Over the past 20 years, market forces have greatly expanded the number and type of residential loans available, but the wide variety of mortgage products on the market now may be headed for a period of contraction and underwriting guidelines are being tightened. Market forces again are partly responsible, especially the recent increase in delinquencies in repayment of subprime loans, with the percentage of subprime loans for which borrowers are behind on payments now in the double digits and increasing.

Although one Wall Street investment bank spokesman said defaults aren’t so much increasing as simply returning to the “normal” levels they were at three or four years ago, most lenders and regulators see the increase in late payments – which rose to 13.2 percent nationwide in the third quarter last year – as “alarming,” said Charles N. Nilsen, the Massachusetts Mortgage Bankers Association’s secretary/treasurer and manager of Chase Home Finance, the New England retail division for New York investment bank J.P. Morgan Chase.

Investment banks are a major purchaser of subprime mortgage loans. Investment banks buy subprime loans in bundles from originators, repackage them as securities, and resell them to institutional investors, explained Steven Kaplan, a mortgage banking attorney and partner at the Washington, D.C., office of Kirkpatrick & Lockhart Preston Gates Ellis.

“There certainly has been an increase in early payment defaults on these loans,” Kaplan said, referring to consumers who don’t make required payments in the early months after the origination of a loan. Both investors and originators have concerns about these, he said.

“They are a concern for the originator, too, because the mortgage loan purchase-and-sale agreements allow an investor to require a seller to repurchase a loan if there is an [early payment default].”

He said he didn’t think increasing early payment defaults necessarily mean that mortgage-backed securities are not performing as expected. Rather, “the big thing going on now is that investors are much more active in demanding repurchase in the case of early payment defaults.

“Certainly, as new products develop, you have to be very conscious of the risks,” he explained.

Rising default rates are causing increased investor scrutiny of mortgage products in general and notably with stated-income loans, which require no verification of income to qualify, and loans designed for borrowers with poor credit histories, Nilsen said.

These and other, higher-risk products such as interest-only and payment-option adjustable-rate loans, which have the potential for negative amortization where the mortgage balance can actually increase, are the most at risk for default, Nilsen said.

Such loans initially may be offered at better than Prime rate to start, but the rates shoot up in a short period of time.

Rising default rates are behind recent government crackdowns on so-called “exotic” mortgages. For example, the federal government issued guidelines related to marketing and underwriting standards for pay-option and interest-only mortgages last September that apply to banks and credit unions the federal government regulates. Massachusetts and other states followed soon after with their own, substantially similar guidelines for the non-bank mortgage companies they regulate. Kaplan said stated-income loans also are being subjected to greater scrutiny in some states.

The federal guidance “spurred an additional round of scrutiny on both the investment and regulatory level,” he said.

The guidance, in part, became necessary because the number of mortgage products, driven by rising home prices and a desire to meet the needs of an increasingly diverse pool of prospective homebuyers, has expanded greatly in recent years. The push to enable more borrowers to become homeowners also has loosened underwriting standards for many mortgage products.

Ready Buyers
Regulation apparently had a direct effect on loan originator product offerings this month, according to the Massachusetts Mortgage Bankers Association, which reported in its Jan. 18 e-newsletter that Ameriquest-affiliated Argent Mortgage and several other subprime lenders had, on Jan. 11, temporarily stopped accepting applications for refinance and higher interest-rate purchase-loans that are secured by owner-occupied properties, to comply with an emergency Rhode Island Division of Banks regulation relating to that state’s Home Loan Protection Act.

“I have heard that many of our good friends at the RI-MBA [Rhode Island Mortgage Bankers Association] and their legal and legislative counsel have scheduled emergency meetings to address the situation,” MMBA Executive Director Kevin Cuff wrote to the trade association’s 400 company members.

Defaults also are largely responsible for investors pulling funding from companies that offer subprime loans and proposing their own guidelines for those that want to maintain a partnership, industry experts say.

Recent dramatic examples include subprime lending giants Ownit Mortgage, Mortgage Lenders Network USA and Fieldstone Investment Corp., which closed or are restructuring to keep investors happy.
California-based Ownit shut down in December after investors demanded it buy back over $165 million in loans on which borrowers had missed payments. Mortgage Lenders Network USA, of Connecticut, which stopped funding loans late last month and now is subject to cease-and-desist orders in several states, is struggling to find new investors after a temporary agreement with the Lehman Bros. investment bank ended.

Maryland-based Fieldstone restructured the financial agreements it had with JP Morgan Chase, Credit Suisse Group and Lehman Bros. last month, in exchange for nearly $2 billion in lines of credit.

Investment bank Bear Stearns’ EMC Mortgage Corp. unit, meanwhile, is suing yet another subprime originator, MortgageIT Holdings of New York, demanding it buy back questionable loans worth $70 million.

One Massachusetts source said he’s heard investment banks Lehman Bros., Merrill Lynch and Bear Stearns are readjusting guidelines on the types of loans and borrower credit histories they’ll accept.

Representatives from these firms declined comment, but Kaplan, who counts mortgage lenders and investors among his clients at Kirkpatrick & Lockhart, said front-line subprime market investors are, indeed, “becoming more careful to ensure that loans are underwritten in an appropriate manner and that the creditor has complied with all applicable guidelines.”

Nilsen said he is aware of certain Wall Street firms that invest in those higher-risk loans tightening some underwriting guidelines, but could not comment on JPMorganChase’s position.

Eric Nelson, president of United Funding Corp. of Milford and Boston, said he’s noticed some funding guidelines tightening, mostly in the last six months to a year.

“I’m finding that lenders are now requiring higher credit scores to do 100 percent financing,” a product broker-lender United Funding offers, Nelson said. So-called foreclosure bailouts, in which a new lender works out an agreement with a borrower in trouble, are also a tougher sell to investors these days, he said.

A Merrill Lynch spokesman declined comment on why his company disassociated itself from Ownit, but offered a press announcement it issued last September, explaining why it had an agreement to acquire subprime mortgage origination franchise First Franklin, of San Jose, Calif., for $1.3 billion.

“This acquisition, and the origination platforms in particular, fills an important gap for us domestically, providing a significant presence in both the wholesale and online retail channels,” Michael Blum, managing director and head of Merrill Lynch’s Global Structured Finance and Investments Group, said in the release.

Global Markets and Investment Banking Group President Dow Kim offered that Merrill Lynch was looking forward to “working with the experienced teams at [First Franklin and three other companies Merrill Lynch recently acquired].”

What does the future hold for the subprime mortgage loan market? Kaplan doesn’t see it as overly grim – just different.

“I don’t know if [investors] are necessarily shying away from [subprime loans] as much as they are becoming more careful to ensure that a loan is underwritten in an appropriate matter, and that the creditor has complied with all applicable guidelines,” he said.

“Someone will always buy these loans. There is no doubt,” Nilsen said. “The question becomes, as their performance changes, how do they keep their projections for performance accurate? Do they have to be more conservative to balance the return – and what would be the end result of that?”

MMBA’s Cuff echoed those sentiments. While he concedes that lenders probably should not offer riskier loans such as interest-only and option-payment mortgages to borrowers with less-than-perfect credit, he said there will always be someone out there to invest in such loans.

“No one is ever going to leave the market,” Cuff said, “because, in the end, it is profitable.”