Will slow and steady win the race?
US lawmakers are trying to ease the pain of homeowners caught up in the sub-prime debacle with tighter regulation and a push towards greater use of long-term fixed-rate mortgages over unpredictable adjustable-rate deals. Will a new era of thrift replace the sub-prime excesses? Perhaps not if the US feels the playing field is not level. Julian Marshall reports.
Countrywide Financial has not enjoyed the best of publicity in recent weeks. The biggest mortgage lender in the US, led by controversial chief executive Angelo Mozilo, has attracted a series of difficult headlines.
Recently, it has been caught up in reports of sweetheart loans to "friends of Angelo", including former Fannie Mae executives, a story that even dragged in US presidential hopeful Barack Obama.
Ex-Fannie Mae chief executive James Johnson resigned as part of Obama’s team screening potential vice-presidents after the Wall Street Journal reported that he and another former CEO, Franklin Raines, among others, received discounted rates on mortgage loans from Countrywide, a big seller of home loans to Fannie Mae.
This followed on from an incident in May when Mozilo, who the New York Times once described as "the butcher’s son from the Bronx" pressed the wrong key on his computer and inadvertently made public his view that a borrower’s plea for help, prompted by a website, was "disgusting".
Mozilo had intended to forward to colleagues the email from one Daniel Bailey Jr, asking Countrywide to change the terms of his adjustable-rate loan, but instead hit reply and so sent his thoughts into the public domain.
Bailey had used a form letter from www.loansafe.org, which offers advice to struggling borrowers. Countrywide has been flooded with similar emails, giving the company an administrative headache and clearly frustrating Mozilo, whose email said: "This is unbelievable. Most of these letters now have the same wording. Obviously they are being counselled by some other person or by the Internet. Disgusting."
Following the revelation, the company issued a statement saying: "Countrywide and Mr Mozilo regret any misunderstanding caused by his inadvertent response to an email by Mr Bailey. Countrywide is actively working to help borrowers, like Mr Bailey, keep their homes."
Bailey’s email has sparked a heated public debate between those that think borrowers struggling with repayments have every right to ask for help, and those who say they must face up to their responsibilities.
But the debate will be stoked by the concern that well-connected people in positions of power can get preferential treatment over the general public who are struggling to keep their heads above water in the current difficult climate.
Angelo Mozilo, Countrywide Financial's chief executive, was 'disgusted' by pleas for help
Mozilo and Countrywide, which is set to be acquired by Bank of America for a knockdown $4 billion price tag, have a diminishing reputation for the way they regard borrowers struggling to keep up with their payments. And given its rush to the top of the lending volume charts, and the way it got there – pushing just the sort of loans that helped spark the sub-prime crisis – it now has a lot of disgruntled borrowers to deal with, as the market squeezes. Any stories of unfair treatment only stir up further resentment.
Before the mortgage market went belly up, Countrywide was a very flexible lender. Before the crisis broke last year it was offering so-called piggyback loans that permitted borrowers to buy a house without putting down any of their own money. Piggyback loans are now more or less extinct, having been downgraded to junk status and worse by the rating agencies.
Countrywide also sold loans of more than 95% of a home’s value without asking for documentation of a borrower’s income.
Until July 27 last year, it would lend $500,000 to a C-minus rated borrower (the second riskiest). And borrowers could still get a loan, even if they were 90 days late on a mortgage payment twice in 12 months, if they had filed for personal bankruptcy protection, or if the borrower had faced foreclosure or default notices on their property.
Everyone turned a blind eye to this sort of hand-over-fist lending while times were good. Countrywide, although now the notorious figurehead for the US sub-prime lending problems, was not alone in touting for business wherever it could.
And while the markets surged everyone was happy. Sub-prime loans were highly lucrative to the lender, and investors paid more for pools of them because they were likely to bring in higher cashflow.
However, after the mother of all parties, the US is now inevitably suffering the mother of all hangovers. The regulators have taken it upon themselves to administer the painkillers and the harsh words.
There have been a plethora of bills passing through the legislature in recent months. This reached a head in May when the Senate banking, housing and urban affairs committee approved compromise legislation designed to help homeowners in danger of foreclosure by expanding the availability of government-insured mortgages.
The deal was put together by senator Christopher Dodd, a Democrat, and chairman of the committee, and senator Richard Shelby, the senior Republican on the committee. Dodd has subsequently also been listed by the Wall Street Journal as a "friend of Angelo’s".
