Could Tremors in the
Subprime Mortgage Market Be the First Signs of an Earthquake?
Published: February 21, 2007 in
Knowledge@Wharton
This article has been read 799 Times
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
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
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
"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
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
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."