By Izzy Leizerowitz, 2006
Mortgages have been sold and packaged into securities for many years. These securities are repackaged, and traded many times over to investors worldwide. According to a recent article in the Wall Street Journal, it is a $9.1 Trillion market. Of the $3.1 Trillion in mortgages originated in 2005, 68% were securitized. When these packages of mortgages are exchanged between lenders and investors, contracts are drawn that typically define how mortgages in the pool that default early or are found defective or deficient due to underwriting errors, need to exchanged for good mortgages or repurchased back to the seller. When mortgage originations are regularly increasing such as in the last several years due to the hot real estate market, many firms packaging these loans were not really focusing on the repurchase issue, but as the recent real estate downturn has strengthened, the associated costs surrounding mortgage repurchases have now come forward to center stage.
As mortgage originations continue to slow down, we have seen a large increase in early defaults and loans found defective, due to a combination of poor underwriting and an industry wide pressure to close higher risk loans to maintain production volumes. Many lender underwriters were hired during the recent boom to accommodate the crush of mortgage applications and also have had to operate under enormous workload pressures. As a result, the quality of mortgage loan packages have slipped. In the same Wall Street Journal article quoted earlier, it reported that H&R Block recently added $102 million to reserves against repurchased loans in August from its sub-prime banking unit. In a separate study, Credit Suisse analyzed 208 bond pools containing sub-prime mortgages, valued at $234 Billion and found that half of those pools had loans that needed to be repurchased. Even though the repurchased loans represented just under 1% of the total value, the monetary value of those loans is staggering. Finally, Impac Mortgage Holdings, Inc. a California based Real-estate investment trust reported that its repurchases tripled between the first two quarters this year to an amount equaling $100 million.
Investment banks and other entities are working hard to resolve the problem, because essentially lenders need to be able to sell quality loans in bulk, and investment banks need quality loans to bundle in bulk to sell as securities. First, lenders are tightening their underwriting guidelines to weed out high default, high risk loans and borrowers. Second, lenders are also tightening their underwriting guidelines to minimize potential fraud or irregular loans, especially in the credit and appraisal areas. Finally, lenders and investors alike are coming to consulting companies such as ours to analyze their loan portfolios through the utilization of computer modeling to find profiles in these loan portfolios that identify the source or cause of the majority of the repurchased or defaulted loans. These findings will result in significantly lowering a lender’s or investment bank’s repurchasing costs regardless of a soft or rising mortgage origination marketplace.
Secondary Markets – What’s Really Behind Wall Street’s Love Affair with the Mortgage Industry
Consider the following:
Merrill Lynch just bought National City Home Loan Services for $1.3 Billion and First Franklin Financial Corp, also for $1.3 Billion. Bear Stearns recently purchased EMC Mortgage Corp. Deutsche Bank is buying Chapel Funding LLC and MortgageIT Holdings Inc. Morgan Stanley is in the process of purchasing Saxon Capital. According to a published report in Mortgage Servicing News, Centex Home Equity was recently sold to an investment fund.
Logic might seem to dictate that with the real estate market slowdown in full swing and mortgage originations on the downslide, both servicing and originating related mortgage companies might not be on the surface the best businesses to buy at this time. However, the rash of purchases recently made by Wall Street seems to be an indication to us that in this uncertain marketplace, Wall Street wants to be in total control of its profit destiny. First, sub-prime mortgage businesses are still enjoying healthy profits and revenues. For example, according to Paul Muolo in the Mortgage Servicing News, by buying First Franklin and National City, Merrill Lynch is getting two companies that combined for $44 Billion in servicing rights, and a sub-prime origination business that reported earnings of $148 million just in the second quarter 2006. So while the industry may be experiencing a slowdown, sub-prime mortgage businesses still represent the cream of the mortgage crop, profitability wise, and Wall Street understands that when they are looking at potential purchases.
However, we believe that there is another equally important reason why many Wall Street firms have recently gone the ownership route for sub-prime origination and servicing businesses. We believe these firms want a guaranteed source of loans for their mortgage backed securitization businesses. Wall Street has been securitizing sub- prime loans profitably for many years and as reported elsewhere in this newsletter, is a $9.1 Trillion dollar business. In a shrinking origination market, these firms really want to control their own supply of loans for their securities practice, which when you think about it, is what these Wall Street businesses know best.
Property Valuation Methodology – Its Now About Speed, Accuracy, & Financial Security.
What if someone said that a $200,000 residential property could be appraised with a high degree of accuracy in just minutes, and that the appraisal could be insured to cover the lender in the event of an actual loss or foreclosure due to appraisal overvaluation. To quote an overused phrase, “Is that something that would be of interest to you”?
The landscape of property valuation has changed dramatically. While in-person traditional appraisals are very much in demand and still required for most property purchase scenerios, many Home Equity and Refinance lenders now require full appraisals only for properties valued above $250,000. In place of a full appraisal, AVMs (automated valuation models) are becoming the norm. According to an article by J. Brian King in Secondary Marketing Executive, AVMs as the valuation method of choice, rose to 66% of total home equity valuations in 2005. AVMs are statistically based computer programs that use real estate information such as comparable sales, property characteristics, tax assessments, and price trends to provide an estimate of value for a specific property. The strengths of AVMs (Automated Valuation Models) relative to traditional real estate appraisals are speed, reduced costs, consistency, and objectivity. AVMs can significantly reduce the time it takes to obtain an estimate of value and reduce the costs associated with the traditional property appraisal process. An AVM costs anywhere between $5 to $25, so not only is it faster than a full appraisal but also much less expensive.
AVM usage is moving to the first mortgage marketplace. For over 15 years Freddie Mac has effectively employed AVMs internally for its own risk and portfolio management through the development and resale of its Home Value Explorer (HVE) product suite. Lenders selling loans to Freddie Mac today face a version of HVE used by Freddie Mac to determine the level of collateral assessment. According to J. Brian King, the next wave of AVM product development focuses on appraiser assisted AVMs where local appraisers make actual adjustments to AVMs to increase accuracy and valuation, and on insured AVM products where lenders eliminate the risk of using an AVM over a regular appraisal but cost more than typical AVMs. The trend is clear. As property valuation databases become more comprehensive, centralized, cover more geography and are more readily accessible through technology, AVMs will become even more reliable, popular, and cost effective methods of valuing properties in less time.