The new deal seems to have appeased the objections of president George W Bush, who had threatened to veto legislation to rescue homeowners because of the cost and because it would ultimately help the wrong people. "Laws shouldn’t bail out lenders, laws shouldn’t help speculators. Government ought to be helping creditworthy people stay in their homes," he said. "And one way we can do that – and Congress is making progress on this – is the reform of Fannie Mae and Freddie Mac. That reform will come with a strong independent regulator."
The Bush administration was willing to consider the deal if it removed any direct cost to taxpayers.
The Senate bill seeks to create an affordable-housing fund, financed by the government-sponsored mortgage buyers Fannie Mae and Freddie Mac. That fund would put $500 million towards the foreclosure rescue effort.
Dodd said the aim was to shore up the crumbling foundations of the housing market. "The primary goal here is to keep people in their homes, but also to establish a floor, a bottom to all this," he said on announcing the compromise. The foreclosure aid is tied to legislation creating a new regulatory agency to tighten oversight of Freddie and Fannie.
The House of Representatives approved a similar foreclosure rescue bill in the same month.
Under both plans, lenders can limit losses from potential foreclosures by agreeing to reduce the principal balances of loans at risk of default. Borrowers with expensive adjustable-rate loans could then apply to refinance with a more stable, 30-year, fixed rate mortgage insured by the government through the Federal Housing Administration.
On top of interest and principal, the lender would pay a monthly insurance fee, into a fund to protect taxpayers from losses.
The Congressional Budget Office estimates that, under the House bill, up to 500,000 mortgages would be refinanced over the next five years, at a cost to taxpayers of $2.7 billion.
The new affordable housing fund will collect slightly less than half a cent on every dollar of mortgages purchased by Fannie Mae or Freddie Mac. It will continue to exist after the plan ends, with the money going to creating affordable housing, including low-income rental housing.
The Federal Housing Finance Regulatory Reform Act has three aims: to prevent the rising numbers of foreclosures, to create more affordable housing for consumers, and to reform the regulation of the government-sponsored enterprises to improve their role in the housing finance system.
As well as tightening a grip on Fannie and Freddie, it also wants to clamp down on mortgage walk-aways where the defaulting borrower simply sends the keys to the lender before any foreclosure. Merely sending back the keys is not the same as giving up the title. Under the new legislation, before borrowers can get FHA financing they must certify that they have not intentionally defaulted on any debt. Lying about this could lead to a jail sentence.
Equally, if the borrower walks away from a FHA loan they have to repay the government for any loss on the property.
The planned new Federal Housing Finance Agency will oversee Fannie and Freddie and will have the power to order an increase in capital in the event that the safety and soundness of those institutions is at risk. It will also set a new limit on conforming loans, up to $550,000 in the most expensive markets. The current conforming loan limit is $417,000, which was temporarily raised in February to $729,250 under the economic stimulus plan.
The regulators have had a delicate line to walk, having as their top priority to ensure that the crisis did not get any worse, while also needing to address any loopholes in existing regulations to stop a loan crisis happening again.
The Federal Housing Administration modernization bill will expand the reach of the FHA, aiming to provide safe loan alternatives to sub-prime mortgages and make home ownership more accessible.
The FHA programme is intended for mortgage borrowers with weak credit or little cash, who cannot otherwise get an affordable deal, so they are best suited to low-income or first-time buyers.
Most FHA mortgages are 30-year fixed-rate loans and typically they have better rates than other sub-prime mortgages and do not carry pre-payment penalties.
Borrowers get FHA loans from a private lender, as they would with other mortgages. They also pay a low premium to the FHA every month. In turn, the FHA uses those premiums to cover the lender in the event of a foreclosure and requires the lender to look to help the borrower avoid foreclosures if they become delinquent.
If the lender does have to foreclose, the FHA pays the lender the unpaid principal, unpaid interest and part of the foreclosure costs.
Return to fixed deals
The gamble between fixed-rate and adjustable-rate mortgages is one every mortgage holder wrestles with.
ARMs have proven a large factor in the sub-prime mortgage crisis. Now the plain vanilla fixed-rate deals might return to favour.
