Could Tremors in the Subprime Mortgage Market Be the First Signs of an Earthquake?
Published: February 21, 2007
Article courtesy of
Knowledge@Wharton
All materials copyright of the Wharton School of
the University of Pennsylvania
For months,
the steady drip of news about troubles in the
subprime mortgage market looked no worse than
one would expect: merely a comeuppance for lenders,
borrowers and investors who should have known
that high-interest loans to people with poor
credit were risky.
During the same period, many economists started
breathing again after concluding that the superheated
home market of recent years had not become the
bursting bubble many had feared. While home prices
are leveling off, there has been no deep, widespread
decline.
But now some experts wonder whether those sighs
of relief came too soon, especially in light
of the troubles recently experienced by one of
the largest subprime players, HSBC Holdings.
Some suggest that the growing number of borrower
defaults in the "aggressive lending" market,
which includes various types of risky mortgages
besides subprime loans, could shock the broader
housing market and economy after all. Many subprime
borrowers are paying 10% to 12%, compared to
6% to 8% on standard, or "prime," loans,
and delinquencies are rising.
"There's no doubt that we have already
lost about 1 percentage point of [economic] growth
due to the pullback in the housing market," says
Wharton real estate professor Susan M. Wachter.
A retrenchment after years of soaring home prices
fueled by easy money has caused many economists
to trim this year's growth forecasts from 4%
to 3%, she adds.
And it could get worse, she warns. If interest
rates rise, growing numbers of homeowners could
fall behind on aggressive floating-rate loans
they took out in recent years, forcing their
homes onto the market. The glut would depress
prices of homes bought with ordinary "prime" loans
as well. With home values flat or falling, owners
would no longer be able to use refinancing to
convert equity into cash, trimming consumer spending.
The current slump in home building and sales
would persist. "We could potentially have
a housing-led recession," Wachter says.
If this does occur, it could begin in the second
half of 2007 or sometime in 2008, if interest
rates rise.
Others think the U.S. economy could well dodge
this bullet. "I'm sort of an optimistic
pessimist," says Jack M. Guttentag, emeritus
finance professor at Wharton. He expects home
prices to fluctuate aimlessly for two to three
years without a major decline. But the future
is uncertain, he adds, because many of the newer,
risky loans have track records only through the
recent period of rising home prices. "Rising
home prices are an offset to all kinds of trouble," he
notes. "They tend to reduce defaults and
foreclosures that otherwise would occur, because
people who get into trouble find that the best
thing they can do is sell their house and walk
away with some equity."
Incomplete Risk Data
In a mid-February report titled, "Will
the Subprime Meltdown Trigger a Credit Crunch?" Morgan
Stanley analyst Richard Berner concludes it will
not, describing a credit crunch as a condition
in which "lenders deny even creditworthy
borrowers access to borrowing." Many firms
specializing in subprime loans -- offered to
borrowers with credit scores below 620 -- will
go under, he says, but prime lenders' balance
sheets are strong and he expects them to continue
making loans and keeping the economy healthy.
(Credit scores range from 300 to 850, with scores
above 700 generally considered good and those
below 600 counted as very high risk.)
While there is debate over how matters will
unfold, there is little doubt that changes in
mortgage lending have created risks that cannot
be gauged precisely. Wachter notes that the heavy
use of aggressive loans is so new that data on
which lenders and investors base their risk models
is incomplete. "There is the potential for
model error. The models are untested in a down
market."
The classic U.S. mortgage charged a "fixed" interest
rate that stayed the same for the loan's 30-year
life. Once the mortgage papers were signed, the
homeowner's monthly payments never changed, making
payments easier and easier to shoulder as the
borrower's income rose with inflation. Generally,
home values went up as well, so the borrower
could expect to sell at virtually any time for
more than he owed.
But the picture has dramatically changed in
recent years. Wachter estimates that nearly two-thirds
of all home loans issued since 2003 were types
she terms "aggressive." These entail
risks for the lenders, borrowers and investors
in mortgage-backed securities that are not found
in conventional loans. In addition to subprime
loans, this includes interest-only loans where
the borrower makes no principal payments. It
includes negative-amortization loans in which
the borrower pays less than the full interest
payment, with the shortfall added to the outstanding
debt. And it includes loans that require little
or no down payment, or no proof of income.
Subprime lending, the riskiest category of aggressive
loans, soared from $150 billion in 2000 to $650
billion in 2005, according to testimony at a
recent Senate hearing on predatory lending.
Several factors were responsible. One was the
Community Reinvestment Act of 1977, which made
redlining illegal and pushed lenders to make
loans in poorer communities they previously had
avoided, says Kenneth Thomas, adjunct professor
at Wharton. In the 1990s, Congress and the Clinton
administration pushed policies to encourage wider
home ownership, which today is at the highest
level in U.S. history, nearly 69% of households.
"A regulatory climate developed -- which
still exists today -- that favored these loans," he
says. There is a distinction, he notes, between
subprime loans for people who deserve mortgages
and otherwise could not get them, and predatory
lending, which is pushing people into loans they
cannot afford. "Subprime is good, predatory
is bad."
Another factor was work by academics and lenders
who found that people with low credit scores
were not as risky as previously thought. In the
1980s and 1990s, lenders "began to learn
how to trade off one risk factor against another
risk factor," Guttentag says. "A bunch
of guys realized there was a lot of money to
be made for delivering loans to a category of
buyers who had never qualified for loans. They
found that they could charge very high rates
to cover their risk and make large profits."
