Feeling the ripple effect

The Star-Ledger, April 8th, 2007

The Star-Ledger Archive COPYRIGHT © The Star-Ledger 2007

Date: 2007/04/08 Sunday Page: 001 Section: BUSINESS Edition: FINAL Size: 1886 words

Debating subprime lending and who really pays the price


For months, the news from the subprime lending industry has been relentlessly negative, as more and more borrowers with bad credit have fallen behind on their monthly payments – and one lender after another has gone belly up.

Consider the sobering boom-and-bust saga of New Century Financial, once the second-biggest subprime lender in America. The stock has fallen to near zero from $66, giving up 43 percent in just three days in February, and most of the rest when the New York Stock Exchange halted trading in its shares last month.

Since December, a raft of bad loans has sunk more than 30 other mortgage lenders, and many banks and Wall Street firms have seen their shares fall because of their exposure to the turmoil.

How any of this might affect Joe Homeowner and the broader housing and lending markets is an open question – one now being hotly debated among economists and housing experts.

Federal Reserve Chairman Ben Bernanke recently weighed in, telling Congress the problems in the subprime sector don't appear to be spreading to the overall economy. "At this juncture,” Bernanke testified late last month, “the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained.”

While many experts remain sanguine the rot won't spread, Stephen Roach, chief economist at investment banking giant Morgan Stanley, said he believes the subprime meltdown is akin to the dotcom crash of 2000 – “the pin that pricks a much larger bubble.”

Roll back the clock to 2000, Roach said in a recent report, and “the optimists argued that equities as a broad asset class were in reasonably good shape.”

“That view turned out to be dead wrong,” he said.

So, what exactly is the link between the subprime market and the rest of us? The Star-Ledger spoke to a number of housing experts and economists and asked them who is most likely to feel the pain.


Clearly, the ones who stand to get hurt the most are those making payments on subprime mortgages, typically structured as adjustablerate loans that start out with low interest rates and attractive monthly payments, but can balloon into much higher rates and payments.

The delinquency rate for subprime loans has surged to 13.3 percent since it bottomed two years ago, according to the Mortgage Bankers Association. While the rate is below the peak of 15.7 percent in 2002, the actual number of delinquent loans is much higher today due to the surge in subprime lending over the past few years, said Celia Chen, the director of Housing Economics at Moody's Economy.com.

According to a study by the Center for Responsible Lending, a Washington, D.C.-based consumer advocacy group, one in five subprime borrowers who took loans out in 2005 and 2006 could be at risk of losing their homes.

Viewed one way, the vast majority of subprime borrowers are doing fine and own houses they couldn't otherwise afford.

But for cash-strapped families, all it takes is one hiccup – a jump in interest rates, a further drop in real estate values, the loss of a job – for them to be staring down financial ruin and defaulting on loans they shouldn't have taken in the first place, said Harvard law professor Elizabeth Warren, author of “The Two Income Trap: Why Middle Class Mothers and Fathers are Going Broke.”

University of California economist Ken Rosen said he believes as many as 1.5 million homeowners could lose their homes through foreclosure, and that subprime home values could fall as much as 10 percent to 15 percent.


Foreclosures can hurt home values in the surrounding neighborhood, said Almas Sayeed, an economic policy analyst at the Center for American Progress in Washington D.C.

“A spike in foreclosures typically creates a domino effect in a single area, leading to a sharp depreciation in property values, decreased business investments and lower tax revenues, which in turn affect the quality of schools and decreases nearby property values,” Sayeed wrote in a recent report, “From Boom To Bust: Helping Families Prepare for the Rise in Subprime.”

“A foreclosed property that stays on the market too long may become vacant, " Sayeed said . “When potential home buyers see a cluster of homes either vacant or in foreclosure, it undermines investor confidence in an area . . . and can spell economic disaster for communities and neighborhoods.”

Although a disproportionate percentage of subprime loans are made in low - income neighbor - hoods – they are five times more likely in African-American communities than predominantly white neighborhoods – experts said people should not confuse subprime with “poor” or “minority” neighborhoods.

Buyers want to buy as much house and borrow as much money at the most favorable rates – and that psychology is true for some wealthier borrowers just as much as it is for less-well-off borrowers.

“Subprime loans aren't confined to poor neighborhoods,” Warren said. “More low-income people have more dings on their credit, but there are plenty of middle-class and even upper-income people who end up with subprime mortgages.

“This means that when those homes must be sold either in foreclosure or in distress, the price impact is felt throughout the neighborhood.”


As more borrowers default, and the banks that funded the bad loans start taking hits, they are going to become increasingly cautious about lending money – and not just to subprime borrowers, but also to borrowers with good credit, experts said.

