Residential Mortgage Market Report 2007

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MBA Research Monograph Series

The ResidentialMortgage Market andIts Economic Contextin 2007

J y 30, 2007


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Primary author:Michael Fratantoni, Ph.D., Senior Director, Single-Family Research

and Economics

Contributing authors:Douglas G. Duncan, Ph.D., Senior Vice President and Chief Economist,

Research and Business Development

Jay Brinkmann, Ph.D., Vice President, Research and Economics

Orawin Velz, Ph.D., Director, Economic Forecasting, Research andBusiness Development


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Mortgage Bankers Association The Residential Mortgage Market and Its Economic Context in 2007

Introduction and Executive Summary 1

Global Capital Markets, Monetary Policyand the Supply of Mortgage Credit 7

Decelerating Housing Markets 15

The Composition of New Mortgage Originationsand Outstanding Mortgage Debt 19

Trends in Mortgage Delinquencies and Foreclosures 31

The Outlook for the Year Ahead 39

Table of Contents


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The Residential Mortgage Market and Its Economic Context in 2007 Mortgage Bankers Association


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Introduction andExecutive Summary

The purpose of this monograph is to provide a brief overview of the primary economic trends impactingthe housing and mortgage markets as of the beginning of 2007. In doing so, it provides readers withan economic context for the market developments we are anticipating, and for the policy issues thatare likely to be the focus of policymakers and the industry over the next year.

The discussion begins with an overview of the macroeconomic factors that impact the supply of mortgage credit, then moves to a discussion of the current state of the housing and mortgage markets,including origination activity and trends in mortgage performance. The report ends with a discussionof MBAs economic and mortgage finance outlook as of January 2007.

Key points:

The U.S. economy is strong and resilient. The economy will continue to grow in 2007, but at aslightly below trend rate of growth.

The housing market is nearly back to normal. The housing market will regain its footing bymid-to-late 2007, depending on what measure is used. Home sales and starts will likely begin toincrease in mid-2007, but, given the large inventory overhang, prices are unlikely to show anysignificant increase until late 2007 or early 2008.

The residential finance market is fundamentally sound and working efficiently. The housingmarket will continue to benefit from low long-term interest rates. For ARM borrowers, we expectshort-term interest rates to be steady going forward.

As they always will, consumers are choosing products that fit the current economics of the market.


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2 The Residential Mortgage Market and Its Economic Context in 2007 Mortgage Bankers Association

Mortgage originations will fall in 2007 relative to 2006 given the decline in home sales anddiminished refinance activity.

Delinquency rates are evolving as any seasoned observer of the mortgage market would expectthem to do. Barring any unexpected downturn in the economy, the recent increase in mortgagedelinquency rates will likely peak by the end of 2007, but at levels well below those of past peaks.This lower peak will come despite the change in the composition of outstanding loans, namely alarger proportion of subprime loans in recent years.

Global capital markets, monetary policy and the supply of mortgage credit:

The primary reason for the relatively low level of long-term interest rates is the massive inflowsof global capital into U.S. fixed income markets. These capital inflows are the flip side of thehistorically large U.S. trade deficit.

The composition of foreign holdings of U.S. long-term debt securities has changed over timewith a greater volume of foreign investment being directed into mortgage-related securities.This is one reason spreads between mortgage and Treasury rates are tighter than they mightotherwise be.

The U.S. economy has settled into a solid pace of growth, and the job market is still quite strong.

Beginning in June of 2004, the Fed raised the fed funds target 17 straight times in quarter pointincrements. It is not surprising that the economy, and the housing market in particular, has slowedfrom a previously brisk pace in the face of tighter monetary policy.

Several foreign central banks have either begun or have continued to raise their target rates inresponse to domestic inflationary pressures. For global investors, this is yet another incentive to

move out of U.S. assets, putting additional downward pressure on the dollar. Decelerating housing markets:

In 2006, the pace of home sales, both for new and existing homes, declined fairly abruptly.

This decline took place on a national basis. In most cases, sales volumes returned to levels last seenin 2003, a strong sales pace at that time, but not nearly as robust as seen in 2004 and 2005.

As the sales pace dropped, the months supply of unsold homes quickly ramped up. This buildupin inventory changed the dynamics of most housing markets, making them much more favorablefor buyers and reducing the rate of price appreciation.

Over the past five years, according to the OFHEO index, home prices at the national level haveincreased at a greater than 9 percent rate. Over the most recent 12 months, this pace slowed toless than 8 percent, and the annualized quarterly rate in the third quarter decelerated further toless than 3.5 percent.


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Mortgage Bankers Association The Residential Mortgage Market and Its Economic Context in 2007 3

The states in the Northeast and Midwest that have experienced home price declines have beenthose with relatively weak employment growth, out-migration of population, or both.

These same states have experienced high or increasing levels of mortgage delinquencies andforeclosures.

On a national basis, we anticipate that home prices will increase only at low single-digit ratesover the next couple of years.

The composition of new mortgage originations and outstanding mortgage debt:

As with home sales volumes, the volume of purchase mortgage applications declined in 2006.Again, this is well below volumes seen in 2004 and 2005, but still a solid year.

Refinance volumes are well below the refi boom that stretched from 2001 through 2003. It islikely that some portion of the end of 2006 pickup in refinance activity reflects borrowers payingoff ARM loans that either had already or were about to reset to higher payments.

30-year fixed mortgage rates peaked in June of 2006 above 6.8 percent, then fell sharply afterthe Fed paused at their June meeting. At one point in the fall of 2006, the 30-year rate droppedbelow 6 percent.

Interest only (IO) loans, with both adjustable- and fixed-rates, and payment option loans thatallow negative amortization, have become a very important part of the market. In the second half of 2005 and the first half of 2006, IOs accounted for about 25 percent of the dollar volume of originations. In addition to their use as affordability products, these products offer homeownersan innovative and flexible means to more actively manage their home equity.