And yet the lenders have been pushing their interest rates on 30-year fixed-rate mortgages up, even as the Federal Reserve slashed interest rates, and yields on Treasury bonds fell. Rates on 30-year fixed-rate mortgages usually track the movement of 10-year bonds but as deleveraging occurred throughout the financial system that stopped happening.
Earlier this year, Paul Miller, analyst at Friedman, Billings, Ramsey, estimated that the mortgage market was short of $1 trillion in capital.
Miller said $11 trillion of outstanding US mortgage debt was supported with $587 billion of equity, a ratio of 19 to one. As the sub-prime meltdown took hold, confidence in the loans backing the mortgage securities ebbed away. The banks financing them imposed margin calls and demanded more cash to back the loans.
As the highly leveraged mortgage investors sold off assets to meet the margin calls, prices fell. Consequently yields rose, even on those mortgage securities backed by the GSEs and hence considered the safest.
Spreads on Fannie-and-Freddie-backed mortgage securities rose to a 23-year high in March. There were two ways to solve the problem, said Miller: either inject $1 trillion of new capital into the market or allow prices of mortgage securities to fall (and interest rates on home loans to climb). As the market could not raise $1 trillion, prices had to fall.
He predicted six to 12 months before pricing pressure would ease. The pain had to be allowed to play out in order for the market to reach equilibrium.
Other evidence of tightening belts came in April when Fannie Mae told lenders they would now need a minimum credit score for loans it buys. Previously it had no minimum score.
Now customers need a minimum score of 580 for most loans. Fannie also decided to increase the period for re-establishing credit history following a foreclosure from four years to five but it will allow shorter recovery periods for those borrowers with extenuating circumstances for their foreclosure.
Fannie Mae and Freddie Mac hold government charters to support home ownership. They raise money from investors to support combined investments of $1.4 trillion and honour guarantees on loans backing mortgage securities they issue.
The sub-prime crisis has prompted soul-searching in the US over whether there should be more federal intervention or should market forces be allowed to run free.
This has not been helped by the seemingly endless conflict in diagnosis of the state of the economy, based on widely differing data.
In March, the National Association of Realtors Pending Home Sales Index, based on contracts signed in March, fell 1% to its lowest point since the index started in 2001, and 20.1% down on last year. The contracts are a good barometer of future home sales and economists had expected a decline.
Joseph LaVorgna, chief US economist at Deutsche Bank, said the home sales data showed buyers were waiting for less restrictive lending policies. "This matches the results of the Federal Reserve’s senior loan officer survey, which showed mortgage lenders further tightening terms of credit," he said. "The pending home sales data suggest that existing home sales will register further losses in the coming months."
But then in June the NAR predicted a modest rise in home sales as buyers get access to affordable mortgages again.
Lawrence Yun, NAR chief economist, said: "The housing market has been underperforming by historical standards, partly because buyers were hampered by mortgage availability issues but that’s improved and an upturn is more likely."
This followed big falls in house prices in the first half of the year. Yun said policymakers needed to address the fact that a lot of homeowners are facing negative equity. "More needs to be done on the policy front to alleviate hardships and bring fence-sitters back into the marketplace," he said.
Meanwhile, recession talk refuses to go away. Stephen Green, HSBC chairman, was one of many to forecast a gloomy outlook on announcing the bank’s further $2.6 billion in write-downs and a $3.2 billion hit from US customers failing to pay loans on time. This was up from $1.6 billion in the same period last year.
"It seems increasingly likely that the US will enter a recession in 2008, the length of which is uncertain," he said. "The timing of any recovery in the US housing market, which is likely to be be the primary stimulus in restoring confidence to the US economy, is also unclear."
This pessimism was recently backed up by Kenneth Rosen, professor of real estate and urban economics at the University of California-Berkeley, who told a National Association of Real Estate Investment Trust investor forum in New York last month there was a 95% chance of the US falling into recession.
Against this backdrop the government hopes its May issue of tax rebates of up to $600 per adult and $300 per child will stimulate the economy and create 500,000 jobs by the end of 2008.
Treasury secretary Henry Paulson conceded that some people would spend the money on petrol or to pay off credit card debts but said that this would still contribute to economic growth. "I expect the stimulus to make a difference," he said.
As the outlook remains so cloudy, it is highly uncertain whether the lawmakers’ attempts to bolster the market will have any effect. The likes of Mozilo and Countrywide will remain pariahs for some time yet.