On April 14, 1912, the mighty Titanic hit an iceberg and the ship’s fate was sealed in just over 2 hours and 40 minutes. The boat’s structural design and weight made sinking inevitable and swift. Over 1,500 lives were lost, along with personal fortunes amounting to over $600 Million in 1912 dollars.
Icebergs are interesting because only about 10 percent of the ice is visible above water. Seeing an iceberg in the distance is any Captain’s worse nightmare and the iceberg that took down the Titanic was no exception. The famous ocean liner could not manoeuvre around the massive iceberg quickly enough to avoid hitting it.
This tragic story reminds me of some of the subprime mortgage lending problems that actually began a few years ago. Indeed, we have been watching this iceberg for three years now, and investing accordingly. Anyone aware of the fraud and foolish underwriting that has been ongoing in mortgage origination should be honest enough to admit we’ve only seen the “tip of the iceberg” so far, and mortgage lending is heading straight towards a massive piece of ice.
The subprime market and bad loans
The subprime market is overloaded with bad loans that have effectively smashed holes into the hull of this financial ship. It has been surprisingly easy for people buying a new house to borrow hundreds of thousands of dollars by simply telling the bank how much money they make – without any proof. It’s called a ‘stated income’ loan, but many people inside the housing industry call it something else: a “liar loan” or a “NINA” (no asset, no income verification). Forty percent of the subprime market (about $400 – $500 billion of loans), is made up of these loans. At best estimates, half of all subprime mortgages had no income verification. This is no small problem!
How can a clerk at McDonald’s (who claims to earn $10,000 a month on his mortgage application) be approved for a 100 percent mortgage loan on a speculative property? Do you really believe that this marginal borrower – who happened to be approved for a loan with a fraudulent appraisal – will be able to refinance now that housing prices are falling? We don’t think so.
What happens when the loan goes bad? Mortgage companies make lots of money writing “iffy” loans as long as Wall Street can package and sell the securities (and risk) into the capital market. All looked well for the Titanic sailing ahead in the fog, until it was too late. Looks can be deceiving, too, in the subprime mortgage market because the mortgage companies are very thinly-capitalized and highly-levered. A few million dollars of capital can end up supporting reps and warranties on billions of mortgage loans.
The securitization mortgage business relies on trusting the mortgage brokers and bankers, who make representations on aspects of loans and borrower quality. For a few glorious years, rising property prices allowed a borrower to avoid default by rolling a loan (headed to default) into a new larger loan. Now, as subprime defaults are picking up, the lenders are taking a closer look and sending all kinds of bad loans back to the mortgage companies that originally made the reps and warranties, but failed to weed out the fraudulent applications. So, while a lot of subprime lenders made a bundle writing bad loans, now they are being asked to give the money back! This tsunami of fraud is enough to crush the lenders. Market reports show that at least 21 sizeable subprime lenders have already shut down or filed bankruptcy, and the head of Countrywide Financial estimates that as many as 20 to 30 small mortgage originators are failing every day!
A worrying example from the subprime market
Following is a typical example of how the market is turning really ugly:
A mortgage company just funded $100,000,000 of subprime loans. Suddenly, the value of the loans drop when the credit spreads on the risky mortgage collateral moves wider before the mortgage company has an opportunity to sell the securities. Now, that package of mortgages that they paid $100 million for (and intended to turn into bonds and sell for a $5,000,000 profit) can only be sold for $90,000,000. Whoa! A $10 million loss!
Between reps and warranties and widening mortgage credit spreads, most subprime lenders will end up closing down or heading to Federal Bankruptcy Court. Indeed, even mortgage firms with limited exposure to subprime loans could fail. Even if a mortgage company survives, it will now have to dramatically raise interest rates to borrowers and put in place sound loan underwriting.
So, how does a lending market go from one with a credit standard where “A Rolling Loan Gathers No Loss” – making a bad loan bigger to pay existing interest, postponing the inevitable – back to a sane lending market? (This would be a market that would require a solid down payment, an appraisal based on an honest valuation, and an applicant with verifiable income who can prove they can really afford the monthly payment for a number of years.) The answer is, “it doesn’t”.
Over the past six years, home ownership nationwide increased from 66 percent of the working population, to almost 70 percent. Indeed, many loans were extended to borrowers who couldn’t afford to rent because they could not come up with the security deposit. Yet, with a liar loan on income, and a “piggyback second” to 100 percent of LTV, they became lucky homeowners. Only now, however, they’re not so lucky, because they are struggling to make the mortgage payment. I guess their ship really didn’t come in.
Expect a trillion dollar problem in 2007
2007 is a new year and the mortgage world has changed. Credit underwriting is getting more like old-time religion. Don’t expect that housing prices will bail out the lenders. In markets where prices are failing like a stone, lenders will be dangerously exposed to serious losses.
With all these liar loans, coupled with adjustable-rate mortgages that are scheduled to adjust upward within the next 12 to 18 months, I estimate there will be well over a trillion dollars in mortgages that can’t be refinanced, until the incomes of wage earners rise significantly. Many homeowners will be trapped in a house they can’t sell or take equity out of. Mortgage companies, home builders, and real estate agents have already begun seeking new lines of work.
At the moment, the symptoms of bad loans in the mortgage market are a little bit like noticing rats. (We hate to see them!) You may manage to catch a few, but when it comes to rats and mortgage fraud, if you see one, you know there are a 100 or more you didn’t see. Perhaps thousands! It should be no surprise to learn that Wall Street and the hedge funds have quietly begun abandoning ship.
The ocean liner Titanic was designed to hold 32 lifeboats, though only 20 were on board. The esthetic of the ocean liner (too many boats were unattractive) was more important than the safety of the passengers. Only 705 passengers survived because they were lucky enough to get in a lifeboat. I can’t help but wonder how many investors will survive if they don’t grab the first lifeboat.
Written by Richard Benson and published in Benson’s Economic and Market Trends 22/2/2007, www.sfgroup.org