The share of the market accounted for by the government lending programs, FHA and VA, hasdecreased considerably in recent years. Gaining market share have been the prime and subprimesegments.

Much of the stock of outstanding loans has been originated in the past three years. This hasimplications for mortgage delinquencies and foreclosures, as loans tend to hit their peak delinquencyrates three to five years after origination. We estimate that more than 80 percent of outstandingloans have been originated since 2002.

The ARM share of outstanding mortgages has grown from about 18 percent in 2003 to about25 percent as of the third quarter of 2006.

With the home price gains of the past few years, there has been a substantial growth of homeequity, even for recently originated loans. Even if home prices remain flat or decline somewhatfrom their current level, most homeowners have built up a cushion of equity over the last severalyears that could act as a buffer in any downturn.


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Trends in mortgage delinquencies and foreclosures:

Mortgage lenders stand to lose financially when loans do not perform, and thus have significantincentives to prevent foreclosures. Historically, on a national basis, mortgage lenders lossmitigation efforts have helped three out of four borrowers who enter the foreclosure process

avoid a foreclosure sale. Mortgage delinquencies are still caused by the same things that have historically caused mortgage

delinquencies: life events, such as job loss, illness, divorce or some other unexpected challenge.Foreclosures following delinquencies may be caused by the inability to sell a house due to localmarket conditions after one of the above items has occurred.

As we had expected, delinquency rates increased across the board in the third quarter. However,increases in delinquency rates were noticeably larger for subprime loans, particularly for subprimeARMs. This is not surprising given that subprime borrowers are more likely to be susceptible tothe cumulative increases in rates we have experienced, and the slowing of home price appreciation

that has resulted. The percentage of loans in the foreclosure process was 1.05 percent of all loans outstanding at

the end of the third quarter, an increase of six basis points from the second quarter of 2006.A basis point is 0.01 percentage points.

Across all loan types, the states with the highest overall delinquency rates were Mississippi, Louisianaand Michigan. Based on foreclosure inventory rates across all loan types, the top three stateswere Ohio, Indiana and Michigan. From the third quarter of 2005, 44 out of 51 states saw theirdelinquency rates increase, while 35 states saw an increase in the foreclosure inventory rate.

The most important driver for the elevated serious delinquency rates in the Midwest is thepersistent loss of employment, especially manufacturing employment, which is a result of ongoingproductivity gains. Loss of employment is one of the most common unanticipated shocks tohousehold finances.

There are many false claims about mortgage lenders profiting from foreclosures. In reality, everyparty to a foreclosure loses the borrower, the immediate community, the servicer, mortgageinsurer and investor.

The market is working, responding to a changing economic environment quickly and appropriately.In response to mortgage payment performance that has deteriorated somewhat from the verystrong performance of recent years, investors have demanded higher returns in the form of widercredit spreads, particularly for loans originated in 2006.


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These price signals from the capital markets directly and immediately impact the rates thatmortgage lenders can offer to borrowers, in this case particularly to borrowers with blemishedcredit. The result of these adjustments in the capital markets will be that risk-adjusted returnswill be equalized across segments of the market. Far from being a problem, these clear marketsignals will help the market to more efficiently maintain its equilibrium.

We would strongly caution policymakers to avoid any regulatory or legislative actions that wouldimpede the ability of the market to respond to changes in underlying economic conditions orcontinue to be innovative in creating credit solutions for borrower needs. An important role of publicpolicy should be to facilitate efficient markets, as these will ultimately benefit consumers.

We expect the housing market to fully regain its footing between the middle and the end of 2007.In the meantime, we anticipate some further increases in delinquency and foreclosure rates in thequarters ahead.


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Over the past fifty years, we have seen two interest rate regimes. From the 1950s through 1980,interest rates increased as inflation spiraled upwards. Then, beginning with Chairman Volcker, andcontinuing with Chairmen Greenspan and Bernanke, the Fed has committed to maintaining a lowinflation environment, resulting in a sustained downward trend in long-term interest rates.

0-Year TreasurY, Fed Funds raTe and MorTgage raTe

Source: Federal Reserve Board, Freddie Mac

Today, we operate in increasingly globalized markets. One outcome of this trend has been whatformer Chairman Greenspan referred to as a conundrum even though the Federal Reserve hasraised its short-term interest rate target 4.25 percentage points over the last 3 years, long-term rates

Global Capital Markets,Monetary Policy andthe Supply of Mortgage Credit


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have remained relatively flat. Although long-term inflationary expectations are well-contained, andeconomic growth is forecasted to be somewhat below trend, the primary reason for the relatively lowlevel of long-term rates is related to the massive flows of global capital into U.S. financial markets.

TreasurY Yield Curve

Source: Federal Reserve Board

These capital inflows are the flip side of the historically large U.S. current account deficit. Thiscountry imports more than it exports by a considerable margin: the deficit is about 7 percent of GDP.The deficit must be financed with borrowings from abroad, both from foreign official (government)and private investors.

u.s. CurrenT aCCounT

Source: Bureau of Economic Analysis


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This imbalance in terms of trade and capital flows is also unprecedented in that almost everyregion of the world is a net lender to the U.S. As shown in the chart below, Asia including Japan, theoil exporting countries and Europe have been running current account surpluses while the U.S. hashad increasingly large current account deficits.

CurrenT aCCounT BalanCes around The World

Source: Europe and Global Imbalances. Philip Lane and Gian Maria Milesi-Ferretti

The series of ever larger yearly deficits has steadily eroded the net foreign asset position of theU.S., making the country the worlds largest debtor. An examination of the composition of theseborrowings shows that it is primarily in the form of debt securities. The U.S. net position in bank

loans, equity securities and foreign direct investment (FDI) is approximately balanced.

neT Foreign asseT PosiTions (PerCenT oF gdP): euroPe and The u.s.

