This post first appeared on Minyanville.

The Obama administration is busy touting the burgeoning success of its mortgage modification program. Unfortunately, it’s a farce: Out of one side of his mouth, the President touts a dedication to the besieged middle class, while from the other, lauds a loan modification program which steals money from struggling homeowners in favor of banks — already the recipients of billions in taxpayer-funded bailouts.

The ploy would be amusingly hypocritical if it weren’t so sad.

According to the Wall Street Journal, the Treasury Department claims that the Home Affordable Modification Program, or HAMP, has begun more than 650,000 so-called “trial modifications” since its inception this February. The commonplace explanation for the latest in a host of failed mortgage modification schemes is that it’s a natural first step to getting struggling borrowers back on the regular monthly payment track.

HAMP mandates that in order to qualify for a permanent loan modification, borrowers must first complete a trial period of three months with lower payments, in addition to submitting the proper documentation required for a more permanent solution. On the surface, this seems logical, even fair: Only after a show of good faith should homeowners be allowed a second chance.

Lenders like Wells Fargo (WFC), Bank of America (BAC), JPMorgan Chase (JPM), and Citibank (C), however, are required to show no similar evidence of good faith.

And I’ve yet to read a news story that accurately describes how this program works: Even as banks ask borrowers to cough up monthly payments on a house that’s likely to be hopelessly underwater, the foreclosure process continues.

Notices of default turn into notices of trustee sale, which turn into trustee sales, which turn into repossessions and eventually evictions. Meanwhile, as the homeowner is given a false sense of security that scraping together payments each month could save his house, lenders are under no obligation to grant a stay of foreclosure.

In other words, banks determined to take a loan through the foreclosure process can easily — and with Washington’s blessing — grant a trial modification which allows them to pinch a final three months of payments from homeowners already on the verge of financial insolvency, while offering nothing more than an empty promise in return.

To be sure, many of these homeowners got themselves in over their heads by overextending their debt load on an overpriced home. Foreclosure, in some cases, is a reasonable solution.

But an initiative touted as a long-awaited success in the battle against foreclosures is in fact just another way for Washington to redirect money from the pockets of ordinary Americans — however economically downtrodden — to big banks surviving solely by suckling the government teat.

This post first appeared on Minyanville.

Appraisers just can’t get it right.

During the housing boom, mortgage brokers, real-estate agents, and even borrowers sought out appraisals supporting the highest possible home price. Appraisers, fearful of losing business, inflated their valuation findings, which exacerbated the run-up in home prices.

Now, after nearly 4 years of home-price declines, appraisers are getting it wrong again — but in the other direction.

On May 1 — while the financial media focused on construing a blip up in housing data as signs of an imminent bottom — little was made of new appraisal guidelines that went live and immediately began to eat away at the core of the nascent housing “recovery.” To be sure, trade groups like the Mortgage Bankers Association and the National Association of Realtors (NAR) fought the revised rules, but to no avail.

Stemming from a lawsuit filed by New York Attorney General Andrew Cuomo alleging Washington Mutual (JPM) and First American Corp illegally conferred on the results of home appraisals with the goal of inflating prices, the new rules put up a Chinese wall between banks like Citigroup (C), Wells Fargo (WFC), Bank of America (BAC), and appraisers. The goal was to create an environment where appraisals would reflect an expert’s unbiased assessment of a home’s true value, rather than evaluations tailored to a lender’s desire to make a loan.

The new rules affect loans guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE), but since the 2 government-run mortgage giants effectively control the secondary mortgage market, they’ve become the defacto guidelines for the entire industry.

In order to separate lenders and appraisers, appraisal-management companies (AMCs), cropped up, offering banks access to a network of appraisers around the country. This makes the appraiser selection process random, preventing collusion. And while AMCs claim appraisers are selected using proprietary scoring algorithms that evaluate performance, the reality is that jobs are handed out on the basis of fastest turnaround time and lowest cost.

In short, we’ve traded bias for incompetence.

Readers of this column know that I have little, if anything good to say about the NAR — which is not only the Realtors’ trade organization, but a powerful Washington lobby. Nevertheless, earlier this week, when the NAR released data on existing home sales, their statement about appraisers’ role in killing purchase transactions was dead on the mark:

“The increase in sales is less than expected because poor appraisals are stalling transactions. Pending home sales indicated much stronger activity, but some contracts are falling through from faulty valuations that keep buyers from getting a loan. Lenders are using appraisers who may not be familiar with a neighborhood, or who compare traditional homes with distressed and discounted sales.”

