by Paul Jerome
The lending term populating portfolio buy/sell agreements to package and sell loans into the secondary market to Wall Street investor groups is the term "sold with recourse". As the loan goes bad, some before the first payment is made; many lenders are being asked to buyback bad loans per portfolio selling contract. Only problem, many of the wholesale sub-prime (higher risk loans) mortgage originators are being forced out of the business lacking the funds to buy back the loans. One of the major sources of revenue for a wholesale sub-prime originator is selling loans into the secondary market at say 105% (could be more-could be less) of the portfolio face value. When the buy window shuts for new loan originations, the loan may be worth maybe 95% of the face value and the originating wholesale lender takes a hit before getting out of the blocks. When the game is over, it's over.
For example, if a loan is sold into the secondary market which has an original face of $250,000 with an interest rate of 7.875%. The payment on this Adjustable Rate Mortgage (ARM) with a two year fixed rate and then the remainder of 28 years that will adjust every 6 months. This loan among a portfolio of other loans would be sold for the 105% premium thus the originator would receive: $250,000 x 105% = $262,500 thereby giving a gross profit of $262,500-$250,000 = $12,500.00. This would give the portfolio buyer an approximate gross yield of 7.373% for the first year, if on time payments are received and is paid as agreed.
Portfolio buyers are not "babes in the woods" who just got into the secondary market business. There are refined tools to underwrite loan portfolios from looking at each loan in the bulk sale to looking a just a sampling. The Street is hungry for high yields with tempered risk. When risks become unmanageable the money spigot is shut off of throttled down. When times were good many of the new hybrid sub-prime loans were lumped in with the less risky loans to make up a portfolio or some in other cases it's made up with just the hybrids. It depends on the loan seller's and the loan buyer's contractual agreement. Most of the 2/28s ARMS (Fixed for 2 years then adjust every 6 months thereafter) carry a two year prepayment penalty. The loan was sold as a two-year Band-Aid loan to allow borrowers to set their credit histories right and improve their positions. With improved credit histories a borrower could qualify something like a conventional loan with a much lower rate and even a 30 year fixed term giving the borrower some stability and certainty of principal and interest payments for years to come. This was great as long as the market prices were increasing by sufficient amounts to allow sufficient equity to absorb the closing costs on the lower interest rate loan. With a general market turn down on price appreciation in many areas of the country, many borrowers found themselves upside down where they owed more than the property appraised. Thus the plan of rolling into a lower rate on a fixed rate basis at the end of the two-year period was foiled.
It is here that many borrowers were set up from the get go to fail. With the option of refinancing at the end of the two-year period foregone, the borrower was now faced with the margin and index kicking in to determine he new rate adjustment. In the prior example above the 7.875% fixed for two years is set to adjust to a rate of the index (Six Month LIBOR Index), currently at 5.32% plus the margin which was at 6.5%. The index plus the margin would give a rate of 5.32% + 6.5% = 13.82% adjusted upwards to the nearest .125% (1/8th). Per the ARM Rider attached to the mortgage the rate increases were limited to a 1.000-% increase per every six months. So if the index remained the same the first rate increase at the end of the two year period would be 7.875% + 1.00% = 8.875%. The payment would move from $1,812.67/month to $1,982.73/month with two years of amortization and pay down of the loan or an increase of $170.06/month. On the surface this isn't too bad, but in six months it will go up to 9.875%, then 10.875%, then 11.875%, then 12.875%, then as long as the index remains (it could go up some more) the same leveling off at 13.875%. It would take two years to get there from the fixed rate period. Tracking the payment progression: Month 336 at 8.875% = $1,982.73/month; Month 330 at 9.875% = $2,156.51/month; Month 324 at 10.875% = $2,333.47/month; Month 318 at 11.875% = $2,513.12/month; Month 312 at 12.875% = $2,695.06/month; then on month 312 the rate floats to 12.875% = $2,878.92/month. This is an increase from the original $2,878.92(month 312)- $1,812.67/month (the original payment) = $1,066.24/month increase. For most families, this is a devastating hit. Many do not survive this hit. It destroys family budgets. This borrower has been set up to fail. The lifetime cap on this particular loan is pegged at 15.00%.
When things were flying high, the possibility of continued appreciation was good that would bode well for the refinance at the end of the two-year period and the Band-Aide loan would be paid off with a replacement loan at a much reduced rate and on a fixed rate basis. But appreciation did not happen to save the day. The market fell and the borrower is upside down with an accelerating payment. If the market would appreciate a degree it could save the day, in the meantime the payments erode any hopes of maintaining a family budget. Some options are (1) to sell quickly and possibly get the lender to consider a "short sale" where they settle for less than what is owed. (2) Pay the cash difference at the closing table just to get from underneath the payment (however many sub-prime borrowers have not had a lot of cash to work with). (3) Propose a deed in lieu of foreclosure where the property is just given back. (4) Stay and get second jobs and tough it out till the market turns. (5) Possible Chapter 7 or Chapter 13 Bankruptcy to deal with the other debts that is owed. A Bankruptcy would buy a few months on the mortgage but would lead to a foreclosure with continued non-payment on this secured debt. The whole challenge is complicated with being upside down on the loan. If it falls to foreclosure in the early years then the "full recourse buybacks" kick in to the original wholesale mortgage originator.
Again, many of these wholesale mortgage originators with a flood of buyback demands have had to close their doors and go out of business. The major institutional paper buyers, to protect themselves have found it necessary, in some cases, to take over those companies to give themselves a chance to get their lost money through the flood of foreclosures. This transfer happens by negotiation and agreement with much of the management team and staff continuing to run the business and engineer a recovery during this rough patch of sub-prime mortgage originations. The days in the Sub-Prime Mortgage Business with Lower Credit Scores, high Loan To Values, Interest Only, Stated Income on Fixed Income Borrowers, Option ARMS, and other high risk products may have seen the last ray of sunshine for a while. These programs are being locked away in a dark place for another time and another hot market. Federal and State governments are seeking more control of these types of loan products, which can be hazardous to consumers. Watch for more development in that area with hearings and such.
A borrower can have some input in this loan scenario as it happened in this case. If the loan documents and the entire loan program is not totally understood then it may not be the best deal for the family. The brutal use of the margin which guarantees the increase needs to be scrutinized closely. A borrower needs to take a moment and see what those payment increases will mean to the family budget if every thing does not turn out as the "peachy keen" picture that may have been painted. On 2/28 ARMs caution is the word. Option ARMs can be a challenge as well. Regardless of the mortgage product, borrowers need to demand explanations for every detail and possibility. The borrower is betting all their chips in this case and the house has the advantage. A borrower needs to even up the game and give themselves a fair shot of making the mortgage work for their budget. If the loan product appears looks "scary" it probably is.
About the Author:
Dale Rogers is a bad credit mortgage expert who contrubutes to the Broken Credit Blog website. Broken Credit Blog is a free site online assisting the public with information on credit repair, responsible mortgage lending, and refinancing.
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