Source: Europe and Global Imbalances. Philip Lane and Gian Maria Milesi-Ferretti


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The composition of foreign holdings of U.S. long-term debt securities has changed over time,though. According to UBS, in 2006, 44 percent of central banks around the world were approved toinvest in MBS and ABS, up from 2 percent in 1998. Only 3 percent of central banks invest only inU.S. Treasuries, down from 31 percent 4 years ago. UBS estimates that central bank purchases alonecan absorb half of the net new 2007 supply of MBS and ABS. Additional demand will come from

stabilization funds held by the oil exporting countries and private foreign investors. All of thisimplies that GSEs and domestic banks are unlikely be large net purchasers of mortgage securities inthe year ahead, as there will be substantial competition for these assets from foreign investors.

Changing CoMPosiTion oF Foreign holdings

Source: U.S. Department of Treasury

One impact of this diversification by foreign investors and others out of Treasuries and intomortgages and other debt securities is that spreads across fixed-income markets have been compressed.Some describe this as a result of investors reaching for yield, accepting additional risk for less thanthe historically required excess return. Mortgage spreads continue to be narrow for much of themarket, although spreads on the lower-rated tranches of subprime securities have widened recentlyfollowing increased levels of subprime delinquencies, as the failure of some subprime lenders hascaused investors to recalibrate their expectations of losses on these securities.


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Yield sPread: 30-Year Fixed MorTgages and 0-Year Treasuries


As economist Herb Stein famously noted, trends that are not sustainable tend to reverse. Thesame will be true for this trend of ever larger current account deficits. Most likely, the reverse willcome through a gradual decline in the foreign exchange value of the dollar, which will increase theprice of imports for U.S. consumers, and decrease the price of U.S. exports for foreign consumers. Inthe past year, export growth has been above import growth, but it will need to grow much more tosignificantly reduce the trade deficit.

There is a chance that foreign investors could suddenly lose confidence in the dollar, leading toa precipitous decline in its value. This would coincide with a sharp decline in the value of U.S. debtsecurities, leading to a spike in interest rates. This scenario is unlikely, but is possible, and should beon radar screens as we move ahead. Note that the chart below regarding the exchange rate is tradeweighted, giving greater weight to countries who are primary trading partners of the U.S.

exChange raTe



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The U.S. economy has settled into a solid pace. The auto and housing sectors are a drag ongrowth presently, leading overall GDP to grow slightly below our estimate of its trend growth rateof about 3.25 percent. However, the job market is still quite strong. In December, the unemploymentrate stood at 4.5 percent, below what most economists view as the non-accelerating inflation rate of unemployment (NAIRU), the unemployment rate below which inflation will begin to accelerate, as

firms bid up wages to attract workers, leading to increased pressure on prices.

uneMPloYMenT raTe

Source: Bureau of Labor Statistics

For much of 2006, most of the inflation story related to sustained high energy prices. However,

as energy prices declined towards the end of the year, core inflation, which excludes food and energyprices, remained stubbornly high, and outside of the Feds implicit target range. In public comments,Fed officials consistently have noted that they are uncomfortable with the pace of inflation, and seeinflation, not weak growth, as the primary risk to the economy in the near term.


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inFlaTion

Source: Bureau of Labor Statistics

These sentiments are in the context of the Feds recent pause after a two year march of increasingrates. Following the recession at the early part of this decade, the Fed lowered its rate target to a40-year low of 1 percent. Beginning in June of 2004, the Fed raised the fed funds target 17 straighttimes in quarter point increments. Fed officials spoke of bringing the funds rate to a neutral level,a level which neither stimulated nor held back the economy. By June of 2005, at a target rate of 5.25percent, the Fed apparently had reached this level. A mountain of empirical research suggests that thecumulative impact of a monetary policy tightening is realized with long and variable lags, oftentaking 18 to 24 months to play out. Thus it is not surprising that the economy, and the housing marketin particular, has slowed from a previously brisk pace in the face of tighter monetary policy.

MoneTarY PoliCY



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However, the global capital flows mentioned earlier have an effect here, as well. Even thoughthe Fed paused in June, other central banks around the world have not. The Japanese central bankrecently lifted its target rate above zero percent for the first time in years. The European Central Bankand the Bank of England also have been raising their target rates in response to domestic inflationarypressures. For global investors, this is yet another incentive to move out of U.S. assets and into those

denominated in euros or yen, putting additional downward pressure on the dollar. To some extent,this is another factor that argues against the Fed cutting rates in the near term if it does, this willfurther incent global investors to sell dollar assets. At some point, the increase in import prices couldcause inflationary pressures to heat up.

inTernaTional raTes are rising rel aTive To u.s. raTes

Source: Financial Times


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As noted below, the housing market has been impacted substantially by the cumulative impact of the Feds increases in short-term rates over the past few years. 2003 was the record in terms of totalmortgage originations with close to $4 trillion of new loans made. But 2004 and 2005 were successivelybigger years in terms of home sales and purchase mortgage originations, fueled by a strong economyand low interest rates. In 2006, the pace of home sales, both for new and existing homes declinedfairly abruptly.

ToTal hoMe sales

Source: National Association of Realtors, Census Bureau, and MBA Forecast

Decelerating Housing Markets


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This decline took place on a national basis. In most cases, sales volumes returned to levels lastseen in 2003, a strong sales pace at that time, but not nearly as robust as seen in 2004 and 2005.

exisTing hoMe sales BY region

Source: National Association of Realtors

Prior to the falloff in sales volume, the absolute number of unsold homes on the market had beenincreasing. However, when the sales pace dropped, the months supply of unsold homes quickly rampedup, particularly for condos, the vehicle of choice for many investors. The buildup in inventory changedthe dynamics of most housing markets. After years of sellers being able to name their price, in mostmarkets buyers once again had some negotiating power. Homes stayed on the market longer, and by

some measures over certain time periods, median sales prices fell on a national basis. We expect thatthe inventory of unsold homes has peaked for this cycle, and that by the middle of 2007 the housingmarket will regain its footing, with home construction and home sales beginning to increase modestlyfrom that point.