Currently embroiled in this very scenario, my firm, Cirios Real Estate, is witnessing first-hand just how bad the new appraisal rules are.

Assessing a property’s value in’t rocket science, despite appraisers’ claim that their extensive training and years of experience make them the only people qualified to determine home prices. All it takes is access to the right information, an understanding of what drives desirability, and a little pride in one’s work.

That last criterion is perhaps the most difficult to find. Appraisers earn a flat fee for their services, giving them little incentive to provide the best analysis possible. Knowing they can now earn repeat business by turning around jobs in 48 hours and charging less than their competitors, there’s little reason to go the extra mile to ensure appraisals take into consideration only the best information to come up with the best possible results.

Sure — there are good appraisers out there with integrity that offer up great analysis. But as lower priced, lower quality work becomes the norm (thanks to the new appraisal guidelines), the best appraisers will seek greener pastures – as well they should.

Lawrence Yun, the NAR Chief Economist, finally got it right when he said, “Sometimes policy can lead to unintended consequences.”

By ANDREW JEFFERY

This post first appeared on Minyanville.

As a growing number of economists, pundits and real-estate professionals assure us the housing market’s worst days are over, prospective home buyers need a trusted advocate to make sure they don’t end up on the wrong side of someone else’s trade.

More often than not, that person will come in the form of a real-estate professional working on the buyer’s behalf and earning a commission for their trouble. Below are 5 simple questions you can ask to gauge whether a given candidate is looking out for your best interests – or his or her own.

But first, a word on terminology.

The terms “agent,” “broker” and “realtor” are often thrown around interchangeably. This isn’t exactly right. While laws differ from state to state, acquiring a broker’s license typically requires a series of courses on real estate practices, principals, finance, law, appraisal and the escrow process. A broker can use his license to form a brokerage, and the company can then perform services as a licensed entity.

In many states (like California) a licensed broker can not only conduct real estate transactions, but earn commissions for arranging mortgages and other types of real estate-related loans. For this reason, a brokers license offers the holder huge potential earnings power.

An agent is a step below a broker. While requiring a license, an agent is normally treated as an employee of the broker and thus the broker is responsible for the actions of the agents under his charge. If an agent screws up, his reputation (and license) as well as his broker’s is on the line. Agents can typically conduct the same transactions as a broker, but must do so under the supervision of their boss.

Finally, the term “Realtor” is used to specifically identify a real estate broker or agent who is a member of the National Association of Realtors, or NAR. The NAR is a nationwide trade group that collects member dues, lobbies in Washington and runs marketing campaigns urging Americans to buy homes. The NAR is conspicuous in its role as national housing cheerleader, as it’s chief economist Lawrence Yun has been predicting an imminent bottom in prices since early 2006.

1. Is it a good time to buy?

Of any question a buyer is likely to ask his broker (or agent), this may be the first. And the most important. The answer itself isn’t nearly as important as how the broker responds.

Any broker that says definitely that yes, this is a great time to buy, should be eyed with skepticism. Without knowing a buyer’s specific circumstances, understanding localized market trends and the underlying value of a specific home, saying it is a great time to buy is a sales pitch, pure and simple.

Brokers will often cite low interest rates, high levels of affordability, low replacement costs and home prices that have fallen precipitously from their peaks as reasons its never been a better time to buy. But ask yourself, all those conditions were true six months ago — was it a great time to buy then?

The proper response to this question from a responsible broker is to answer the question with a question, or questions. How much money have you saved? How long do you plan on owning the home? How much money do you make? How much is your other debt service? What are your contingencies if you lose your job? How is your credit? What are your other motivations for wanting to buy?

Only armed with answers to these and other questions can a broker — or a buyer for that matter — determine whether its the right time to buy.

2. Are home prices near a bottom?

As with the previous question, the answer should be in the form of a question. Where and when are you looking to buy? Do you want a move in ready home or one that needs some work?

While there is no crystal ball as to the direction of home prices in the near or long term, a broker should have a clear understanding of the dynamics effecting his or her local market. I hear ad nauseum here in California that home prices are stabilizing because demand is up, prices are down and homes are receiving multiple bids. But those are external symptoms of market machinations underneath the surface.

