The Subprime Meltdowns Dubious One Year Anniversary

Robert L. Labbé - January 10, 2008

The crisis in the US subprime mortgage market is fast approaching its one year anniversary. Although in retrospect it was several years in the making, on February 7, 2007 HSBC Holdings (HBC), one of the largest banking organizations in the world, and (formerly) a major player in the US subprime mortgage sector, issued a statement in London announcing "a substantial increase in the provision for loan losses with respect to mortgage services operations", and indicated its charge for bad debts would be $10.5 billion for 2006 due to "accelerated delinquency trends across the U.S. sub-prime mortgage market".

HSBC's announcement was arguably the wakeup call that brought to the fore what soon came to be recognized as a nationwide financial crisis. It rattled mortgage stocks the following day and in the weeks and months to follow hundreds of lenders went out of business. According to MortgageDaily.com more than 86,000 mortgage workers lost their jobs in the year. Almost all of the major Wall Street firms and money center banks went on to report multi-billion dollar subprime related losses throughout the remainder of the year and many more are expected to come to light when the ink dries on 2007 year-end earnings reports. Countrywide Financial (CFC), the nation's largest lender, now trades at a fraction of its year ago share price and most of the public residential lenders have suffered similar or worse fates, with a litany having either filed for bankruptcy, closed shop or severely curtailed operations. The US residential lending industry is now a shadow of what it was only twelve months ago.

The numbers are staggering: US Subprime mortgage losses are by some estimates expected to reach $300 - $400 billion before the dust settles. The growth of subprime lending since the mid 1990's has been explosive. The Federal Reserve estimates that the number of subprime loans now totals 7.75 million, representing 14% of the US mortgage market. Default loan rates have skyrocketed, nearing 20% as of October 2007 according to Friedman Billings Ramsey Investment Management. The same FBR report shows that 8% of subprime loans are currently in foreclosure. With labor market conditions worsening broadly across the US in the final months of 2007, along with an estimated 2.5 million adjustable rate mortgage (ARM) resets expected between this year and next, both defaults and foreclosures are expected to continue to creep up.

What happened? Loose underwriting standards, stated income, no asset, interest only and other exotic "hybrid" loans combined with a lack of investor due diligence eventually made it possible for almost anyone with a loan broker and an application to obtain a mortgage loan. An overabundance of eager lenders enticed by commissions and yield spread premiums slowly eroded loan quality to the point of near evaporation. As a managing director of Morgan Stanley puts it: "Little or no-money-down loans opened the door for the weak borrower and paved the way, in part, for the collapse of the integrity of the Alt-A/subprime market". "Extending those (loan) products, however, to investors and speculators for vacation and second homes began the slow change from "originating to the right borrower" to "originating to a minimum payment." The other shoe dropped when properties stopped appreciating, making refinancing no longer available as a viable bail out option. The tremendous era of US home price appreciation, which saw real prices increase in the ten year period from 1997 through 2007 by 85% according to Robert Shiller, came to an abrupt end. Home price appreciation no longer created equity which could be tapped like a live-in piggy bank with yet another refinance loan and the party was over.

What's next? Fannie Mae CEO Daniel Mudd recently said the mortgage crisis and its effect on the housing market will be a drag on the entire U.S. economy, and he urged lawmakers and lenders to pursue "the most generous means possible" to help out borrowers facing sharply higher mortgage payments in the next few years, and called the FHASecure Plan orchestrated by the Bush administration to help distressed homeowners with high-priced mortgages with a five-year freeze in mortgage rates "an important step".

Mudd went on to say "The most effective steps, historically, are solutions that buy time to restore normal housing supply and demand." Fannie Mae predicts home prices will fall by 10 - 12 % from their 2005 peak before the housing market can rebound and UBS researchers anticipate states with strong price gains during the boom could drop as much as 15% before hitting bottom. Earlier this year, Lawrence Yun, chief economist for the National Association of Realtors said in what is viewed as an optimistic assessment that the exact timing and the strength of a home sales recovery is a bit uncertain and "a meaningful recovery in existing-home sales could occur as early as this spring, or it may be further delayed toward late 2008." Others estimate a more drawn out timeline for recovery, especially if the economy goes into a recession in 2008.

What is certain is that for the US home market to recover, the mortgage market will need to recover hand in hand as home purchases are financed transactions. The FHASecure Plan, a voluntary measure, is as Mudd indicates "an important step" albeit limited in scope as it is expected to help only 240,000 households avoid foreclosure. Nonprofit organizations such as the National Foundation for Credit Counseling can be of tremendous value in educating at risk homeowners of their work out options as can more responsive loan servicers. Increased regulation aimed at curtailing predatory lending is certainly called for as are national licensing standards for the mortgage industry. Conversely, hasty overregulation could despite the best of intentions exacerbate the credit crisis by further tightening available credit and harming the very people it's designed to help. Ultimately however, real estate values will continue to be readjusted by the marketplace and greater home affordability will in the end play the largest role in restoring order.

Robert L. Labbé is President of MorCap Fund Advisors, LLC. He can be reached at rlabbe@morcapadvisors.com

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