The Sub Prime and Alt-A Part One column described a thought experiment...how two individuals entered into a home purchase with a mortgage note, then worked out a mutually satisfactory arrangement when circumstances changed. That's a very similar situation to what is facing millions of borrowers and a few lenders and investors today: the Sub Prime and Alt-A mess.
Just how big a problem does the sub prime represent, and what could and should the parties have done to prepare themselves for the situation they find themselves in today?
The last ten years has seen a remarkable transition in mortgage lending in our country. It was part of a the flattening of the world that Tom Friedman described in his remarkable book, The World Is Flat.
The computers, the Internet, technology in general shrunk the world and allowed globalization on vast scales...financial markets exploded, as capital was free to move from one country to another with profound ease. That capital, much of it foreign, began chasing safe and high returns. Mortgages, in the form of mortgage backed securities, became very popular. Demand for high returns grew and mortgage backed securities seemed the perfect choice.
James P. Gaines describes the ascent of the Sub Prime market in the July issue of Terre Grande, titled "the Value of Subprimes" . Dr. Gaines makes the case that the growth of the sub prime market has done good things for our economy and for homeownership in our country. To quote a few of his points:
The widespread availability of nontraditional, higher-risk mortgage products spurred previously excluded home buyers to enter the market despite poor credit histories, irregular employment or lack of a down payment.
High-risk mortgage instruments are estimated to make up 25 percent or more of all mortgage loans originated since 2001. An estimated 10 million to 12 million sub prime loans have been originated since 2003, and at least two-thirds of those carry adjustable rates. Sub prime mortgages are designed for lower-income households with low credit scores and feature higher loan-to-value ratio loans with significant prepayment penalties.
Millions of people bought homes who might not otherwise have done so. Some were victimized by illegal practices; many were unprepared and ill-equipped for the financial responsibilities of homeownership. Some believed these alternative loans were their only chance to own a home and wanted to take the risk.
Essentially, sub prime loans replaced government loans for many low-income, first-time buyers. Since 1998, FHA and VA loans have declined from 30 percent to less than 10 percent of the residential market; sub prime loans have increased from less than 2 percent to more than 14 percent of the total market (Figure 2). Major home builders relied on the expanded affordability created in the market. The National Association of Home Builders (NAHB) estimates that two-thirds of the top 200 home builders had mortgage finance subsidiaries making sub prime loans, and the rest had relationships with lenders in the sub prime market.
Home ownership is a critical part of the American Dream. The last thirteen years have allowed home ownership to a much larger proportion of the population, and that's a good thing.
While home ownership and the sub prime markets have grown together, we should remember that sub prime, while growing, is still a small part of the total outstanding mortgages in our country, as the graph below depicts.
Remember too that sub prime and adjustable rate mortgages are not new. We have plenty of experience with those niches. We knew that that sub prime and adjustable rate loans carried more risk for a variety of reasons. These loans were made with full knowledge of those risks, and that's why they carried higher rates, higher fees. Now, as Dr. Gaines reports,
According to the Mortgage Bankers Association (MBA), by the end of 2006 the sub prime mortgage foreclosure rate was nine times greater than prime loan foreclosures - 4.5 percent versus 0.5 percent. About 14.3 percent of sub prime loans were between 30 and 90 days delinquent compared with 2.8 percent of all prime loans. An estimated 1.2 percent of all mortgages in the United States were in foreclosure by the end of 2006; 5.3 percent were between 30 and 90 days delinquent.
Since 1998, U.S. foreclosures on sub prime loans averaged 5.7 percent compared with 0.5 percent for prime loans (Figure 3). Sub prime delinquencies and defaults averaged 12.1 percent compared to 2.4 percent for prime loans.
While all of this is serious stuff, it's not new, and it's not anywhere near the the peak reported just five years ago. My point is that because of this history it is was well known what problems were likely to occur in the sub prime portfolio.
