Risky Loans Story Surfaces more Fully
By MortazaviBlog on Mar 24, 2007
Several weeks earlier, in mid February 2007, The Wall Street Journal first reported on the risky subprime loans' defaults and subsequent mortgage-backed securities losses. The news gradually broke into the more popular press. A couple of weeks ago, BusinessWeek, carried a cover story about the subsequent volatility in the stock market, and now, The Economist carries a "briefing" on the subprime defaults. (Subscription may be required for viewing.) According to The Economist, of the $40 tillion debt market (including the $10 trillion mortage market), only $650 billion relates to the adjustable-rate subprime loans. This has some optimists believing that the economy will avoid a credit crunch. Others, like Stephen Roach of Morgan Stanley, have "called subprime mortgages the new dot coms," according to The Economist.
Of the $10 trillion mortgage loans, some 75% are repackaged as mortgage-backed securities (or bonds). Some two thirds of borrowers have good credit and fixed interest rates. However, a growing number have weak credit and adjustable rates, and "little, or no, cushion of home equity."
When the housing market began to slow, lenders pepped up the pace of sales by dramatically loosening credit standards, lending more against each property and cutting the need for documentation. Wall Street cheered them on. Investors were hungry for high-yielding assets and banks and brokers could earn fat fees by pooling and slicing the risks in these loans.
Standards fell furthest at the bottom of the credit ladder: subprime mortgages and those one rung higher, known as Alt-As. A recent report by analysts at Credit Suisse estimates that 80% of subprime loans made in 2006 included low “teaser” rates; almost eight out of ten Alt-A loans were “liar loans”, based on little or no documentation; loan-to-value ratios were often over 90% with a second piggy-bank loan routinely thrown in. America's weakest borrowers, in short, were often able to buy a house without handing over a penny.
... A new study by Christopher Cagan, an economist at First American CoreLogic, based on his firm's database of most American mortgages, calculates that 60% of all adjustable-rate loans made since 2004 will be reset to payments that will be 25% higher or more. A fifth will see monthly payments soar by 50% or more.
... Mr Cagan marries the statistics and concludes that—going by today's prices—some 1.1m mortgages (or 13% of all adjustable-rate mortgages originated between 2004 and 2006), worth $326 billion, are heading for repossession in the next few years. The suffering will be concentrated: only 7% of mainstream adjustable mortgages will be affected, whereas one in three of the recent “teaser” loans will end in default. The harshest year will be 2008, when many mortgages will be reset and few borrowers will have much equity.
Mr Cagan's study considers only the effect of higher payments (ignoring defaults from job loss, divorce, and so on).... Mr Cagan's work suggests that every percentage point drop in house prices would bring 70,000 extra repossessions.
The financial markets should be able to whether these losses, The Economist observes. Mr. Cagan's estimate of losses, $112 billion, compare with the $600 billion "wiped out on the stockmarkets as share prices fell on February 27th." However, loss of confidence will affect the collateralized debt orbligations (CDOs) markets and may lead to demand for higher spreads and a classic credit crunch.
Finally, a historical dictum: A loose monetary policy instituted to save the economy from the disasters of one bubble can only lead to another bubble, perhaps of a larger impact.
The bursting of the stock-market bubble in 2000 led to a plunge in investment at American firms. To stave off recession, the Federal Reserve loosened monetary policy. Short-term interest rates fell to historic lows, propping up consumer spending, but also fuelling the housing bubble and sowing the seeds of today's upheaval.
Only disciplined frugality, savings and attention to real assets, and not more legislated regulatory burdens, can help rein in break-neck speculative swings.
In the meantime ...
Nancy Trejos of The Washington Post reports the most recent housing statistics released by U.S. Department of Commerce on March 26. The statistics speaks of a sharp drop in new home sales in February and it has pulled down all three major indexes on the Wall Street on its release. There is quite a bit of regional variation, Trejos reports:
The supply of new homes for sale increased by 1.5 percent in February to 546,000. At the current sales pace, it would take 8.1 months to get through that supply, up from 7.3 months in January and 6.4 months a year ago.
By region, the Northeast had a 26.8 percent drop in home sales, the steepest decline in the country. The Midwest had a 20 percent drop. The South, which includes the Washington region, was down 7 percent.
The West was the only part of the country to have an increase in sales, up 24.6 percent from January.