and the borrowers continue to default.
If you have these non-Agency RMBS in your portfolio now, seriously consider unloading a substantial portion of them. The market for them is a thin one and you want to get out before the liquidity disappears.
As for the newer jumbo RMBS, investors do not seem very interested in them. One which was recently issued by Credit Suisse – CSMC Trust 2014-IVR3 – appears to have been conservatively underwritten. The average loan-to-value ratio (LTV) was only 72%. But nearly 50% of them were originated in California. Remember what I said about the total insanity of refinancing in California as well as HELOC originations there during the bubble years. The day of reckoning for California is coming. I urge you to avoid these recent RMBS like the plague.
Finally, with QE winding down, do you want to gamble that the large banks can continue their charade of apparent profitability? Reality has a way of overtaking illusions. I strongly urge investors and their advisors to assume the worst and act now to lock in profits and preserve your assets.
Keith Jurow is a real estate analyst and former author of Minyanville's Housing Market Report. His new subscription real estate report – Capital Preservation Real Estate Report – launched last year.