It seems that a nice long discussion on subprime mortgages is the cure for insomnia.  Well, for those that did NOT fall asleep reading my last post, I have some additional thoughts on the matter.

In my last post I pointed out that most borrowers in subprime mortgages are forced to refinance after 2 or 3 years due to do dramatic increases to their rate and payments.   Part of the reason for a higher than normal default rate on subprime mortgages is due to flattening real estate prices nationwide.  Let's say somebody borrowed 100% of the value of their home two years ago, and in their real estate market prices where flat or declining in the intervening two years.   So, their house is worth the same (or less) now as when they originally took out the loan 2 years before and therefore at the present day they still are maxed out at 100% of the value of their home.  They may have been excellent borrowers and paid all of their payments on time for the past two years.  This does not matter.  Their rate will still adjust at the end of the 2 year period and cause their payments to dramatically increase.  This could mean an increase in hundreds of dollars a month in their mortgage payment.  Remember, this was done on purpose by the Wall Street investors to force the borrowers to refinance, thus paying off the investors and freeing up the investors' money to re-invest at current market rates.  However, if the home has not appreciated in the 2 years since they took the loan, it makes it impossible for the borrower to refinance.  The reason is because of the closing costs of the new refinance transaction.  In a typical refinance, the closing costs are included into the new (now higher) loan amount since most borrowers do not have the cash on hand to pay for these costs.  Because the borrowers do not have enough equity to refinance, and they cannot afford the new current higher payments, eventually many of these borrowers default on their mortgage.

However, a new trend is emerging right now that I think will exacerbate the problem.  Because Wall Street investors are over reacting to the current market they are dramatically limiting their guidelines, forcing the lenders who sell their products to do the same.  The borrower who could have qualified for the 100% mortgage 2 years before can only qualify for a 90% mortgage today even with the exact same financial profile they had 2 years ago.  This is because the guidelines are so much more limited now.  So, not only is it impossible for subprime borrowers to refinance out of adjusting mortgages in flat real estate markets, it is impossible for subprime borrowers to refinance even in rising real estate markets.  A borrower's home would have to rise in value more than 10% in order renfinance.

I think there are three things the Wall Street investors are doing that are self-inflicting more pain than necessary in the subprime market:

1.    As mentioned in my previous post on this topic, they are forcing lenders out of business by demanding the lenders repurchase entire loan portfolios that Wall Street knows the lender does not have the cash to buy.  This puts the onus of the bad loans on the Wall Street investors instead of on the lender who sold Wall Street the loans.

2.    They are forcing good, performing loans into the higher adjustable rates in markets where increases in real-estate prices are non-existent and the borrowers do not have the equity or cash on hand to refinance.

3.     They are restricting their guidelines so that even borrowers in markets with good real estate appreciation still cannot refinance out of their now adjusting mortgages.

The solution to the first problem is simple.  Wall Street should stop forcing the lenders to repurchase all the loans sold to them by a certain lender, thereby forcing that lender into bankruptcy.  Instead, Wall Street could try working more with the lender on those loans that are not performing.

 As for the solutions to the 2nd and 3rd problems, market rates today are not so much higher than they were 2 years ago that it is worth taking a good, performing loan and forcing it to default.  There is nothing more expensive to an investor than a default forcing a foreclosure.  Any investor would much rather take a slightly lower rate of return on an investment that they know will not default.  I think Wall Street should take a look at those loans that are ready to have their rates adjust, and if those loans are good, performing loans then they should simply make the unilateral decision to extend the fixed rate period for a few more years.  For example, they could look at all of the loans in their portfolio, and all of those loans that either have zero late payments, or maybe just one 30 day late payment, they could extend the fixed rate period for, say, 2 more years.

With the topsy-turvy logic of the loan business, most investors would not consider this.  They say "Well, we can't do this, we need to make sure they re-qualify for the terms of the loan, we need to re-check their income and credit and job history, etc."  This doesn't make logical sense.  Those borrowers who are in 30 year fixed mortgages don't have to re-qualify every few years if they are not refinancing.  As long as they are paying their mortgage on time, the investors have no problem.  That is why I think extending the fixed rate period for a few years until the real estate markets return to (somewhat) normal would be a smart thing for the investors to do with these performing subprime loans.