Thursday, March 15, 2007

The Sub-Prime Meltdown

There has been significant recent financial press coverage of the sub-prime mortgage sector meltdown. Subprime lenders offer mortgages to homebuyers who do not qualify for regular mortgages, usually because of low credit scores. It is time to take a deeper look at this meltdown and its impact on homeowners, mutual funds, banks, and mortgage seekers.

Some Background: Why is the Subprime Market falling apart

Traditionally, banks serviced the loans that they made to homeowners; meaning that your mortgage payments went to the bank that made the homeowner the loan. This also ensured that the bank carefully screened loan applicants because the bank would not want to be stuck holding a non-performing loan. The advent of securitization changed all of this. Most loans were wrapped up into investment packages by mortgage lenders with the help of investment banks and sold to institutions such as hedge funds, pension plans, high income mutual funds, private equity firms, investment banks, and other “qualified investment entities”.

The primary impact of securitization was to take the risk of individual mortgages out of the hands of lending institutions; this was hailed in the market as a great step in financial evolution. The reality is that securitization removed the incentive for banks to carefully qualify loan applicants and caused the banks to focus on maximizing the fees associated with originating loans. Requiring applicants to meet traditional loan standards in terms of income, debt ratio, and down-payment quickly flew out the window.

Traditionally loan applicants were required to have a 28-33% top ratio (meaning your PITI payment cannot be more than 1/3 of your monthly salary) and your bottom ratio to be 33-38% long term debt; meaning your car payment, visa card payment, other loans, plus your PITI cannot exceed 33-38% of your monthly salary. Banks normally required a 10% down payment; in many cases a 20% down payment was required.

These mortgage standards quickly forgotten in the “securitization era” in which banks rushed to maximize the number of loans originated to increase collected fees. The mortgage brokers and executives at mortgage firms rushed out to spend their high bonuses from all the hefty fees.

In recent years, lenders sold off the bulk of their originated loans to Wall Street investment bankers such as Goldman Sachs, which securitized the loans into asset-backed securities (CMOs).

Everything was looking rosy except for one little detail, all the securitization packages had clauses in the fine print stating that the lending firms would have to take the investment packages back and refund the money if more than a small percentage of the homeowners defaulted on loan payments. In financial jargon, the securitization units would be returned for a full refund if tranches failed to adequately perform within the guidelines of the covenants.

As homeowner defaults increase nationally, lenders such as New Century (the second largest sub-prime lender) are being forced to take back bad loans from the investors and investment banks. If the mortgage lender does not have adequate reserves to cover the returned loans then they are forced to file for bankruptcy.

Major banks are putting aside large reserves to deal with their subprime exposure. For example, HSBC put aside more then $10B. Other subprime lending firms do not have this much collateral, and their credit facilities have been cut-off from outside institutions who are seeking to limit their exposure.

Over 25 subprime lenders have gone out of business in the last four months. More are likely to follow. A complete list can be found here:

Information on CMOs

What is the impact to Subprime Loan Holders

Over 15% of the outstanding mortgages at the end of 2006 in the US are subprime and given to homeowners with low credit scores. An additional 24% of the outstanding loans in the US are deemed risky and are outside traditional lending standards.

Currently 12% of subprime borrowers are delinquent in payments. The sub-prime default rate is now up at 10.7% up from 6.1% in early 2006. Also sub-prime loans now represent 24% of the newly originated loans in 2005 and 2006 compared to 10 years ago where they accounted for only 3% of the mortgage market.

Recent press indicates that as adjustable mortgage rates increase over 2.2 million Americans are expected to lose their homes during the next two years. Every month, this number keeps increasing as new surveys are released.

They key problem for most homeowners with subprime loans originated in 2005 and 2006 are that their rates are shortly due to increase. Most received loans with low teaser rates and minimal down-payments. These teaser rates are due to reset, and at this point as lending standards are being tightened no bank will offer them a new loan. Many of these home owners will see their monthly payments double or triple.

As rates soar, 2.2 million Americans risk losing homes this year

Valley may be insulated from mortgage morass

Outlook for Subprime Lenders seen as Bleak

With over 25 firms going under within the past 4 months, the outlook for the subprime lenders is generally bleak. The majority of these firms will either declare bankruptcy, stop operations, or be sold over the upcoming months in the opinion of most industry analysts. Many of these mortgage firms had oversized ambitions coupled with their ignorance of risk and drive for revenue from fees. For example this quote from an article from Economist is very telling:

“Last March, ResMAE, a mortgage lender catering to risky borrowers, cut the ribbon on its new headquarters in Brea, California. The sprawling, 135,000-square-foot building dwarfed the company's 458 local employees. But it fitted the firm's outsized ambitions. Less than a year later the company, rather than its ribbon, was facing the chop. This week it said it had filed for bankruptcy and was selling its assets for a diminutive $19m.”

America’s riskiest mortgages are set to pop. Where will the shrapnel land?

