On the Road Again

Industry officials my colleague Brad Finkelstein and I spoke to at the Mortgage Bankers Association's annualconvention in Boston were pretty sanguine about the dangerous time that lies ahead for the mortgage market thisyear. Yet, they also saw a couple of areas that won't be as bad that industry firms can use as countercyclicalplays.

ROUNDTABLE PARTICIPANTS: Jay Fuller, managing director, Vertice; Steve Jacobson, president, Fairway IndependentMortgage Corp.; Bob Yeary, chief executive, Reverse Mortgage Solutions; Ron Litt, president, Market Kenetix.

MARK: The question on everybody's mind is when will we get to the bottom of the mortgage recession and how longwill it take for the market to get back to a good, thriving level of business?

RON: That is a pretty fair question. I don't know what the definition of good, thriving business is. I don't believewe have reached the bottom yet. I think the deceleration has slowed down somewhat because all the weak sistersfell out early. We're still having some issues. Countrywide is not out of trouble. There are people with solidfinancials that are paying the price of overvalued properties and bad loans. I think it is going to be a while,maybe another year.

JAY: We have the data that shows when the resets are going to happen. So it seems pretty clear that 2008 is goingto be problematic because there are just going to be, structurally, things that are built into that. To me whatwe need to watch is a spillover into the overall economy and we get a lowering of the bar, if you will, triggeringeven more of what is happening.

BOB: I don't think we've addressed the option ARMs. We tend to talk about the resets on the 2/28s and 3/27s, butthe option ARMs, we have a lot of those loans

that are going to cap out in a little while too, and that is going to be a real nightmare.MARK: Can any of these borrowers be refinanced into a 30-year fixed? The rates for those loans are still extremelyattractive.

RON: The problem is the collateral. The value of the collateral has been declining before this whole thing started,and I don't see that rebounding. A lot of the markets were overpriced to begin with -- California, the Northeast,the Detroit area -- those are going to be problem areas geographically for refinancing. Some parts of the country,it will not be as much of a problem. Some markets are insolated from all that growth like the central part of theU.S., for example. I think it is going to be a real problem; I think we are going to still see an increase in foreclosures.It will be like it used to be in the '80s in Houston where during the oil crisis people just walked away from theirhouses.

MARK: Mailed in the keys. It wasn't an expression; it actually happened.

BOB: The surprising thing was that 6% delinquency wasn't the amazing number but that 94% of the people whose houseswere worth half of what they paid for them were still making their payments. That happens in Texas, now I don'tknow if in California we are going to have that same kind of customer. I'm focused on the reverse mortgage sectorand we're seeing a lot of people wanting to come into that now. And we don't know yet how the FHA bill will shakeout. With the lessening of the audit requirements, that could open a whole new marketplace for the small brokerthat was traditionally not involved with the FHA product.

MARK: I was going to ask about what niches were still workable. FHA is one, reverse mortgages are another. Whatabout multifamily or small-balance commercial? Is that viable?

RON: I see commercial as a place where a lot of brokers are moving. A lot of the branch companies, for example,are opening up commercial divisions and going after that small commercial business.

JAY: [Vertice] is part of Wachovia, and we're planning to bring out in the first quarter a small multifamily, fiveto 20 units, $250,000 to $2 million range. We're going to have to be careful and really control the processingbecause it is a different enough animal from the residential broker, from what they are doing. There is a marketthere that may make some sense.

MARK: If everybody gets into it, isn't there overdeveloping? It's a distinct possibility.RON: It is a possibility, but you have more flexibility in the commercial market to differentiate yourself. Youcan do it a bunch of ways because you don't have all of the regulatory constraint that you have in the residentialmarket.

JAY: Your funding sources are going to have to be pretty solid with that because that is not a particularly liquidproduct today. So you are going to have that pretty well tightened up to make a consistent market for it.

MARK: The consequences of one bad loan are much higher than one guy defaulting on a single-family house becausethe loan amounts are so much bigger.

JAY: But it is clearly a different underwrite. We seem to have put all of our eggs into the FICO basket, it hasseemed to me over time, but it is really a cash flow exercise. It is nice that the borrower has a good FICO, butyou are really looking at the property, in and of itself, to develop cash flows.

BRAD: Steve, what are your branches asking for in terms of product from you?

STEVE: Having been on the origination side for 23 years and been through it at different times, the products areshrinking as far as what is available. And as we all know, people are going to continue to buy and sell [houses]based on their needs. People are going to get married, they'll get divorced, and they'll need money. It is basicallyagency product, the market has corrected itself and now we have to adjust. It almost reminds me of back in the'80s when we talked with somebody and asked "What is your job stability? What's your cash? What's your credit?What's your income?" And all four of those, assuming that the appraisal was good, would have had to make sense.So to me it is back to the basics. The established originators will do OK because they will pick up other people.All of us are looking for quality -- quality originators, quality people, quality markets -- if you don't havequality and you don't have people who are established, this probably isn't a good business to be in.

MARK: How about the jumbo market?

STEVE: It is just starting to come back.

BOB: That is what I am hearing, that we are starting to see more things. But I have a number of friends in thesubprime business, and they are just not seeing anything. They have customers that are in trouble, but they haveno place to go.

JAY: That is going to be quite a way aways, the jumbos -- they're still having problems clearing all of the piecesof the jumbos, so that is not happening. I think

we're going to take whatever product category at the very top of the credit spectrum and carefully reintroduceit and build credibility. It is hard to look around the industry and see who has any moral authority to lead usout of this situation.MARK: I've been saying everything old is new again.

