House of Cards
The unsound loans that fueled the housing boom are starting to collapse.
Mar 12, 2007, Vol. 12, No. 25 • By ANDREW LAPERRIERE
Last week the stock market experienced one of its largest drops since the 9/11 terrorist attacks. While there were a number of causes, one major factor is investor concern that problems in the subprime mortgage market--which caters to consumers with poor credit ratings--are going to spread. This could lead to higher-than-expected foreclosures, job losses in construction and real estate, lower consumer spending, and possibly a recession.
Despite low interest rates and an economy operating at essentially full employment, during the past few months subprime mortgage delinquencies have spiked to record territory. About two dozen subprime lenders have closed their doors, and the stocks of several major subprime lenders have plunged. Home prices are roughly flat nationwide in the last year, but, as the chart shows, the rate of appreciation is in free fall. After soaring the past few years, real estate prices in southern Florida, once the epicenter of the housing boom, have dropped in the past year by 6 percent in Miami and 18 percent in Sarasota-Bradenton, according to the National Association of Realtors. What's going on?
It is becoming increasingly clear that the housing boom was built on a weak foundation: easy money. The boom started in earnest when the Federal Reserve slashed interest rates in response to the 2001 recession. The lower rates cut monthly payments, boosting demand for housing and pushing up home prices. As home prices kept rising, loan terms became easier but fewer loans went bad, because homeowners in financial distress could usually refinance or sell their homes at a profit.
But the Fed's loose monetary policy also created a credit bubble that led to today's problems. Confidence in ever-rising home prices and cheap money fueled speculation, which in turn boosted demand and pushed home prices higher still. Another major factor: the insatiable demand by investors for mortgage-backed securities, which provided the funds for a five-fold expansion of subprime lending. (Because "subprime" borrowers have a less than stellar history of paying their bills on time, they pay a higher rate of interest, always alluring to investors with a stomach for risk.) Some of the growth of subprime lending was a favorable development that put home ownership within reach for millions of lower-income people.
But in the past couple of years, loans once known in industry parlance as "toxic waste" have become standard practice. For example, borrowers with checkered credit histories have been able to buy a home with no down payment and no verification of income. What's worse, the initial mortgage payment typically accounts for close to half of the borrower's (nonverified) gross income--and even that high payment is based on a teaser rate. Most subprime loans are 30-year adjustable rate mortgages (ARMs), but the interest rate resets after two years, and the payment rises significantly. Critics call these so-called 2/28 loans "exploding ARMs." The Center for Responsible Lending estimates that one in five subprime loans originated in the past two years will end in foreclosure.
But the lack of prudent lending standards hasn't been confined to the subprime market. In fact, the same risky practices (little or no down payment, no verification of income, high payments as a share of income, low teaser rates) began in the Alt A market, a not-so-easy-to-quantify middle ground between subprime and prime borrowers. Fully 81 percent of Alt A loans were extended with reduced or no documentation required from borrowers, according to First American LoanPerformance. Inside Mortgage Finance, an industry publication, estimates that subprime loans accounted for 24 percent of the consumer market last year and another 16 percent were Alt-A loans. So, fully 40 percent of mortgages originated in 2006 were risky.
Given the relatively fixed supply of homes, the spike in demand fueled by risky mortgages was a key factor in the unprecedented increase in home prices. Even as the housing market has cooled, the price-to-income ratio and other common-sense metrics of home valuation are still off the charts. It now costs half as much to rent as to own in the Mid-Atlantic and many other regions, powerful evidence that the market price of real estate is divorced from its underlying economic value.