The top real estate story trending on social media last week was CNN Money's story pointing out a potentially troubling trend in the mortgage business: sub-prime mortgages are making a comeback.
Is this further proof of the limitless greed on Wall Street? Have we forgotten the pain of 2008 and 2009? Is the market once again opening pandora's box?
The answer to all of the above is no. This is actually not a big deal.
The market is different today than it was even just a few years ago
Back in February, the Mortgage Bankers Association released its quarterly report on delinquency and foreclosure rates of mortgages in the U.S. The report was very, very positive.
Delinquency rates were at their lowest since the first quarter of 2008. The foreclosure inventory rate was also at the lowest point its been in six years. Decreases in delinquency and foreclosure were measured consistently -- in 49 states plus the District of Columbia. Florida, the state with the highest rates, has seen the ratio improve by nearly 60% from the peak.
You may be thinking, "Yes, but the numbers looked great back in 2007 before everyone recognized the mountains of bad loans that just hadn't gone delinquent yet."
That argument is true of 2007, but not 2014.
Fannie Mae (OTC:FNMA) and Freddie Mac (OTC:FMCC) are no longer in the sub-prime business. All of the largest mortgage banks have made dramatic reductions in volume of sub prime loans. In fact, only the FHA remains as a significant player in the niche. In 2007, the garbage was there and we just couldn't smell it. Today, there is no stench because there is no garbage.
The most recent Federal Reserve stress test results confirm it. For everything you need to know about the stress test results, click here. Bottom line: for the big mortgage banks, the stress tests were a big victory that confirms conditions today are nothing like they were in 2007.
Sub prime is back. But not in a big way
Wells Fargo (NYSE:WFC) made waves earlier this year when the company announced it was lowering its required credit score for FHA loans. Most mortgage lenders draw a line on credit scores around 680. Above that level and the borrower's credit is good, below and the borrower is an increased risk. Generally, 640 marks the entrance to sub-prime territory. Well's announced that for FHA backed loans, its minimum score would decline to 600--low, but still 60 points above the FHA's bottom limit.
Wells is the nation's largest mortgage originator, but sub-prime lending is far, far away from achieving the kind of scale needed to spur a repeat of 2007. Don't forget Fannie and Freddie back about 80% of the entire mortgage market, and both are out of the sub-prime business altogether.
And getting that FHA sub-prime loan is no easy task. The FHA has increased the required fees and premiums for these types of loans just this year. The FHA will generally require a hefty downpayment, sometimes north of 25% to borrowers with weak credit history or tight cash flow. And despite the Federal Reserve's near-zero interest rate policy, these borrowers are shelling out upwards of 8% or even 10% in annual interest payments.
For borrowers with the lowest credit scores and tightest cash flow, the FHA even requires the loans to be underwritten by hand and documented even more thoroughly than a typical mortgage. These loans are not the no-verification, low-doc, no money down loans of 2007.
Don't worry about sub-prime. In 2014, the mortgage business has bigger challenges
The biggest concern for mortgage banks in 2014 is not sub-prime loans. Its finding ways to efficiently comply with new regulations while still growing the business in a slow growth economy with soon-to-be rising interest rates. Well's income statement felt some of that pressure last quarter, and more challenges remain.
This move back to sub-prime is but a drop in the ocean. Don't let it spook you or your investment in any of these banks.