The Correction: How Bad Does It Hurt?

As I write this, news is breaking that Countywide Financial Corp. is converting to a thrift. Dutch bank ABN Amro Holding NV is contemplating selling its U.S. mortgage operation (which boasts $200 billion in servicing rights) and the Democrats have taken control of both the House and Senate.

Here's some more facts to throw into the boiling stew: subprime lenders are seeing their profits squeezed and the phrase "loan buybacks" are becoming commonplace in the earning statements of publicly traded mortgage firms. Meanwhile, the yield curve is as flat as and ironing board, home values and home sales are headed south of the border, and residential finance executives are begging their family physicians for Xanax prescriptions.

Had enough yet? OK, I'll let up. What I'm trying to say is this: it's a wild and wooly time in the mortgage industry right now, and you'd better strap yourself in because it's going to get interesting. It's already interesting. You might even say it's the worst operating environment the industry has faced since 2000 when refinancings accounted for just 15% of production. (Back then the subprime industry was dusting itself off from the bond market meltdown of '98/'99.)

But first, let's talk about the "positives." The mortgage industry is a cyclical business. It has peaks and valleys. Two years back I wrote a column suggesting that perhaps the industry's cyclicality had calmed down a bit, that the next market correction wouldn't be so bad. I'm not abandoning that premise, at least not yet.

It's a difficult operating environment. It's not pretty, but that's the nature of the business. The best thing that might be said for the current market is that all the pain the industry is going through right now should pave the way for "normalcy" later on. And the very best thing about the current situation: that home speculators have left the market.

I'm not a big fan of speculators. I'm a big fan of investors - but investors are not speculators. Sensing easy money, speculators enter a market, inflate housing values and contribute to real estate bubbles. In this last cycle, speculators used zero-down mortgages - including payment-option ARMs - and flipped homes in a matter of months, making huge returns. "Newbie" speculators entered the market and did the same. The next thing you know speculators, in some markets, accounted for 30% of sales. That's not good. Today, speculators are leaving in droves. That's good.

Investors buy homes, fix them up, rent them out and help improve neighborhoods. At least that's what the good ones do. Investors aren't in the business for a quick killing. They know it might take a few years to see returns on their capital.

And now for the bad news. (It probably sounds like I just gave you the bad news.) The two biggest issues facing the industry right now are profit margins and loan buybacks. Profit margins will only improve when lenders can successfully increase the interest rate they charge for loans while their cost of funds remains the same. If a lender cannot increase its rates, it then has to find a lower cost of funds.

Depositories that fund residential loans have a cheaper cost of funds than non-bank lenders. (Why do you think Countrywide is converting to a thrift?) The one easy solution for the industry would be to convince the Federal Reserve to start lowering short-term rates. Good luck with that.

Currently, lenders cannot hike their mortgage rates because they know if they do, a competitor will beat them on price. It's a conundrum. For now, the production side of the industry is in a holding pattern. Origination volumes are decent by historical standards because refinancings are strong. How long this phenomena will last is anyone's guess.

As for loan buybacks, the situation could be leveling off but don't bet on it. Wall Street and other secondary market investors are tightening the screws while dictating stronger underwriting. This isn't such a bad thing. Perhaps, the industry was drinking a bit too much from the no-downpayment/no-documentation whiskey bottle. In the long run tighter underwriting is good for the industry. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com