Editor’s note: This is part one of a four-part series on the crisis in subprime mortgage lending. Part one looks at how economic events like the dot-com stock market bust and the flow of global investment capital helped ease access to credit, fueling a housing boom. (Read Part 2, Part 3 and Part 4.)
There’s growing concern that easy access to credit, rather than fundamentals like housing supply, demographic trends and wage growth, was the primary driver of a dramatic run up in housing prices during the housing boom.
And if lenders gave rise to the housing boom, then lenders — and those who fund and regulate them — may also taketh away.
As subprime lenders go belly up or lose access to funding in an avalanche of delinquencies and foreclosures, there are fears that a glut of real estate-owned homes, or REOs, could flood the market, and depress prices in the hardest-hit areas.
Upwards of $500 billion in adjustable-rate first-lien mortgages are set to reset this year, at a time when the rise in delinquencies and foreclosures is making lenders reluctant to make new loans to those who may need them most.
Compounding the problem, investors, regulators and lawmakers may overreact to the worsening situation by tightening up credit to the point where troubled borrowers are unable to refinance on better terms.
"It’s a cycle — loans default and the risk goes up," said Chicago-based mortgage planner Dan Green. "Wall Street demands a higher return, so lenders have to increase their interest rates. That causes more defaults, because more people are stretched, so rates go up again.
"What’s making this cycle a little interesting," Green says, "is they are trying to reduce risk by reducing the pool of people they will lend to. I am making several calls a day to people I know who are in these loans. I tell them there will be short-term pain," but that they need to refinance now, before a credit crunch arrives.
If the loans that fueled the boom become unavailable, first-time home buyers who are ready to make the plunge may be unable to obtain loans that suit their needs. Even homeowners with sensible loans could get hurt in the fallout, because of the ripple effect that would take place if sellers who are ready to move up to pricier digs aren’t able to sell their starter homes to first-time buyers.
Patrick F. Stone, the chairman of The Stone Group, an Austin, Texas-based commercial brokerage and development company, says it’s hard to get a handle on just how big the problem will become.
"There is a tendency to assume people are idiots when they are not," Stone said. "Anybody who has that (adjustable-rate mortgage that’s ready to reset) has been trying to figure out something to do with it," Stone said. "But it’s naive to think it isn’t going to cause a great deal of stress."
Stone, a former chief executive officer of Fidelity National Financial’s FNIS division, also serves as vice chairman of the board of directors at Metrocities Mortgage LLC. But, he said, his views are his own. Stone and other lending industry veterans say one reason for the rise in delinquencies and foreclosures is that loan products created for sophisticated, high-income borrowers were marketed to people who didn’t understand how to use them.
But it’s a problem the industry has been dealing with since the slowdown in the housing market began, and originators found themselves repurchasing loans they sold to Wall Street investors when borrowers went into early payment default.
"This is not at all analogous to the S and L crisis," Stone said of the failures that swept the Savings and Loan industry in the 1980s. "It’s been falling apart for a year and a half. My gut feeling is that a great deal of the problem has already been digested, because we’ve been digesting repurchases now for coming up on six quarters. Regulators are just starting to realize there is a problem."
The pain in the lending industry will be great, with many small- and medium-sized lenders going out of business or bought out by competitors, Stone and others predict.
"All the money the mortgage industry made for two to three years, from 2003 to 2005, they started giving it back in 2006, and there will be more (losses) in 2007," Stone said. "At the end of the day, we’ll see a washout in the mortgage industry."
Hundreds of thousands of families — some have predicted as many as 2 million — will lose their homes, and housing markets that saw the most sudden run-ups in prices are expected to take the biggest hits. Although prices may not necessarily come down in every market, appreciation is likely to slow.
"A lot of intelligent people I know think we are in for five to seven years of minimal house (price) appreciation while income catches up, restoring affordability," Stone said. "We’ve seen it many, many times in the housing market. A lot of times house prices move up then tend to move laterally while incomes catch up. "
Bargain-basement interest rates
Some economists believe that the housing boom was precipitated, at least in part, by the drastic fall in interest rates following the dot-com stock market crash. After tech stocks collapsed in 2000, the Federal Reserve attempted to stimulate the economy by slashing short-term interest rates to encourage borrowing. The Fed rolled back the short-term federal funds rate from 6.5 percent in May 2000 to 1 percent in June 2003. Long-term rates followed suit, falling from about 8.5 percent to 5 percent during the same period.
A corresponding dip in mortgage rates gave people shopping for homes more buying power, sparking a wave of home purchases that helped start home prices on an upward climb.
The all-time record for U.S. mortgage originations was set in 2003, with nearly $4 trillion in new loans made. From 2001 to 2005, housing prices spiraled upward at a rate of 9 percent per year nationwide, with double-digit appreciation in most areas outside of the Midwest.
The U.S. economy dodged a major recession, even when the dot-com stock market collapse was followed by the Sept. 11, 2001, terrorist attacks. But the drop in long-term interest rates also left investors in U.S. Treasuries looking for similar securities that delivered a better return.
Some turned to mortgage-backed securities — packages of home loans bundled for sale on Wall Street — providing liquidity to "private-label" lenders that compete with the government-sponsored enterprises Fannie Mae and Freddie Mac.
