Friday, November 30, 2007

Brother Can You Spare a Mortgage Payment?

Yesterday, Martin Gruenberg, vice chair of the Federal Deposit Insurance Corporation taught one heck of a class at the Consumer Federation of America's consumer financial services confererence. BNA reports that Gruenberg explained it all: why the subprime mortgage collapse happened, and how it got so bad so fast. The image he painted is haunting and stark. What we see now, Gruenberg explained, is exactly what we saw in the home mortgage market before the Great Depression.

Before the Big Crash, most mortgages were unstable, short term and required the borrower to pay off the principal balance at the end of the term (a balloon payment). In the wake of economic collapse, the market changed to embrace Federal Housing Administration (FHA) policy and the longer, flatter thirty year fixed rate home mortgage. The 30 year fixed dominated the market from the 1930's through the 1980's. Enter recession and sharply rising interest rates. The home mortgage market responded with the re-appearance of the adjustable rate mortgage (ARM) which accounted for 15-25% of the home mortgage market between 1980 and 2000.

Then something happened. Between 2001 and 2006, the percentage of all home mortgages that were 30 year fixed dropped from 84% to 55%. Adjustible rate mortgage products' share of the market grew from one quarter to almost one half of new mortgages. During the same period, subprime mortgages as a percentage of the home loan market grew from 5 to 20 percent. (For last year, Standard & Poors reports subprime originations were $421 billion; the Mortgage Bankers' Association reports all originations were were $2.5 trillion.) Almost all of these subprime loans had adjustable interest rates, and most featured an interest term known as "2/28," where the rate resets sharply upward by 5 or 6 points after two years and on short intervals thereafter. Gruenberg reported that the subprime loans were underwritten at the original teaser rate based on the borrower's statement of his or her current income with no documentation required as to credit history and with no expectation that the borrower could continue to make the payments at the reset rate given his or her stated income. In plain language, subprime lenders sold their mortgage products without regard to the borrower's long term ability to repay. Greunberg and others noted that subprime lenders aimed their product at minority borrowers, and the marketing worked. Between 2001 and 2006, 55% of all black home mortgage borrowers signed on for subprime mortgages, as did 47% of all Hispanics. Only 18% of all non-Hispanic white customers opted for them.

But wait, there's even more. During the same 5 year period, the home mortgage originators began "securitizing" their loans. In 2000, most home mortgage originators sold loans to government sponsored entities (Fannie Mae and Freddie Mac). Only about 18 percent of all home loans were sold to private investors as of 1999. By 2006, 70% of all mortgages were sold to private investors who in turn sold securities backed by the payment streams to yet another set of private investors, all explained for you in an earlier RLR post, Tranche Warfare.

Subprime mortgages originated in the boom years of 2005 and 2006 will reset in the fourth quarter of 2007 and the first quarter of 2008. 2 million adjustable rate subprimes will reset during 2008.

Those who do not study history are doomed to repeat it.

[The photo of Florence Owens Thompson and her children is by Farm Security Administration photographer Dorothea Lange and was taken in Nipomo, California, in March of 1936. ]

1 comment:

Alison M. Kilmartin said...

What I don't understand is why we didn't see this coming in time to prevent it from happening. OR, for those who saw it coming, why the rest of us didn't listen to them. I consider myself a casual observer of the economy and even I had a sense that the sub-prime/ARM market was a house of cards just waiting to fall. I'm sure I wasn't the only one, so how and why did we let it get this bad? Did everyone just think it was someone else's responsibility to throw a flag on this play? Did we all walk over the cliff together just because everyone else was too? Isn't that one of those Everything-I-Need-To-Know-About-Life-I-Learned-In-Kindergarten lessons? "Now Johnny, would you walk over a cliff just because everyone else did?"