Housing Threatened by Defaults in Sub-Prime Mortgage Market
By Kathleen M. Howley and Jody Shenn
Feb. 1 (Bloomberg) -- Prince Jones Jr. paid $170,000 a year ago for a six-room Cape-style home in St. Paul, Minnesota, financing it with an adjustable 30-year mortgage.
Jones, 27, got a so-called sub-prime loan because he was a first-time buyer who is a self-employed barber, has debts and makes about $500 a week. He planned to refinance before December when his monthly payment could jump to $1,646 from $1,291, hoping a good payment record on this mortgage would secure a lower rate.
Then last March, a drunk driver smashed into Jones's eight- year-old pickup truck, injuring his spine and putting him out of work for four months.
``It's stressful to have to choose between food, child support or bills,'' said Jones, the father of a seven-year-old daughter and a three-year-old son. He's cutting hair again, though plagued with back pain. ``My initial plan was to refinance at better terms, but by then lenders didn't want to talk to me.''
In the year since Ben Bernanke became chairman of the Federal Reserve, the nation's central bank has led a push by regulators, including the Comptroller of the Currency and the Office of Thrift Supervision, to raise mortgage lending standards, making it tougher for borrowers like Jones to get a loan. Reducing the number of people who can secure a mortgage also may threaten the recovery of the U.S. housing market that the National Association of Realtors is predicting for the end of 2007.
Lending Standards
``As the Fed tries to tighten credit standards, some borrowers who planned to roll over a mortgage into a better product are going to get caught in the corridor and may end up in default,'' said Joseph Stiglitz, the 2001 Nobel laureate in economics who teaches at Columbia University in New York.
Sub-prime mortgages, home loans with rates at least 2 or 3 percentage points above the safest, so-called prime loans, are given to people with poor or limited credit histories, or high debt burdens relative to their incomes. Such loans made up about a fifth of all new mortgages last year, according to the Mortgage Bankers Association in Washington.
The pool of money available to borrowers like Jones who don't have the highest, or prime, credit ratings is shrinking as investors in mortgage-backed securities shy away from riskier sub-prime loans. More restrictive lending standards makes it more difficult for people to purchase houses, said Angelo Mozilo, chairman and chief executive officer of Calabasas, California- based Countrywide Financial Corp., the U.S.'s largest mortgage lender.
`Chain Reaction'
``If you get too restrictive on that, it could have a material effect not only on people's lives, but it's a chain reaction,'' Mozilo said in a Dec. 5 interview. ``If people can't buy the used home, then the people who are in that home can't buy a new one.''
U.S. foreclosures begun on sub-prime adjustable-rate mortgages, or ARMs, rose to a four-year high of 2.19 percent in the third quarter as borrowers struggled to pay mortgage bills while interest rates increased, the Mortgage Bankers Association reported. During the five-year boom in housing prices, homeowners who fell behind on mortgage payments could sell their homes and pay off their loans or get better refinancing terms based on the higher value of their property.
The U.S. housing slump that began in 2006 probably will reach bottom in the third quarter of this year as sales of previously owned homes fall to an annualized rate of 5.9 million before rising to 6 million in the fourth quarter, according to a Jan. 17 forecast by David Berson, chief economist of Fannie Mae, the world's largest mortgage buyer.
Fed Meeting
Measured annually, sales won't recover until 2008, when they rise to 6.02 million from 5.98 million this year, Berson said. Sales reached an all-time high of 7.08 million in 2005. The Federal Reserve raised its benchmark overnight lending rate 17 times between mid-2004 and last June. That boosted the average U.S. rate for a 30-year annually adjusting mortgage to 5.49 percent last week from 3.98 percent in June 2004, according to data from Freddie Mac, the second-largest mortgage buyer.
Federal Reserve policy makers yesterday decided to hold the benchmark rate at 5.25 percent, citing ``firmer economic growth, and some tentative signs of stabilization'' in the housing market.
Fed Governor Susan Bies said in a Jan. 11 speech that regulators are concerned about sub-prime loans made with low down payments or limited proof of borrowers' incomes. It's a theme she started last year, telling bankers at a June 14 Mortgage Bankers Association conference in Half Moon Bay, California, that ``competition for borrowers and declining profit margins may have forced lenders to loosen their credit standards to maintain their loan volume.''
