If you have picked up the paper in the last month, you know that the subprime (also called nonprime) mortgage business has blown up in recent weeks.
At first, it seemed like the problems were confined to the low-quality subprime business, mainly stemming from firms that were funding mortgages with short-term borrowings. However, we're starting to see problems creeping into higher-quality mortgages.
Before we get into the problems, we first need to go over some mortgage basics. Most banks do not write subprime mortgages and instead cater to borrowers with higher-quality credit. Most banks also sell the majority of the mortgages that they originate. They earn a fee and sell the actual loan into the secondary market, often to the government-sponsored entities Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac buy conforming mortgages, which are the traditional 15 or 30 year fixed mortgages made to borrowers with FICO credit scores of at least 620 (called prime borrowers) who also have documentation showing income and assets. This type of mortgage is still the most popular accounting for 37% of all mortgages originated in 2006.
Moving down the scale, we get to Alt-A loans. These are mortgages for prime borrowers who for some reason do not provide all the documentation that the government-sponsored entities require in terms of income, employment history, etc. These low-documentation or non-documentation loans are popular with the self employed.
Most banks write Alt-A mortgages, but they sell them into the secondary market to generate fee income.
How will the the Sub-Prime blow up affect the banks?
We don't believe that the problems in the Alt-A market will get as bad as those in the subprime market, but we believe that the fears the subprime blowup created in the market and deteriorating credit quality will result in problems for the banks. In the short run, the banks that write Alt-A mortgages could be hurt in two ways: Banks won't be able to sell the mortgages into secondary market, and/or they will have to repurchase the mortgages that they already sold into the secondary market.
As a result banks are tightening credit standards and loan to value parameters primarily in the Alt-A products. Fully documented conforming or convential loans have seen little impact and we expect the number of "bad loans" to be dramatically reduced going forward.
This insight was brought to you by Trevor Gravitt of First Horizon Home loans. You can reach Trevor at 425-712-4807 or by email at Tgravitt@firsthorizon.com
