Sea Change or Course Correction?

After years of relatively smooth sailing with the wind at its back, the tide is turning for the housing and mortgage finance markets. Whether this means JHv VJHAa minor course correction or a major sea change for the industry remains to be seen. * Applying a nautical analogy to the mortgage finance industry, although imperfect, is somewhat apt. Just like the sailing ships of yesterday, the mortgage market is subject to forces beyond its control. And external conditions can shift from favorable to foul in an instant. * In recent years, many lenders had used words such as "great" and "fantastic" to describe their business as the industry sailed full-speed ahead. But now some of the buzzwords heard are "tight" and "competitive," as well as "uncertain." * As the tailwind dies down, clouds are gathering in the form of intensifying competition and efforts to maintain volume even as margins shrink. There is no question that firms are working harder for the same result as a year ago. * All eyes remain on the Federal Reserve as economists and executives alike speculate as to when and at what point the Federal Open Market Committee (FOMC) will cease and desist tightening monetary policy.

Even sharper focus has fallen on new Fed Chairman Ben Bernanke. As he takes over the ship's command from retired "Commodore" Alan Greenspan, Bernanke appears to have the confidence of the market to keep a steady hand on wheel. However, he remains untested.

Rate outlook

The consensus among executives who spoke to Mortgage Banking is the Fed is poised to stop raising its target for the Fed Funds rate by the middle of this year-with perhaps one more 25-basis-point hike following the 25-basis-point hike at the FOMC's March 28 meeting, bringing the Fed Funds level up to 5 percent.

"The Fed has moved from [a posture] of raising interest rates on autopilot to being more data-driven in its assessment on monetary policy," notes Norman Frey, senior vice president and asset liabilities manager for Impac Mortgage Holdings Inc., Newport Beach, California, a real estate investment trust (REIT). "So it's going to take a look this year very specifically at the state of the economy, the state of the labor market and what the inflation indicators are saying."

Executives agree that rate volatility is not expected to be a challenge in terms of adequate pipeline hedging and fallout.

"We try to position ourselves for many scenarios, and not spend too much time trying to predict," says Maria Fregosi, group senior vice president of ABN AMRO Mortgage Group, Ann Arbor, Michigan. "The market has evolved to the point that there are interesting mortgage products no matter what the rate environment is."

Product preferences

While price competition among the major loan product typesprime, alternative-A and nonprime-continues to ratchet up, nonprime and particularly alt-A products have experienced significant competitive changes over the last year as some of the "large [Wall S]treet firms" enter the market, according to Anne Peacock, senior vice president-managing director at Minneapolis-based GMAC Residential Funding Corporation (GMAC-RFC).

"Conforming products represented our largest volume last year, and that trend will continue in 2006. Subprime, followed by alt-A, represent a significant percentage of the products we acquire," says Peacock.

"Year-to-date [in] 2006, we have seen an increase in our homeequity and jumbo volume, while our alt-A volume has been relatively constant. A large increase in subprime volume during the second half of 2005 has been moderated slightly in early 2006."

Over the past year, Frey says that lmpac-whose "bread and butter has been alt-A,"-has observed an explosion in the alt-A market as mortgage brokers and borrowers became more aware of alt-A loans, prompting prime and subprime borrowers to migrate into the alt-A space.

Since then, the market has come under significant pressure, but lmpac expects that macroeconomic trends-including rising incomes, a growing labor force and continued household formation-will continue to favor the alt-? market in 2006 as the characteristics of alt-? mortgages become more understood by borrowers, and capital markets investors continue to accumulate performance data on prepayments and credit experience, notes Frey.

An ever-blurring line

Within the last year, Paramus, New Jersey-based Opteum Financial Services LLC-a retail, wholesale and correspondent lender-has migrated away from "riskier credit" products and toward alt-A, according to Jeff Pancer, Opteum's senior vice president-secondary marketing.

"We see tremendous rate and credit competition at the intersection between A-paper loans and alt-A, and we're seeing thinner margins as a result. We haven't pulled out of any market per se, but we have definitely shifted our product mix away from subprime," says Pancer.

"In the period [from] November [2005] to March, we have seen execution in this market drop significantly. Couple that with the lower margins, [and] we are just not willing to take on the more significant credit risk for a thinner margin," he adds.

One of Opteum's biggest concerns, notes Pancer, remains the "ever-blurring line" between A products and alt-A products.

"Where does A end and alt-A begin? It's this issue that continues to erode the margins on the alt-A side, making it difficult to manage profitability versus the increased risk to the lender and investor," says Pancer.

"Execution in the subprime market seems to have leveled off, albeit at lower premiums, compared to last year. Lenders are going to have to lower costs in order to maintain/resume profitability in the subprime area," he says.

Pricing in the nonprime segment, although still highly competitive, "has eased up some" during the past year, prompting Phoenix-based 1st National Bank of Arizona (FNBA) to take a closer look at nonprime lending, according to Patrick Lamb, president of FNBA's mortgage banking division.

"FNBA has never been a big player in prime because the margins have always been insufficient to meeting our target," says Lamb. "Last year, we stayed away from nonprime due to price competition. This year, we have increased our competitiveness as a result of others backing off their pricing."

Hot spots for price competition

Geographically speaking, executives tell of select hot pockets of the country-including California and Illinois, as well as Massachusetts, New York and New Jersey-where lender price competition for origination business has become "cutthroat."

