Saturday, November 24, 2007

Rising Rates to Worsen Subprime Mess

The Wall Street Journal, Ruth Simon, 24 November 2007

The subprime mortgage crisis is poised to get much worse.

Next year, interest rates are set to rise -- or "reset" -- on $362 billion worth of adjustable-rate subprime mortgages, according to data calculated by Bank of America Corp.

While many accounts portray resetting rates as the big factor behind the surge in home-loan defaults and foreclosures this year, that isn't quite the case. Many of the subprime mortgages that have driven up the default rate went bad in their first year or so, well before their interest rate had a chance to go higher. Some of these mortgages went to speculators who planned to flip their houses, others to borrowers who had stretched too far to make their payments, and still others had some element of fraud.

Now the real crest of the reset wave is coming, and that promises more pain for borrowers, lenders and Wall Street. Already, many subprime lenders, who focused on people with poor credit, have gone bust. Big banks and investors who made subprime loans or bought securities backed by them are reporting billions of dollars in losses.

The reset peak will likely add to political pressure to help borrowers who can't afford to pay the higher interest rates. The housing slowdown is emerging as an issue in both the presidential and congressional races for 2008, and the Bush administration is pushing lenders to loosen terms and keep people from losing their homes.

Banc of America Securities, a unit of the big Charlotte, N.C., bank, estimates that $85 billion in subprime mortgages are resetting during the current quarter, and the same amount will reset in the first quarter of 2008. That will rise to a peak of $101 billion in the second quarter. The estimates include loans packaged into securities and held in bank portfolios.

Larry Litton Jr., chief executive of Litton Loan Servicing, says resetting of adjustable-rate mortgages, or ARMs, has recently emerged as a bigger driver of defaults. "The initial wave was largely driven by a higher frequency of fraudulent loans...and loose underwriting," says Mr. Litton, whose company services 340,000 loans nationwide. "A much larger percentage of the defaults we're seeing right now are the result of ARM resets."

More than half of the subprime delinquencies and foreclosures this year involved loans that hadn't yet reset, and thus were due to factors such as weak underwriting and falling home prices, according to Rod Dubitsky, an analyst with Credit Suisse.

The majority of subprime ARMs due to reset next year are so-called 2-28 loans, which carry a fixed rate for two years, then adjust annually thereafter. In a speech earlier this month, Federal Reserve Governor Randall Kroszner explained how a typical 2-28 subprime loan issued in early 2007 might work. He said the interest rate on the loan would start at 7%, then jump to 9.5% after two years. For a typical borrower, that would add $350 to the monthly payment.

Besides the $362 billion of subprime ARMs that are scheduled to reset during 2008, $152 billion of other loans with adjustable rates are set to reset, according to Banc of America Securities. The other resetting loans include "jumbo" mortgages of more than $417,000 and Alt-A loans, a category between prime and subprime. The latter category is the riskier, in part because it includes borrowers who provided little or no documentation of their income or assets.

The number of borrowers facing higher payments isn't growing merely because the amount of loans with resets is higher. Another factor is that those with a looming reset now have a tougher time sidestepping it by refinancing or selling their home. "There is a large amount of borrowers who are in products that either no longer exist or that they no longer qualify for," says Banc of America Securities analyst Robert Lacoursiere.

Falling home prices mean that many borrowers have little or no equity in their home, making it tougher for them to get out from under their loans.

Treasury Secretary Henry Paulson and the chairman of the Federal Deposit Insurance Corp., Sheila Bair, have been pressing lenders to modify terms in a sweeping way, rather than going through a time-consuming case-by-case evaluation that could end up pushing many people into foreclosure. Officials at the Federal Reserve and in the Bush administration have estimated that 150,000 mortgages are resetting a month.

Ms. Bair has proposed that mortgage companies freeze the interest rates on some two million mortgages at the rate before the reset to help borrowers avoid trouble. "Keep it at the starter rate," Ms. Bair said at conference last month. "Convert it into a fixed rate. Make it permanent. And get on with it."

Picking up on that theme, California Governor Arnold Schwarzenegger in the past week announced an agreement with four major loan servicers, including Countrywide Financial Corp., the nation's biggest mortgage lender, to freeze the interest rates on certain ARMs that are resetting. The freeze would be temporary, rather than for the life of the loan. The program is aimed at borrowers who are living in their homes and making their mortgage payments on time, but aren't expected to be able to make the higher payments after reset.

The mortgage industry opposes a blanket move to modify loans that are resetting, says Doug Duncan, chief economist of the Mortgage Bankers Association. While modification may make sense in some cases, he says, it may also simply postpone the inevitable or reward borrowers who didn't manage their finances wisely. Mr. Duncan says the industry is working with government officials and consumer groups to develop principles that could be used to determine quickly who qualifies for a modified loan.

The political efforts are aimed at keeping the U.S. economy out of a housing-triggered recession. The Mortgage Bankers Association estimates that 1.35 million homes will enter the foreclosure process this year and another 1.44 million in 2008, up from 705,000 in 2005.

The projected supply of foreclosed homes is equal to about 45% of existing home sales and could add four months to the supply of existing homes, says Dale Westhoff, a senior managing director at Bear Stearns. This is a "fundamental shift" in the housing supply, says Mr. Westhoff, who believes that home prices will drop further as lenders "mark to market" repossessed homes.

Foreclosed homes typically sell at a discount of 20% to 25% compared to the sale of an owner-occupied home, analysts say. Lenders are eager to unload the properties, and the homes tend to be in poorer condition.

