Evolution of a Financial Crisis

November 17, 2008

First the price of risky products rose sharply…Then some of them disappeared altogether.

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

Recently, I decided it was time to take a hard look at the data 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 November 7, 2008. The interest rates quoted all assume zero points.

Borrowers Pay More on Larger Loans and Riskier Loans

The data show that the price of a mortgage to very low-risk borrowers who need loans no larger 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 and/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.

Loans With Less Than Full Documentation Disappear

The same pattern is 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 .52%.

On November 23, 2007, this spread had widened to .94%. On November 30, 2007, the quote on No Documentation was gone, meaning that lenders were no longer offering it. On December 14, 2007, the quote on No Income was gone. On May 23, 2008, the quote on Stated Income was gone. From that date until now, full documentation has been required by the wholesale lenders.

Borrowers Pay More For Low FICO Scores

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 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% on a 740 to 6.45% on a 620, a spread of 0.30%. On September 14, 2007, that spread had widened to 1.37%. On September 21, 2007, the 620 quote was gone. On Feb 15, 2008, the spread between the 740 and 660 hit 4.04%, but 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 was. Note that stated income loans may still be available at some depository institutions that don’t depend on the wholesale market, though they may call them something else.

Piggyback Loans Gradually Disappear

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

80/20/0 deals were available until September 28, 2007, 80/15/5s until December 28, 2007, 80/10/10s until February 8, 2008, and 80/5/15s until March 28, 2008. That was the end of the piggybacks. Borrowers who put less than 20% down today are back to using mortgage insurance.

Rate on Non-Conforming Loans Explodes

Dramatic changes occurred in the relationship between interest rate and loan size. On May 4, 2007, the rate on a $417,000 conforming loan was 5.78% while the rate on a $418,000 non-conforming loan was 6.06%. The larger loan was not eligible for purchase by Fannie Mae and Freddie Mac. The rate difference of .28% was not significantly different from those of prior years.

On November 7, 2008, the rate on the conforming $417,000 loan was 5.76%, virtually unchanged, but the rate on the non-conforming $418,000 loan was 8.73%! Fannie Mae and Freddie Mac, despite their pains and 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.

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