The State of the Loan Market and How Much You Can Borrow September 2008 (Part I)

Two years ago, the loan market was easy. It was like being one of those third world countries tapped into the IMF back in the nineties. Of course you could get a loan, and if you didn't make enough to handle the payments, the lenders were still eager to loan you that money.

Anyone who hasn't been hiding in a cave knows that's no longer the case. It's been like watching an ammunition depot self destruct in slow motion, Hollywood style. One load of ammo catches fire and cooks off spectacularly, thereby spreading the fire to the surrounding loads of ammo, which in turn cook off and spreads it to the ones further on down the line. One group of loans that should never have been made destructs, resulting in short sales and foreclosures, lowering the prices of property as more properties needed to sell than new buyers wanted to buy. This, in turn, made it more difficult for people who might have been okay otherwise to finance out of their nonetheless risky loans when the appraisals didn't come in, thereby causing more short sales and foreclosures, a positive feedback loop if ever I've seen one. Not in the terms of being desirable, but in the same sense of falling dominoes, progressive disaster, and nuclear chain reactions: one causes more.

On the other hand, in many areas of the country, those explosions have pretty much reached the edge of the ammunition depot. The people who are left have pretty much all managed to get themselves into stable, sustainable situations. They may not be as well off as they are two years ago, but they can handle what they've got.

The people who have really been burned by all of this is the lenders, and people who invest in lenders and mortgage backed securities. I say this not out of sympathy for them, because I and many others were warning of precisely what was going on while they joined the rush, but rather to help clarify and understand why lenders are so paranoid right now. Subprime lenders are essentially out of business - the customers the few remaining subprime lenders are looking for seem to be people who qualify A paper but don't realize it. It's gotten so bad that even lenders who kept sane and intelligent loan guidelines have been hurt by the meltdown.

Things tend to flow cyclically in the loan business. Two years ago, everything was riding high and loans were easy as the result of about fifteen years of nothing but good experiences with real estate loans. Losses were small by comparison with historical standards and minuscule by comparison with the present simply because prices had been rising that whole entire time. This encouraged lenders to serially relax their standards and their guard. Fifteen years is a long time in the lending business. Because fewer people stay in one job, or with one company, the critical mass of people who had been through the Savings and Loan meltdown in the late eighties and early nineties was now gone. They retired, they went into business for themselves (often as agents and brokers happy to encourage the new excesses), or they moved into another line of work. The low numbers of such people left at the lenders were insufficient to keep their co-workers, supervisors, and subordinates from going off the deep end with constantly loosening lending standards.

Indeed, those loosening lending standards were a major part of what drove the bubble. I have written about this more than once. The Mortgage Loan Market Controls the Real Estate Market. When lenders are loosening standards, more and more people find it easier to qualify for bigger and bigger loans, and what economists refer to as Demand for real estate increases. Drastically. But this was all driven in a vicious circle by rising values which fueled loosening standards which came right back around to fuel rising values. When the bubble stopped expanding, things started going wrong for the lenders. Because values were no longer rising, lenders stopped loosening standards. Because things had gotten way beyond sustainable and affordable levels, this meant values started falling, and lenders tightened standards because they were suddenly experiencing what are euphemistically called, "Adverse results," by which those describing it mean, "Those lenders lost their shirts - and their pants, socks, shoes, underwear, and quite possibly their first born children. What this means in the real world is that people couldn't afford their homes because they couldn't afford the current loan, they couldn't refinance, and they couldn't sell. A complete reverse of the vicious cycle I described a few sentences ago resulted, with tightening loan standards driving lowering values which in turn drove the lenders into further tightening standards. Instead of earning interest on the money they loaned out, the lenders have been losing the money they had in the first place. This is pretty much the state of the cycle right now.

So let's review what's available right now. Second trust deed lenders have been hurt the worst, because the first trust deed gets every penny they are owed before the lender on the second get a cent. Indeed, in quite a few cases, the first mortgage holder has emerged smelling like a rose and looking like a genius, while the lender that signed off on the second mortgage ends up completely broke. Second lenders, whether "piggyback" or "stand alone", HEL or HELOC, were the first to pull back on their lending standards. The rates weren't bad by historical standards last I checked, but they all want full documentation of income and max out just below ninety percent loan to value ratio, while in some cases limiting themselves to as low as sixty-five to seventy five percent loan to value, no matter how well you can afford the payments. Loan to Value Ratio doesn't keep the borrower from defaulting, although it can motivate borrowers to try harder, lest they lose the investment. It protects the lender from losing money in case of default. The problem has been way too many defaults, so second lenders have become completely paranoid about loan to value ratio. If you want to go above 90% loan to value, the only way to do that right now is with a single loan.

First trust deed lenders are, for the most part, perfectly willing to make loans to 100% of the value of the property providing they can get a guarantee, either government or Private Mortgage Insurance (PMI), issued on the loan. There are some exceptions to this. Declining markets subtract 5% off the maximum loan to value ratio. Extreme examples of this subtract ten percent, or even fifteen. Since the value of the property as far as the lender is concerned is the lesser of the purchase price or appraisal, this can mean you can't (or your prospective buyer can't) buy at that price even if you (they) do have 5%, 10%, or whatever is applicable to put down. Ladies, and gentlemen, I am very glad that the San Diego market has had the declining market designation removed. But so far as the loan amount is insured against loss, the lenders are willing to venture their money. Kind of like people who keep seven figures in savings accounts, because they're scared to take a loss, so they earn less than inflation in interest and pay ordinary income taxes on it. (Note: FDIC only insures the first $100,000 at any given institution).

The problem we're having right now is that all of the private mortgage insurers I'm aware of have, in the last month or so, gotten out of not only the 100% business but even the 95% business. So 90% of value is as high as "conventional" loans can go right now, because without that private mortgage insurance, lenders are too frightened. So you need 10% of property value in the form of down payment to buy without the government getting involved, 20% in some situations if you don't want to pay for mortgage insurance.

(Continued in Part II, dealing with solutions)