RON: As far as product is concerned we are back to the '80s, but I also believe that the broker market is not goingto look like it looked before we started this downturn, even when it settles down and comes back. There are obviouslygoing to be fewer, but there is going to be a lot more discipline imposed by companies they are affiliated with,branch companies. I know there are good ones that impose a lot of discipline on their people and act essentiallylike retail outlets. But there are still some loose cannons out there that don't understand the regulatory process-- or don't know the regulatory process, shockingly -- and I think the stronger branch companies are going to absorbsome of those.

JAY: And we're going to have to be careful that FHA doesn't become the subprime dumping ground through all of this,and what could have been a very viable area for us to grow our business and have it be productive, we mess thatup also. It is one of the things that concerns me. If they figure out how to implement it, we all have to havethe discipline -- it isn't just the brokers -- we all have to have the discipline to be responsible.

RON: That's why I don't think the broker picture is going to look the way it used to look. I think there will bea lot more control and oversight imposed from the top down in all of the organizations. This is almost like thelast stand. We've got to get it right this time or else there may not be another time.

MARK: When the brokers first got their push, they were all prime refinance specialists. That market went away afterthe 1993 boom and they went into subprime. Is it possible they will migrate into doing agency paper again?

RON: I think that is highly likely. I think we're going to see more of that and it is not unrealistic to expectto see some subprime come back eventually. As the lenders develop a little more confidence and get a little morerelaxed, they'll dip their toe into the subprime arena again. Hopefully, we will never get this wildly out of controlthe way it was before the problems really started. I think some subprime will come back, but not for a while yet.

BOB: It will be interesting to see what the states do with all their regulation, what the feds are going to dowith their regulation. We don't know how the whole thing

is going to shake out. But we know the number of brokers is going to be a lot thinner, a lot of them already haveleft the business. In agency paper, they are not going to get the kind of commissions the subprime business broughtin.MARK: That is why people didn't do FHA loans, they did subprime.

BOB: I know of people who made $15,000-$20,000 on a subprime loan, where on a typical FHA they would make justa couple of thousand.

RON: That is why I think the compensation model for the broker is going to change as well. Because of that, themargins just aren't there anymore. I don't think they'll ever be there. There is going to be more of a cost ofdoing business because of [increased] oversight and control. Without some product differentiation it has becomemore of a commodity product than it has ever been, and that is where the good marketing companies will come tothe fore.

JAY: But there is nothing wrong with having to compete on good service instead of stretching the credit envelope.

BOB: Absolutely not! That is what we used to all do. You had FHA, VA, and conforming conventional, and that wasit. And we all went out [and told clients] "we can process, we can close quicker, we don't renege on our commitments."Those things we all used to say, and most of it was true in those days.

JAY: Another dimension is that there will be a lot fewer wholesalers for brokers to choose from with all of that.We certainly see that now as [brokers] look and figure out "Who can actually fund my loan? Who is going tobe here after the lock period to do that?"

BRAD: But Steve, with fewer wholesalers in the market, isn't it an opportunity for a company like yours, wherea mortgage broker who is looking for outlets might hook up with someone who can aggregate for them?

STEVE: I think there are opportunities there. We do about 70% of our stuff as correspondent, and you are just realcareful about who you pick to do business with. American Home got us in trouble, and we had loans funded but couldn'tsell. You go to the banks and be conservative with who you pick. We all need to be careful on the broker side oron the small mortgage banker side on who we pick as partners.

MARK: What do you think the new subprime environment, once things come back to normal, will be? Is it going tobe companies that have depositories who can still fund loans when Wall Street decides suddenly not to fund anymore?Is it going to go back to monoline subprime companies, of which dozens left the business this year?

STEVE: I think it will be regional banks. We're already seeing it. You're seeing the jumbo product being done ina local marketplace because they have excellent money they want to loan and it is good product. They know the marketplaceand they will do loans in Boston, but not Atlanta.

BOB: We're going to see Wall Street back in. They have got this big machine -- they've got to have product in someway or shape.

STEVE: When do you think that will happen, Bob?

BOB: I don't know, I think it is going to take a long time. I get tired of hearing the brokers' taking all theheat for the subprime chaos. The borrowers who claim they

didn't know what they were getting. I'd say in maybe 5% of the cases they didn't know what they were getting. Theaggregators had their contracts with Wall Street, and Wall Street said "just keep throwing stuff against thewall," and guess what, it was sticking. The contracts said you can't do that, but it was sticking to the walland they were getting paid. Then they decided to change things.JAY: It is hard for me to see a standalone subprime model working anytime in the future with that. I just can'tsee how you could put your capital and think you are going to be able to avoid some kind of disruption. It is entitiesthat have multiple funding sources and are able to switch if they need to.

RON: I would tend to agree with that. I don't see anybody putting their eggs in one basket for a long time. Thereis a lot of pain associated with that right now. This whole industry works on a pendulum basis, and I think thependulum will swing back. But it won't ever come back as far as it has unless we get some other outrageous inflationof property values or something like that.

JAY: Which is really a shame, because there are lots and lots and lots of people who deserve to get credit in thesubprime area, and they're just not going to get it. That is undeserving for them.

BRAD: How much of a role did government housing policy have to play for causing the subprime crisis?

JAY: I think it was really a combination of grade and leverage and passing the hot potato called credit risk around,and nobody really knew where it really was. We still have CRA, there is still the push to that well, so the governmentpolicy influence is still there. It was just really cheap money.

RON: There is plenty of blame to go around. Everybody took advantage of the opportunity. The opportunity was puton the table and everybody said this is what can be done.

JAY: With that being said, what a great opportunity. When we get to the other side of the crisis, you'll have awhole lot less competition, but you will still have the biggest market out there and the social need embedded inall that, to bring some service to bear on that. I'm looking forward to that. It is painful to get there. We'veall been on the deep side of the cycle, and the real value is added as you start coming out of the bottom partof the cycle. Housing is not going away.