There is no doubt in my mind that the plunge in home sales is due to tighter lending guidelines. Our spring sales are just horrible. We are down 14% (LA) to 41% (Riverside), in year over year sales this March, compared to March 2006. We had stabilized our sales, with February sales fairly close to those of last year. Then in March, a sudden drop in sales. With low unemployment and buyers still out shopping, the only explanation for this sudden drop in demand is tighter lending.

I decided to learn a bit more about the mortgage side of the housing market, and interviewed three pros. Thanks Bob, Rich, and Morgan, for taking time for us at California Housing Forecast.

Bob Brittingham, CFIC Manager/Broker, (858) 731-8840 office, (858) 731-8847 fax, www.cfic.com/lajolla

Rich Harvill, (760) 798-4893 hm, (760) 707-3083 cell

Morgan Brown, COO of New Day Trust Mortgage, Blown Mortgage, 949-859-3045

In the report below, I use the term "bank" or "lender" as anyone who originates the loan.

What's going on with lending these days?

100% financing has really shrivelled up. A big chunk of sales in California was from buyers who had no money for a down payment. As defaults on 100% financing of loans has sky rocketed, lenders are tightening credit, shutting the door to many buyers. My guess is the horrible spring selling season is the result of this tighter lending. Since early this year, borrowers who wanted 100% financing needed a FICO (credit score) of at least 680.

On the refinance side, a lot of the people who try to refinance are turned away because of falling property values. The refinance side is where a big chunk of the mortgage lending occurs, since we have we have people pulling cash out of their homes, or trying to change from an adjustable rate mortgage (ARMs) into fixed rate mortgages.

Part of the underwriting process is a home appraisal, ordered by the lender. The appraiser comes up with a value for the house by comparing it to similar homes nearby which sold in the last 6 months. Those comparable homes are known as "comps". Banks used to take the appraisals at face value, or even pressure the appraiser to hit higher numbers (according to some online reports), but recently the banks are getting tougher. They eliminate some of the appraiser's comps, and do more risk analysis and field reviews. As a result, lenders are reducing appraisals by $25K or $50K. Even if that lower appraisal shows the borrower has equity, there are still cases where he cannot qualify for a loan.

Let's use some simple numbers to explain how a guy cannot refinance, even though he has equity in his house. Say the appraisal shows his house his worth $100K, and his current loan is $80K. The loan to value (LTV) is the percent of the house value that is borrowed: $80K/$100K, or 80%. You can say he has 20% equity. Now the appraisal goes through lender review, where the guys scrutinizing the appraisal decide the house is really only worth $90K, raising the LTV is 90%. With a high LTV, he is a bigger credit risk, so he has to pay a higher interest rate. That makes the monthly payments higher than they would be for an 80% LTV loan. Yes, lenders charge higher interest rates whenever the borrower adds a layer of risk, due to high LTV, low FICO, showing no proof of income, buying a house that is not the main residence....

Ok, the guy can get a mortgage, but can he afford the payments? The guy qualified for $100K when rates were 3%, but can he qualify when rates are 6%? With the loan at 90% LTV, his best rate is 6.5%, let's say. Does he have the income to pay the mortgage at today's higher rate?

The percent of income paid for debts is called the debt to income ratio, or DTI. The banks will only let you spend up to half your income on your housing costs. So take your paycheck (before taxes and social security are taken out), and you can spend half of that on your mortgage, taxes, and insurance. So a higher interest rate raises the monthly payment, and can bring you over that 55% DTI. Lenders actually have 2 DTIs they use: a DTI for housing debt, and a DTI for all debt which would include credit cards, student loans, car payments. They look at the minimum payment for all debt, add it up, and expect it to be less than their maximum number.

But there's more. The law says that the lender must prove the new loan has a benefit to you. This requirement is supposed to avoid predatory lending. They must show you, the borrower, gets either a lower monthly payment or cash back at closing. But in an odd twist, refinancing out of your adjustable rate loan is not beneficial, so the loan fails on this test and you are turned down. The reason for this failure is because today's higher interest rates, combined with the higher LTV, would give you a higher payment. Thankfully, some lenders are now re-evaluating the "benefit" criteria, to accommodate folks who are pro-active in getting out of their ARMs.

A guy with a resetting ARM - what are his options?

This is a guy with an ARM, who knows he can't afford the higher payments when his ARM resets. He can't afford to sell the house, since he doesn't have at least 6% equity to pay the realtor fees. Here are the options for this guy:

• refinance, if he qualifies
• give lender a "deed in lieu of foreclosure"
• let the house go back to lender in foreclosure, and end up with a foreclosure on his credit report

What is "subprime", "prime", "Alt-A"?