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MonThs suPPlY For neW hoMe sales and real residenTial invesTMenT

Source: Bureau of the Census and Bureau of the Economic Analysis

A more accurate gauge of home values, the Office of Federal Housing Enterprise Oversight(OFHEO) repeat transactions index, has not shown a decline in home prices at the national level,although it has shown some declines in values for a handful of states. Because the OFHEO index isbuilt upon repeat transactions on the same properties, it controls at least somewhat for the qualityof homes being sold; the National Association of Realtors (NAR) median sales values are heavilyinfluenced by the composition of sales, and have no controls for changes in the quality or geographicdistribution of homes being sold.

Over the past five years, according to the OFHEO index, home prices at the national level haveincreased at a greater than 9 percent rate. Over the most recent 12 months, this pace slowed to lessthan 8 percent, and the annualized quarterly rate in the third quarter decelerated further to less than3.5 percent.

The states that have experienced home price declines in recent data, a handful of states in theNortheast and Midwest, have been those with relatively weak employment growth, out migration of population, or both. As will be examined below, these same states have experienced high or increasinglevels of mortgage delinquencies and foreclosures. We anticipate that home prices at the national levelwill increase only at low single-digit rates over the next couple of years. With inflation running at twoto three percent, there is a greater likelihood that real (inflation-adjusted) home prices will declineat the national level, but it is unlikely that the OFHEO index will show a decline in nominal homeprices on a year-over-year basis.


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hoMe PriCe groWTh raTes

Source: Office of Federal Housing Enterprise Oversight (OFHEO)


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oWner oCCuPied uniTs WiTh MorTgage or hoMe equiTY deBT

Owned free

and clear 34%

Mortgage or home equity loan

66%

Source: 2005 American Housing Survey

According to 2005 American Housing Survey (AHS) data, only 66 percent of homeowner householdshave a mortgage on their residence. As shown in the chart above, the other 34 percent own theirhome free and clear. This fact is important to keep in mind when considering the market impact of any changes in mortgage originations or any trends in mortgage product choice.

As with home sales volumes, the volume of purchase mortgage applications declined in 2006.Again, this is well below volumes seen in 2004 and 2005, but still a strong year. Total mortgageoriginations in 2006 were the fifth highest ever.

The Composition of New Mortgage Originationsand Outstanding Mortgage Debt


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20020 PurChase index: Week Moving average (seasonallY adJusTed)

Source: MBAs Weekly Application Survey

Refinance volumes are well below the refi boom that stretched from 2001 through 2003. 30-year fixed mortgage rates peaked in June of 2006 above 6.8 percent, and then fell sharply after theFed paused at their June meeting. At one point in the fall of 2006, the 30-year rate dropped below6 percent. This decline in long-term rates was sufficient to spur an increase in refinancing, with therefi share of applications rising above 50 percent in certain weeks.

20020 holidaY adJusTed reFinanCe index: Week Moving average



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30-Year Fixed MorTgage raTes: 0PresenT


Although the evidence is not definitive, it is likely that a large portion of this refinance activityreflects borrowers paying off ARM loans that either had already or were about to reset to higherpayments. In many cases, borrowers with an ARM could expect their rate, which might have beenclose to 4 percent if they originated a loan in 2003, to rise to a 7.5 percent rate. This at a time whenthey could get a 30-year fixed rate at 6 percent. Not surprisingly, given the low level of fixed mortgagerates, and the inverted yield curve, which led to a very narrow spread between FRM and ARM rates,the share of loan applications that are ARMs declined through much of 2006, reaching 20 percentby the last week of the year.

arM share vs. long/shorT TerM inTeresT r aTe sPread



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Traditional and Non-traditional Mortgage Products

A continuing topic of interest in 2006 was the marked growth in the use of so-called non-traditionalproducts. The regulatory agencies have defined non-traditional as including interest only andpayment option loans.

A recent Wall Street Journal Online/Harris Interactive personal-finance poll indicated that youngerborrowers have been more likely to use non-traditional products. For example, the poll indicatedthat 23 percent of 1834 year old borrowers have an interest only product, while only 7 percent of 4554 year old borrowers do. This aligns with the notion that these products are often used to extendaffordability.

Interest only (IO) loans, with both adjustable- and fixed-rates, and payment option loans thatallow some amount of negative amortization, have become a significant part of the mortgage market.In the second half of 2005 and the first half of 2006, IOs accounted for about 25 percent of the dollarvolume of originations. In the first half of 2006, there was a move towards fixed-rate IOs mirroringthe overall trend in the market towards fixed-rate products. Payment option loans accounted forabout 15 percent of the dollar volume of originations. (Note that MBAs Mortgage Origination Surveyclassifies payment option loans separately, so it is not appropriate to add the IO percentage to thepayment option percentage to get an overall non-traditional share.)

IO loans permit the borrower to make interest only payments for some portion of the loan term.For IO ARMs, a common structure has the interest rate fixed for 5 years, and an interest only periodof 5 years, followed by 25 years where the loan amortizes, i.e. the principal balance is paid down,and the rate can adjust on an annual basis. For fixed-rate IO loans, a common structure is for therate to be fixed for the entire 30 years, with a 10-year interest only period. Note that borrowers canat their discretion make payments of principal during the interest only period.

Payment option loans typically give borrowers a choice of 4 different payments with each monthlystatement. Borrowers could make fully amortizing payments calculated over a 30- or 15-year term.Alternatively, they could make an interest only payment, which would not reduce the loan balance,or a minimum payment less than the interest only payment. Making the minimum payment wouldnegatively amortize the loan, as the interest due above the minimum payment would be added to theloan balance. Typically, the extent of negative amortization is capped at 110 or 115 percent of theloans original balance.