Foreclosure moratoriums put in place late last year limited the number of bank owned homes dumped onto the market. This constricted supply, and coupled with tax incentives, low interest rates and aggressive marketing from the NAR, led to a situation where in some areas, for some homes, demand outweighs supply. But that doesn’t mean the situation will persist — in fact, the smart money is betting it won’t.

This dynamic is far from ubiquitous, as most high end markets remain illiquid with prices tumbling into an apparent vacuum.

Real estate is, and will always remain, local.

3. How do you determine which homes to show me?

Not to beat a dead horse, but this question should be met with yet another series of questions. What size home are you looking for? Are schools important to you? How close do you want to be to public transportation? Do you care about being within walking distance to shops and restaurants? What style of home do you like? Do you want a yard?

A good real estate broker should be a blank slate, absorbing your preferences, desires and reasons for buying without injecting his own bias. Just because your agent loves a certain home and thinks its a great buy, doesn’t mean it fits your criteria. Don’t be afraid to tell your broker that you don’t like a particular home.

Brokers should show you a variety of homes, below, within and above your price range, to give you a sense of what is out there on the market. With prices still coming down in most areas, you may walk inside your dream house and decide its worth it to keep renting — and saving — for another year until prices fall to something you can afford.

Until you feel comfortable your broker is showing you everything that may fit your criteria, perform your own searches on the myriad free websites out there. Redfin.com is a great resource for the metropolitan areas it covers, while Trulia.com, ziprealty.com and even Realtor.com have excellent free search features.

4. What are my financing options? How much can I afford?

While real-estate brokers are often legally allowed to arrange loans, more often than not its a dicey legal proposition for the broker to sell you a house as well as a mortgage.

Nevertheless, brokers should be well-versed in available financing, rates, qualification requirements and whether sellers require a mortgage pre-approval letter to accompany any offer (these days, most do). If your broker doesn’t know the answer to a certain question, that’s OK as the rules change almost daily, but he should actively pursue the answer and report his findings back without too much delay.

Shopping around for the best loan terms can be a time consuming and confusing process, but it must be done. Gone are the days where Wells Fargo (WFC) always gave you the best rate, or your buddy down at Chase (JPM) could get you a great deal. Keep in mind most loans these days are originated to Fannie Mae (FNM) and Freddie Mac (FRE) guidelines, which means most big lenders offer similar loan programs.

All things being equal, choose a lender you feel you can trust (not just the one offering you the best deal) and always have a backup.

Lastly, never trust a broker to “tell” you how much you can afford. This decision, especially in an environment where home prices are likely to fall for the foreseeable future, should be one each buyer must make for himself.

Plans change, life doesn’t always follow the path you hope it does. Being conservative in what you can afford, leaving a cushion and planning for the unexpected are paramount in today’s uncertain market conditions.

5. Provide me with examples of a few closings you are the most proud of over the past year.

This question gives your broker a bit of an opening to sell himself, and will go along way towards helping figure out whose side he is actually on. If your broker launches into a a story about this cute young couple he helped get into the house of their dreams, move along, cute young couples rarely make savvy home buying decisions and are easy prey for aggressive brokers. Also pass if you hear things like, “I found this great house right when it came on the market, we jumped at it and got in before the other buyers had a chance to bid.”

Sellers, by and large, are still unrealistic about how much they can sell their homes for. This means that when houses come out onto the market, the asking price is nearly always above where it will actually go for. Be patient, make your broker work for his money.

Although there are situations where multiple bids will come in from prospective buyers, chances are this isn’t a house you want to buy. Most of this sort of activity is going on in areas with high levels of foreclosures. Now that the moratoria are lifted, banks will start flooding the market again come next month. All that great news about limited supply will become ancient history as prices plunge once again. The house itself may be great, but just because homes are “cheap,” doesn’t mean they won’t get cheaper.

A good response is one where a broker tells you a story of a buyer he worked with for months, go to know a few neighborhoods that fit all the pertinent criteria, and waited for the right house to come on the market. Many sellers will list their house at a “hopeful” price for the first 30 or 45 days, then drop it down to something more reasonable. Rarely will a house sold in the first couple weeks be a “steal” for the buyer.

Your broker should stress that patience, research and shrewd negotiating got his client a great home at a great price.

To be sure, there are other questions to ask of a prospective broker, but this is a good start. Finding a broker should be treated like a job interview, after all, even though the commission may not be coming out of your pocket, you, as the buyer, end up paying one way or another. Make sure your broker is worth his salt.