According to Wachter, her research showed that
many people deemed not creditworthy actually
were paying more in rent than they would if they
could get mortgages. For many renters, the obstacle
to home ownership was not the size of the monthly
payment, but the need for a down payment of 10%
to 20% of a home's cost. In the 1990s, lenders
began addressing the problem with low- and no-down
payment loans, and with computerized loan approvals
that used a more scientific approach to judging
applicants' credit worthiness, she says.
The final factor was the mushrooming in the
1990s of "securitization," the bundling
of home loans into bond-like securities that
could be bought and sold on the secondary market.
This allows lenders to get loans off their books
so they can lend more.
Fannie Mae and Freddie Mac, the quasi-governmental
lenders, had long sold mortgage-backed securities,
but these companies were restricted to making
prime loans. Once other lenders realized money
could be made from subprime borrowers, they began
bundling these loans into securities. "What
happened in the middle 1990s was the development
of private-label mortgage-backed securities,
as opposed to these quasi-public enterprises
which had implicit government backing," Wachter
says.
In 2003, Fannie and Freddie purchased and repackaged
about 70% of loans that wound up on the secondary
market. By the end of 2006, that figure had fallen
to 40%, reflecting other lenders moving into
this business.
Although these securities carry higher risks,
they are popular with hedge funds and other investors
because subprime borrowers pay higher interest
rates than prime borrowers -- often 3, 4, or
5 percentage points more. That has made subprime
securities especially attractive in recent years,
as rates on many fixed-income holdings have languished
in the low and mid single digits.
To get mortgage brokers to push these profitable
loans, lenders typically offer commissions equal
to about 3% of the loan, compared to 1% for a
prime loan, Guttentag says. "A lot of brokers
just specialize in subprime loans."
17 Rate Hikes
Several studies have shown that subprime loans
have been pushed very hard in poorer communities,
often to borrowers who could qualify for prime
loans with better terms.
The subprime lending industry was doing fine
until the Federal Reserve started its string
of 17 hikes in the short-term interest rate in
the summer of 2005, taking the rate from 1% to
5.25%. Four out of five subprime loans carry
floating interest rates that, after the first
year or two, change every 12 months as short-term
interest rates fluctuate. Because of the Fed
hikes, homeowners who received these loans in
2005 are now finding their monthly payments rising
by 30% to 50%, leading many to fall behind in
payments. "None of this would be an issue
now if we did not have 17 straight increases
in rates," Thomas says.
About 70% of subprime loans have prepayment
penalties that can make it too expensive for
homeowners to refinance to conventional fixed-rate
loans with lower interest rates. Because home
prices are flat or falling in many of the poorer
neighborhoods where subprime loans are most common,
even those owners who can handle the prepayment
penalties may find it impossible to get new loans
large enough to cover their balances on the old
ones.
The result: increasing numbers of defaults and
delinquencies. At the end of 2003, about 7% of
subprime loans were in foreclosure or serious
delinquency -- with payments at least 90 days
overdue, according to Morgan Stanley's Berner.
By late 2006, the figure had soared to 12.6%.
For all mortgages, the figure is 1.4%. Although
the Fed stopped raising rates last August, Wachter
notes that much of the damage is yet to come,
since many adjustable loans still haven't had
their first rate adjustment.
The Mortgage Bankers Association says between
$1.1 trillion and $1.5 trillion in floating-rate
mortgages will adjust in 2007, but expects about
half to be refinanced so that the borrowers will
not face payment increases. About six percent
of all homeowners have subprime loans with adjustable
rates. "I think we are still on the downside
of the curve," Thomas says. "Things
will get worse before they get better."
Aggressive lending allowed people to buy homes
who otherwise could not have, and that increase
in demand is part of the reason home prices soared
in the first half of the decade. In a December
2006 paper, "Aggressive Lending and Real
Estate Markets," Wachter and co-author Andrey
Pavlov of Simon Fraser University concluded that
neighborhoods and cities that had high concentrations
of aggressive lending suffered the largest home-price
declines after the market cooled.
They focused on neighborhoods in which disproportionate
shares of loans were ARMs -- adjustable-rate
mortgages. "For each one-percent higher
share of ARMs in 1990, the price decline increases
by 1.3% for that neighborhood," they write.
This is an ominous finding for inner-city neighborhoods
where aggressive loans are prevalent. Broader
markets at greatest risk are in Florida, Arizona,
the District of Columbia, Nevada, California,
Illinois and Utah, Wachter and Pavlov say.
But will problems in areas like these send ripples
through the national economy? Although Wachter
worries that it could, Thomas does not think
so. He notes that banks and other lenders that
do not specialize in subprime loans appear quite
healthy. "I don't see this Doomsday scenario
at all, the reason being that the financial markets
are so strong," he says, adding that the
wildest excesses have already been curbed as
lenders, under pressure from state and federal
regulators, have tightened credit standards and
demanded larger down payments and proof of income,
he states.
Hundreds of billions of dollars worth of securities
based on aggressive loans have been sold on the
secondary market, and some investors are sure
to suffer if homeowners default. The seriousness
of this has been made clear by recent stories
about investors pressuring lenders to buy these
securities back.
Most experts believe securitization generally
works to reduce risk in the marketplace, because
easy trading of these securities allows lenders
to pass risk to investors who feel able to shoulder
it. It is widely believed that hedge funds are
among the major investors in securities based
on subprime and other aggressive loans, but no
one knows for sure.
Securitization, says Guttentag, "does diversify
the risk," but, he adds, "We don't
have any good data on who exactly holds those
securities."
One of the largest subprime players, HSBC Holdings,
announced early in February that bad debts had
exceeded a staggering $10.5 billion in 2006,
sending shivers through the industry. "What
other cases are out there like that?" Wachter
asks. "We don't know."
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