Creative, Exotic Loans!

So called “exotic” loans are not so exotic at all. They are purpose driven. They fulfill specific market needs. They are however the 2007 Congressional tell-tale of a pending unmet need of the borrower. Of course, in the wrong hands a misused loan product or a misinformed borrower can result in devastation. What I think is exotic is the possible infusion of unnecessary “RAhD” and “RAhC” into the mortgage banking market system. The sad truth is we may have naked lenders and naked government backed securities. Ginnie Maes are guaranteed against principal loss by the full faith and credit of the federal government, but Fannie Mae and Freddie Mac are not. Fannie Mae and Freddie Mac have to absorb the foreclosure fall out if borrower’s default. These mortgage pools are not rated. Are the triple-A corporate sponsor bonds able to support the risk? We have a large volume of high loan to value loans (with a high risk of default) that will reset to even higher rates compounded by a period of lowering property values, without mortgage insurance. This is critical because the lowering property values will create borrowers with no exit capabilities. These factors have the potential to feed upon itself and create broad economic trouble and loss of market liquidity. Lenders created and brokers sold non-insured loans (especially high ratio piggyback first liens with high variable rate revolving home equity line of credit (“HELOC”) second liens) to meet the market demand and rapid growth of homeownership. But did the government sponsored entities or GSEs (such as Fannie Mae and Freddie Mac) understand the risk of a first “conforming” (80%) lien without mortgage insurance; tied to the same borrower who had a piggyback overpriced 20% silent or secret second without mortgage insurance? Did the market properly price this risk? Did investors overcharge borrowers for this risk by overloading the borrower’s monthly cash burden? Worse yet, many of these secret seconds are not closed ended seconds, but revolving credit (card) type HELOCs. The GSE regulatory reporting guidelines were developed before the avalanche of piggybacks (The Hidden Risks of Piggyback Lending, C.A.Calhoun, PhD). Whether the market truly understands these risks or not, the risk therein must be truly mitigated by mortgage insurance type products that are shared in costs and benefits by all market participants, including the borrower.