By 2005, private-label lenders — including banks, Wall Street investment firms and insurance companies — had overtaken Fannie and Freddie in the secondary mortgage market, issuing a record $1.2 trillion in MBSs. The GSEs, still recovering from management and accounting scandals, issued only $908 billion in MBSs — the lowest level in five years.
With the economy heating up, in the summer of 2004 the Federal Reserve changed course and began raising short-term interest rates. But this time, long-term rates didn’t follow in lock step.
When the Fed last summer finally completed a series of 17 straight interest-rate increases, the federal funds rate — the rate banks charge each other for overnight loans — stood at 5.25 percent, where it has remained since. But to the surprise of some economists, long-term interest rates stayed relatively flat, in part because of the flow of global capital into U.S. financial markets.
America’s huge appetite for imported goods means foreign investors are awash in dollars.
According to a policy brief by Democrats serving on the House Committee on Financial Services, foreign ownership of Treasury securities has more than doubled since 2001, from $1 trillion to $2.2 trillion.
China increased its U.S. debt holding more than fivefold during that period, from $61.5 billion to $339 billion. OPEC nations including Iran, Venezuela and the United Arab Emirates boosted their holdings by 116 percent to $104.8 billion. Foreign investors now hold 42 percent of publicly held U.S. debt, with interest payments to foreign investors totaling about $100 billion a year.
Demand for U.S. debt, in the form of Treasuries, has kept long-term interest rates from keeping pace with the recent rise in short-term rates. By late 2006, the yield spread between short- and long-term rates had become inverted, with long-term investments earning lower returns than short-term notes.
It seemed to some observers that foreign investors, and not Fed policies governing short-term rates, had become the deciding factor in determining the rates on long-term investments, including mortgage loans.
The government doesn’t track MBS purchases by foreign investors. But according to a Jan. 9 report by Barclays Capital, Asian investors were the largest buyers of mortgage-backed securities in 2006, outstripping even U.S. banks. MBS purchases by Asian Investors have grown to an estimated $120 billion a year, and Barclays Capital expects purchases to remain strong in 2007.
According to analysts at UBS Investment Bank, in 1998 only 2 percent of the world’s central banks were approved to invest in MBSs and asset-backed securities (ABSs are investments backed by home equity loans). By 2006, 44 percent had the green light to put their money into securities backed by America’s booming housing markets.
In the meantime, U.S. home prices continued to appreciate rapidly. Although mortgage lending peaked in 2003 at the tail end of a refinancing boom, home sales didn’t reach an all-time high of 9 million until 2005. With home prices appreciating at a much faster rate than growth in incomes, many families were priced out of the market, reducing demand and contributing to the resulting slowdown in the housing market.
Exotic loans become commonplace
Lenders began offering nontraditional loans that allowed borrowers to purchase homes they might not otherwise have been able to afford, especially in markets where home prices had seen annual increases at double-digit rates.
These nontraditional or "exotic" loan types, such as payment-option ARM and interest-only loans, allowed borrowers to start out making monthly payments that in some cases didn’t even cover all of the interest owed on a loan, let alone the payback on any of a loan’s principal.
According to the Mortgage Bankers Association, interest-only loans accounted for 25 percent of loans originated in the second half of 2005 and the first half of 2006, and pay-option loans had a 15 percent market share (there can be some overlap between the two).
Another innovation was the hybrid 2-28 and 3-27 ARM loan, which let borrowers start out making payments at a lower interest rate for two or three years, before the loans "reset" to a higher rate.
By the third quarter of 2006, adjustable-rate loans accounted for 25 percent of all mortgage loans, up from 18 percent in 2003. The trend was even more pronounced in high-cost areas such as Nevada, where ARMs accounted for 42 percent of outstanding loans — the highest rate in the country, according to a recent MBA white paper.
Also popular during the boom were 80-20 "piggyback" loans, involving a smaller second mortgage loan to get around the traditional requirement of making a 20 percent down payment on a home.
With home prices climbing faster than incomes, lenders began offering "low doc" or "no doc" stated-income loans, which let borrowers claim the income they needed to qualify for a loan without having to prove it.
Many of these nontraditional loan types had long been available to sophisticated borrowers with high incomes. But when they were offered to borrowers with blemished credit scores — so-called subprime borrowers — the loans tended to end up in default more often.
Many subprime borrowers who relied on ARMs expected to refinance before their interest rates went up, only to find those plans thwarted when home-price appreciation slowed or reversed. Buyers with little or no equity found themselves "upside down" — owing more to their mortgage lender than their home was worth. When interest rates on their loans reset, the payment shock from increased monthly payments put many into foreclosure.
The mortgage lending industry continues to defend nontraditional, hybrid ARM and piggyback loans as "affordability products" that help first-time home buyers in high-cost markets.
But just because families were suddenly able to qualify for and purchase homes previously above their means didn’t mean they’d be able to keep them, said California-based mortgage broker Steven Krystofiak.
"Right now homes are very obtainable, not affordable," said Krystofiak, who as founder of the Mortgage Broker Association for Responsible Lending has lobbied lawmakers for restrictions on stated-income and interest-only loans. "I would disagree wholeheartedly with those who call them affordability loans, and say they are obtainability loans."
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