Some Thoughts on Low Rates, Credit Freeze, and Politics

Recently both financial media and many politicians have alluded to historic low mortgage rates. President Obama even cited them in his last press conference and proclaimed that his mortgage plan lead in part to falling mortgage rates. First, the only reason that mortgage rates are low is because the economy is in such bad shape that the trajectory is deflationary. That is the best news for mortgage rates. Then, another statistic is often cited and that statistic is mortgage applications, which have been going way up. That's certainly true and applications have increased as rates have decreased.

Now, here is what no one is talking about. I don't know of any statistic to measure this but from my own anecdotal evidence I believe that we are in a period in which a record number of mortgage applications are denied. I say this because in the mortgage business we are facing the reality of what everyone else refers to as a "credit freeze". What a credit freeze means in mortgages is shifting rules daily, long delays, and banks consistently announcing they are going out of business.

In the last few months, Fannie/Freddie have tightened up restrictions on all condos. It is now becoming more and more difficult to see condos get approved with Fannie/Freddie, and furthermore, it is those obscure rules, that almost no one reads, in their by laws that often kill deals. They have created a maximum debt to income ratio of 55% (there used to be no maximum and outstanding credit could make up for a high dti). Furthermore, second mortgages have no been reduced to 80% of the value of the property. Finally, it is now nearly impossible to get any loan for any property over 80%. That's because Mortgage Insurance companies are near extinction. FHA still offers loans with little money down though even FHA has increased its down payment.

Basically, what is happening in banking can be looked at like this. Think about someone that had an awful night of drinking with an alcohol like tequilla. You could even think of a child that had a traumatic experience in water. Often, this creates a visceral rejection of those things, water and tequilla. The financial industry had a similar traumatic experience only it is much more intense. Now, it is having a similar visceral reaction to everything that it deems caused it. Stated went away a long time ago. No money down loans are extinct. Investment loans are now nearly impossible to finance. Even condos and just about every property type but a single family residence is getting more and more difficult to finance. The industry is rejecting everything that it identifies as leading to the traumatic experience.

What does this create? It creates the worst of all worlds. Rates are very low but almost no one gets them. The only people that currently get those low rates are those that see no adjustments to their rate. That now means a credit score of 740 or above. It means a minimum of 20% equity and that's only on a single family residence. It's worse than that. With low rates, we have seen a massive increase in applications. Yet, we have, because the guidelines are so fluid, seen a massive increase in denied loans. As such, we have an industry full of work but it's an industry in which the work is almost entirely unproductive. That's because more and more professionals start with loans that can be done but rule changes in the middle of the process mean they can't be done when you get to the end. I spoke with one pro that had a borrower with an 800 plus credit score, put 20% down but still had the loan denied because the condo was rejected by Fannie. I had one where the borrowers started out being approved but were at 57%. Then, the loan took so long that a new approval had to be run and now they were denied because of the new rule about 55%. Now, these sort of mortgage war stories are not unusual. They happen at all economic cycles. The difference now is that they are happening to people with perfect credit. (in my case the borrowers had scores just under 800) In fact, now, it takes near perfect credit just to qualify. Yet, what the mortgage market is seeing is that perfect credit is only the beginning of the game. What's happened as a result of the credit freeze is that even those with perfect credit are having difficulty qualifying.

Make no mistake, at least as far as mortgages are concerned, credit has only frozen more since January. In fact, this credit freeze started in the beginning of 2007 with the end of sub prime. It has continued to progress with Alt A going away, and then conforming (those with good credit) getting more and more stringent. This continues to be the trend and there is absolutely no sign of reversal. What we will see over the next several months is that a perfect loan, one that will get the rates that politicians talk about, will become more and more difficult to attain. Everyone else will see their rates shoot up over the going rate. Furthermore, less and less people will qualify for a loan.

Worse than that, this is very likely a problem of psychology not economics. Many thought that an injection of capital would unfreeze the markets. That turned out to be inaccurate. Now some are saying that removing the "toxic assets" will unfreeze the markets. The reality is likely that banks are scared to lend. Fannie/Freddie are scared to lend. Their fear is that the economy will get worse and they will have even more bad loans on their books. As such, freeing capital won't help fix the credit freeze. Furthermore, their fear is totally justified, understandable, and worse than that, very ingrained in their psyche.

There's more. The economy can't possibly recover without the credit markets unfreezing somewhat. Since the credit markets are looking for a recovery to feel better about lending, then we may in fact be facing a vicious cycle. Each of the two parts is looking to the other for leadership, and both will be impotent without the other moving. Neither will be the first to move.

That's why I haven't bought any of this happy talk about the economy hitting a bottom and beginning a recovery. We don't have a recovery in lending. We are still in cycle of frozen credit. Without a recovery there, there is no economic recovery, and the credit markets need to economy to recover before they recover, and vice versa.