The deterioration in the subprime mortgage market has already triggered tighter bank lending standards, judging by the Fed's January Senior Loan Officer survey. Sixteen percent of responding banks reported tightening lending standards for residential mortgages – the biggest surge since 1990.

“The easy credit of the past two years has been integral in prolonging the housing boom,” said Chen of Moody's Economy.com. “The extension of credit to households with poor borrowing histories increased the demand for housing. . . . Turning off this credit spigot will extend the housing market downturn.”

The Mortgage Bankers Association predicted the number of mortgage lenders that are vulnerable to failure this year could be more than 100.

“Whenever you see a lack of competition in anything, it's never good for the consumer,” said Daniel McDonald, chief executive of Central State Appraisal Services. “Right now, a lot of lenders are merging, falling by the wayside, disappearing entirely or being eaten up by large Wall Street firms.”


Tighter credit markets could translate into a decrease in the number of home purchases, experts said. That, in turn, could lead to a further softening of home prices.

“There will be more homes in an over-supplied market and not as many people who can step in to make purchases” said Dean Baker, co-director of the Center for Economic and Policy Research. “At a minimum, it means financing is drying up for those with less-thanperfect credit, and that spells fewer home buyers.

“And foreclosed properties will add supply to a housing market that already has too much.”

Mark Zandi, chief economist for Moody's Economy.com, is projecting a doubling of subprime defaults this year to 800,000 – homes that will go on the market at a discount and will ultimately weigh on the market. He said he also believes 500,000 fewer Americans will be able to obtain financing because of the tighter standards.

“A lot of people think they are insulated from this problem, but home sales start at the bottom,” McDonald said. “If first-time home buyers aren't coming into the market, they can't push the secondtime homeowner up the ladder, and then the retirees who anticipate selling their house and are usually in the upper price points don't have buyers for their homes, so they can't move.”


The surge in real-estate wealth allowed consumers to supplement their income with something economists call “MEW” – short for mortgage equity withdrawal.

MEW occurs when homeowners take equity out of their homes or capital gains from residential real estate sales and spend the money on all sorts of things. Since 1995, for every dollar gain in real estate assets, homeowners have, on average, extracted about 41 cents, according to Economy.com.

Although consumer spending seems to be holding up so far, Chen said MEW fell an annualized 47 percent in the fourth quarter of 2006, to about $589 billion. And the decline in “active MEW” – the cash-out refi and home-equity component of equity withdrawal – was even more severe, falling an annualized 67 percent to $273 billion in the fourth quarter, she said.

“Those homeowners who are running into trouble will weigh on overall consumer spending as they struggle to keep up with their mortgage payments and have no home equity to cash out,” Chen said. “To be sure, these households tend to have below-average consumption, but they still contribute to retailers' bottom lines.”


The world of mortgage lending has changed a lot since the days of “It's a Wonderful Life.” Back then, the home loans that do-gooder George Bailey wrote from his small savings and loan in Bedford Falls stayed in Bedford Falls.

Today, the subprime salesman is one link in a very long chain that starts with individual home buyers on Main Street and ends with investors in exotic credit derivatives all around the globe.

Mortgage lenders use money provided by bigger banks such as National City or Wells Fargo to make loans. Once completed, the mortgages are sold to Wall Street banks that package hundreds of loans at a time into mortgagebacked securities that, in turn, are sold to various investment groups such as hedge funds, insurance companies and mutual funds. To further complicate the picture, these securities are sliced and diced into different layers of risk.

Bill Bonner, founder and editor of the newsletter “The Daily Reckoning,” likens the mortgage market to a giant pig.

“After the best lenders have taken the AAA++ hams and ribs, there remain many body parts you might show to your daughter only if you wanted to see her make a face and hear her say, 'Eeewww!' “ he said. “The low-priced stuff is too disgusting for most people to put directly on the table, so the unidentified scraps are typically run through the grinder. Then, they are packaged into old-fashioned, purepork, mortgage-backed sausages.”

Hundreds of billions of dollars worth of these “sausages” have been sold on the secondary market.

So when subprime borrowers start missing payments, it is not just the individual lenders that wring their hands, but an entire financial system, said Guy Cecala, publisher of Inside Mortgage Financing Publications.

“When anything blows up, they will all get hit by shrapnel,” Cecala said. “Even the local banker down the corner who may have very tight underwriting standards. The bank may not be doing these subprime loans, but they probably invest in these securities that are backed by the very mortgage loans they don't like.

“It's a tangled web.”

_ Sam Ali may be reached at (973) 392-4188 or sali @starledger.com._

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