Wednesday, March 21, 2007


Mortgage Meltdown

Mortgage Meltdown

March 21, 2007;

Stock markets world-wide have sold off the past few weeks over concerns the collapse of the subprime mortgage industry could prolong and deepen the housing slump and threaten the health of the U.S. economy. Federal Reserve officials and most economists believe the problems in the subprime mortgage market will remain relatively contained, but there is compelling evidence that the failure of subprime loans may be the start of a painful unwinding of a housing bubble that was fueled by easy money and loose lending practices.

Whether measured in absolute terms or time-tested metrics such as price-to-income or price-to-rent ratios, the rise in U.S. home prices during the past six years is unprecedented. What's more, not only has mortgage debt doubled during this time, but loans have been offered on imprudent terms (for instance, a no down payment, no income verification loan to a borrower with a checkered credit history).

It's no coincidence that the five-fold growth in subprime lending occurred at a time when home prices soared to nosebleed territory. As home prices kept rising, fewer loans went bad because the homeowner could almost always refinance or sell the property at a profit. (Until the past year or so, it seems the only person in California who sold his house at a loss was the convicted lobbyist who in 2003 bribed former Rep. Randy "Duke" Cunningham by buying his house at an inflated price and selling it six months later for $700,000 less.)

As the home price boom gained momentum and delinquencies dropped, lenders offered progressively easier and riskier lending terms. Common sense suggests that the boom-time mania that led banks (and investors in mortgage-backed securities) to offer dangerous loans to individuals with poor credit histories also led them to offer the same kinds of risky loans (no income verification, no down payments, high payments as a share of income, low teaser rates) to individuals with good credit scores.

Far from being limited to the subprime market, the data show these risky loan features have become widespread. According to Credit Suisse, the number of no or low documentation loans -- so-called "liar loans" -- has increased to 49% last year from 18% of purchase loans in 2001, a nearly three-fold increase. The investment bank also found that borrowers put up less than a 5% down payment in 46% of all home purchases last year. Inside Mortgage Finance estimates that nontraditional mortgages -- mostly interest-only and pay-option ARMs that allow the borrower to defer paying back principal or even increase the loan balance each month -- which barely existed five years ago, grew to close to a third of all mortgages last year.

The Alt-A market, a middle ground between subprime and prime, has increased seven-fold since 2001 and accounted for 20% of home-purchase loans last year. Fully 81% of Alt-A loans last year were no or low documentation loans, according to First American Loan Performance. Why have borrowers employed this kind of risky financing? Because it was the only way many of them could afford a home in some of the hottest housing markets, where prices more than doubled in five years.

It should come as no surprise that delinquencies on these unconventional loans have increased sharply. Investors were shaken last week by a Mortgage Bankers Association report which found that mortgage delinquencies hit nearly 5% at the end of last year and that prime adjustable rate loans deteriorated at a faster rate than subprime ARMs. A recent UBS report finds that the 2006 Alt-A loans are "on track to be one of the worst vintages ever." This is no subprime niche problem.

Even if bad loans are more widespread than previously expected, many housing bulls say, the impact on the housing market and the economy will be minimal because total losses due to foreclosures will be a small percentage of outstanding mortgage debt and a still smaller share of the economy. A similar argument holds that bad loans won't lead to a broader foreclosure problem because the average American has plenty of equity in his home.

Foreclosure losses as a share of the economy will be small and most homeowners have a comfortable amount of equity in their homes. In fact, about one-third of homeowners have no mortgage and own their homes outright, but they are not the reason home prices have been driven to the stratosphere. Home prices -- like all prices -- are set at the margin. It was the marginal buyer, particularly the subprime borrower and housing speculator, who drove prices higher. The easing of lending terms increased the demand for homes, and since the supply of homes is relatively fixed (or inelastic), this increase in demand quickly translated into higher prices. As the loose lending practices are inevitably reversed -- and there is a wide chasm between current lending practices and prudent lending terms -- fewer people will be able to afford to buy a house, which will reduce demand and push home prices lower.

It's not the size of foreclosure losses as a share of the economy that matters, it is the effect those losses have on the availability of credit. When banks (and investors in mortgage-backed securities) begin suffering losses, they inevitably pull back. This is why so many subprime companies have gone bankrupt virtually overnight; investors balked at buying subprime loans except at a steep discount, which produced immediate losses. In effect, their ability to profitably finance new loans was eliminated.

What's more, the bank regulators are only now beginning to tighten lending standards and will be under increasing pressure from Congress to do more. After growing by nearly 50% in the first half of 2006, nontraditional loan growth has turned negative since the bank regulators issued new guidelines last September. The CFO of Countrywide recently told an investor conference that 60% of the subprime loans the company is making won't meet proposed federal rules likely to take effect during the summer. The concern that tighter lending standards could reduce access to financing is the reason a widely watched survey of homebuilders conducted by the National Association of Homebuilders dropped earlier this week.

The report by Credit Suisse estimates mortgage originations could drop 21% during the next year or two because of tighter credit standards. Coupled with high inventories of unsold homes and the additional supply likely from distressed sellers, this drop in demand could produce an unprecedented nationwide decline in home prices. Merrill Lynch estimates prices could drop as much as 10% this year. A price drop of this magnitude would lead to a vicious cycle in the housing market and pose a major risk to economic growth. And, of course, it would create a raging political firestorm.

Tomorrow the Senate Banking Committee will hold a hearing featuring the bank regulators as well as top executives from a number of subprime lenders, all of whom are likely to be the subject of some tough questioning. The collapse of the subprime industry and the increase in foreclosures are serious issues and congressional oversight is important and appropriate. However, Congress should proceed with caution as legislation designed to protect the consumer from "predatory" lending could exacerbate the credit crunch just beginning in the subprime market.

The fact that Congress is now holding hearings on the fallout from the second major asset price bubble in the last decade should prompt some broader questions. For example, what role did the Fed's loose monetary policy from 2002-2004 play in fueling the housing bubble? Should the Federal Reserve reexamine its policy of ignoring asset bubbles?

Asset bubbles are harmful for the same reason high inflation is: Both create misleading price signals that lead to a misallocation of economic resources and sow the seeds for an inevitable bust. The unwinding of today's housing bubble is not merely an academic question; it is likely to inflict real hardship on millions of Americans. To reduce the risk of a similar outcome in the future, it is important that policy makers, economists, and policy analysts properly diagnose the root causes of the current housing bust, not just its symptoms.

Mr. Laperriere is a managing director in the Washington office of ISI Group.


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