Just when you thought it was safe to go back in the water….

Huge studio productions have always been the much anticipated summer event. Back in the day there was JAWS and ET and STAR WARS, the grand daddy of them all

While the usual thoughts of summer conjur up memories of warm summer days filled with picinics and beach afternoons; no summer season would be complete with out the annual release of the “Summer Block Buster” movies. Will anyone in remember the films that graced the big screen this past summer?

We’ve had a few respectable contenders with Transformers, Live Free: Die Harder, but I think the block buster of this past year will be the horror movie played over and over in my mind of the failed mortgage companies of the summer of 2007. Too many mortgage companies have collapsed under the repurchase pressures of the Sub-prime and non-prime EPDs.

While the mortgage industry has historically managed to maintain a steady economic business opportunity in good times and in bad; the sub-prime debacle has absolutely devastated our industry. Why? What happened to cause such incomprehensible destruction and the “Nightmare on Wall Street”?

If you log on to any Mortgage Banking industry site you will see blogs with every one pointing the finger at the other guy. The truth is that we are all somewhat responsible, but no one is exclusively to blame. Boy that sounds politically correct doesn’t it. But let’s take a little walk down memory lane and look at what has transpired in the industry and economically over the past 10+/- years.

In 1997 the ALT A industry was booming. Several REITs (Real Estate Investment Trusts) emerged taking advantage of the sophisticated tax structures the entities provided and securitization of Mortgage Backed Securities was on the rise. Sub-prime had also emerged over the 10 previous years, establishing it’s self as a credible lending sector.

Going way, way back to the age of dinosaurs, Devo and the early 80’s; sub-prime didn’t exist. Mortgage Bankers that lent in this credit sector were known as Hard Money Lenders, loan sharks so to speak. But as housing prices continued to rise and FHA could no longer satisfy the demands of the lower credit profile borrower to obtain home ownership, sub-prime emerged. Oh, the brilliance of marketing. Changing the name from hard money to sub-prime; implying that the credit profile was just slightly less than prime, helped put a positive spin on this market sector.

Sub-prime lenders established guidelines based on the collateral and equity in the property. In this market sector, the property was the principal criteria for sound lending. The max LTV was 75%. Additionally, borrowers who had marred credit were prepared to pay a higher interest rate for the risk associated with the loan. The spread between ALT A and Sub-prime interest rates was easily 300 bps. The lending philosophy was that borrowers with poor or no credit history were higher risk and the lender should be compensated for assuming the additional risk. So as the lender, if you were lending to a borrower with excessive risk based on the previous credit profile, you had a substantial equity position and were paid a higher coupon.

As stated in her testimony before the Federal Reserve Board, Sandra F. Braunstein, Director, Division of Consumer and Community Affairs indicated that the Sub-prime market grew from fewer than 5% market share in 1994 to 20% in 2005 for new loan originations. The good news was that the expanded access to credit increased homeownership from 1995 to 2005 from 65% to 69% of all households. This means that nearly 67 million households now own homes as compared to 65 million 10 years ago. This increase in home ownership was across the board but in percentage terms the largest increase was made in minority households.

In the ALT A credit sector the risk model was built with the baseline credit assumptions of a full documentaion, single family residence. owner occupied, 80% LTV conforming loan. ANY additional variance in the risk would increase the default frequency probability and thus result in a higher risk to the lender. So ALT A pricing was built on a risk based model.

To the contrary, Sub-prime risk model was built with an assumed 9% delinquency frequency, with a 3% default factor in the baseline analysis. As we discussed earlier, in addition to the higher risk assumptions, lenders held a greater equity position to off-set the risk.

The disconnect came gradually over a period of time. Sub-prime surpassed all other origination channels as the sector grew at record pace. Now, what to do with all this production? Securitize, of course!

As the demand for the bonds generated by the Sub-prime loan MBS and ABS structures grew at a ferocious pace both the Wall Street firms and the originators collaborated to generate more and more volume to feed the beast. This was when the credit criteria began to deteriorate. While ALT A was also generating MBS and ABS offerings, the excess spread in the sub-prime transactions made them more attractive to the bond investors. Of course it was understood that the bond investors were assuming greater risk, they were also receiving a greater yield and rate of return.

But we still need more volume…..necessity the mother of ALL genius, here’s the brilliant idea.