These terms refer to the credit score and the type of loans people can get. The magic number that separates subprime from the rest of the pack is 620. Subprime is a FICO score below 620.

Prime loans, also known as conforming loans, have the lowest long term fixed interest rates. They are traditionally the loans that Fannie Mae or Freddie Mac, the government sponsored enterprises (GSEs) would buy, so they have to meet pretty stringent requirements, like a high FICO score, a downpayment, a maximum loan amount of $417K (and it was even lower a few years ago), and be amortized over 15 or 30 years.

A jumbo loan is for people who need to borrow more than the conforming limit of $417K and have a good credit score.

Alt-A is the truly exotics and a decent credit score. The Alt-A borrower has more income or more assets. All those investors or people with borderline credit that needed high mortgages are likely in the Alt-A category. If you have good credit, but want to get a no-documented-income loan, you're an Alt-A guy. You pay a higher interest rate to compensate the lender for the extra risk. For example, an Alt-A loan could be 5.5%, while a no-doc Alt-A is 9%. Ouch.

For lots of great details about the inside scoop on mortgages, read my summary/analysis of the Credit Suisse report Mortgage Liquidity du Jour: Underestimated No More, right here (subscribers)

Why does Colorado have more foreclosures than bubblicious California?

Have you seen all the news coverage of the high foreclosure rate in Colorado? What is going on there? The main reasons that Colorado has so many more foreclosures than California, is the appreciation, regulations, and the types of loans people got.

The high appreciation in CA is buffering anyone who bought before 2004. A homeowner is more likely to have equity in CA. Most people who bought a long time ago, even if they refinanced, have enough equity. In contrast, CO had only 5-6% annual appreciation, so the lax lending caught up to them faster. A guy whose mortgage payment went up could easily sell in CA, but not in CO..

CO had little regulator oversight until a new law went into effect in January 2007. Anybody could open ABC Lending, and borrowers received few disclosure forms. In CA, a broker has to register as a business and get a real estate license.

CO also had more subprime borrowers, and more lending on properties which fall quickly in value in a downturn. It is common in CO to buy a piece of land and put a manufactured house on it. Lots of contractors bought some land, and put a double wide and a road on it. Regardless of the market, these homes are harder to sell, so anyone who finds themselves in trouble is less likely to find a buyer. As the market turned down, these homes became difficult to sell, and they lost their value fast.

Is lending still lax?

Lending is getting tighter. With a bad credit score, one day out of bankruptcy, and 30% equity, they will still let you spend over half your gross pay on housing costs: mortgage, insurance, taxes, and homeowners association dues. On a stated income loan, where people basically make up their income, you can borrow up to 55% of that stated income.

If you want 100% financing, you need a better credit score than in the past. You would need at least a 660 FICO. Countrywide, the largest lender, eliminated 100% financing for subprime borrowers. Subprime borrowers can only borrow 90% LTV, meaning they have to come up with a 10% down payment. How many people with bad credit scores can come up with $60K when buying their first home? We can now understand why the housing sales are just falling so fast. A move up buyers has that kind of money from the sale of their home, but few first time buyers have that kind of cash.

On a prime loan, you can go 38 - 43% DTI. Seems pretty lax to me. I know I could not sustain a lifestyle where 43% of my gross income went to my mortgage, taxes, and insurance.

What's the mortgage broker's favorite loan?

These guys have told me the 30 year fixed, the 10 year interest only, or an Option ARM are their favorite products. One broker said the 10 year IO is best, because most people don't live in their homes for more than 10 years, so what's the point of paying down the principal? Another said the 10 year IO is bad, because when the IO period is up, you are shifted into a 20 year amortizing loan, so it's a more expensive product.

They all recommend that you talk with at least 3 mortgage pros, which should include a bank and a mortgage broker.

How is employment? Layoffs?

The back room staff is being let go, but the commissioned salespeople are still there. Just as in real estate, brokers are paid by commission, so there is no cost to keeping the brokers when sales are falling.  In a commission-only business, slowing sales create more demand for employees, since there is no fixed cost to having them. In some cases, the employee actually pays a monthly desk-use fee to the agency, so having more employees increases the income from desk space and incremental sales. One contact said he expects a refi boom in 9 months, as more people try to get out of their adjustable loans that start having higher payments.

Why did lenders make loans that were almost guaranteed to fail?

Well, they did not seem guaranteed to fail at the time. These exotic loans were created at a time of exponential growth in housing prices. The investors thought the rising prices protected them. If a $400K house was bought with 0% down, and the house is appreciating at 25% per year, then the lender can still get his money despite a foreclosure sale. When lenders noticed prices were dropping, they changed their lending guidelines but they were not fast enough. Others actually lowered their lending guidelines to make up for the lower volume created as prices got too high.

