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Mortgage Lenders Face Long Rehab
Potential home buyers have far fewer choices when applying for a loan these days.


Largely gone are the subprime, jumbo and other exotic options that were readily available during the housing boom. Now the only type of mortgages on the block are the blandest around, all conforming to underwriting standards set by government-backed loan guarantors. For mortgage lenders and banks, such as Countrywide (CFC) , Washington Mutual (WM) , Wells Fargo (WFC) and Wachovia (WB) , and for armies of mortgage brokers around the country, their business recoveries may center on how long the all-conforming, all-the-time trend persists.


That's a horizon likely not visible for several years, much less 2008. And lenders may have to downsize and temper profit expectations going forward, some analysts say.


"The mortgage industry will not ever again be the way it was in the last four years," says Ajay Rajakhyaksha, head of U.S. fixed income strategy at Barclays Capital. Businesses that relied on mortgage lending will have to shrink down and expect to make less money going forward, he says.


An explosion of exotic mortgage underwriting dominated the market over the past four years, fueling outsized profits and excess leverage for borrowers, banks and Wall Street debt underwriters, but it ground to a halt in the second half of 2007, when a credit crunch gripped the globe.


Home foreclosures and delinquency rates have reached record highs in the third quarter of this year, according to the Mortgage Bankers Association. This finally led to U.S. Treasury Secretary Henry Paulson's plan to help a swath of mortgage borrowers by freezing loan rate resets, but many argue the plan helps only a small group, and the least needy.


"Unless you can put a floor under home prices, you can't bail out the housing market," Rajadhyaksha says.


The housing market's slump created a wave of credit downgrades for mortgage-linked securities this summer. The fallout caused once yield-hungry investors around the world to halt purchases of the mortgage loan derivatives called mortgage-backed securities and collateralized debt obligations, or CDOs. This led to the deluge of writedowns by brokers and investment banks that sold these derivates, such as Citigroup (C) , Morgan Stanley (MS) , Merrill Lynch (MER) and Bear Stearns (BSC) .



Rajadhyaksha notes that historically, 80% of mortgages originated in the U.S. were conforming to Fannie Mae (FNM) and Freddie Mac (FRE) underwriting standards, meaning that these government-sponsored entities were able to guarantee the loan.


In recent years, that ratio dropped to just 35% of mortgages were conforming, as more esoteric mortgages gained dominance in the wake of historically low 1% interest rates set by the Federal Reserve in 2003. That excess will take time to reverse, Rajadhyaksha says.


Punk Ziegel & Co. analyst Dick Bove believes the mortgage industry will contract for four to six years before the glut of homes is worked off.


New-home sales at the end of October were about half of what they were at the peak of the housing boom in June 2005. The inventory of new homes hit a 17-year high in August. Existing-home sales are down 26% from February, and as of October, the inventory glut reached a 10.8 month supply, a multidecade high. Many economists believe home prices will fall another 5% to 15%.


Among some of the worst-hit lenders still in business, Countrywide posted a $1.2 billion loss for the third quarter, or $2.85 a share, sending its stock down 30% that day, amid concerns the company faces problems funding itself.


Washington Mutual has seen its profits wane as well, and just last week it announced plans to cut its dividend by more than half while it attempts to raise capital in the market for convertible preferred shares -- often a last resort source of funding for companies with balance sheet issues.


Any progress for borrowers and lenders in 2008 will depend largely on the path of interest rates. The beginning of the current credit crunch coincided with higher interest rates, as the Fed had inched the benchmark fed funds rate to 5.25% through 2006; the 10-year Treasury rate rose above 5% in June of this year.


Since then, the Fed has attempted several rate cuts and unorthodox steps to improve liquidity and bring down key interest rates that impact mortgage resets and corporate funding rates. Most economists expect the Fed will continue to slash rates and work to help borrowers refinance mortgages into the least-expensive loans possible, despite rising inflationary pressures.


With Treasury bond rates relatively low lately, mortgage refinancing activity from exotic loans into more traditional already has been quite active. The Mortgage Bankers Association refinance index jumped 4.3% in the week ended Wednesday, after climbing 32% the week ending Dec. 5.


The wrinkle in keeping interest rates low and borrowers refinancing is a resurgence of inflation pressures, which economists expect to continue through 2008, given the spike in oil prices this fall. Already, despite continued credit market pressures, Treasury bond rates have risen this week.


Treasury yields impact fixed 30-year mortgage rates. Thursday morning, the Labor Department reported that energy prices drove up producer prices to a 17-year high. Wednesday morning, the Labor Department reported import prices are running higher by 11.4% from a year ago -- the highest pace in 17 years as well.


Punk Ziegel's Bove, however, says the current crisis is not unique to past mortgage industry woes of prior decades, which did nothing to stem the resurgence of nonconforming lending once the excess was washed out. He notes the most recent was a wave of subprime lending that wound down in the flight-to-quality panic of 1998 after the hedge fund Long Term Capital Management decided to liquidate its assets. That led to the end of subprime lenders such as The Money Store and Green Tree Financial, among others.


Bove also recalls a boom of second-mortgage lending in the 1980s, as well as scandals throughout the years surrounding lenders practicing "red-lining," or discriminating against borrowers in immigrant or low-income neighborhoods.


Bianco Research's James Bianco might agree, as long as the government doesn't wrap its arms too tightly around the current problem.


"If you want to look to the other side of the valley, there will be a day that comes when things are going swimmingly, and the mortgage industry is going to want to have some flexibility in product offers," he says. "They won't have that flexibility if the industry is hemmed in with restrictions about Fannie and Freddie guaranteed mortgages."

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