Local bankers assess consequences of subprime nosedive, Fed intervention

Late last year, Tom Shimmens, longtime senior vice president and manager of Central Bank’s real estate department, looked into the phenomenon of subprime mortgage lending and saw it as a chance for greater profits and better customer service.

Shimmens estimated that 15 to 20 percent of the mortgage market had been drained away by subprime mortgage companies—generally through independent brokers and Internet access—as the housing boom fed the prospects for less-creditworthy individuals to own homes.

Central Bank and other financial institutions in mid-Missouri tended to avoid the higher-risk subprime market, focusing instead on conventional mortgage lending to standard customers, although competition had eroded standards that once applied to the business. Central Bank is the flagship of a holding company that owns Boone County National Bank and a dozen other community banks in Missouri. Central Bank and its sister facility, Jefferson Bank, rank as the largest mortgage lender in the capital, and BCNB is Columbia’s largest bank by a large margin.

Executives at the region’s largest banks talked with CBT about the subprime mortgage-lending crisis and the impact of possible federal intervention. Mortgage brokers in central Missouri did not return the Business Times’ phone calls, however.

Deborah Graves, vice president for the mortgage lending division of BCNB, estimated that up to 20 percent of the mortgage loans in the Columbia market had come through the subprime niche, or far below the national rate. Subprime and near-prime mortgages accounted for about 40 percent of all mortgages in the United States last year.

Central Bank’s flirtation with the subprime market proved to be a cautionary tale.

Shimmens approached Bob Robuck, the former bank president, and his successor, Ken Littlefield, about moving into subprime territory to defend the institution’s turf. “We wanted a vehicle for people with credit issues who were still bankable,” Shimmens said.

Robuck and Littlefield “approved it, but they were adamant about not making loans just to make loans” and post bigger profits, Shimmens said. Robuck in particular “was diligent about doing the right thing.”

Edging into greater involvement with “B&C,” or riskier investment paper, had proved a slippery slope for other lenders. While they earned higher profits, they often suffered public-relations setbacks as consumer groups attacked them; subprime contracts often were viewed as predatory lending. Subprime lenders charged fees that were considered exorbitant by the lowest-income borrowers and those who were the most vulnerable.

Early in 2007, Shimmens reached out to Wells Fargo—the nation’s fifth-largest bank and a major subprime lender from its subsidiary in Des Moines—and hired a man to launch Central Bank’s entry into territory that was once the province of subprime lenders.

The move into subprime largely died, the victim of poor timing. The Wells Fargo veteran had been hired as dark clouds grew over the nation’s housing boom—a 6-year-old growth field that had bailed out the country when stocks collapsed in 2001—and its subprime niche.

“That whole market disappeared. It just vanished,” Shimmens said.

That man from Wells Fargo now simply shares space with other personnel who originate loans at Central, largely dealing with conventional loans.

Jeff MacLellan, chairman of the Landrum Co., First National Bank’s parent company, said banks in the Columbia area generally avoided “the whole subprime thing; banks didn’t play in that game. This bank made a conscious decision four or five years ago that it didn’t make any sense. It was not good for you (as a borrower).”

Graves said Boone County National has made only “a handful” of loans that observers could consider “subprime”—a category that has no firm definition. She allowed that required down payments have eroded substantially in the past 15 years, largely because they had formed such substantial barriers to home ownership, particularly for first-time buyers.

The subprime nosedive
While little-known subprime lending began fraying last December and a major British bank set aside $2 billion to cover problems in the American mortgage market in February, by August the subprime collapse had become the subject of dinner-table talk across the country—even the world.

Dogged by rising delinquency and default rates, the industry became notorious as its collapse overwhelmed the mortgage industry and dealt a global stock market setback that cost the Dow 1,000 points in one week and spread to Asia and Europe. The Federal Reserve Board is still considering additional steps to halt a “credit crunch” that threatened to bring American business to a near-halt. More than 100 lenders across the country have closed their doors, and 90,000 employees have lost jobs, often at higher-level salaries.

At its most basic level, the subprime problem had its roots in raising capital for the mortgage industry. As the subprime companies expanded their work, they began bundling their mortgages into securities that sold like hotcakes on Wall Street because they promised higher rates of return.

Traditional mortgage lenders, such as banks, continued to rely on federally chartered Freddie Mac and Fannie Mae to buy their loans and replenish their funds.

Often overlooked, however, was the likelihood that securities assembled by subprime lenders would have significantly higher default and delinquency rates by their less creditworthy customers. “It’s not like this is a surprise,” Shimmens said.

Complicating the mix nationally was the continuing decline in home values, which undermined the value of properties bought through those securities. Between the plummeting home values and unknown delinquency and default rates on mortgages packaged in subprime securities, investors in securities and brokerage houses could not tell the value of what they held.

By late August, mortgage difficulties had begun spilling over into consumer credit, playing havoc with credit card eligibility and rates and personal loans, especially in areas that already had faced difficulties with subprime mortgage lending.

