Crisis Makes High-Risk Mortgages Obsolete

In mid-2007, I began to compile data on wholesale mortgage interest rates that promised to provide better insights into the market than any existing data source. The rates are those quoted by wholesale lenders, which offer their loan programs through mortgage brokers and mortgage banks. In offering these programs to borrowers, the loan providers add their retail markups, which can vary widely among different programs and different lenders. Wholesale price data thus has less statistical "noise" than retail data.

Recently, I decided it was time to look at the numbers to see what they say about the evolution of the financial crisis. The beginning point for the data is May 4, 2007, and the end point is Nov. 7, 2008. The interest rates quoted all assume zero points.

The data show that the price of a mortgage to very low-risk borrowers for loans smaller than the conforming loan limit of $417,000 was not significantly different at the end of the period than it was at the beginning. (At the beginning of the period, $417,000 was the largest loan eligible for purchase by Fannie Mae and Freddie Mac.) But on riskier transactions or loans larger than $417,000, borrowers paid increasingly higher prices over the period. In many cases, lenders stopped quoting prices on high-risk loans altogether.

This pattern is clearly evident in the relationship between interest rates and documentation requirements. These requirements ranged from "full documentation" (lowest risk), to "stated income" (greater risk), to "no income" (even greater risk), to "no documentation" (greatest risk). On May 4, 2007, the spread between full documentation and no documentation was 0.52 percentage points.

On Nov. 23, 2007, the spread had widened to 0.94 percentage points. On Nov. 30, 2007, quotes on no documentation loans were gone, meaning that lenders were no longer offering them. On Dec. 14, 2007, quotes on no income loans were gone. On May 23, 2008, there were no quotes on stated income loans. Since then, wholesale lenders have required full documentation.

At the beginning of the period, FICO credit scores had little impact on rates if the mortgage was otherwise low risk. For this reason, I assessed the relationship between FICO and the rate on a fairly risky loan: a cash-out refinance with stated-income documentation. The FICO scores for which I compared rates were 740, 700, 680, 660 and 620.

On May 4, 2007, the rate ranged from a low of 6.15 percent for a score of 740 to 6.45 percent on a score of 620 -- a spread of 0.3 percentage points. On Sept. 14, 2007, that spread had widened to 1.37 percentage points. On Sept. 21, 2007, the 620 quote was gone. On Feb 15, 2008, the spread between the 740 and 660 scores hit 4.04 percentage points, and the following week the 660 quote was gone. On May 16, 2008, the 680 quote was gone, leaving only the 740. On May 23, 2008, the 740 quote disappeared as well. Wholesale lenders had stopped offering loans with stated-income documentation, no matter how good the credit. (Stated-income loans may still be available at some depository institutions that don't depend on the wholesale market, although they may call them something else.)

At the beginning of the period, piggyback second mortgages were widely available as a substitute for mortgage insurance in cases in which borrowers made down payments of less than 20 percent. These deals were known as 80/20/0, 80/15/5, 80/10/10 and 80/5/15, where the first number was the percent of the property value provided by the first mortgage, the second number the percent provided by the second mortgage and the third number the percent of the down payment. The riskiest to the second mortgage lender was the 80/20/0, with the risk declining as the borrower's down payment increased.

The 80/20/0 deals were available until Sept. 28, 2007; 80/15/5s until Dec. 28, 2007; 80/10/10s until Feb. 8, 2008; and 80/5/15s until March 28, 2008. That was the end of the piggybacks. Borrowers who put less than 20 percent down today have to buy mortgage insurance.

Dramatic changes also occurred in the relationship between the interest rate and loan size. On May 4, 2007, the rate on a $417,000 conforming loan was 5.78 percent while the rate on a $418,000 non-conforming loan was 6.06 percent. The larger loan was not eligible for purchase by Fannie Mae and Freddie Mac. The rate difference of 0.28 percentage points was not significantly different from prior years.

On Nov. 7, 2008, the rate on the conforming $417,000 loan was 5.76 percent, almost unchanged. The rate on the non-conforming $418,000 loan, not eligible for purchase by Fannie or Freddie Mac, was 8.73 percent. Rates were in between for loans larger than $417,000 but otherwise eligible for purchase by the two mortgage giants.

Fannie Mae and Freddie Mac, despite their troubles, continue to support the conforming market more or less normally, but the private secondary market for mortgages not eligible for purchase by the agencies has imploded. I will discuss the implications of this for borrowers next Saturday.