Why have these loans gained in popularity? They have existed as niche products for twenty or moreyears, but it is only in the last 34 years that they have gained mass market appeal. We believe thatchanging interest rates and housing market environments can at least partially explain the changingpopularity of different mortgage products.

An important point is that credit spreads across all types of fixed income securities: corporate

debt, emerging markets debt and mortgages have been historically tight in the last few years. Largelyas a result of the massive flows of global capital, Treasury rates have been low, leading investors toreach for yield by moving into securities with higher risk. The flow of capital into these securitiescompressed credit spreads including spreads on mortgages relative to other assets. As a result of thesecompressed credit spreads, risk spreads related to all types of mortgage products and features werereduced, making non-traditional products much more appealing to borrowers.


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originaTions BY loan PurPose and aMorTizaTion TYPe For suBPriMe loans

Source: MBAs Midyear 2006 Subprime Mortgage Originations Survey

A further analysis of data from MBAs Midyear 2006 Mortgage Originations Survey showslittle trend in first mortgage LTVs over time. The weighted average LTV over the past two years hasremained in the mid-70s. The distribution of LTVs has changed somewhat, with a slightly largerproportion of loans in the 7180 and higher LTV ranges.

With respect to credit score, its trends in MBAs Mortgage Origination Survey have been stable.About half of the dollar volume of first mortgage originations in the first half of 2006 were for loanswith FICO scores above 700. About three quarters were for loans with FICO scores above 650. Of the remaining one quarter, most were in the 600650 bracket.


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Analysis by Bear Stearns of 2005 originations provides a more detailed breakdown by marketsegment. This chart only captures a portion of all securitized product. MBA estimates that totalfirst mortgage originations in 2005 were approximately $3 trillion, while the total originations fromthis chart are $813 billion. However, some of the comparisons across market segments are quiteinteresting. Note that average loan size and FICO score is highest in the prime sector, and lower for

the near prime and subprime sectors.LTV and cash out percentages are lowest in the prime sector. The proportion of loans that are

option ARMs is highest in the near prime sector. These sources report that one percent of subprimeloan volumes are Option ARM; other sources suggest that there are no subprime Option ARMs.The investor share is highest in the near prime sector, while the interest only share is highest amongprime ARM loans.

loan CharaCTerisTiCs BY seCTor: 200 originaTions

Sector

Orig.Bal.

($MM)InitialGWAC

Avg.LoanSize($K) FICO

Comb.LTV

%CA

%FullDoc

%Cash-Out

%Investor

%IO

%Prepay Penalty

%Option ARM

GrossMargin

Prime ARM $123,575 4.25 $453 732 73.9 54.0 4 4.3 26.4 4.5 55.1 15.4 24.4 256.2

NearPrime ARM

$189,195 3.88 $321 711 80.0 50.2 24.9 34.9 14.2 45.1 52.6 43.9 282.4

Subprime ARM $290,601 7 .10 $200 624 85.9 32.2 5 6.9 51.2 5.5 30.4 72.4 1.1 582.6

PrimeFixed $47,114 5.86 $499 742 70.6 39.2 54.7 27.6 1.0 15.2 1.7 NA NA

NearPrimeFixed

$94,944 6.21 $215 717 76.2 26.8 40.0 38.3 15.7 28.9 15.6 NA NA

SubprimeFixed $66,446 7.48 $128 636 81.2 26.9 70.2 68.4 4.0 5.5 76.6 NA NA

Source: Bear Stearns, Loan Performance

Changing focus to discuss the composition of outstanding mortgages, several trends emerge.First, the share of the market accounted for by the government lending programs, FHA and VA,has decreased considerably in recent years. 1 These programs accounted for more than 30 percent of outstanding loans in 1998. Today, they account for about 10 percent of all outstanding loans. Gainingmarket share have been the prime and subprime segments.

See the 2006 RIHA study Lender Perspec tives on FHAs Declining Market Share at www.housingamerica.org .


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ouTsTanding loans BY loan TYPe: PresenT

Percent

98 99 00 01 02 03 04 Q1 Q2 Q3 Q4 Q1 Q205 05 05 05 06 06

FHA VASubprimePrime

0

10

20

30

40

50

60

70

80

90

100

Source: MBAs National Delinquency Survey

The other noteworthy characteristic of the market relates to the record-setting refi year in 2003,when 30-year rates were at 40-year lows, and the strong purchase years of 2004 and 2005. With thisbunching of activity, much of the stock of outstanding loans was originated in the past three years.This has implications for mortgage delinquencies and foreclosures, as loans tend to hit their peakdelinquency rates three to five years after origination. Moreover, the data indicate that more than86 percent of outstanding loans have been originated since 2000, and 80 percent since 2002. Forsubprime loans, an even greater proportion was originated in the last couple of years, with almost75 percent of outstanding subprime loans originated since 2003. The average age across all loansas of the end of 2005 was three years. For FHA and VA loans the average was five years, while forsubprime ARMs the average loan was only two years old.

ouTsTanding loans BY originaTion Year (q 200 daTa)

Percentageof sample

0

5

10

15

20

25

30

35

40

Pre-1998 1998 1999 2000 2001 2 002 2003 2004 2005

Source: MBAs NDS Origination Year Supplement


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The ARM share across all types of mortgages has grown from approximately 18 percent in 2003to approximately 25 percent as of the third quarter of 2006. Among prime mortgages, the ARMshare has increased from about 16 percent in 2003 to about 20 percent; for subprime mortgagesthe ARM share increased from about 45 percent to about 59 percent. ARMs have typically beenmore popular in high housing cost areas. For example, California has always had a higher ARM

share than much of the nation, while Texas and other states in the Southwest have had consistentlylower ARM shares. In the third quarter of 2006, Nevada had the highest ARM share in the countrywith 42 percent of outstanding loans being ARMs. The Nevada housing market has boomed inrecent years as population growth rates have consistently been in the double digits. These recentbuyers have followed the national trend of choosing ARM loans at a higher rate than homebuyersin earlier years.