One example of such intense competition might be found in ultrawealthy Fairfield County, Connecticut. Located in the southwest corner of the state and part of the New York metro area, Fairfield County is informally known as the "Gold Coast," as it is one of the wealthiest counties in the nation.

Peter DiDomenico, sales vice president and general manager of Westport, Connecticut-based Threshold Mortgage Co., observes that previously absent big players have come into the region and established a retail presence in a big way.

"The Fairfield County market is a market where we are seeing lenders coming in and setting up bricks and mortar like they never have before," says DiDomenico. "So here in Fairfield County, and probably in Westchester County [New York], we're starting to see the gloves [go] up and it's becoming a real fight."

Last fall, Seattle-based Washington Mutual announced the opening of five retail banking stores in Fairfield County as part of the company's continuing growth effort in the New York metro area. Countrywide Home Loans Inc., Calabasas, California, has also established an area presence, notes DiDomenico. The increased competitive lending environment, he says, has resulted in a narrowing of loan margins.

"They're certainly narrowing, because you have a lot of loan officers in the business that weren't doing as much volume as they were in the past, and they're willing to work for a little bit less money. That's one part of it," DiDomenico explains. "Then you have a lot of lenders that have a lot of fixed costs, and they need to constantly churn out volume to cover that-so [for] those lenders, the baseline pricing has improved as well."

Fear factor

Mortgage Banking asked executives what their top concerns were for the overall economy and the mortgage industry, specifically, during the coming year. While their answers varied on the particulars, the common themes revolved around fear of the unknown.

The most commonly cited concerns were the potential for a significant decrease in the value of home prices, the interest-rate environment and another energy price spike that deflates other kinds of consumer spending.

Although favorable demographics and the explosion in affordable mortgage products helped to cultivate the demand for home financing-which pushed the overall homeownership rate to nearly 70 percent-Peacock says GMACRFC remains alert to the fact that mortgage rates are climbing as the Fed attempts to guard against inflation.

"A rising-rate environment does have the potential to slow the pace of home-price appreciation, which may lessen the demand for housing as an investment and/or wealth opportunity," says Peacock. "Moreover, rising energy prices and increasing debt burdens have increased uncertainty about the financial ability of the U.S. consumer, since many believe the consumers have already tapped a significant portion of the equity available in their homes and no longer have as many funds to make purchases or to pay down other debts."

DiDomenico says his worst-case scenario isn't so much an adverse event as it is the potential bad timing of such an event-especially during the traditionally busy but also traditionally high-inventory spring home-selling season.

"If something happens to unsettle the real estate market during the spring, I think it could then maybe create some sort of crash in real estate prices and a significant decline in mortgage business," says DiDomenico.

"If there is some disruption, some disaster, something that unsettles the market [in the spring], I think that will be a problem and that will cause problems really beyond six months or a year-and that could really negatively impact the market for a few years to come," he says.

FNBA's Lamb nominates as his worry the more probable and more worrisome concern of an increase in fraudulent activity, particularly as the housing market slows and lending competition intensifies.

As Mortgage Banking has reported, the Mortgage Bankers Association (MBA) has named fraud against lenders-its prevention and prosecution-as one of its top advocacy priorities this year. MBA has called for the allocation of more federal government and law-enforcement resources to combat fraud (see Mortgage Banking, March 2006, p. 9).

For her part, ABN AMRO's Fregosi notes the industry's ongoing concern about the "plethora" of old and new regulations that contribute to the high cost of both compliance and noncompliance for the industry. Lamb agrees.

Adding to the regulatory glut and to lender worries are the socalled anti-predatory-lending laws at the state and local levels, and the potential disruption these various and sundry laws cause to securitization activity. In previous instances, secondary-market investors and rating agencies have chosen not to securitize loans in states where such laws used broad and subjective standards and where the liability was far ranging.

"We have already seen a significant increase in predatory lending legislation at both the state and county levels," says Lamb. "Despite our national charter and consistency in being reviewed nationally by the OCC [Office of the Comptroller of the Currency], we are constantly altering our behavior based upon extremely conservative views imposed by the securitization market."

Peacock, however, notes that the industry has generally adopted effective processes in response to legislative concerns, such as the use of third-party compliance and internal due-diligence processes to mitigate predatory lending risk for their business and their investors.

"Rating agencies and investors are expecting sound practices from our industry, and that has driven changes to the origination and acquisition process to meet their expectations," says Peacock.

Heading for the exits

Meanwhile, the industry should expect consolidation-either though acquisition or departure-in the lending community this year, executives predict.

The smaller subprime lenders that are already struggling to compete will be among the first to leave the business, one way or another, says Pancer.

"Smaller alt-A players can remain competitive so long as they keep costs down and maintain good relationships within the investment community," he says. "Smaller A-paper players will find it hard to compete with the large lenders."

FNBA's Lamb agrees, predicting that 30 percent of the smaller nonprime and alt-A players will either leave the business or be acquired this year. "Many small lenders who were growing through the good times didn't plan on losses due to repurchases, which are coming back to haunt them," he says. "This is compounding the profit pressure already there due to market compression."

However, despite the many opportunities for acquisition, Lamb says he doesn't believe there is any reason to pay a purchase premium in the current environment.

The bottom line, notes Fregosi, is that the mortgage industry isn't experiencing anything new or revolutionary-it's just business.

"The mortgage business is all about cycles. It appears that we are in a cycle of margin compression," says Fregosi. "That has traditionally meant that there is consolidation in the lending community."