By ANDREW JEFFERY

This post first appeared on Minyanville.

With mortgage rates at historic lows, housing prices plummeting, and Washington throwing billions at housing-market recovery efforts, why is it still so damn hard to get a loan?

And while the easy answer is that banks are flat-out broke, the real answer may lie in an esoteric corner of mortgage finance which has all but disappeared: warehouse lending.

In the heyday of the housing boom, small mortgage companies were able to compete with huge financial institutions by tapping so-called warehouse lines of credit. Using cash from their warehouse lender to fund loans at the closing table, as big banks do, these smaller mortgage shops could often provide better service than their bigger competitors, though at the same low rates.

Warehouse lenders, often big banks themselves — remember Washington Mutual and Countrywide (Bank of America (BAC))? — held onto loans until they were sold in the secondary market. Turnaround time could be anywhere from a few days to a few months for larger, more complex transactions.

The benefits to being able to finance one’s own loans rather than just acting as a broker were numerous. Having a warehouse line gave mortgage bankers better control over the closing process, enabling them to beat out big banks in terms of response time and customer service.

By aggregating loans on a warehouse line, bankers could bundle them together and sell packages at a premium, rather than selling them off one by one. And since they could sell loans to any bank on the street, most such originators offered loan programs just as varied as those of even the biggest institutional lenders.

At the height of the boom, it was estimated that almost half of the over $3 trillion in annual loan production was first funded on a warehouse line.

As the mortgage market began to collapse, big purchasers stopped buying, and warehouse lines filled up with unwanted loans. Warehouse lenders began margin-calling clients, cutting off funding capacities, and capturing every penny they could from the few sales that actually went through.

The result, which can be plainly seen on websites like The Mortgage Lender Implode-o-Meter, was that hundreds of small bankers closed up shop.

Now, as banks scramble to handle the flood of requests for refinances at super-low interest rates, the mortgage industry is once again facing a credit crunch. By one estimate there’s only $25 billion in available warehouse lines to support the $2.8 trillion in mortgages expected to be written next year.

Mortgage bankers I speak with say the only thing holding them back from giving out more loans is a lack of warehouse capacity.

According to the Wall Street Journal, one solution being floated by the Mortgage Bankers Association (or MBA) is for Fannie Mae (FNM) and Freddie Mac (FRE) to provide government-backed warehouse lines to the few intrepid mortgage bankers still eking out a living in this nightmarish market.

The MBA argues that, since big banks like JPMorgan (JPM), Citigroup (C) and Wells Fargo (WFC) don’t need access to warehouse lines, they’re pushing out the smaller guys and stymieing competition. There’s little incentive for a Chase or a Citi to reopen its warehouse lending group, since the move would just allow competitors to grab market share from the very profitable business of originating loans.

While it makes logical sense for regulators to allow Fannie and Freddie to prop up this segment of the market, it may run contrary to other bank-friendly initiatives. Fees generated by writing new mortgages may be the only thing keeping the likes of Bank of America and Citigroup from tapping even more government support to stay afloat.

By ANDREW JEFFERY

This post first appeared on Minyanville.

The answer? An emphatic no. This is simply the latest example of legal plunder perpetrated by the federal government against law-abiding, tax-paying citizens.

The Obama administration’s scheme to help troubled borrowers centers on subsidizing interest payments, which would help borrowers make ends meet without angering those investors expecting full payments each month. This marks the first time the government is intervening directly with taxpayer funds to ease the burden of monthly mortgage payments.

Bloomberg reports the plan will be voluntary for lenders like Wells Fargo (WFC), Citigroup (C) and Bank of America (BAC), and will employ many of the tactics previous modification efforts have used (ineffectively), such as loan extensions and principal reductions. Modifications identified as having a net present value will be targeted, where foreclosing would be more expensive than changing the loan terms.

The program aims to establish a standard for loan modifications that can be used industry-wide. That’s an absurd claim, which demonstrates the extent to which lawmakers misunderstand the scope of the problem. It’s a bit like saying every American must cut their hair the same way: It would be laughable it weren’t so sad.

Each mortgage, each borrower, each lender, each home is unique; each situation is different. Individual banks can barely standardize the documents required to close a loan, so the notion that there can be one standard for approving a loan modification — an intensely complicated procedure involving countless interested parties — is ridiculous.