arM share BY loan TYPe

Percentof Loans

0

10

20

30

40

50

60

70

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q22003 2004 2004 2004 2004 2005 2005 2005 2005 2006 2006

Prime ARM Share FHA ARM ShareSubprime ARM Share Total ARM Share


With the home price gains of the past few years, there has been a substantial growth of homeequity, even for recently originated loans. The Federal Reserves Flow of Funds data show that aggregatehome equity increased from $9.4 trillion in 2004 to $11 trillion by the third quarter of 2006. In thecharts below, this growth in equity is tracked by state by examining the initial LTV at originationfor the 2004 and 2005 cohorts, then calculating the LTV as of the second quarter of 2006. The loanbalance changes through amortization (assuming a 30-year term and holding the rate constant at theinitial rate). The home value changes based upon the cumulative change in the state-level index.

According to this analysis, even for 2005 originations, mark-to-market LTVs have droppedappreciably in most areas of the country. The implication is that even if home prices remain flat ordecline somewhat from their current level, most homeowners have built up a cushion of equity overthe last several years that could act as a buffer in any downturn.


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To conclude, the stock of outstanding mortgages is predominantly composed of young loans.Due to the strong housing markets of recent years, homeowners have built up a substantial bufferof home equity. Therefore, even though we anticipate somewhat weaker housing markets over thenext couple of years as the market normalizes, as well as some modest increases in overall mortgagedelinquency and foreclosure rates, we do not expect any significant decline in overall mortgage credit

quality, although there could be some further weakening in the subprime sector.

esTiMaTed Change in CurrenT lTv BY sTaTe For 200 originaTions

Percent

A K A L

A R A Z

C A

C O C

T D C

D E F L G

A H I I A I D I L I N K

S K Y L A M

A M D

M E

M I

M N

M O

M S0

20

40

60

80

100

2005 Loans Original LTV 2005 Loans LTV as of 2006 Q2

Percent

M T

N C

N D

N E

N H N

J N M N

V N Y

O H

O K

O R P A R

I S C

S D T N T

X U T

V A V T

W A

W I

W V

W Y0

20

40

60

80

100

2005 Loans Original LTV 2005 Loans LTV as of 2006 Q2

Change in LTV by State (AlaskaMississippi)

Change in LTV by State (MontanaWyoming)

Source: OFHEO, FHFB and MBA calculations


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Mortgage lenders stand to lose financially when loans do not perform, and thus have significant incentivesto prevent foreclosures. Historically, on a national basis, mortgage lenders loss mitigation efforts havehelped three out of four borrowers who enter the foreclosure process avoid a foreclosure sale.

Mortgage delinquencies are still caused by the same things that have historically caused mortgagedelinquencies: life events, such as job loss, illness, divorce or some other unexpected challenge.Foreclosures following delinquencies may be caused by the inability to sell a house due to local marketconditions after one of the above items has occurred.

As we had expected, delinquency rates increased across the board in the third quarter. However,increases in delinquency rates were noticeably larger for subprime loans, particularly for subprimeARMs. This is not surprising given that subprime borrowers are more likely to be susceptible to thecumulative increases in rates we have experienced, and the slowing of home price appreciation thathas resulted. It is important to remember that delinquency and foreclosure rates have been quite lowthe last two years.

In the third quarter of 2006, more than 95 percent of borrowers were current on their mortgage.The delinquency rate for mortgage loans on one-to-four-unit residential properties stood at 4.67percent of all loans outstanding in the third quarter of 2006 on a seasonally adjusted (SA) basis,

up 28 basis points from the second quarter, and up 23 basis points from one year ago, according toMBAs National Delinquency Survey. A basis point is 0.01 percentage points.

The increase was driven by increases in delinquencies for all major loan types, most notably forsubprime and FHA loans. Delinquency rates for prime, subprime and FHA loans increased on aseasonally adjusted basis relative to the second quarter.

Trends in Mortgage Delinquenciesand Foreclosures


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ToTal delinquenCY raTe BY loan TYPe


The percentage of loans in the foreclosure process was 1.05 percent of all loans outstanding at theend of the third quarter, an increase of six basis points from the second quarter of 2006, while theSA rate of loans entering the foreclosure process was 0.46 percent, three basis points higher than theprevious quarter. Compared with the third quarter of 2005, the percentage of loans in the foreclosureprocess was up eight basis points while the percentage of loans entering the foreclosure process wasup five basis points.

ForeClosure invenTorY PerCenTage BY loan TYPe



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Delinquency rates increased during the third quarter of 2006 for all loan types. The delinquencyrate increased 15 basis points for prime loans (from 2.29 percent to 2.44 percent), increased 86 basispoints for subprime loans (from 11.70 percent to 12.56 percent), increased 35 basis points for FHAloans (from 12.45 percent to 12.80 percent), and increased 23 basis points for VA loans (from 6.35percent to 6.58 percent). As noted above, the largest increase was for subprime ARM loans, whose

delinquency rate increased from 12.24 percent in the second quarter of 2006 to 13.22 percent in thethird quarter.

ToTal delinquenCY raTe BY arM and Fixed


Across all loan types, the states with the highest overall delinquency rates were Mississippi (11.05percent), Louisiana (9.50 percent) and Michigan (7.44 percent). Based on foreclosure inventory ratesacross all loan types, the top three states were Ohio (3.32 percent), Indiana (2.90 percent) and Michigan(2.20 percent). All state level results are not adjusted for seasonal effects.

