The mortgage industry has suffered a severe liquidity problem. It is not as if there is not a lot of money out there it is that there is an enormous amount of doubt about the true value of mortgage backed securities. Lowering the Discount Rate may have helped perception but it has not reestablished liquidity for Jumbo mortgages.
The problem has an easy solution - going forward. I proposed it last week.
1) No loans to folks with bad credit (<640 credit score) without full documentation that they at least have the potential to make the payment.
2) stated income A-paper (good credit) should be bumped up about 0.625% in RATE above full doc.
I am going to add a third point. The GSE's (FHLMC & FNMA) must be more adequately capitalized and the Federal government should clarify whether or not it is standing behind FHLMC/FNMA debt. It literally is not but everyone acts as if it it. That make absolutely no sense.
Adequately capitalized GSE's need to up their loan limits and securitized jumbo mortgages.
That is it. The bump in rate for stated may be a bit excessive but what we need is liquidity. Corrections can be made later.
This problem was cause by irresponsible lending. It is not the result of exogenous forces.
Q: But Shouldn't the Fed Solve the Problem by Lowering Rates?
A: This gets confusing. Today, the Fed lowered the discount rate which is the rate at which bank can borrow money directly from the Fed. That is largely symbolic because because very few people borrow money directly from the Fed window because there is a stigma associated with it. Banks believe that it is a great way to get scrutinized. In addition the Discount rate is evey now higher than the Fed Funds rate.
What is much more important is the Fed funds rate. That is an open market rate at which banks lend money to one another for 1 day. The Fed sets a target and intervenes with open market operations to keep that target. The most important thing the Fed did today was not to lower the discount rate but to indicate that they will start lowering the target for the Fed funds rate. Check out this language: "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth,'' the Federal Open Market Committee said today. ``The committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects."
In English "prepared to act as needed" means lower the Fed Funds target at the next FOMC meeting. At least that is what I think.
Is the Fed bailing the mortgage industry out? No. Fed bailouts are not appropriate to undercapitalized companies which take undue risks. A Fed bailout sends the wrong message and only encourages risk in the future. As William Poole of the Fed says, "everyone knows that a policy of bailouts will increase their number."
The Fed also injects money with repurchase agreements whereby short term cash is loaned in exchange for securities which are then repurchased by the borrower. What is of paramount importance is banking liquidity and the Fed will provide that as necessary by injecting massive amounts of cash into the system with repos and outright purchases.
How Did All of This Start?
I answered that last week. I said that for the most part this started with a relaxation of lending standards and that was created by greed and stupidity. But greed and stupidity are forces which are always present.
The question I will address is "Why did this happen now?"
This happened because we have been living in an "Age of Abundance" and too much money has been available to lend and lending standards in the mortgage industry and elsewhere were lowered. Strangely, we try to disguise this. Our notion of poverty is strange if many people below the poverty line own a car and a cell phone. But I am not trying to comment on society except to say that this abundance of wealth engendered bad lending. The wealth is not merely here in the US. There has been a massive decrease in worldwide poverty recently and there are massive wealthholders all over the world. Most of these wealthholders had a piece of the MBS market.
An end to bad lending may be a temporary inconvenience to most mortgage folks and a downright disaster to the folks who capitalized on bad lending but, going forward, it will be entirely good and hopefully the economy will be a little smarter.
For me the truly interesting thing is the functioning of this free market. It is not about the Fed or the mortgage business per se this is an absolutely perfect example of the free market working to correct a very serious problem. The invisible hand of the free market is rewriting morgage guidelines right now.
Dick Lepre
640 may be a bit high for a "no stated income" cutoff point. For example, some very successful real estate investors make most of their money by borrowing against equity (showing net losses on tax returns), and use too much credit for their scores to be that high, in spite of spotless payment records and a large "war chest" of available funds.
I think making the loans available, but modifying the rates to cover the risks is a better option, especially if someone can provide bank statement proof they have enough money coming in.
It is certainly true that a lot of blatantly ridiculous loans have been made, and should not continue to be made... but let's not toss the baby with the bath water right yet.
Will business credit lines become the new mortgages for professional investors?
Posted by: Frank | August 19, 2007 at 11:50 PM
Frank,
I am hardly suggesting that my numbers are the result of some finely tuned process and the economic equivalent of Maxwell's Equations. I am suggesting something to get this parked car moving again.
I am deliberatley erring on the side of caution because, frankly, I do not think that anything else will work at present.
Posted by: Dick Lepre | August 23, 2007 at 03:20 PM