When regulated lenders make riskier loans, they are required to increase their loan loss reserves to allow for the potential future problem of those loans. Booking higher loss reserves tends to lower current income and reduces the quarterly income reports so important to public companies stock prices. But it also provides the necessary cushion to absorb those losses which might occur in the future, such as the sub prime book of business is now experiencing.
Again from Dr. Gaines:
The current national sub prime foreclosure rate of 4.5 percent is less than half the peak rate reported in fourth quarter 2001 and 21 percent less than the eight-year average. The current 4.3 percent foreclosure rate is nearly 40 percent less than the peak foreclosure rate reported in fourth quarter 2002. The real difference in the peak and current foreclosure rates, though, is the substantially greater number of sub prime loans today versus 2001 and 2002.
Assuming a total of 12 million sub prime loans, the eight-year average level of delinquencies and foreclosures suggests that about 1.45 million loans will go into delinquency and about 684,000 into foreclosure. If the sub prime foreclosure rate climbs to 10 percent or 15 percent, 1.2 million to 1.8 million loans will be vulnerable to foreclosure.
The growth in sub prime did not come by accident. Yes, it was helped by improving computerization of financial markets, globalization, the Internet, new financial instruments. But it was also encouraged by other sources. Dr. Gains again:
For at least 30 years, housing advocacy groups, organizations and government agencies at all levels called on the private sector to be more active and aggressive in fostering homeownership by, among other things, making mortgage credit available to lower-income, higher-risk buyers.
A plethora of state, local and federal housing programs and initiatives were created to increase homeownership through subsidized payments, below-market interest rates, tax credits, down payment assistance and a host of other schemes. Most of these efforts never reached the numbers of potential homeowners that the sub prime market reached.
The private sector found a way to make loans to low-credit, previously unfinanceable households so that they could own homes. While this effort was spurred by profit, not altruism, the effect on homeownership throughout the country was nevertheless profound.
Indeed the private sector did find a way to make those loans, and indeed the effect was profound.
The borrowers paid dearly for those loans in the form of high upfront fees (often rolled into the loan amount) and a loan agreement that often allowed interest only payments in the initial period and then much higher rates when the ARM arrangements kicked in.
The mortgage originators packaged those loans into Mortgage Backed Securities which were then evaluated by the investment banking houses like Bear Stearns who priced those packages for sale in the secondary market, often for foreign buyers. The evaluation, the explanation of that evaluation, the assessment of the risk of these packages should have been well known by the purchasers. The price paid for each MBS package should have included a discount for the risk they were assuming.
In each step along the way toward the expansion of the sub prime portfolio, there were plenty of opportunities to evaluate and understand the risk that was being taken on, and opportunities for providing for that risk as prudent business managers were available.
In my simple mind that raises four questions.
First, did the regulated entities who elected to grow their sub prime portfolio book loan loss reserves sufficient to cover their expected, historical losses, or did they elect to provide less, consciously pumping up their quarterly earnings reports?
Second, did the non regulated entities who took advantage of the growth in the sub prime market properly account for the risk of that portfolio with similar loss reserve increases?
Third, did the investment bankers who packaged those loan into MBS properly evaluate those packages, and price them in the secondary market at a level to reflect the nature of the risk they were peddling?
Fourth, did the purchasers of those MBS packages, just as smart and savvy as the investment bankers allow for that same risk when buying the product?
The reality is, whether the answer to each of those questions is yes or no, the decisions that were made will have to be lived with, and like you and I in the thought experiment in Part One of this series, the players should be left to deal with the results of those decisions.
In our thought experiment, you and I settled the problem in a way that minimized the loss and effects on all parties. Is it too much to ask that the participants in the current sub prime handle their mutual problems in a similar way?
Next, we'll talk about what those parties could and should do, and what the governments and regulators should and should not do to resolve this problem.
The author is the owner of Acorn Appraisal Associates, a 22 year old firm offering a wide range of quality appraisal services to the Financial and Business Communities in the greater Houston SMSA
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