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The mortgage mess

March 23, 2007 | Page 5

IN JULY 2005, the Economist labeled it the "largest financial bubble in history"--a huge increase in housing values, especially since the start of the decade. In markets across the U.S., the value of housing units doubled or even tripled, and construction of new homes and sales of existing homes hit records year after year.

Last summer, the bubble burst, and the real estate boom came to a screeching halt. Housing prices have declined precipitously since--last month, the average price of a new home was down 9.7 percent from the same time last year, the biggest plunge in 36 years.

But falling real-estate values are turning out to be just the beginning of the story. In recent weeks, the so-called sub-prime mortgage market has crashed--a crisis that could mark the beginning of a far more dangerous stage of this financial cycle.

PETRINO DiLEO explains how the crisis of so-called "sub-prime mortgages" came about--and whether this is the opening stage of a looming recession.

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WHAT ARE sub-prime mortgages?

SUB-PRIME mortgages are given to borrowers who typically have low credit and/or low income. Interest rates on these loans are usually two to five percentage points higher than on prime loans. The idea is that these mortgages are a way for borrowers who might not otherwise qualify for loans to buy homes.

But this sector has morphed into a classic predatory lending environment. Stories are emerging of mortgage brokers fudging applicants' incomes on forms or ignoring it entirely--and rushing through approvals on loans that have little prospect of getting paid back.

For borrowers, these sub-prime loans seem affordable at first, but then quickly become more than a household can bear.

Sub-prime mortgages have grown into an increasingly large part of the overall mortgage business--accounting for about 20 percent of loans originated last year, worth a total of $605 billion.

WHAT'S CAUSING the current crisis?

LENDERS HAVE been pushing sub-prime mortgages with full knowledge that borrowers wouldn't have the financial means to pay them off. But the danger was papered over by how the loans are structured.

Most commonly, payments in the first two or three years of a sub-prime mortgage are quite low. They cover just interest on the mortgage, not any of the actual loan amount, or principal--and sometimes not even the full interest, leading to situations where the principal actually rises in the first years of the loan.

Thus, under this structure, an initial payment on a $200,000 adjustable rate mortgage might start as low as $643 a month--less than the average rent in many markets--but then rise to $1,578 by its sixth year. Meanwhile, the overall loan amount, or principal, rises from $200,000 to $214,857.

Basically, you end up worse off several years into the mortgage then when you started.

While these practices have been going on for some time, they were masked when housing values were increasing. In that environment, borrowers could more easily sell their homes--usually, for more than they paid--before the higher payments kicked in.

Now that the housing market has dried up, families no longer have that option, as there is no way to sell the house for as much as they paid.

The result is clear--delinquencies and defaults on mortgages are skyrocketing. In the sub-prime sector, delinquencies are up to 13.5 percent of total loans--from 12.8 percent the previous quarter--according to the Mortgage Bankers Association.

And that's just the tip of the iceberg. According to a new Center for Responsible Lending study, 2.2 million American households are at risk of losing their homes this year due to foreclosures--worth an estimated $164 billion--in the sub-prime mortgage market.

This crisis is part of the broader attack on the U.S. working class. The big increases in housing prices helped make up, at least partly, for the stagnant incomes and dismal job growth numbers of recent years. Though the housing boom was centered in the middle class, at least some working families were able to take advantage of easier access to mortgages--to buy homes, watch the value rise, and then re-sell quickly.

More commonly, workers were able to pull equity out of existing homes--by refinancing at low interest rates, and taking the difference in cash to supplement household income. This is a big reason why the savings rate in the U.S. dropped into negative territory for the first time since the 1930s.

But if rising housing values helped compensate for stagnating or falling wages, that period is now over.

WILL THE problem spread to the broader mortgage market?

THE ANSWER isn't yet clear. Delinquencies on "prime" mortgages, while rising, are still quite a bit below where they are for the sub-prime market.

On the other hand, the same kinds of payment structures that exist for sub-prime mortgages are also used in many prime mortgages. In 2005, when the housing boom was still going full bore, one-third of all mortgages originated included low-cost introductory periods.

Those loan payments will be resetting throughout this year and 2008--and with housing values falling, growing numbers of borrowers will be left owing more on their mortgages than their homes are worth.

In these cases, families will make the decision that it's not worth paying the mortgage--and voluntarily go into default.

Overall, according to the Web site's estimate, $2 trillion in adjustable-rate mortgages (ARMs) began resetting at higher rates late last year, leading to a rise in payments on these mortgages of $50 billion a year by 2009. One analyst estimated that 19 percent of the 7.7 million ARMs taken out in 2004 and 2005 are at risk of default today.

HOW CAN mortgages cause a problem in the broader economy?