Mortgage Crisis Spirals, and Casualties Mount

Outlook For Subprime Lenders Seen As Tough

Another subprime lender, ResMAE, files for bankruptcy

Subprime: The Risk to Wall Street
As subprime woes widen, the money machines at Morgan Stanley, Goldman and other banks may sputter.


There is significant fear that the subprime mortgage meltdown will spread upward in the market. There are a significant number of outstanding loans from the past few years to non-subprime credit homeowners with adjustable rates who do not meet normal lending standards. The default rate on these loans has also been increasing in the past few months as the rates have been resetting. The adjustable interest rates for a large number of these loans are due to reset over the next two years leading to increased payments for these homeowners. As mortgage credit standards start to tighten due to subprime meltdown, it will be more difficult for these homeowners to refinance into new loans.

Mortgage Defaults Start to Spread

Credit Standards – Time to Tighten

One immediate impact of the subprime meltdown was the tightening of credit standards. This will make it more difficult for homeowners to get a loan. Banks will expect applicants to have solid credit scores, normal debt ratios, verifiable income, and proper down-payments. This will hurt many homeowners with risky ARM loans attempted to re-finance into fixed rate. It will also impact homeowners who are trying to use the equity built up in their homes to get a loan to spend on consumer items (cars, boats, etc.). People using their homes as ATM machines is likely to come to a grinding halt shortly.

In my opinion, the tightening of credit standards for home loans is long overdue. Or should I say returning to traditional standards. Over 25% of the mortgage loans made in the past 3 years in the U.S. would have never been originated if proper standards were enforced. The loose credit standards also helped fuel the wild speculation that led to over-sized real estate price increases in many U.S. local markets, placing these markets in a significantly overvalued state and ripe for a tumble.

Homeowners stuck as lenders cinch standards

Freddie Mac toughens subprime standards

New Standards for Mortgage Lenders?
As more homeowners fall behind on payments, there's talk about whether lenders should be required to ensure loans they issue are suitable for consumers.

Tighter Lending Rules May Hurt

How will all of this impact a homeowner?

Current homeowners will be impacted by the tighter lending standards and increased foreclosures associated with the subprime meltdown. The impact of tighter lending standards is outlined above. Foreclosures are now reaching 5 year highs in many local markets and are expected to more then double over the next two years. Increasing foreclosures generally hurt the local real estate market and will slow housing appreciation. The foreclosures will act as another factor that will cause downward price pressure in many US markets that have “bubbled-up” over the past few years (e.g. CA, FL, NY, D.C., etc.). The impact of foreclosures on your local market will vary by the percentage of foreclosures in your particular area and how they are handled relative to nominal market pricing.

Also keep in mind that recent real estate statistics show home prices falling at the fast rate in 14 years, and prices are down in half of the metro areas at the end of 2006. Increasing foreclosures will add to this slide.

Foreclosures rip neighborhoods,1299,DRMN_414_5352848,00.html
“Foreclosures in Denver since 2003 will log a fivefold increase by the end of the year, a trend that is tearing apart neighborhoods throughout the city.”

Home prices fall at fastest rate in 14 years

Housing Sales Drop in 40 States, Prices Down in Half of Metro Areas

"The National Association of Realtors said the states with the biggest declines in sales from October through December compared with the same period in 2005 were: Nevada, down 36.1 percent; Florida, down 30.8 percent; Arizona, down 26.9 percent; and California, down 21.3 percent."

"In all, median home prices fell in 49 percent of the 149 metropolitan areas surveyed, the largest percentage of areas showing price declines in the 27-year history of the Realtors' price survey. "The price declines were led by an 18 percent decline in the Sarasota- Bradenton-Venice area of Florida."

Are my Mutual Funds safe?

Stocks of subprime lenders have certainly taken a hit, though few stock funds appear to have a concentrated portfolio of subprime lender stocks. In most cases your diversified stock mutual funds are not at risk due to the subprime meltdown. It is a different case in the High Yield Income and REIT mutual fund sector. Some select-type funds have been focused mortgage debt, including a lot of subprime debt to enhance yields. At the Regions Morgan Keegan Select High Income Fund, for example, 13 percent of holdings are unrated mortgage-backed debt. REIT funds that are focused on mortgage debt rather then operating real estate are also at risk.

It is important that you evaluate the holdings of your High Yield Income and REIT funds. It may be time to cycle out of funds that are highly concentrated in risky mortgage debt.

Mutual Funds at Some Risk on Mortgages

Investors in mortgage-backed securities fail to react to market plunge

How are Hedge Funds playing the Subprime Meltdown?

How are the professionals such as hedge funds playing this? Hedge funds that are bearish on housing are spending billions shorting credit default swaps or an index of such swaps. Many hedge funds are shorting the ABX.HE Index, a basket of 20 credit default swaps that reference subprime asset-backed securities. The following article is a good reference for the activity of hedge funds relative to subprime debt.

