Yogi Berra was right: "It's deja vu all over again." Unfortunately, 1994 is starting to look eerily like those bad old days of 1987-88.
The market is coming down off a record refinancing boom; capacity exceeds demand; the bond market is shaky, and the savings and loans are back. Top that, Freddie Kreuger!
For those who have forgotten what the landscape looked like circa 1987, here's a short walk down memory lane.
S&Ls desperate for fee income were blithely originating deeply discounted teaser ARMs, often 200 to 300 basis points below secondary market trading levels.
Underwater Loan Pricing
This meant that portfolio lenders were originating product anywhere from 6 to 10 points underwater. Why would a portfolio lender originate loans of 3.5% when it could invest in securities paying 5.5% and at the same time avoid credit and payment-shock risk at adjustment? That's a mystery with which the industry is still grappling today.
Not only were mortgage bankers up against irrational pricing, they were also competing against products inherently flawed from a credit perspective: high LTVs, no-doc or low-doc loans, and negatively amortizing teasers.
The wisdom of such products was demonstrated when housing prices fell in Texas, the Northeast, and, more recently, in California, and loan losses soared.
Today's mortgage bankers probably thought that the hard lessons of the 1980s had been learned once and for all and the irrational pricing and risky products were a thing of the past. But as my teenage daughter would say, "Not!"
With the recent rise in rates, S&Ls and to a lesser degree commercial banks are rushing back into the market, hell-bent on repeating their past mistakes.
Today, for example, the secondary markets expect a start rate of 6% on an ARM. But many California S&Ls are offering starter rates of 3.5% or less. To make matters worse (for the institution), the product often is a high-LTV, negative-amortization, COFI adjustable.
And the borrower was most likely qualified at the teaser rate.
Adding a negative amortization feature to a high-LTV loan geometrically increases the risk. The teaser feature adds payment-shock risk, particularly for those lenders who qualify borrowers at the start rate. Negative amortization goes against all sound credit principles by reducing the willingness to pay.
Repeating the 1980s
Banks should remember what happened when they capitalized interest expenses on commercial real estate loans in the 1980s.
The teaser start rate dramatically increases the implied cost of the periodic and life caps. It also encourages teaser chasing by consumers, thereby reducing the value of servicing.
Every first-year economics student learns that you price on marginal costs, not average costs. For example, if your marginal cost of funds is greater than your average cost of funds, you could be losing money on every new loan.
Is Cross-Selling Worth It?
Even if the institution believes it can achieve its targeted return on equity at the teaser rate, it is not using its capital in the most efficient manner. As discussed earlier, the institution could buy a more capital-friendly security with higher yield, no credit risk, and less cap risk.
The only possible rationale for this strategy could be the focus on obtaining the customer for cross-selling opportunities.
While I'm not aware that anyone has successfully executed against his strategy, originating loans at 6 to 10 points underwater is an expensive price to pay for a customer. I feel pretty safe in saying cross-selling opportunities could be obtained in a far less expensive and less creditrisky manner. For example, the institution could buy servicing.
Facing irrational ARM pricing isn't the only thing giving mortgage bankers that feeling of deja vu. The end of the refinancing boom is tempting lenders to once again stretch the credit envelope in a desperate search for volume and revenue to cover heavy fixed expenses.
B loans are becoming A loans as underwriting guidelines are stretched. LTVs are being raised and documentation requirements reduced. Even the B paper market has been affected.
Despite experience which demonstrated that significant equity is needed to provide a cushion against the borrower's reduced creditworthiness, we now are seeing LTV's on Bgrade loans stretching to 90%. To compound this increased credit risk, we have seen a dramatic tightening in margins.
The mortgage industry seems doomed to repeat its mistakes. Whenever rates rise and volume contracts, lenders cannot resist the temptation to underprice and take increased credit risk.
So what's the mortgage banker to do?
It takes courage, but the answer is: "Just say no!" Don't chase volume by stretching credit. It just takes too much interest to make up for unpaid principal.
Mortgage bankers must recognize that we are in that phase of the cycle where we must once again get costs in line with the reality of today's competitive marketplace and its size.
Controlling costs and not going over the credit cliff will be the keys to surviving until the next cycle,