It would be one thing if the plan offered even the remotest possibility of stabilizing the housing market. It doesn’t. The few borrowers who may be helped will have little effect on a massive, disjointed housing market that remains determined to run its course despite government efforts to stop the bleeding.

The societal implications of this program are downright frightening.

Washington cutting checks to borrowers who can’t make their mortgage payments sounds like a benevolent act attempt to reach down to struggling families — and in some cases, it may certainly help. But it also fosters dependency on the federal government and incentivizes bad behavior.

It now appears we’ve reached a point in this crisis where differentiating between those worthy of help and those left to pick up the tab is determined primarily by how poorly one managed their personal finances. The worse the decision, the greater the federal assistance – and it’s true for government bailouts of bad choices on the part of individuals and institutions alike.

The message this sends to the rest of us – those who are still living up to their obligations and trying in good faith to eke out a living during tough times: Throw in the towel.

By ANDREW JEFFERY

This post first appeared on Minyanville.

From expansive estates in the Hamptons to mansions on the Malibu cliffs, the rich are watching their vast real-estate wealth evaporate before their eyes.

Perhaps no market epitomizes the ultimate surrender of high-end real estate than the island of Manhattan, where housing prices had held relatively stable until quite recently, despite broad declines across the country.

Turmoil on Wall Street, the collapse of Lehman Brothers, and layoffs at big employers like Citigroup (C), JPMorgan (JPM), Morgan Stanley (MS) and Goldman Sachs (GS) have finally taken their toll on the once-proud market for overpriced, undersized refuges from the concrete jungle.

The Wall Street Journal reports housing inventory in Manhattan jumped 39% in the fourth quarter as sales plunged – even as prices managed to eke out a 3.1% gain from a year ago.
Meanwhile, condominiums and cooperative apartments currently under contract to be purchased are selling at a whopping 20% below the prices paid just last summer. As sales data reflecting those transactions emerge in the coming months, Manhattanites may finally wake up to the reality that their housing market is no longer immune from the afflictions the rest of the country knows all too well.

Compounding the effects of an abysmal bonus season throughout the financial industry, ongoing job cuts, and generally weak economic conditions, lenders continue to scale back the availability of so-called jumbo mortgages. These loans, too big to fit within the ever-narrowing lending guidelines of Fannie Mae (FNM) and Freddie Mac (FRE), don’t qualify for a government guarantee.

Banks take on more risk by originating these loans, and charge higher rates for the pleasure. Bankrate.com (RATE) reports jumbo rates remain more than 1.5% higher than their smaller, conventional counterparts.

Since most Manhattan condos and co-ops are purchased with jumbo loans, these persistently high rates mean prices on the island are being only marginally supported by recent, aggressive moves by the Federal Reserve and Treasury Department to spur home buying.

Wells Fargo (WFC), now the nation’s largest mortgage lender after completing its acquisition of Wachovia, isn’t helping matters for high-end buyers. The California-based bank announced yesterday it would stop offering jumbo loans through its wholesale (or broker-originated) channel. MortgageDaily.com reports Wells cited low market demand and higher risks in its decision to suspend jumbo offerings for mortgage brokers.

The ongoing financial crisis, which arguably originated in the narrow winding streets of Wall Street, has now come full circle. The same bankers, traders and financiers who levered houses up beyond all rationality are now seeing the dark side of structured finance gone awry.

Some will wisely sell now, while they still can, take their lumps and move on. Others, stubbornly clinging to their former glory, are likely to go down with the ship.

By ANDREW JEFFERY

This post first appeared on Minyanville.

With millions of homeowners falling behind on their monthly payments, one in 6 underwater, and countless more struggling to keep up, politicians and banks alike are jumping on the loan modification bandwagon.

A modification – or “mod,” as it’s known in the industry — is simply the bank agreeing to change a borrower’s loan to make it more affordable. Mods usually result in a lower interest rate, principal forgiveness or some combination thereof.

For banks, adjusting loan terms is a way to keep cash coming in the door - even if it’s less than they’d been hoping for when they originally wrote the loan. For troubled borrowers, mods can provide an alternative to default and eventual foreclosure. It’s for these reasons that FDIC Chairman Sheila Bair and big banks like JPMorgan (JPM) and Bank of America (BAC) are aggressively promoting mods as the best way to fix the housing market.

The flood of troubled mortgages has also fostered a cottage industry that caters to distressed borrowers. Some are honest folks aiming to help struggling borrowers by using their mortgage expertise and contacts to negotiate better deals on behalf of their clients.