Funds Swap Into Subprime Short Plays

How Should I Trade Subprime Stocks in the market?

Since the news is out, most of the downside for the stocks in the subprime sector is over. It would not be wise to short these stocks now from potential reward to risk perspective. Most of the upcoming play on these stocks is on the long side. Some of these mortgage lenders will survive and still have credit facilities open to them. All of these lenders have been pounded recently in the market, and are due for a bounce back. In fact the best play on lender stocks right now may be to wait for the bad news to bottom out and then buy stocks of the stronger lenders which are not going bankrupt.

Take a look at the fundamentals of the firms in the sub-prime market before entering a long trade. Evaluate the news regarding credit covenants, etc. Which firms have already put aside cash to cover losses on mortgages (meaning payments to re-purchase secularized loan packages)? HSBC (with subprime exposure) has already done this to the tune of over 10B, how about others such as CFC? Which of the smaller firms relative to this market (NFI, FICC, HMB, ORGN) are toast, and which will survive? Start with the fundamentals in this situation to figure it out. The firms with the financial strength & resources will weather the storm and are possible set-ups for long-side trades. The weak firms will go under when the investors demand repayment for failing secularized loan packages.

Note that I do not urge investors to speculate on these subprime mortgage stocks at this time. The entire sector is very risky at the moment.

Should I feel sorry for the Mortgage Lenders?

The short answer is “No”. Keep in mind that the executives and brokers in these mortgage lending firms were focused on how huge their yearly bonuses were going to be from collecting lots of fees. There was no incentive whatsoever to look out for the long-term prospects of the firm. Seeing the writing on the wall, most of these executives and brokers starting leaving the sub-prime firms in droves starting six months ago, many of them thinking that they hit the lottery. Reading the writing on the wall, many executives in public mortgage firms are still cashing out piles of stock options at an accelerated rate.

Countrywide Chairman Selling Shares like mad....

I expect that in the future we will see Congressional hearings where these executives will attempt to explain why they were enriching their own pockets while their firms were sliding towards bankruptcy.

What should an existing home-owner in an overpriced local market do now?

First let me state that I believe a primary home is an excellent long term investment when all the factors are taken into consideration (tax-benefits, no rent, quality of life, etc.)

However if you are homeowner in a market that has appreciated greatly over the past few years then you should take some steps to minimize the impact from the sub-prime meltdown and possible real estate market slide. These steps include:
1) Clean up your financial house (in terms of cash flow, spending, loans, etc.)
2) Get into a fixed rate loan. Rates are still low. No more ARM.
3) If you are considering getting a HELOC for home re-furbishing projects or other purposes, then you should open the line of credit soon before standards tighten up. (Note: I am generally not a HELOC fan, but if you need a HELOC get it now).
4) Take steps to insure that you are living within normal debt ratios relative to your mortgage payments. (e.g. sell that SUV with the $800 per month payment and buy a cheap car).
5) Plan to hold your house through any market dip which may possibly last up to 7 to 10 years (historically).
6) This is not the time to consider upgrading to a new home that is barely affordable for your family or for speculating on a second home. Stick with what you have now and remodel is necessary.
7) Don't get overly concerned about all of this subprime and bubble commentary.... You will ride out any real estate market changes; there is no need to be anxious if your financial life is in order relative to your home. Remember that owning a home is a good long term investment.

Most current homeowners should not panic about the risk of a downturn or its impact. The key thing is to have your financial house in order. This means getting a fixed rate loan, and living within standard debt ratios; coupled with the ability the keep the house long term and ride out any cycles. Keep in mind that a primary home is a good solid long-term investment when all the factors are considered!

What should a Potential New Home Owner Do?

Keep in mind that a home is an excellent long term investment. The key words being “long term”.

If you plan to hold the house long-term (10 years+) and can afford the home with a standard fixed-rate loan that is within normal mortgage standards then you should proceed with purchasing a single family home in a good neighborhood.

However if you can only afford the home with an ARM loan and fall outside of normal lending standards in terms of debt ratio, down payment, etc. or you plan to own the home for less then 5 years then you should reconsider your purchase of a home. Especially if you are located in a market that has greatly appreciated over the past few years (CA, FL, NY, etc.).

First time homeowners in areas with significant price run-up over the past few years may want to pay special attention to the local market conditions before considering a purchase during the next couple of years; and attempt to not buy at a local peak. However you should not get hung-up on attempting to time the local market, if the right house comes along and is affordable as a long term investment then you should go for it.


It is likely that the subprime banking meltdown is just the tip of the iceberg of the overall real estate problems that we will see over the next couple of years. Homeowners should prepare themselves to weather the storm by having their “financial house” in order. Investors should evaluate if their REIT or High Yield Income holdings are at risk.

The key thing for most homeowners is not to panic as more bad news comes out relative to real estate. Owning a home is a great long term investment that adds quality to your life.


Anonymous said...

Will Friday be an economic doomsday?