By now, most of you know about the problems in the mortgage industry. When I started originating loans in 1985, I had never heard of subprime loans. For those of you who dont know, a subprime loan is a mortgage that is provided to a borrower(s) whose credit is such that they may not qualify for a conventional or FHA/VA mortgage. Most of these loans in recent years have been at 100 percent financing.
Many subprime lenders have disclosed that their bank lenders are pulling their funding, and that they dont expect to meet the repayment demands by their creditors. The big bank lenders include Bank of America Corp., Citigroup, Inc., Credit Suisse Group, Goldman Sachs Group, Inc., and Morgan Stanley. As I sit here writing this article, another lender may be going under. As of right now, 38, no, check that, 39 national subprime lenders have either been purchased by other lending entities, reorganized, filed bankruptcy or have closed their doors for good.
Subprime lenders rely on short-term financing from Wall Street firms and big commercial banks to make home loans. Those lines of credit allow the lender to provide the funds borrowers use to pay for their homes. The subprime lenders then use the money they get from the sale of the mortgage in the secondary market to pay down the financing. At the same time, providing such financing allows the big banks to buy loans from subprime lenders to repackage them into tradable securities.
In addition, subprime lenders are indicating that some of their bank lenders are accelerating their requests for them to buy back from them all outstanding mortgage loans financed under their respective funding agreements after lenders defaulted on those loans. If lenders cant afford to repurchase the loans, the result could be a forced liquidation of the loans and other assets.
Why did subprime loans get so popular? Subprime loans made up 12.75 percent of the $10.2 trillion mortgage market in 2006, up from 8.5 percent in 2001, according to Inside Mortgage Finance. The homeownership rate has grown to 69 percent from 65 percent over the past decade, about half of which came from subprime lending, according to a study by the Federal Reserve Bank of Chicago.
Seeking new clients at a time when home values were soaring in many markets, emboldened lenders raced to offer easy credit with loans, such as piggyback loans, requiring no down payment and no-doc loans that let borrowers state their incomes without supporting documentation.
Subprime lenders charge higher interest ratestypically 1 to 4 percentage points more than on loans to more credit-worthy borrowers. Investors, eager for bigger returns, have fueled demand by purchasing securities that are backed by these mortgages. That has enabled many mortgage bankers to turn around and sell their loans after making them, enabling more loans and reducing their risk. Some experts have blamed falling home prices/values for the reason borrowers began defaulting on their mortgages. If they cant refinance and consolidate their debt, then the homeowners have a problem paying their mortgage payment.
Who stands to lose? Firms that specialized in subprime mortgages are feeling pain right now, as are financial institutions that lent to those firms. But the subprime market is fairly fragmented: The top three subprime lenders had a roughly 21 percent combined market share last year, and the top 10 controlled less than 60 percent of the market, according to a UBS (global investment firm) report.
Because so many of these mortgages were used to back bonds that were then sold off to investors world-wide, the risk has been spread more broadly through the economy. In 2005, two-thirds of home mortgage bankers were securitized, according to the FDIC. Investors in the derivatives market who sold protection against the riskier loans stand to lose money if defaults increase. Therefore, the overall effect on the economy may be minimal.
Some statistics follow:
Nearly 1.2 million foreclosure filings were reported last year, a 42 percent rise from 2005. That is a rate of one in every 92 U.S. households.
Colorado, Georgia and Nevada had the nations highest foreclosure rates last year, according to RealtyTrac. Among the top 100 metropolitan areas, Detroit, Atlanta and Indianapolis lead the pack.
About 80 percent of subprime mortgages today are adjustable-rate mortgages, or ARMs, that have been nicknamed exploding ARMs because they have low fixed-interest payments in their first few years, but then usually adjust to higher interest payments.
Creative, new subprime loanspiggyback, interest-only, and no-doc loans, among othersaccounted for 47 percent of total loans issued last year. At the start of the decade, these type of loans were less than 2 percent of total mortgage loans.
Borrowers have never been more leveraged. Loan-to-value ratios, the loan amount expressed as a percent of the property value, have grown to 86.5 percent last year from 78 percent in 2000.
Most economic forecasters in a new WSJ.com (Wall Street Journal) survey believe recent turmoil in the subprime mortgage market is likely to spread to the broader mortgage market, and they expect a widely followed index of home prices to fall this year. Economists still think the U.S. will avoid a recession and even a significant rise in unemployment.
The markets may have over-reacted, said John Lonski of Moodys Investors Service. Only businesses significantly exposed to subprime will be hurt. Mortgage repayment problems arent as widespread as we are led to believe.
What does this mean for us in northern Illinois? Because many subprime lenders have either cut back the usage of combo loans (first and second piggyback), or they have eliminated them altogetherwe may see a decline in home purchasing this year. Homebuyers will need to look at loan products offered by Fannie Mae, Freddie Mac or FHA/VA for their financing needs. Why? These loans are protected by mortgage insurance and Fannie Mae, and Freddie Mac are approving these loans with credit scores that were once considered subprime scores.
But, as is often the case, there is disagreement among the economists about the risks the subprime market poses to the overall U.S. economy. Just fewer than half the economists said they expect the economy to get better over the next year, while 27 percent expect it to get worse and 22 percent think it will stay the same. In the latest WSJ/NBC poll, 49 percent of Americans said they expect the economy to remain the same, while 31 percent said they expected things to get worse and just 16 percent said they expect improvement. The economists are also more optimistic about the stock market. Three-quarters of the economists expect stocks to rise; fewer than half of Americans feel the same way.
According to the American Housing Survey for 2005, the most recent date for which data are available, 33 percent of all homes are owned outright and 57 percent have traditional mortgages, leaving just 10 percent potentially affected by ARM woes.
Doom and gloomabsolutely not. The U.S economy is still strongthe mortgage industry and Wall Street will sort this out. By this time next year, well see the subprime industry come back stronger. There is too much demand for this type of home financing. Perhaps the underwriting will be a little tighter.
John R. Johnson is branch manager for VanDyk Mortgage Corp. in Rockford. He can be reached at firstname.lastname@example.org.
from the April 4-10, 2007, issue