THE EFFECTS of all this aren't limited to the handful of sub-prime players--the best known being New Century Financial, which stands on the edge of bankruptcy.

What has become clearer in the past couple weeks is that New Century Financial--and other troubled firms like Fremont Realty Capital, NovaStar Financial and Accredited Home Lenders--are backed heavily by some of the biggest names on Wall Street, which means the sub-prime crisis can be passed on to all of Wall Street.

New Century grew by getting huge lines of credit from Wall Street banks to originate its loans. All told, the company had $8.5 billion in credit lines with just four investment banks. It owes $2.6 billion to Morgan Stanley (which helped underwrite $9.8 billion in credit for the company since 1998), $900 million to Credit Suisse Group, $800 million to IXIS Real Estate Capital Inc., $717 million to Citigroup and $600 million to Bank of America Corp.

These lines of credit are being called in, but New Century doesn't have enough cash to pay them down--sending the company to the verge of bankruptcy.

But the effects are even more widespread. First, many of these same banks--notably HSBC, Lehman Brothers and Bear Stearns--are also sub-prime lenders themselves. Plus, Goldman Sachs, JP Morgan and Citigroup are now talking about buying sub-prime lenders because their stock prices have fallen so much.

These same banks also buy sub-prime mortgages and put them into large pools called "mortgage-backed securities." Bonds are created based on these massive pools of mortgages--which tend to be $1 billion or larger--and then sold off to investment banks, pension funds, hedge funds and other institutional investors, which choose which risk level they want to buy. The highest-rated and least riskiest bonds pay off at lower rates, while the riskier bonds--such as ones tied to sub-prime loans--pay off at higher rates.

It's helpful to understand that one person's mortgage is someone else's investment.

In the past, the relationship was simple. If a bank thought it could get a 6 percent or better return on its money based on the fact that you would be a good bet to pay back your mortgage in full, the bank would give you a mortgage and hold it on its balance sheet. That model predominated for decades, and the overall mortgage market remained small.

In 1980, the total amount of outstanding mortgage debt in the U.S. was $1.4 trillion. By 1990, the amount had more than doubled to $3.8 trillion. But things really began taking off in 1999 and 2000, when outstanding mortgages rose from $6.3 trillion to $13 trillion as of the end of 2006.

The "securitization" industry took off at the same time, beginning in the mid-1980s. At that point, large investment banks got the idea that, rather than holding mortgages on their own books, they could put them into mortgage-backed securities pools and sell the bonds.

The pools offer higher returns than Treasury bonds or corporate debt, so they became very attractive very quickly, especially as long as delinquencies and defaults remained very low.

For mortgage originators, this model meant they could vastly increase their lending volume. Rather than keeping mortgages on their books for 30 years, they kept them for six months or less, then sold them to investment banks.

The investment banks warehoused the loans and built them up into pools big enough to offer as securities. They reaped huge fees for putting these deals together. Last year alone, banks and brokerages pocketed $2.6 billion for underwriting mortgage-backed securities. Meanwhile, investors in the bonds got a nice return--again, so long as defaults remained low.

The rapacious demand for these mortgage pools--especially the higher-yielding bonds tied to sub-prime loans--meant that originators have been under enormous pressure to generate new loans that could be bundled into these pools. That led to a lot of mortgages being extended that really should not have been.

As a whole, about $6.5 trillion in mortgage debt (about half of total mortgage debt) is now held in these kinds of securitizations, according to government data--an increase from $372 billion in 1985.

So in 20 years, you have the creation of an entirely new financial instrument--one that is capable of transmitting the crisis of one sector of mortgage loans throughout the financial world.

SO WILL the problems spread more widely?

THAT'S THE general fear, and one of the main reasons why there has been such skittishness in the stock market. It has become apparent that investment banks have very high exposure to mortgage debt in a variety of ways--through lending to originators, buying back loans, and arranging securitizations--so if the problems spread to other kinds of mortgages, Wall Street could take a big hit.

Many people with 401K or pension funds may not even realize that they are exposed. For example, the New York State Teachers Retirement System has a $91.5 billion investment in the sub-prime mortgage lender New Century Financial. And many, many funds are invested in the mortgage-backed securities market.

Another possible effect as bad debt mounts on the investment banks' balance sheets is a broader credit crunch--when the banks raise interest rates and become stricter about lending requirements.

There could be what economists call a "flight to quality"--meaning bond investors will move money from other securities into "safer" U.S. Treasuries. That could make debt more expensive for a lot of companies--a major blow to the economy given how large a role that debt plays in everything corporations do today.

What is happening today doesn't guarantee that the U.S. economy will head into recession in the immediate future. But it certainly makes that possibility more likely.

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