Herd instincts took hold of markets. As of the end of March, a relatively modest 5.1 percent of subprime mortgages had entered foreclosure, compared to 9.4 percent in 2000 and 2001, when a recession took hold, according to the Mortgage Bankers Association. “The problem is not as severe as the perception of it,” said Littlefield, the former state finance commissioner for Missouri and Texas.

Littlefield noted that the same conditions seemed to apply to every economic cycle as it roiled the banking industry. “You always are encouraged to push the envelope in these cycles—the loosening of credit standards, the appreciation of real estate values that exceeded rationality (in California, Florida and Texas, for example). Lenders start to think they cannot lose money. Borrowers keep counting on appreciation” of real estate to prop up risky mortgages. No one feels the need to trim the excesses “as long as everyone is making money and having a good time.”

But the prospect of a downturn more severe than 2000 and 2001 loomed large because the mortgage securities market had disappeared, 2005 and 2006 mortgage delinquencies were running higher, and tightening of credit had eliminated the prospect that homeowners in trouble could easily refinance.

Central banks around the world attempted to fend off the liquidity crisis by pumping money into their country’s economies.

President George W. Bush ruled out a federal bailout of homeowners who faced foreclosure, as some political figures lobbied against efforts to help lenders, borrowers and investors who had made poor business decisions.

But on Aug. 17, the Federal Reserve Board—which already had pumped billions into the financial system—responded with an unexpected cut in the discount rate, which technically is the interest charged to banks that borrow money from the Fed but increases national economic liquidity.

Local banks bet on reductions in federal funds rate, although they say no credit crunch exists here
The discount reduction did little to calm the uncertainties that threatened the financial system and could turn the entire economy on its head. Even the head of Countrywide Financial, the nation’s largest mortgage lender that had exhausted its $12 billion in lines of credit, talked about the likelihood that the liquidity crisis would create a recession.

Analysts worried, in the short term, about $50 billion in adjustable-rate mortgages that will face sharply higher interest rates—and payments—beginning in September and likely begin spreading the economic losses into Main Street America. Potentially more worrisome was $1 trillion in commercial debt expected to expire and need renewal in six weeks.

Federal Reserve Board chairman Ben Bernanke hinted that the Fed might move to cut the important federal funds rate, probably by its meeting on Sept. 18 or before, because the subprime problems had leeched into damage for the broader economy, although he, like Bush, fended off talk about bailouts for lenders. Bernanke said the Fed would act “as needed” to preserve the current economic expansion.

Local bankers tended to greet a possible federal funds cut with circumspect comments although they said the national conditions that have focused attention on the move don’t exist here.

Littlefield said “there’s a consensus developing” that the Fed will act on a federal funds cut “within a month to six weeks… The prime is tied to that. So when you lower the prime, you’re lowering the cost to the buying public. You put more money in the pocket of consumers.”

While banks have latitude on setting the prime rate charged to their best customers, the current level is 8.25 percent, compared to 5.25 percent for the federal funds rate. The prime had been 3 percent more than the federal funds rate since 2000.

MacLellan cast another vote for the likelihood of a rate cut. Six weeks ago, “I would have said that the bias for reducing rates was not very strong. Now the bias toward reducing rates is highly likely between now and the end of the year. It could happen multiple times,” he said.

But MacLellan was among the bankers who maintained that “to be very honest, I don’t think there is a credit crunch in central Missouri. There just isn’t one.”

Graves agreed and noted that a federal funds cut could provide a windfall “bonus,” particularly for business customers in central Missouri.

Said Teresa Maledy, president and CEO of Commerce Bank’s central Missouri region, “What is good for the economy is good for the bank. The Fed will have to be thoughtful, without inviting unintended consequences. It’s important that people don’t overreact.”

Cuts in the federal funds rate and the prime tend to make sense because the credit crunch has grown in the country’s and the world’s capital or securities markets, not the traditional banking industry and the areas of the economy that it controls.

Cuts in the federal funds rate and the prime also have little direct relationship to mortgage rates, which tend to be tied to the lower 10-year U.S. Treasury bill rate.

Politicians like U.S. Sens. Christopher Dodd of Connecticut and Charles Schumer of New York have begun pressing for the Office of Federal Housing Enterprise Oversight to lift the caps it placed on the ability of Fannie Mae and its smaller competitor, Freddie Mac, to buy mortgages from banks and other lenders.

The likelihood of changing mortgage terms
Bankers also were looking for regulators to tighten the conditions for mortgage loans, although they said the impact on central Missouri should be minimal.

The change has been a while in coming. Even for exotic loans like interest-only and adjustable-rate mortgages, Fannie Mae and Freddie Mac will not require lenders to apply strict underwriting standards until next month, despite the enhanced likelihood of default.

But “even on the conventional side, if we tighten up, it’s tougher for people who struggle to get credit,” Shimmens said, or the potential customers who eventually became involved in subprime mortgages.

