Wednesday, March 14, 2007
Business Times - 15 Mar 2007
Subprime loans crisis offers some lessons
Rising defaults on non-traditional loans cast a pall over the nation's financial sector
By LEON HADAR
SOMETIMES you don't need a professional economist to warn you that there might be an economic problem on the horizon. When a friend had told me in 1998 that he was leaving his (quite lucrative) regular job to become a 'day trader' and that he was pulling some of the money out of his pension plan to invest it in a new and promising dot.com company, I had a strange sensation of hearing a balloon burst. I decided that it was time to sell my 'aggressive' technology stocks.
So when a few months ago, one of the nice ladies who cleans my apartment once a week told me that she was about to purchase a home in Washington, DC, I was once again hearing a balloon burst.
The cleaner is a young immigrant from El Salvador, unmarried and with three kids, a member of what sociologists would refer to as the 'lower-middle class' or even 'poor', which was certainly not the profile of the average American homebuyer, most of whom need to qualify for a mortgage loan, which requires the borrower to provide documentation of their annual income as well as some down payment.
I knew that the housing market in the Washington area was quite expensive and I doubted very much that my cleaner had that kind of money or that she could even apply for the loans from a Federal government agency which usually offer liberal qualifying criteria and require smaller down payments. Perhaps she had won the lottery or did her rich aunt pass away?
US housing market struggles
In a way, the lady from El Salvador helped to introduce me to the subprime mortgage market which provides non-traditional loans or mortgages to borrowers even if they had bad credit or couldn't document their income or provide a down payment. Subprime mortgages generally have interest rates at least 2 or 3 per cent higher than prime loans.
This market in which lenders had made US$640 billion in mortgage loans last year, about a fifth of the total mortgage market, has been quite a lot in the news in recent weeks. Concerns over the financial health of this sector were highlighted after the announcement by New Century Financial Corporation, which used up its cash reserves as rising default numbers forced it to buy back bad loans it had sold to investors, that it would stop making new loans, triggering speculation among analysts that the company was close to filing for bankruptcy protection.
Indeed, New Century warned on Monday of a series of serious financial problems that cast its future in doubt and a pall over much of the nation's financial sector. The problems at New Century, which is considered the number two among subprime lenders, could have a devastating effect on America's struggling housing market as a major source of mortgage financing dries up, especially when one considers that about 35 per cent of all mortgage securities issued last year were in the 'subprime' category, up from 13 per cent in 2003.
Concerns over risky borrowers
Last month, Federal Reserve Chairman Ben Bernanke expressed concerns about the subprime market risks, as he told the US Congress that while household finances appeared to be strong, 'the exception is subprime mortgages with variable interest rates, for which delinquency rates have increased appreciably'.
Most analysts agree that as they tried to increase their profits, lenders applied lax underwriting standards, in some case requiring no documentation of incomes and assets and no down payment to very risky borrowers, including those with history of bad debt and bankruptcy. The result is that delinquencies surpassed 13 per cent in on subprime loans in the latest quarter, and that small and large companies that invest in subprime loans - in the US and abroad - are facing financial difficulties, including possible defaults and delinquencies.
It's not surprising therefore that US Congress is starting to focus on the subprime lending sector and try to figure out if Washington can 'do something' to its problems.
The issue has been discussed in several Congressional hearings. In one recent Senate testimony, Martin Eakes, who heads the pro-consumer Center for Responsible Lending, described the situation in the subprime lending market as 'a quiet but devastating disaster' and warned that the 'ultimate effects are very much like Hurricane Katrina,' and was taking place 'every single day across the country, house by house and neighbourhood by neighbourhood'.
Democrats who now control Congress, including Senate Banking Committee, Senator Christopher Dodd (who is also a presidential candidate), have called on the heads of the subprime industry to tighten underwriting standards and deny loans to very high-risk borrowers and they are considering the possibility of imposing tougher regulation on the industry.
But economist Howard Husock from the Manhattan Institute has suggested that congressional Democrats and others 'are seemingly learning the wrong lessons from the subprime crisis, if it is one'. As Mr Husock sees it, both banks and lower-income consumers have been getting used to 'a new financial world', where those formerly shut out of credit markets are now included, but at interest rates that reflect their risk. 'If we want poorer households to manage their money and assets better, we have to be prepared for them to make some mistakes, and not hurry to overprotect them,' Mr Husock argues.
He thinks that the problems could be managed by requiring lenders to disclose fully the terms of loans and ensure that borrowers read and understand the small print. At the same time, Mr Husock urges consumers and Congress to recognise that America's credit markets today 'are far better than a generation ago - when mortgage lending was confined to savings-and-loan institutions limited in the interest rates they could charge.'
The result then was that institutions avoided risks and were said to deny credit to poorer neighbourhoods. The banking deregulation of the early 1980s, which changed the mortgage industry and allowed lenders to adjust interest rates to risk, has given millions of 'subprime' customers access to credit markets and has helped push homeownership rates to a record level. Mr Husock warns that if lenders were not permitted to adjust rates to risk, they would shy away from higher-risk lending.
'Far better to expect that as Americans get used to knowing their credit score and become familiar with various available loans, they will learn from their mistakes and take the steps necessary - including living within their means - to get loans on favourable 'prime' terms,' he concludes.
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