Gradual tightening

The media has been slow to react to the mortgage tightening. Lenders started tightening their guidelines a few years ago, very gradually.  Their guidelines got stricter for property type, LTV, and DTI.

In Colorado, the tightening started in August 2005, in that part of the market that was getting high numbers of defaults: the lowest end of the market, manufactured homes. Most lenders had offered 95% - 100% financing on these popular double wides on permanent foundations, but as the default rate started climbing in the summer of 2005, lenders quickly responded. They raised the LTV, which meant they wanted anywhere from a 20% - 40% downpayment. (VA still does 100% financing, but VA and FHA don't use FICO scores; they do not allow mortgage lates.)

By December 2005, investors in A-paper (prime) loans saw the trend in higher defaults in the subprime loans, and realized it would spread to any hard-to-sell properties, such as 4-plexes.. Again, properties which are easy to sell were not a concern, because either the homeowner or the bank could get their money out of it by selling it. But properties which are harder to sell, like double wides and 4-plexes, could be a pooblem for the lenders. A single family home holds its value better than a 4-plex unit, is easier to rent, and has a lower mortgage interest rate. So the investors became proactive, and got rid of no money down on a 4plex. By January 2006, you could not get 100% financing on a 4plex at any interest rate;  the lenders wanted at least 5% down. By February, a 10% downpayment was required.

By the summer of 2006, the pool of buyers was shrinking. High prices, made worse by rising interest rates, were the reason for fewer buyers in CA. Another reason was the demand for homes had been pulled forward by easy lending guidelines, so anybody who wanted a home had already bought one, more or less. Refinancing activity also was reduced, as interest rates were rising. So the subprime lenders started fighting for the same shrinking pool of customers and . lowered their standards to keep up volume. The Alt-A lenders kept tightening up on LTV, requiring more money down,

To keep up volume amid a shrinking pool of customers, the subprime lenders just got more agressive and came out with the hybrid Option ARM. While they now required higher FICO scores, they made many exceptions to lure people in. They might allow someone with only 6 months of steady income. The media just this week reported the high number of exceptions, and links them to the rising defaults.

As the market kept slowing, they got more aggressive, giving loans to people who were poor risks. For example, they allowed one (1) mortgage late (a definite "no-no"), gave 100% financing for FICO scores as low as 580 and overlooked judgments against people as long as the judgment was paid off and the borrower had a 600 FICO score. SouthStar Atlanta deliberately shifted most of its business to Alt-A, but Sebring kept getting really aggressive in subprime.

By October 2006, lenders became desperate for volume and resorted to "razzle dazzle" sales methods. "Look what we have!", they were practically shouting over the ads. It was a pure desperation move, but the products they advertised were not really possible. They would promise 100% financing for a 600 FICO, but it required no mortgage lates for one year, and 6 months of reserves. The problem is that anyone needing 100% financing doesn't have 6 months of reserves.  So the ads were really meant to get attention and draw customers.

In November 2006, the first bad news came out. Sebring, and some other lenders, went down. The subprime market chilled, and was basically shut to anyone with a FICO under 620.

By February 2007, 100% LTV was gone for subprimes.

As the housing market peaked, MBS (mortgage backed securities) investors started tightening their lending guidelines. They were still willing to do stated doc, or "stated retired" loans, but only for borrowers with good credit. So gradually the stated doc minimum credit score went up: to 540, to 560, and so on. Likewise, 100% financing, which was available for anyone with a FICO (Fair Isaac Credit Organization , your credit score) as low as 560, now required a FICO of at least 620. Occasionally, you could slip past that higher standard with a niche lender, or a special promotion that a lender offered to the brokers to get more business.

Why would anyone go "stated income"?

Since stated income loans cost more money, up to .25% more, why do it? Well, some people just don't have W-2s to document their income. A waitress gets most of her income from tips, which are not on her W-2. Lenders use a database which cross checks occupations by zip code, to verify the income is reasonable, but as we all know, this feature was abused by borrowers and lenders.  But really, stated income was a way that people could get more house than they could really afford.  The term "liar's loans" is pretty accurate, I think.

Brokers falsified documents

Some loan officer just falsified documents. They hired hackers to alter online bank statements, so now the borrower could get a full doc loan, but of course with false information.

Getting a good price for your loan

If you want to get the cheapest, best loan, this is what you need:

• an established credit history
• 2 lines of credit, each open at least 2 years
• full documentation provided
• FICO of 620 or higher

So a guy with a 700 FICO, three 2-year credit histories, and no proof of income, can get 100% financing.   As you can see, it's still easy to get a loan, just not as easy as it used to be.