Shimmens said federal banking regulators are likely to begin requiring:
• Lenders to force home buyers to invest upfront, likely at least 5 percent, in the property, probably in relationship to their credit scores. The higher the score, the lower the required down payment.

For decades, the home mortgage industry was based on standards that largely required 20 percent down payments. Anything less than that amount required buyers to also purchase expensive private mortgage insurance to guarantee the repayment of the loans.

The old standards became passé after 2001 and the advent of lower mortgage rates, and even banks were not requiring any money down on many conventional mortgages during the boom.

• Mortgage borrowers to have FICO or credit scores of 620 as a minimum. Shimmens, who said Central has not adopted any such changes yet, noted that such a score now is considered a measure of “poor” creditworthiness, so it likely would have a minimal impact on lending. Some national analysts, however, are expecting a threshold of 680, which could dramatically reduce the persons eligible for a home loan.

• Identification and verification of income and assets. Many loans in recent years have been made with little if any documentation of a borrower’s likely ability to repay; those terms have increased the ability of many small business owners to buy homes even if their tax records don’t show substantial income.

The reduction in eligibility has its share of detractors. Littlefield at Central Bank said the bank has a substantial home-equity portfolio that many customers have used to pay down their credit cards. “So we have a concern that if you tighten up on the mortgage side and that goes away, will it have an impact on the ability of people to pay off their credit cards?” he said.

He’s also concerned that tightening the rules could backfire on many historically good customers who face tough times. “Our bank has been lending money to people who are considered marginal, but do you know your customers? People get bad credit scores, usually for a reason—a divorce, an illness, a surge of medical bills. It is difficult to draw the line and when you choose to go over the line.”

MacLellan particularly warmed to the idea of returning to mortgage loans that required the borrower to contribute equity upfront through a down payment. “I’m pretty traditional. If you don’t have anything in the property, you have nothing at risk (through default),” he said.

But MacLellan drew the line at minimum credit scores. “A credit score is one of the things that you ought to look at. But if a customer comes in with a 620 credit score and he has good cash flow and he can put $80,000 into the property, I’m gonna make that loan. I get real concerned with overregulation,” said MacLellan, a banker in the industry for 34 years.

He concluded: “In the end, it’s all fundamental stuff. Can a person afford the loan?”

Maledy said simply that for Commerce Bank, if increased lending requirements took hold, “It still would be business as usual. I don’t see it changing how we do business.”

Graves, who speculated that Boone County National’s mortgage business has increased possibly because of the collapse of the subprime market, noted the proliferation of such loan types as “split loans,” in which the borrower may get a loan for 80 percent of the property at near-conventional rates but often borrows what once was the down payment at substantially higher rates.

Boone County National, although 90 percent of its mortgage portfolio is conventional fixed-rate mortgages, also wants to be sensitive to the needs of a community that, because of its university population, always will have a relatively short-term, transient population, she said. A couple moving to town so one spouse can pursue a doctorate likely will find that a five- or seven-year adjustable-rate mortgage meets their needs because they plan to leave town about the time its rates can rise, Graves said.

Amid a bounce-back, increased prospect
for foreclosures, higher interest rates
Columbia’s real estate market is not poised to absorb any punishing blows of ripples from a national mortgage crunch.

After a record year in 2006, the first six months of 2007 saw the market slump. Sales of single-family residential homes fell to their lowest level since at least 2003. Observers generally attribute that phenomenon to the area’s attempt to work itself out of a serious oversupply situation, although the sales drop has been seen in new homes.

“The Columbia (real estate) market right now is as soft as I’ve seen it in 20 years. It’s just very slow. It’s a buyer’s market,” MacLellan said. “I don’t think it’s because the banks have tightened up.”

Brent Jones of the Jones Co.—president of the Columbia Area Board of Realtors—said much of the local sales problem stems from the national media reports about the difficulties in selling a home and getting a reasonable mortgage.

“People hear the national media. I don’t think the mortgage market has been affected here. Our problem is that our supply is much greater than our demand. The reason things have slowed down is the way the media has portrayed it. Actually it is a good time to buy” because prices have been stable rather than rising and the oversupply problem tends to hold prices down, he said.

The average sale price for a home in Boone County has risen to $164,000 this year, from $162,000 in the first six months of 2006 and $157,000 in the first half of 2005.

Shimmens warned that unless the Fed cuts its rates, banks are likely to begin raising mortgage rates, which before have tended to follow the 10-year T-bill figures. “People are going to see higher (interest) rates,” he said. “It’s going to impact consumers negatively and their ability to buy as much property. Somebody has got to pay for all these losses.”

Another possible concern for national analysts has been foreclosures, which are expected to explode nationally and could affect Columbia home values—but only if a substantial number are reported here.

Columbia and Boone County, as well as the entire state of Missouri, have few if any sources of data about foreclosures.

Bankers and Realtors say the number is increasing but not in an alarming fashion at this point.