Non-Prime Mortgages: Time to Lend Again?

I often hear people wonder aloud why banks won't loosen underwriting standards on home mortgages.I'm beginning to wonder the same thing. That's because I think it is time for lenders to start issuing mortgages to non-prime borrowers again, though not on the same shaky terms that triggered the housing crisis of 2008, of course.

First, the reason why lenders are hesitant to relax loan requirements: The heart of the matter is: Mortgage rates and their profitability margins are so low, it just isn't worth the risk to lend to anyone who is anything but a AAA+ credit-worthy consumer.

Furthermore, it takes an implicit guarantee from Fannie Mae or Freddie Mac, on top of that sterling rating, to make mortgage lending even semi-palatable for a bank or investor.

For better or worse, the housing market is fueled by Wall Street's appetite for mortgage-backed securities.As mortgage rates continue to set historical lows, so do their profitability margins -- as well as the profitability margins of the securities they reside in (that investors typically buy, sell and otherwise trade on).

Being that investors have no appetite for high-risk, low-yield investments, there's simply no money in mortgages right now.As a result there is very limited credit available in the marketplace, especially to non-prime borrowers.

This is in stark contrast to what was a high-risk, high-yield, credit free-for-all environment that was in place from 2002 until the housing market crash in late 2008.

So, it's been two years since the crash and the prevailing thought has become that: Interest rates must be kept low to keep consumers "incentivized" and "transacting."Unsustainable consumer incentives have run their course.A tax credit has been tried and proved expensively ineffective while interest rates have been kept artificially low for too long.These are strategies that treat the illness but do little toward finding a cure.

Current mortgage rates for the most qualified consumers and properties are hovering around 3.99 percent for a 30-year-fixed and as low as 2.875 percent for the 5-year-fixed variety.Yet while mortgage rates are jaw-droppingly low, the housing market is no closer to snapping out of the protracted downward spiral it's been in for a couple years now.You can drop rates to .399 percent, but if only a tiny consumer pool qualifies for such, there isn't enough benefit to impact the market in a meaningful way.

Money needs to be thoughtfully brought back to non-agency mortgage-backed securities, which would require higher interest rates and the yields they offer investors.Huh?Yes, increasing interest rates and the yields that accompany them are required if we want to see credit flow back into the non-agency -- that includes portfolio, jumbo, Alt-A and subprime loans -- mortgage-bond markets. We need more liquidity and credit in the non-prime, non-agency mortgage pools if we want to pull out of the housing quagmire, because there's a huge pool of non-prime borrowers who can afford mortgages.

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Something that gets lost when discussing borrower defaults and foreclosures is that people who were prime borrowers are defaulting just as readily as non-prime borrowers. At the same time, there is an abundance of non-prime borrowers making their mortgage payments in a timely fashion.

I've had the opportunity to personally review residential mortgage-backed securities and can attest that FICO scores and loan-to-value ratios are not the leading factors behind mortgage defaults. That's why I think it's time to bring back the non-prime borrower into the mortgage market.

So, how high do rates need to be?Likely 300 to 400 basis points (3 percent to 4 percent) higher than they are today.

Interest rates of
6 percent to 7 percent on a fixed-rate mortgage are still cheap money, and there is a very large pool of consumers who could afford mortgages with rates in this range but who qualify for nothing under today's agency-backed underwriting guidelines. Get back to mitigating risk with price, but in a more responsible way.

Non-prime borrowers will call for different underwriting standards.I'm not talking about going back to the days of no income, no asset, no job requirements; I suggest going back to more logical and flexible underwriting criteria.A heavy emphasis must still be kept on the substantive components of mortgage qualification: Credit, income and assets.

Despite the robo-signing paperwork mess, there will continue to be abundance of foreclosed inventory flowing into the market -- that desperately needs buyers who desperately need credit -- or the property will continue to rot a hole into the housing market and U.S. economy for many years to come.

We learned a lot from the housing boom and subsequent bust. No one is suggesting that we go back to the period of 2003 to 2007. Increased awareness and transparency on many levels likely will prevent that.

I recommend that lenders increase rates and yields to match the risk of the underlying borrower and security. A bold move like that will get investor liquidity and credit flowing back into a market that is choking itself out.

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