The states with the largest increase in overall delinquency rates in the past year were Michigan(135 basis points), Rhode Island (128 basis points) and Ohio (96 basis points). The states with thelargest increase in foreclosure inventory rate were Michigan (59 basis points), Rhode Island (46 basispoints) and Maine (43 basis points).

From the third quarter of 2005, 44 out of 51 states saw their delinquency rates increase, while35 states saw an increase in their foreclosure inventory rates.

At the regional level, the Northeast region had an overall SA delinquency rate of 4.39 percent,the North Central region had a delinquency rate of 5.44 percent, the South had a delinquency rateof 5.37 percent and the West had a delinquency rate of 2.81 percent, compared to the national rateof 4.67.


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ToTal loans PasT due raTes BY sTaTe For q3, 200


For the foreclosure inventory rate, the Northeast region had a rate of 1.06 percent, the NorthCentral region had a rate of 1.89 percent, the South had a rate of 0.99 percent and the West had a rateof 0.49 percent, compared to the national foreclosure inventory rate of 1.05 percent of all loans.

The most important driver for the elevated serious delinquency rates in the Midwest is the persistentloss of employment, especially manufacturing employment. The main factors contributing to joblosses in the sector include rapid productivity growth, increased international competition and a shiftin demand structure, which substitutes imports for some domestically produced goods. Given thatthese factors will continue to be at work in a growing global market, a large portion of the job cutsin recent years could represent permanent layoffs that will only gradually be offset by job creation inother sectors in the economy. This suggests that the areas delinquency rates could remain elevatedfor some time.

To expand upon this explanation, there are a number of factors that can be identified as beingresponsible for the elevated delinquency and foreclosure rates in these areas.

Loss of employment is one of the most common unanticipated shocks to household finances. Allof the states in the East North Central and East South Central continued to suffer job losses fromtheir peak employment prior to the recession in 2001. In addition, these states are among themost concentrated in manufacturing in the nation. Through a vast improvement in productivitygrowth and increased globalization, it is likely that manufacturing employment will remain soft

in the coming years. Many low-income households have few or no financial assets to cushion them in times of financial

difficulties putting them at risk of being delinquent or of defaulting on their mortgages. TheEast North Centrals median income is somewhere in the middle of the nations, while the EastSouth Central has maintained the lowest median income in the nation.


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A high level of homeownership is a sign of strength for a local economy. However, in the midst of a significant regional downturn, homeowners, who are typically less mobile than renters, may havedifficulty making their mortgage payments, leading to delinquency and potentially foreclosure.

Areas with very strong home price appreciation have lower foreclosure rates. If home priceappreciation is strong, the odds of having a mortgage loan exceeding the value of a home arelower. In addition, strong home price appreciation provides an opportunity for borrowers to liquefyequity in the home in a time of financial distress, reducing the likelihood that the borrowers wouldbecome delinquent or would default on the loan.

Areas that are growing, either due to strong labor markets or because they are popular retirementdestinations, will have strong housing and mortgage markets. Population growth, if very strong,could partly compensate for weak labor markets. By contrast, areas that are losing populationare more likely to experience home price declines and rising foreclosure rates.

On average, loans with a high loan-to-value ratio (LTV) are riskier than lower LTV ones. Borrowerswith little equity in a home can walk away more easily from their homes, putting lenders moreat risk. Furthermore, when the LTV is high, there is increased risk that the home value couldfall below the loan balance, creating a negative situation during the early years of the loan. Theaverage LTVs of loans in most states in the two divisions are significantly higher than the nationalaverage.

A 2003 Federal Reserve Board working paper notes that, on average, foreclosures in judicialforeclosure states take 148 days longer than those in non-judicial foreclosure states. Because ittakes longer for foreclosures to be handled in the judicial states, their inventories at the end of each period tend to be higher.

Market analysts and others have examined other factors, for example the share of a market composedof subprime loans or the ARM share. These factors are not such significant drivers as those listedabove.

With respect to the subprime share, borrowers in distressed areas are more likely to have blemishedcredit as a result of a regional downturn. An increased frequency of job loss and other economicdislocations lead to a greater number of borrowers being unable to qualify for prime credit. Thus,the increase in the subprime share of the market is typically a result, not a cause, of the increasingdelinquency and foreclosure rates.

Adjustable rate mortgages present additional credit risk in an environment of rising interest ratesdue to the potential for payment shock. Historically, delinquency rates on ARMs have been higherthan those on fixed rate mortgages, but ARMs provide many homeowners with financial flexibilityand affordability in the early years of a loan.

There are many false claims about mortgage lenders profiting from foreclosures. In reality, everyparty to a foreclosure loses the borrower, the immediate community, the servicer, the mortgageinsurer and the investor. It is important to understand that profitability for the mortgage industryrests in keeping a loan current and, as such, the interests of the borrower and lender are mostlyaligned. The Fed study cited earlier notes that, estimated losses on foreclosures range from 30percent to 60 percent of the outstanding loan balance because of legal fees, foregone interest, andproperty expenses.


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A home foreclosure is a multi-step process with a notice of default letter being the first step. Severalthings happen before a foreclosure sale takes place. In most instances, the borrower brings the notecurrent, negotiates a payment plan, or sells the house and pays off the mortgage. If these options arenot possible, the borrower can turn the house over to the lender in lieu of foreclosure.

Otherwise, the house is acquired by the lender in a foreclosure, returned to marketable condition

and sold. These types of sales only take place in about 25 percent of all loans that enter the foreclosureprocess. In the remainder of the cases, either the borrower pays off the arrears through an agreedupon payment plan with the lender, or sells the home.

Rates of foreclosure vary as different groups measure foreclosures at different steps of the process.MBA looks at when the foreclosure action is initiated. Some firms look at the foreclosure sales, whileothers look at the foreclosed homes up for sale. These companies are interested in (and make moneyby) marketing foreclosed properties to investors. They typically are less interested in gauging theoverall health of the mortgage market, which is MBAs goal with the National Delinquency Survey.