Others, however, are less upstanding.

According to Mandana Nejad, a real estate attorney and founder of Silver Lining Legal Group, a loan modification firm based in California, troubled borrowers have a lot to be wary of.

“Most loan modification companies are compromised of former lenders and brokers who put homeowners in these horrible loans in the first place,” says Nejad. ”Meanwhile, credit repair and debt consolidation firms are simply out to collect fees, regardless of whether or not they can actually successfully modify a loan.”

Last year, the Bush administration formed HOPE NOW, a government-led effort to get banks and the loan servicers who collect payments on their behalf to step up loan-modification efforts. By most accounts, results were underwhelming, as HOPE NOW counselors often asked for too much, and banks gave too little.

Data show that mods done at the outset of the mortgage crisis ended up in default, despite the lower payments. Without proper screening criteria, mods simply delay the inevitable.

For a mod to work, lenders and borrowers must be able to find common ground. Falling home prices, job losses and massive fraud at the time of origination have exacerbated the challenge of finding new loan terms that make sense for both parties. To complicate matters, if a loan has been packaged into a security, loan servicers are obligated to follow predetermined modification standards set by myriad third-party investors.

Borrowers looking to handle modifications on their own face a maze of legal and bureaucratic complications - not to mention the stress of negotiating to save one’s own home. Nejad tells her clients that anyone can attempt to modify their loan themselves, but doing so requires knowledge of the best strategies for success.

Banks treat mods almost like a fresh loan. In order to get the best deal, borrowers must submit a complete application, write a compelling hardship letter, include verification of income, and often support the home’s current value with an appraisal.

While this is no easy task, troubled borrowers shouldn’t run out and answer the first debt consolidation or mortgage relief advertisement they hear on the radio.

Upstanding modification firms should offer:

• Money back guarantees with no exclusions
• At least one experienced attorney assigned to each case
• Direct access to the borrower’s lender(s)
• No more than a 50% charge up front
• Verifiable success stories, not just web testimonials

Still, successful mods require lenders to take losses. Armed with billions in bailout money, banks are now in a better position to allow their borrowers more affordable loans, even if it means more writedowns and less interest income going forward.

Time will be the true arbiter for the success of Bank of America and JPMorgan’s recent plans, but as pressure mounts to seriously curtail foreclosures, more and more federal money will be thrown at the problem. Other banks are likely to follow suit.

Wells Fargo (WFC) has yet to announce a plan of its own, but – given its recent purchase of Wachovia (WB) and its inheritance of a massive portfolio of California option-ARMs – we shouldn’t have to wait too much longer.

While mods are by no means the magic bullet many are searching for to fix the housing mess, they do offer a way for lenders to retain a cash-generating loan – and borrowers to keep their homes.

By ANDREW JEFFERY

This post first appeared on Minyanville.

The private sector is actively engaging the mortgage crisis with the first broad-based, systemic attempt to prevent foreclosure. Both Bank of America (BAC) and JPMorgan (JPM) are attempting to help hundreds of thousands of troubled homeowners with massive loan modification efforts.

Regulators and bank executives are operating under the assumption that reducing foreclosures will slow record drops in home prices. In turn, this will help stabilize the financial system - and, by extension, the economy as a whole.

This logic isn’t necessarily flawed - but it’s reactive, rather than proactive, which is what’s most needed now.

Most foreclosures are concentrated in regions where homebuilders like Centex (CTX), KB Homes (KBH) and Lennar (LEN) built huge developments, using cheap financing to help fuel speculation and massive over-valuation. These areas, especially those where homes were purchased by lower income buyers, are being decimated by delinquencies and repossessions.

This, however, is widely known. What’s less well-understood is the storm that’s brewing on the horizon: Trouble in the prime mortgage market – where borrowers with good credit are starting to miss payments with alarming frequency — is looming on the horizon.

Recent delinquency data indicates that while defaults on subprime loans are occurring at a less frenetic pace than in recent months, prime borrowers are starting to feel the pinch. In early September – before the financial crisis accelerated in October — the Mortgage Bankers Association released its quarterly delinquency data, concluding,

“The increase in prime ARMs foreclosure starts was greater than the combined increase in fixed-rate and ARM subprime loans. Thus the foreclosure start numbers will likely be increasingly dominated by prime ARM loans.”

There is still a vast misconception that only “subprime” people maxed out credit cards, took out loans they couldn’t afford, and were generally reckless with their personal finances.

