Original source URL: http://www.economist.com/finance/displaystory.cfm?story_id=8706627 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 rates.² 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 lender. 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 reserved. -- -------------------------------------------------------- Escaping the Matrix website http://escapingthematrix.org/ cyberjournal website http://cyberjournal.org Community Democracy Framework: http://cyberjournal.org/DemocracyFramework.html subscribe cyberjournal list mailto:•••@••.••• Posting archives http://cyberjournal.org/show_archives/
