In Shakespeare's tragic play, King Lear, the aging title character decides to divide up his vast land and give the pieces to his three daughters. After a series of complex plot twists, misunderstanding and, yes, a death here and there, the good King Lear goes insane. Apparently, dealing with real estate issues in the Bard's day was just as challenging as it is today.
Perhaps King Lear should have listened to his trusted, yet mysterious advisor, the Fool:
"Have more than thou showest,
Speak less than thou knowest,
Lend less than thou owest...."
For those of us in the mortgage business, the Fool's words sound like good advice on how to manage and maintain a healthy balance sheet. It's timely advice as industry players confront an increasingly uncertain and turbulent real estate environment.
But it's the subject of mortgage risk--and the management of that risk--that has become the topic du jour. In fact, the two most common questions I'm asked are: "What's going to happen with defaults and claims going forward?" and "Who are the holders of credit risk today, and how prepared are the holders to deal with the stress?"
These are certainly two valid questions in view of today's mortgage environment, and they deserve careful consideration. Why? Because insight may tell us if there is an impending real estate crisis stemming from a culture where lenders make loans using credit parameters that make them uneasy, but draw comfort presuming that others along the chain know what they're doing.
To address the first question--What's going to happen with defaults and losses?--we need to look at the three components that would make the greatest impact on defaults and losses: overextended consumers, escalating risk layering in some loan products, and the much-talked-about real estate bubble.
Unfortunately, it's impossible to accurately gauge whether too many consumers are, indeed, overextended and, if that's the case, whether that will lead to rising mortgage defaults and foreclosures. What we can say, however, is that housing afford-ability has been declining since last September, which has been putting more pressure on borrowers to use more exotic loan products, such as interest-only (IO) or option adjustable-rate mortgages (ARMs). These products carry greater potential for default as payments increase due to rising interest rates or amortization resets.
Many industry colleagues I've spoken with have voiced concern about the next component, escalating risk layering in some loan products--the piggyback mortgages, reduced documentation, alternative-A-minus, to name a few--coupled with low FICO[R] scores. These products now dominate the mortgage market, accounting for as much as half of new originations. Is this what the prognosticators were talking about when they heralded the "new era" of residential real estate? I don't think so. As the volume of these types of loans has continued to flood the marketplace, bank regulators have issued guidance on IO and negative-amortization products, requiring enhanced underwriting, reporting and reserving. Everyone I talk to is uncomfortable with these products, yet seems unwilling or unable to take any actions due to competitive factors.
And all that lending has contributed to the much-talked-about real estate bubble and whether there really is a bubble and, if so, whether it is going to burst or simply deflate gradually. I've previously discussed the bubble question, and probably the one thing we can all agree upon is that there are certain metropolitan statistical areas (MSAs) that are more likely to suffer declines in home prices in the event of an economic downturn or a major rise in long-term interest rates. At Radian, we've identified 24 MSAs that fit this description, with the majority located in California, Florida and the Northeast. Because any predictions are hardly an exact science, I'm encouraged that the early signs point to a gradual release of air (in keeping with the bubble metaphor) instead of a bursting bubble. …