Subprime Loans Defaulting Even Before Resets

This story from CNN Money.com (http://money.cnn.com/2008/02/20/real_estate/loans_failing_pre_resets/index.htm?cnn=yes) illustrates why it is foolish to “let the market” decide and police itself. Don’t take this statement to mean that I am a big government liberal. It only is pragmatic and faces the business reality that where there is an opportunity to make fast money, there will ALWAYS be some who abuse the system and work it to their own advantage with no concern for the consequences of others. The mortgage loan industry is no exception and the fact that loans were bundled and resold to foolish/greedy investors left the main players in creating the mess free from consequences since the risk had been transferred to other investors. Had mortgage companies had to hold the loans they originated in the own portfolios, I suspect that sensible underwriting standards would not have been thrown to the wind. Given the fact that what happens in the housing market significantly impacts the larger economy, I believe that we are in for a very rough ride as increased numbers of foreclosures force home values down even further. Here are some story highlights:

For months, we've fretted about the Armageddon that will hit when subprime adjustable rate mortgages start resetting to much higher interest rates. What's happening is even worse: Many of these loans are defaulting well before their rates increase. Defaults for subprime loans issued in 2007 - none of which have reset yet - hit 11.2 percent in November. That represents perhaps 300,000 households, and is twice the default rate that 2006 loans had 10 months after being issued, according to Friedman, Billings Ramsey analyst Michael Youngblood. Defaults are spiking well before resets come into play thanks to the lax lending environment of the past few years. Many borrowers were approved for mortgages that they had little chance of affording, even at the low-interest teaser rates.

In late 2006, the Center for Responsible Lending (CRL), predicted that 2.2 million subprime ARM borrowers would lose their homes in the following two years due to reset shock. But these mortgages were doomed from the start. For instance, in both 2006 and 2007, well over 40 percent of subprime borrowers were awarded mortgages with either little or no documentation of their ability to pay. With these so-called "liar loans," borrowers did not have to show proof of either earnings or assets. In 2007 subprime originations, the DTI hit 42.1 percent, up from 41.1 percent in 2006. Borrowers were simply taking on more debt that they could afford. What's more, many borrowers started out with low- or no-down payment loans, which left them with almost no equity in their home. During the boom, rapid price appreciation meant borrowers built up home equity quickly. That minimized defaults, since owners could draw from that equity to pay their bills - including their mortgages - through home equity loans. But prices fell starting in 2006,leaving borrowers with less home equity to draw upon when they run into financial problems.

But instead of cutting back on risky loans, lenders kept lending. Why? "Because investors continued to buy the loans," said Doug Duncan, chief economist of the Mortgage Bankers Association. Despite their quality, subprime mortgages were as profitable as any other for lenders like Countrywide (CFC, Fortune 500) and Wells Fargo (WFC, Fortune 500), who were able to quickly securitize the loans and sell them in the secondary market. The loans sold easily because they carried the promise of high yields. "As long as you could sell the loan, you made the deal," Duncan said.