Wednesday, September 27, 2006

What happens when credit tightens

The end of suicide loans

There has been speculation on the web as to what happens when bond holders lose their appetite for the high risk loans. In reality there are only a few scenarios:

      1. An end to “no-document” loans (better income, savings, and employment verification).

      2. Tighter qualification requirements for exotic loans (e.g., qualify for the maximum payment not the minimum).

      3. Higher interest rates

      4. Fewer mortgages being offered

      5. Higher down payments (risk reduction)

I've been reading at some blogs I respect how they expect interest rates to spike as the 1st choice response. This I disagree with. Why? There is to much money looking for a “safe return.” Thus, I would expect that instead investors would want to minimize risk. Thus, ensure the FICO scores are high enough to qualify, triple verify income and savings via 24 months of documents (or even more time?).

The easiest risk management would be to increase the required down payment back up to 20% or 10% + PMI. I can even envision a return to the old standard where, except for a starter home, the bank expected a 20% down payment and a payment of the home's last year's appreciation. So if homes went up 6% in a year, a minimum 26% down payment was due. That would be true risk reduction.

The likelihood that bond buyers will have an appetite for mortgage backed securities (MBS) backed by exotic loans is pretty low. In fact, I expect bond buyers to be shy of these loans for 5 to 7 years.

Thus, do I expect interest rates to go up on mortgages? A little. But mostly for risk aversion processes to creep back into the mortgage system.

This will still stop about 1/3rd of home sales. Thus the upgrade market will thus stall...


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