Subprime Lending: Past Its Prime?

By Focardi, Craig | Mortgage Banking, May 2007 | Go to article overview

Subprime Lending: Past Its Prime?


Focardi, Craig, Mortgage Banking


Unless you've been living on a remote island or rural outpost without Internet, e-mail and telephone access for the past six months, you've heard all about the implosion of the U.S. subprime mortgage lending sector. This development, along with slowing home-price growth and rising mortgage delinquencies, has put lenders in a conundrum about their mortgage businesses as they evaluate strategies for revenue and profit growth.

This column examines recent trends in lending volume, home prices, subprime loan product risk and loan delinquencies, to answer the question: What should lenders do about the lending credit risk they currently hold?

Background: Mortgage lending market growth

The interest-rate/home-price cycle has been working in reverse since the peak of the mortgage refinancing boom during 2003-2004. Rising rates have reduced affordability for new buyers, slowed home-price growth and caused rising mortgage payments for those with adjustable-rate mortgages (ARMs). According to the Mortgage Bankers Association (MBA), in 2006 mortgage lending volume plummeted 17 percent. Excess lending capacity shrank after more than 25 mergers, acquisitions and company shutdowns. As short-term interest rates rose and home-price growth slowed, subprime, second-home and investor lending volume declined as many homeowners could no longer refinance, take equity out of their property or buy second homes.

Uncertainty over future home-price growth is further clouding the picture for lenders and consumers alike. Since 2003, pessimists have been saying that many homes are overvalued. Optimists have replied that the economy is strong, interest rates are still relatively low and demand is steady. But negative facts have finally caught up with the optimists.

The National Association of Realtors[R] (NAR), Chicago, reported that the median price of an existing home nationwide fell by 2.7 percent during the fourth quarter of 2006 and rose only 1 percent for the year. Further, Cleveland-based National City Corporation's economics office reported in its quarterly House Prices in America analysis that home prices in 23 percent of U.S. metropolitan statistical areas (MSAs) declined during the fourth quarter.

In 2007, MBA forecasts that ARM share of purchase conventional loans will drop from 22 percent of the market last year (according to the Federal Housing Finance Board) to 12 percent this year as rising rates, a flattening yield curve and ARM rate resets cause many consumers to refinance into fixed-rate mortgages (FRMs).

But many borrowers whose ARM rates are resetting during 2007-2008 are caught between a rock and a hard place. Weaker home prices and rising delinquencies have led to major revisions in loan underwriting guidelines. Zero-down-payment loan programs are falling out of favor, as are reduced-document loan programs, because lenders can no longer rely on rising home prices as security for the loan if a borrower defaults. As a result, borrowers' monthly payments are skyrocketing, yet many borrowers can't refinance because they no longer qualify at the higher rate and payment.

The subprime scare

Nowhere has the impact of rising rates and falling home prices been felt more than in the subprime mortgage sector. During the week of March 12, 2007, concern over mortgage company stock prices, borrower defaults and declining home prices helped send the Dow Jones Industrial Average Stock Index spiraling down more than 240 points (2 percent) in one 24-hour period. The stock market is starting to recover, but subprime mortgage lenders and mortgage-backed securities (MBS) investors will be doing damage control for the next couple of years.

In a perfect storm with negative consequences, subprime mortgage delinquencies are skyrocketing at the same time that lending volume and home prices are flat to declining. MBA estimates that total subprime delinquency rates (loans delinquent or in foreclosure) typically average between 10 percent and 15 percent across economic cycles, but that delinquency rates had already jumped to about 17 percent in the fourth quarter of 2006. …

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