"People didn't leave the house happily," says Jason Bosch, a broker with Home Center Realty in Norco, Calif. "There are often signs of that. There's used, dirty carpet. The grass is dead." Mr. Bosch says he now has about 120 bank-owned properties for sale or in escrow compared with none a year ago.

Federal Reserve Chairman Ben Bernanke told Congress earlier this month, "A sharp increase in foreclosed properties for sale could...weaken the already struggling housing market and thus, potentially, the broader economy."

The big concern is a vicious cycle in which foreclosures push down home prices, making it more difficult for borrowers to refinance and causing more defaults and foreclosures.

Real-estate agents, who look at prices for comparable homes, or comps, say the sale of bank-owned properties can have a big impact. "One month the comps are showing one price and then a bank comes in and sells a property for $30,000 less," says Randal Gibson, a real-estate agent in Henderson, Nev. "All of the sudden, that's the new comp. It hurts everyone in the neighborhood."
The Wall Street Journal, Kemba J. Dunham & Ruth Simon, 24 November 2007

For people hoping to refinance a home, it should be good news: Yields on U.S. Treasury securities are falling -- which translates into lower mortgage interest rates.

However, the upside of refinancing might not be as great as some expect, due to continuing turmoil in the housing market. Some borrowers could find the savings aren't as great as they expected -- or that they are being shut out of refinancing entirely, as lenders tighten their standards.

For weeks, yields on the 10-year Treasury notes have been moving lower. They fell to 4.02% on Wednesday and slipped to 4.01% on Friday, a new low since September 2005 -- and meaning they are low enough that mortgage rates are also starting to come down.

Despite the industry's problems, some lenders are trumpeting the news of lower rates to entice borrowers to consider refinancing.

Lenders, reeling from rising defaults and foreclosures of home loans, are being stricter about lending. They are also asking for higher "risk premiums," (the amount above Treasury rates that borrowers have to pay to compensate for the risk that the loan won't be completely repaid) even from the best borrowers.

"There's no question that risk premiums have widened," says Doug Duncan, chief economist of the Mortgage Bankers Association. As mortgage losses have climbed and the credit markets have dried up, so has this premium.

For example, interest rates on conforming 30-year fixed-rate mortgages dropped slightly in the past week to an average of 6.26%, according to HSH Associates, a publisher of consumer-loan information based in Pompton Plains, N.J. That is down from a recent high of 6.76% in mid-July, or 0.5 percentage point.

But Treasury rates have fallen further. The "spread," or gap, between 10-year Treasurys and 30-year fixed-rate mortgages has widened substantially, to 2.22 percentage points now from just 1.52 percentage points in June, according to HSH.

This explains why refinancing isn't delivering the savings that some homeowners had hoped for.

"I would have expected...rates to be better than they are," says Steven Walsh, a mortgage broker in Scottsdale, Ariz. Mr. Walsh says that some of his borrowers have called him looking to refinance and take advantage of lower rates, but are going away empty-handed.

In other cases, borrowers who want to refinance are being stymied by tighter lending standards, particularly in markets where home prices are declining and lenders are becoming particularly cautious about appraisals.

For the week ended Nov.16, the refinance share of mortgage activity increased to 50.3% of total applications from 50.2% the previous week, according to the Mortgage Bankers Association.

Borrowers with good credit and, if refinancing, a chunk of equity in their homes are best positioned to benefit. "To be a successful refinancer in this marketplace, you have to be much more of a traditional kind of borrower," says Keith Gumbinger, a mortgage analyst with HSH Associates. "You need to have some equity in your home. You need to be documenting your income or assets. You need to have reasonable or good credit."

Martin Quijada, an architect from Gilbert, Ariz., who has perfect credit, has been looking to refinance his mortgage loan recently. But two banks with good rates wouldn't sign off on the appraisal, says Mr. Walsh, his broker. Another bank agreed that the appraisal was fine but had "terrible rates," Mr. Walsh said.

"I was expecting a much simpler process," says Mr. Quijada, who plans to hold out for now, in hopes of getting a better rate later.

But Mr. Walsh warns that, even if rates drop further, Mr. Quijada will still have to deal with the appraisal issue.

Many borrowers with good credit have been running into such roadblocks recently. According to the Federal Reserve's Senior Loan Officer survey from October, 40% of the U.S. respondents reported that they have tightened their lending standards on prime mortgages, compared with only 15% that reported having done so in the July survey.

Borrowers with good credit can benefit from the lower interest rates, says Mr. Duncan of the Mortgage Bankers Association, "but if you're in a market where property values are falling, it may not make much of a difference." It is a particular problem if the loan balance is greater than the home's current value.

The news is mixed for borrowers seeking "jumbo" mortgages. These are the loans that exceed the $417,000 limit for those eligible for purchase and guarantee by mortgage institutions Fannie Mae and Freddie Mac.

On the one hand, rates on 30-year fixed-rate jumbo mortgages have dipped below 6.97%, according to HSH Associates, after reaching as much as 7.46% in August. But that is still well above the 6.60% average for these loans in early June, when the credit market was less jittery and the gap between conforming and jumbo loans was narrower.

For individuals looking to borrow or refinance, shopping around is particularly important in the current environment. For instance, Mr. Gumbinger says, banks or credit unions that hold onto the mortgages they issue -- as opposed to selling them on to other investors in the form of mortgage securities -- may now offer better rates because they aren't dependent on securitization and thus may have more capital available for lending.

"You can't make the assumption that the loan price at lender A is the most competitive price in the marketplace," he says. "There's a wide variety of prices."

Melissa Cohn, a New York mortgage broker, tells her clients who wish to refinance in the next three to six months to move quickly. "Lender guidelines will continue to get more stringent in the next few months before they ease up again," she says.