In order to understand the health of the mortgage market and capture credit conditions, one hasto look at the dynamics for the entire market. Many other measures simply reflect certain parts of

the process, and can vary significantly based on local conditions. It is important to consider changesin the percentage of foreclosure sales or foreclosed homes for sale in the proper context. Due to along-run trend of an increasing homeownership rate, there are many more loans outstanding . Evenif the foreclosure rate is unchanged, the number of foreclosures will increase. One must look at thepercentage of foreclosures against historic norms. Even with the expansion of credit availability withthe growth of the subprime market, foreclosures are well below their historic highs and will not havea macroeconomic impact.

Mortgage companies have recognized the impact of foreclosures on their bottom lines and overthe last ten years have developed innovative techniques to help borrowers resume payments. Theseoptions have proven successful both for homeowners and servicers.

ForeClosure invenTorY raTes BY sTaTe For q3, 200



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The market is working. In response to mortgage payment performance that has deterioratedsomewhat from the very strong performance of recent years, investors have priced for the increasedrisk, demanding higher returns in the form of wider credit spreads, particularly for loans originatedin 2006. These price signals from the capital markets directly and immediately impact the ratesthat mortgage lenders can offer to borrowers, in this case particularly to borrowers with blemished

credit. The result of these adjustments in the capital markets will be that risk-adjusted returns will beequalized across segments of the market. Far from being a problem, these clear market signals willhelp the market to more efficiently regain its equilibrium.

Second, this widening of credit spreads in the secondary markets passes back through to newborrowers in the form of higher rates. This means lenders reduce credit availability to less creditworthyor subprime borrowers first.

Third, we have no evidence that the increases we have seen in delinquency and foreclosure ratesare the result of non-traditional products such as interest only or payment option mortgages. Theseproducts have made up a significant portion of originations in recent quarters. However, we do nothave and are not aware of information that would indicate significant deterioration in performance

related to the non-traditional products.Finally, given the first three points, we would strongly caution policymakers to avoid any regulatoryor legislative actions that would impede the ability of the market to respond to changes in underlyingeconomic conditions. An important role of public policy should be to facilitate efficient markets, asthese will ultimately benefit consumers.

We expect the housing market to fully regain its footing in the middle of 2007. In the meantime,we anticipate some further increases in delinquency and foreclosure rates in the quarters ahead.


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The economy will continue to grow, but at or slightly below our estimate of the trend rate of growth.Growth is expected to pick up during the spring of 2007, as the drag from housing and autos comesto an end. Payroll employment growth is expected to moderate somewhat further, in lagged responseto the slowdown in economic expansion underway since the spring of 2006, raising the unemploymentrate to close to 5 percent by the end of 2007. Core inflation is expected to moderate gradually. Fedpolicy is expected to remain on hold, with the federal funds rate staying at 5.25 percent throughoutthe year. As hopes for an easing of monetary policy fade, long-term interest rates are expected to backup, with the yield on the 10-year Treasury at 5 percent by the end of 2007.

Home prices will increase in 2007, but at a much lower growth rate than we have seen in thepast few years. Home sales are expected to decline through the middle of 2007 before picking upslightly in the second half of the year. For all of 2007, new home sales are projected to decline about8 percent relative to 2006 levels, compared with a decline of about 7 percent for existing home sales.For 2008, new and existing home sales should be up by about 3 percent relative to 2007.

Homebuilding activity likely reached a trough in the fourth quarter of 2006. However, activityshould improve very modestly this year. For all of 2007, we expect total housing starts to declineby about 14 percent relative to 2006. The decline will be more pronounced in single-family starts,

which are projected to be down 16 percent, compared with about 4 percent for multifamily. For 2008,housing starts should increase about 5 percent relative to 2007.

Slowly improving inventories of unsold homes should cause home prices in 2007 to be flat relativeto 2006. The gains in the median home price for both new and existing homes should be about 1 to2 percent through 2008.

The Outlook for the Year Ahead


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Mortgage originations will fall in 2007 relative to 2006 given the decline in home sales anddiminished refinance activity. For all of 2007, we project that purchase originations will decline byabout 5 percent from 2006s level to $1.33 trillion. Given the drop in mortgage rates in the fourthquarter of 2006, refi originations will be strong in the first quarter of 2007. Furthermore, as asignificant share of loans with adjustable rates will face their first reset in 2007, we expect that a

portion of these loans will be refinanced into either fixed-rate mortgages or into other adjustable-ratemortgages with an initially lower rate, providing strong support for refi activity this year. We expectrefi originations in 2007 to decline by about 4 percent relative to 2006 to $1.06 trillion.

Total originations in 2007 are projected to decline by about 5 percent to $2.39 trillion from anestimated $2.51 trillion in 2006. They should decline by an additional 4 percent to $2.29 trillion in2008 as a result of a drop in refi originations of 10 percent. Purchase originations should be aboutthe same as the 2007s level.

The narrow spread between fixed-rate mortgage and adjustable-rate mortgage yields has caused theshare of loans with adjustable mortgage rates (both purchase and refi) to decline to about 23 percent of the number of loans by the end of December, according to the Mortgage Bankers Association weekly

survey of mortgage applications. The share of loans with adjustable mortgage rates from the FederalHousing Finance Board (FHFB)s Mortgage Interest Rate Survey (which only includes conventionalloans for home purchase) showed a more pronounced decline in the usage of adjustable rate mortgagesfrom 31 percent at the beginning of the year to 14 percent in November. We believe that this measureof the ARM share will remain at about 1415 percent through the end of 2008.

annual MorTgage ProduCTion

Source: Mortgage Bankers Association and Department of Housing and Urban Development

Residential Mortgage Market Report 2007

Documents

Transcript of Residential Mortgage Market Report 2007