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Pisani's Trader Talk:  A Primer on the Mortgage Business

Friday, 3 Aug 2007 | 3:58 PM ET

CNBC's Bob Pisani reports on what traders are telling him at midday:

With all the worries over mortgage lenders, here's a CNBC 101 on how the mortgage business works, and why it is in a bit of a tizzy at the moment.

Let's look at an example of a typical mortgage company, call them XYZ Mortgage.

Let's say on a given day XYZ commits to fund $300 million in mortgages (these are examples, but in the ballpark of a typical large lender).

XYZ Mortgage will not typically hold any of these loans. Instead, they will sell them in the secondary mortgage market.

NYSE Midday Hit
Bob Pisani reports on the trading day from the NYSE.

But that takes time. In the meantime, they have to close the loan and give the money to the home seller. They don't usually supply the money from their own coffers. They go out and borrow it. They get loans from lenders to cover that gap. This is known as a "warehouse line." These loans will be repaid once the loans are securitized in the secondary market. They are only short-term.

Here's the problem. The lenders are now saying we will give you the money, but the collateral that you are basing the loans on are worth less, so we will lend you less money than you wanted. On top of that, the loans you have already made may be worth less, so we are asking you to put up more money. This is called a "margin call."

To boot, the people at the other end of the deal--who will buy the loans in the secondary market--are demanding a lower price and a higher yield. The mortgage banker is getting squeezed at both ends.

Look what happens when they try to sell the loan (actually pools of loans) into the secondary mortgage market. Let's look again at that $300 million in loans that XYZ Mortgage just originated on one day.

Of the $300 million, perhaps $200 million will be "conforming" mortgages (currently those loans for as much as $417,000 for a one-family house loan) that will most likely be sold to Fannie Mae or Freddie Mac.

The remaining $100 million are "nonconforming" and must be sold into the private market. Who will buy them? Hedge funds, insurance companies, and average investors.

These loans would typically be sold at a profit--so, for example, $100 million in loans would be sold at $101 million ("par plus one" in lending terms) for a $1 million profit.

But now investors are saying they won't take that--they will only buy the $100 million in loans for, say, $95 million. But if that happens, XYZ Mortgage loses $5 million in value and $1 million in profit. They can only fund the mortgages they have committed to if they make up the $5 million shortfall from their own company. If this happens just one day, it's no problem--but if it happens every day for weeks, and the company thinks this is not going to end for months, the company may have to close its doors or renege on its loan commitments. At the very least, it will have large losses.
That's what the problem is with Countrywide. They said they have $50 billion in short term funding available. The Street believes them. The problem is the Street thinks it may cost them a lot of money to get all the loans funded that they have committed to already. It's concerns over an earnings hit.

What has to happen? Mortgage veteran Barry Habib, who runs Mortgage Market Guide, believes that:

1) credit markets have to stabilize.

2) mortgage lenders need to be able to sell the current backlog of committed mortgage loans.

Habib believes nonconforming loan rates (those over $417,000) will move up to attract the buyers of those loans, and that they could range between 7.50% to 8.0%, but they should settle lower than that eventually.

Why just nonconforming loan rates going higher? The problem is that many of the nonconforming loan pools often had a sprinkling of the exotic: subprime, and Alt-A loans in them.

Here's what was being talked about before the market opens:

Despite the fact that American Home Mortgagehad to close its doors, Countrywide went out of its way to say they had plenty of liquidity.

Global contagion of the credit turmoil has impacted Germany's third-largest mutual fund which stopped redemptions after losses.

Nonfarm payrolls a tad disappointing, on the low side of expectations.

NYSE Morning Preview
Bob Pisani reports on the trading day from the NYSE

With the Bank Index down 10% since June 1, Morgan Stanleytoday became one of the first firms to upgrade big cap banks as a group, saying "we believe the shares already reflect severe asset mark-to-markets and a Bear market in capital market flows." Morgan believes banks will rely on expense management and share buybacks in the second half of this year to support EPS growth and offset any further weakness in credit and margins.

Buybacks continue. Procter & Gamble in a big buyback, $24 billion to $30 billion over next 3 years, at least 12% of stock outstanding if all is done. That was one of several this week, including Hasbro$500 million buyback (or 10.9% of the shares outstanding) and Marriott, a 40 million share buyback (or 10.6% of the shares outstanding).

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