Reprieve for Jones
Jones's house was scheduled to be auctioned to pay off his mortgage the week before Christmas. In early December, he contacted Acorn Housing Corp., a Chicago-based non-profit consumer group, which worked out a payback plan that adds $300 a month to his mortgage payment and lets him keep his house -- at least for now. That means his usual 10 a.m. to 6 p.m. shift has gotten longer as he does additional $16 hair cuts to pay his mortgage.
``I'm working longer days now to try to pay the additional amount every month,'' Jones said. ``I don't know what I'm going to do when the rate goes sky-high, if I can't refinance.''
U.S. regulators, including the Federal Reserve, issued a joint statement in September calling on banks to raise loan standards and increase disclosure for interest-only mortgages and option ARMs, whose minimum payments often fail to cover the interest owed and increase the total size of borrowers' debt. That prompted officials in 24 U.S. states to establish similar directives and some already have been set.
`Banging on the Door'
More regulation may eliminate the ability of homeowners with adjustable-rate mortgages, like Jones, to refinance with new loans, leaving them vulnerable to higher payments. Some mortgage bond investors say that may hurt both current loans and the overall housing market, according to Dale Westhoff, a senior managing director at New York-based Bear Stearns Cos., the largest underwriter of mortgage bonds.
Lenders such as General Electric Co.'s WMC Mortgage, Accredited Home Lenders Holding Co., New Century Financial Corp., and Fremont General Corp. have raised their criteria for sub- prime loans.
Mortgage Lenders Network USA Inc. of Middletown, Connecticut has gone out of business, and Agoura Hills, California-based Ownit Mortgage Solutions has filed for protection from creditors in the past month as their pool of investors shrank and costs increased.
``The sub-prime wholesalers who used to be banging on the door have been conspicuously absent in the last few months,'' said Keith Shaughnessy, president of Littleton, Massachusetts- based Foundation Mortgage Corp.
`Monster Beneath'
Underwriting standards for sub-prime loans have been too low for at least a year, resulting in loans being issued to borrowers who have little chance of paying them back, Shaughnessy said. That will hurt the insurance companies, pension funds and asset- management firms that are holding some of the U.S.'s $6 trillion of mortgage-backed securities in their portfolios, he said.
``There's a monster beneath the surface of the financial markets,'' Shaughnessy said. ``No one knows when or where the credit crisis is going to rear its ugly head.''
Typical sub-prime loans have rates that are below the levels they will adjust to even if the Fed doesn't raise rates. The ability of the so-called teaser rate to rise quickly causes some consumer protection groups to call the loans ``exploding ARMs.''
``Some borrowers aren't aware that with an exploding ARM, their rate can double in a two-year period,'' said Sharon Reuss, a spokeswoman for the Center for Responsible Lending in Durham, North Carolina. ``There's too much smoke and mirrors.''
Higher Yields
Investors are demanding an average 1.6 percentage points more than benchmark rates to buy BBB-rated bonds backed by sub- prime mortgages, up from about 1 percentage point in August, data compiled by Barclays Capital show. Investors seek ``significantly'' higher yields to own the securities whose underlying borrowers struggled to meet their obligations within a year of taking the loan, according to the securities unit of London-based Barclays Plc, the third-biggest U.K. bank.
``A lot of people cut corners in a bid to keep monthly payments low by taking out riskier adjustable loans at a time when fixed rates were near historic lows,'' said Greg McBride, a senior financial analyst at Bankrate Inc., a research firm in North Palm Beach, Florida. ``With the increase in short-term interest, that risk has come home to roost.''
Since July, when ABX indexes based on 20 sub-prime mortgage securitizations created in the first half of 2006 debuted, the annual cost of credit-default-swap protection on BBB bonds bought with contracts tied to one of the indexes has about doubled to more than 3 percentage points, according to Barclays.
The percentage of borrowers as of September who had fallen at least two months behind on sub-prime mortgages taken out last year was the highest ever, twice the average, according to data compiled by Zurich-based UBS AG. Credit-rating companies Standard & Poor's, Moody's Investors Service and Fitch Ratings have grown more skeptical about how the riskier loans will perform.
``I'm at the barber shop from open to close,'' Jones said in a Jan. 30 telephone interview as he was leaving his house for work. ``I can't do more than that.''