Subprime loans defaulting even before resets

It turns out that massive interest rate spikes aren't the problem -- many borrowers couldn't afford these mortgages even at the low, introductory interest rates.

By Les Christie, CNNMoney.com staff writer
February 20 2008: 5:59 AM EST

NEW YORK (CNNMoney.com) -- 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 .

"I was rather shocked by the characteristics of the 2007 loans," said Youngblood.

Hybrid ARMs start with very affordable fixed-rate terms of two or three years. After that, rates can jump three percentage points or more, and then re-adjust even higher every six months to a year. On a $200,000 mortgage, a reset could add nearly $400 to the monthly mortgage payment.

Originally, concerns about these loans focused on the fact that that most homeowners wouldn't survive such pricey resets. 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.

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.

And even when borrowers did go on the record about their earning power, it didn't bode well. Both 2006 and 2007 ushered in a large proportion of loans with high debt-to-income ratios (DTI), which indicates the percentage of gross income required to pay debt. 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, lines of credit or cash-out refinancings.

But prices fell starting in 2006,leaving borrowers with less home equity to draw upon when they run into financial problems.

Median home prices fell 5.8 percent nationally, and by double digits in many areas. That, along with the deterioration in underwriting, changed the default math.

Owners with mortgages worth more than their homes simply began walking away from their homes when costs become unmanageable.

Lenders were slow to react
By late 2006, lenders knew that the housing market was heading south. Foreclosure filings took off during the third quarter that year, up 43 percent from 12 months earlier, according to RealtyTrac, the online marketer of foreclosure properties.

And the National Association of Realtors started to report median home-price drops in some markets.

But instead of tightening standards and 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. Thus, lenders transferred the risk to the investors.

"As long as you could sell the loan, you made the deal," Duncan said.

Lenders needed the fees that these loans generated because their finances were weakening. Their cost of borrowing money was rising, while competitive pressures were keeping mortgage interest rates low.

"Lending had been highly profitable through the second quarter of 2005," said Youngblood, "but by 2006 many lenders were running into red ink."

So, they revved up lending to increase short-term profits. And, to outside analysts, there appeared to be nothing wrong with loan quality.

"There were very few overt changes in industry underwriting guidelines," said Youngblood. What did change, he said, was that lenders were making more exceptions to their standard practices.

If borrowers had reasonable credit scores but short work histories, they might be approved for loans that would have been turned down in the past. An inability to prove income from, say, a part-time business, might be tolerated.

"These exceptions generally amounted to no more than 5 percent [of subprime loans] before 2006," said Youngblood, "but they represented the majority of these loans issued in 2006 and 2007."

The reason for that shift: Lenders depended on independent mortgage brokers for much of their business, and the brokers were pushing them to approve subprime loans because they delivered big profits for the brokers.

"Lenders felt they had to take the loans to preserve their access [to the rest of the loan pool]," he said. They were willing to accept some risky subprime loans so that the mortgage brokers would also send them safer prime and Alt-A loans.

Of course that's a bet that went bad. And it's likely to get worse as resets for ARMs issued in 2006 and 2007 kick in this year.