Contrary to the current confusion; ALT A lending was never designed as a credit solution. I can confidently say this since I was member of the original team responsible for the introduction of the first insurable high LTV ALT A loan program known as the Smart Loan. Prior to the introduction of this product, the only true ALT A loan was the Barclay’s NO Doc with a max LTV of 65%. The Smart Loan was created in the early 1990’s by ICI Funding and CMAC mortgage insurance as a solution for the documentation requirements necessary to process a traditional prime mortgage. Whether a loan was a conforming loan sold to the GSEs or a jumbo loan sold to a private investor; all the documentation requirements were the same. Even the private investors mirrored the underwriting and documentation standards of Fannie and Freddie. All income must be sourced and verified. The guidelines required a borrower whose income was generated by more than 25% commissions or bonus’ to provide full documentation to verify the income with 2 years tax returns. It was often challenging to represent the same income as cash flow because you could only add back to the adjusted gross, interest and depreciation. That didn’t even address the sophisticated self-employed borrower, so guidelines and programs needed to be modified to address these issues but continuing to maintain an acceptable level of risk. Underwriting guidelines were 33/38 for 80% loans and 28/33 for 90% and 25/28 for a 95%. A little tougher standards than what we see today. But how to address the qualifying ratios and manage the risk?

The assumptions were that with increasing home prices escalating along with personal income; borrowers were living at a much higher percentage of their income. The ALT A loan programs were designed for the borrower described as Young Urban Professional, yes a Yuppie. The risk assumptions were that these baby boomers were earning more and spending more. According to the US Census Bureau the median income in 1992 was $42,416 and in comparison to the traditional salaried wage earner, the Yuppie was earning upwards of $100,000 per year. This information is relative because there is a huge difference in someone living at 45% of $3500 per month verses 45% of $10,000 per month.

The ALT A loan “program” and I stress the word program, since the general impression was that this would be a flashy marketing product and never take hold; was designed to provide alternative documentation options to the “A:” credit borrower. So what happened?

As we discussed earlier, Sub-prime and ALT A were emerging products in the market with both credit sectors vying for more and more volume. The opportunity to increase the available market share laid in the emerging markets of first time home buyers and borrowers whose credit profile or document-able income had traditionally excluded them from homeownership.

With a spread of 300 bps differential between the two channels there had to be opportunity to capture some of the ALT A market share. ALT A products were out performing the sub-prime products so somewhere, someone or a committee of someones made the assumption that with 300bps of excess spread at their discretion to support the additional risk, sub-prime could offer the same reduced documentation options as ALT A making their sector more competitive and attractive to more borrowers. This was the first mistake! While the goal was achieved in a increase in production, it was a slippery slope. The Sub-prime lenders couldn’t hold on to the spread differential and with more and more pressure to generate more and more volume at any price; including selling your soul to the devil, and throwing away all fiduciary responsibility to the borrower. Quickly all of the compensating risk factors, excess spread, LTV /equity and documentation slipped away.

And suddenly the clear cut identity of ALT A smeared into the Sub-prime or Non-prime disaster of 2006-2007. Mega lenders crippled by repurchase requests due to poor credit quality, sub-par performance and just about any reason the end investors could think of in order to get rid of the deteriorating loan. With the EPDs and the repurchase requests exceeding any analysis for loss reserves; these companies were forced to close their doors. The total fatality of mortgage bankers since late 2006 is over 226 according to Mortgage Implode.com

It aggravates me that so many active participants in this evolution are standing around dumb struck that the market has deteriorated. Appreciation was a false bottom supporting the increased risk. How many years did we hear “The bubble is gonna burst, it just has too!”? It seems incredible to me that so many are in shock and awe of the end results. What did anyone really expect? It is reminiscent of the big pyramid schemes of the 1970’s. Early in, early out made a lot of money.

So what’s next?

“The mortgages written in 2006 in the subprime market are probably the most troublesome. They haven’t hit the reset point yet on interest rates,” Richard Syron, chairman and CEO of Freddie Mac, told a Boston audience.

The market has already started the adjustment process. The LTVs have adjusted, 80/ 20’s and 2/28 are obsolete. Focus on core values of Quality, Integrity are incumbant upon the mortgage banking industry. The must be continued education of the mortgage broker bringing value to him and his customer. Directing and guiding the transaction and the borrower toward a product that is manageable for the long term. The primary pupose is to provide secure mortgage products that promote home ownership maintaining fiduciary responsibility to the homeowner.