This couldn’t be further from the truth.

As the economic slowdown swirls outward into the broader economy, cracks are starting to form in established neighborhoods that have thus far experienced minimal home price depreciation. Many of these areas experienced stratospheric appreciation – just as their subprime neighbors did – but the strong job and stock markets insulated middle- and upper-middle income homeowners from rising interest payments and the slowing economy.

As mortgage underwriting requirements have tightened in recent months, home buying has slowed in these more well-to-do areas. This trend is being masked by spikes in the distressed sales driving broad housing market indicators.

As layoffs continue, homeowners in these areas will be forced to sell for the first time in years. The illiquidity in these markets means it will take just a few such sales to readjust prices dramatically downward. Homeowners that don’t sell by choice, particularly if they’ve accumulated equity in their homes, are apt to be less picky about their price.

Furthermore, it’s likely the recent onslaught of modification programs, tomorrow’s election, and pundits’ continued obsession to call a bottom in housing will encourage buyers to step back into the market. Increased sales transactions – even if they continue to be concentrated in distressed areas – will fuel the perception that the housing market is stabilizing.

This is likely to encourage a fresh round of selling, as anxious homeowners leap to take advantage of “improving” market conditions. This new supply won’t necessarily offset inventory that’s kept off the market by preventing foreclosures on a unit-to-unit basis; instead, the supply will simply crop up in different neighborhoods.

The subprime mortgage crisis may indeed be waning; its final battles are now being aggressively fought in Washington and bank boardrooms across the country. The prime wave, however, is just beginning to crest.

This post first appeared on Minyanville.

As the debate rages about whether or not we’re finally approaching a floor in home prices, let’s examine the value of another asset: The mortgage.

When considering a home-buying transaction, buyers (and sellers) typically worry most about the value of the house. Lenders, on the other hand, are much more concerned with the value of the mortgage.

From a lender’s perspective, the economic value of a loan is its expected future cash flow in the form of interest payments. The key word in that phrase – and why a loan’s value isn’t purely derived from its rate – is “expected.”

To a bank, a loan is just a product, like an iPod is to Apple or a BlackBerry is to Research in Motion. The value of that product is just how much someone will pay for it. Loans with higher coupons, adjusting for risk, are worth more than those with lower coupons, because they fetch more on the open market.

Mortgages, or debt of any kind, are priced relative to their face value, or “par.” A $100,000 mortgage that’s worth par would cost $100,000. Prices are then expressed as a percentage of par. That is, a loan with a face value of $100,000 that’s worth 102.50 (percent) would cost $102,500.

Subprime loans are often considered “bad,” while prime loans are presumed to be “good.” Many assume, therefore, that high-quality prime loans are worth more than those lousy subprime ones. This isn’t entirely accurate.

“Good” loans are the ones where you’re appropriately paid for your risk, whereas “bad” ones are those in which you’re on taking too much risk relative to return. As Professor Sedacca often says, “If you aren’t being paid to take risk, don’t take risk.”

Consider the following 2 mortgage situations, ask yourself which one a lender is likely to value more highly:

Borrower A has impeccable credit, can make a sizable 30% down payment on her family’s first home, but will have to stretch to make the monthly payments because her husband just quit his job to stay home with their second child. The mortgage carries a low 6.00% rate, or coupon, because of Borrower A’s good credit and the low loan-to-value ratio (loan amount divided by sales price).

Borrower B has poor credit, stemming from medical problems that put him out of work for the past 12 months. Credit-card bills piled up, payments were missed and he had a hard time making ends meet. Healthy now, Borrower B is looking to refinance his existing mortgage on the home he’s lived in for 20 years. He needs some extra cash to finish paying off bills and get back on track, so he’s looking for a loan to value of 90%. The mortgage carries a high 9% coupon because of Borrower B’s bad credit and the loan’s high loan-to-value ratio.

I designed the examples to prove a point, but I would take Borrower B’s “subprime” mortgage over Borrower A’s every time. Even though Borrower A’s perceived risk (by the numbers) is less than Borrower B, Borrower A is probably more likely to default. Despite Borrower’s A big down payment, the low coupon may not cover the additional default risk.

Banks often write mortgages with the intent to sell them on the open market. Whether the loan is sold individually or packaged in a security, the higher the coupon, the higher the potential value for the ultimate owner (provided, of course, the risks are properly measured and evaluated).

