Housing collapse: lenders going bankrupt


Richard Moore

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American mortgages

Bleak houses
Feb 15th 2007 | NEW YORK
From The Economist print edition

America's riskiest mortgages are set to pop. Where will the shrapnel land?

LAST March, ResMAE, a mortgage lender catering to risky borrowers, cut the 
ribbon on its new headquarters in Brea, California. The sprawling, 
135,000-square-foot building dwarfed the company's 458 local employees. But it 
fitted the firm's outsized ambitions. Less than a year later the company, rather
than its ribbon, was facing the chop. This week it said it had filed for 
bankruptcy and was selling its assets for a diminutive $19m.

ResMAE is one of over 20 casualties among America's ³subprime² mortgage lenders,
which serve borrowers with spotty credit histories at higher interest rates. 
This end of the market took on $605 billion of new mortgages last year, more 
than a fifth of the total. But as interest rates have climbed, these loans have 
soured and the shares of bigger subprime lenders, such as Countrywide Financial 
and IndyMac, have sagged.

Does the rot run deeper? That fear ran down a few spines on February 7th, when 
HSBC, Europe's biggest bank, revealed that bad loans at its American subprime 
mortgage division were 20% higher than expected. The same week New Century, the 
second-biggest such lender in America, projected a big drop in loans this year 
because of poor market conditions.

They are not the only ones exposed to America's home-loan blues. Citigroup 
peddles mortgages to risky borrowers through CitiFinancial, its consumer-finance
arm. Subprime lenders have also been scooped up by investment banks, including 
Morgan Stanley, Merrill Lynch and Deutsche Bank, in recent months. Notably 
absent are Fannie Mae and Freddie Mac, America's government-sponsored mortgage 
giants. Both were set up for people who dreamt of homeownership, but could not 
afford it. They also have the best data on borrowers, including those rejected 
for loans in the past. Perhaps they knew something others did not.

Indeed, the woes of the subprime lender are mostly self-inflicted. After 
interest rates turned up in 2004, mortgage-makers could no longer count on 
custom from homeowners looking to switch to new mortgages at cheaper rates. 
Saddled with expensive lending platforms, mortgage-writers were desperate for a 
new source of revenues. They found two: riskier borrowers and riskier products.

They loosened their lending standards as the demand for loans started to drop in
2004. They also resorted to ³alternative² products with enticing terms and 
off-putting names, such as ³negative-amortisation² loans (which set repayments 
so low that the debt gets bigger) or ³hybrid² adjustable-rate mortgages (with 
low teaser rates that jump after a few years). About 27% of all mortgages made 
in 2006 were of such non-traditional kinds, according to Inside Mortgage 
Finance, a newsletter.

Not content with these two moneypots, the more eager lenders began to combine 
them to make a third. They offered risky products to insecure borrowers. 
According to the Federal Deposit Insurance Corporation (FDIC), hybrid mortgages 
made up three-quarters of all new subprime loans in 2004 and 2005. The FDIC 
reckons many firms underwrote hybrid loans assuming that borrowers would 
refinance them quickly, before the low introductory rates jumped. But this was a
reckless assumption when interest rates were rising and house prices softening.

An over-reliance on unseasoned risk models is also partly to blame for bad 
underwriting. Subprime and alternative mortgages belong to ³uncharted 
territory², says Sheila Bair, head of the FDIC, making ³modelling credit 
performance exceptionally difficult². The chief executive of HSBC, Michael 
Geoghegan, admitted as much in a conference call last week: ³You've got to have 
history for analytics...the fact of the matter is there [isn't history] for the 
adjustable-mortgage rate business when you've had 17 jumps in US interest 

The pressure to lend did not only come from within. Even as mortgage-writers 
lured borrowers with soft terms, they were themselves tempted by the strong 
appetite of investors for riskier assets. Wall Street banks did a roaring trade 
packaging bunches of subprime loans into mortgage-backed securities, and selling
them on to investors, greedy for yields (see chart).

The art of securitisation, as it is called, adds liquidity to the market and 
allows risks to be parcelled out to those most eager to bear them. Over the past
few years, it has also freed up cash for more lending and earned banks pots of 
money. But it may have made a wobbly subprime market even wobblier. Banks are 
traditionally supposed to know a bit about the borrowers on their books. But in 
many cases, their loans did not stay on their books long enough for them to 
care. Mortgages were written for a fee, sold to investment banks for a fee, then
packaged and floated for another fee. At each link in the chain, the fees 
mattered more than the quality of the loans, which could always be passed on. 
³This was classic market failure,² says Anthony Sanders, a mortgage expert at 
Ohio State University's Fisher College of Business. ³The private sector wanted 
fees and got them, and they did not much care what happened afterwards.²

Some banks do get caught holding the live grenade. FDIC reckons that depository 
institutions hold $3 trillion of mortgages. Much of this is higher-quality 
stuff, but not all. And even banks eager to securitise their loans sometimes 
retain the ³residual²‹the most risky slice where losses hit first. CreditSights,
a research firm, notes that Bear Stearns holds about $6.8 billion in residuals, 
although only a fraction is below investment grade. Banks that write mortgages 
are also contractually obliged to buy back securitised loans if their 
underwriting is shown to be shoddy or if the loans sour too quickly. That is 
what felled ResMAE and is hurting Accredited Home Lenders Holding, a San Diego 

Burnt palms

Diversified banks will not meet the same fate. Many big ones, notes Howard Mason
of Sanford Bernstein, a research outfit, were careful not to mix risky products 
with risky borrowers. Wells Fargo, for instance, sells most of its alternative 
mortgages to ³prime² customers. Citigroup sells to subprime borrowers but does 
not offer alternative mortgages. However, the unregulated non-bank mortgage 
lenders, like New Century, could suffer.

Should loan losses climb, investors in mortgage-backed securities will also get 
burnt, especially those holding the riskier, higher-yielding bonds. Financial 
engineers worked their mysterious magic with these securities, turning the 
junkiest mortgages into high-grade, sometimes AAA-rated, securities. They could 
do this only with the blessing of credit-ratings agencies, which made a 
profitable business out of rating these securities. But critics say the agencies
got complacent, and doubt the pooled loans were sufficiently diverse, or sliced 
up with sufficient art truly to have dispersed risk. One possible blind spot is 
that the dodgiest mortgages all behave similarly in times of stress. Another is 
that it is hard to avoid heavy exposure to mortgages from California, the 
biggest market in America, where alternative products were popular.

No one quite knows in whose hands these little bombs will ultimately explode. 
The hope is that the risks are widely and thinly spread. The fear is that they 
all sit in the lap of a few big hedge funds. But the real casualties may be 
homeowners, who often took out risky loans they could barely afford or did not 
understand. The FDIC has already tightened rules on underwriting 
negative-amortisation loans, and the Senate has begun to hold hearings on 
predatory mortgage lending. With Democrats now in charge of Congress, there is a
fair chance the politicians will act. The Eliot Spitzer of the housing downturn 
may be about to start his charge.

Copyright © 2007 The Economist Newspaper and The Economist Group. All rights 

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