Mortgage originators (both banks and brokers) and Wall Street firms used this concept to push bad loans onto borrowers. Whether Goldman Sachs (GS) wanted to issue a mortgage-backed security or Wells Fargo (WFC) planned to park the loan on its balance sheet, both earned more from higher coupon loans, so that’s what they asked for from their salespeople and brokers.

One of the most highly sought-after types of mortgages were those with a high loan-to-value ratio, written for speculative investment properties where borrowers didn’t have to state their income. These loans carried a very high coupon because of the high perceived risk of default.

However, since homeowners in areas experiencing rapid appreciation like Phoenix, Las Vegas, Florida and California could easily sell their way out of a problem during the boom, the actual risk on these loans remained low. Wall Street demanded precisely this kind of loan, and brokers wrote them. Whether the borrower could really afford the payments didn’t matter, since they could just sell the house at the first sign of trouble.

Of course, when appreciation stalled, actual risk shot up, and even high rates didn’t compensate banks for the risk these loans now carried.

Since Wall Street could earn far more packaging and securitizing these high-risk loans than they could on boring, low-coupon prime loans, they paid mortgage brokers and bankers higher commissions to write them. These originators, being good salespeople, aggressively marketed these loans to borrowers that fit these highly profitable criteria.

Homeowners, watching their neighbors get rich speculating on condos in Miami, had little to no financial incentive not to join in. That’s not to say there weren’t some who made responsible decisions - but enough people got caught up in the mania that, well, we are where we are right now.

So this brings us back to your mortgage. How much is it worth?

Remember to think about it from the bank’s perspective.

The next time you hear offers like “no closing costs!” or “low introductory rate!”, think about why the bank would do this. If it’s not charging fees to close the loan, you can be sure it’s making up that lost income with a higher rate. If it’s offering a teaser rate, the higher payments you’ll be making when the coupon adjusts upwards will more than make up for that low payment in the first few months.

The best way to get the best deal is to think about what loan will be worth the least to your lender. Low rate, low fees, low risk… Who wants that boring paper?

The answer: You do.

This post first appeared on Minyanville.

Despite the Armageddon-esque financial turmoil of recent weeks, one thing about America hasn’t changed: If you really want someone to do something, sue them.

They lined up in droves: Cities, counties and states sued the pants off Countrywide for its shady lending practices. California, Illinois and Florida all alleged the lender fleeced American homeowners, jamming them into loans they had no hopes of repaying.

Now, Bank of America (BAC), who purchased the troubled California-based lender earlier this year, is stuck cleaning up the mess. Earlier this month, the bank agreed to pay more than $8 billion to settle lawsuits filed against Countrywide. Friday, the Los Angeles Times ran through the details of its plan to help as many as 395,000 troubled borrowers:

• Only owner-occupiers (not investors) with subprime or option ARMs qualify for assistance
• Interest rates may be reset as low as 2.5%
• Prepayment penalties and late fees will be waived
• Upside-down borrowers may have principal reduced
• Borrowers who lost their homes (or don’t qualify for assistance) will receive an average of $2,000.

Notably, Bank of America managed to get most investors who bought Countrywide’s mortgage-backed securities to agree to the plan. Holders of these assets have previously balked at such sweeping plans, since modifications usually lower a loan’s cash flow and decrease the value of securities behind it.

Efforts to get lenders to work aggressively with borrowers to avoid foreclosure have been largely ineffective. To be sure, there has been progress, but it’s fallen mightily short of promises the Bush Administration made last year when it announced its pilot program, HOPE NOW.

The aggressive plan, which Congressman Barney Frank, capitalism’s new public enemy number-one, called “the first truly comprehensive plan we’ve seen from the private sector,” could set the stage for a deluge of lawsuits.

The precedent has now been set: The way to stop foreclosures is to start suing banks.

I remember sitting in a meeting in early 2006, when a German bank that had lent our mortgage finance firm a few hundred million dollars asked why we didn’t get into the lucrative option-ARM market. The response: “We don’t want to touch those things. They’re a class action lawsuit waiting to happen.”

Indeed.

Other than Countrywide, the biggest writers of option ARMs during the boom were Washington Mutual, Bear Stearns and Wachovia. Not a single one remains independent.

The proud new owners of these banks, JPMorgan (JPM) (WaMu and Bear) and Wells Fargo (WFC) (via Wachovia) would do well to beef up their legal departments.