Wednesday, January 6, 2010, 11:36AM ET - U.S. Markets close in 4 hours and 24 minutes.

Jack M. Guttentag The Mortgage Professor

Subprime Crisis, Part III: State of the Market

Email this Page IM this Story Bookmark this Story Add to your Del.icio.us account Digg this Story Print this Story

Very Good (33 Ratings): 3.939394/5

Posted on Tuesday, May 29, 2007, 12:00AM

In the first two articles in this series, I explained the immediate cause of turmoil in the subprime market as the ending of house-price appreciation, and the underlying cause as a myopic tendency for lenders to make loans that worked only if house prices continually rose. This article focuses on the current state of the market.

The Current Pain

The 32-odd subprime lenders who failed have garnered the least sympathy. Put simply, they gambled and lost. But some borrowers fall into that category as well because they were looking to profit from house-price appreciation. Instead, they are facing foreclosure.

Investors in securities issued against pools of subprime mortgages have also felt pain as the market value of these securities has declined. Lehman Brothers estimates the decline at $19 billion. Most of it is concentrated among the riskiest of the securities, which promised the highest yields. (No collection plates are being passed for them, either.) Securities rated AAA, which are first in line to be repaid and last in line to take losses, have been impacted very little.

Mortgage brokers have not been significantly affected. A few have lost access to subprime lenders, but most of them have been able to replace defunct lenders with other lenders.

The big losers are those borrowers who, as unwitting victims of hype and deception, took out mortgages that were unworkable if house prices stopped rising. Now that prices have stopped rising, many of these borrowers are waiting for the next shoe to drop. They have ARMs (adjustable-rate mortgages) on which the rate will reset to a much higher level in future months.

Market Remains Open

This is the good news, and it should not be taken for granted. When the international banking crisis erupted in the early 1980s, the market adjustment stretched over a decade during which there was virtually no new lending.

The subprime lenders who remain are the more cautious ones. They are also more likely to be affiliated with other firms with deep pockets, which will help them ride out any future market disturbances.

Of course, the profit potential in subprime lending is not what it once was. Investors require a higher yield than before, especially on the riskiest securities. This has caused a tightening of underwriting requirements that has effectively lopped off the riskiest segment of the market.

Underwriting Requirements Are More Restrictive

Underwriting requirements are the conditions that borrowers must meet to be eligible for a loan. They are significantly more restrictive now than they were a year ago. One of the most important shifts is the virtual disappearance of the 100% (no-down payment) loan.

Periodically I receive an advertisement from a subprime wholesale lender rep advertising what is available from his firm. (He thinks I am a mortgage broker.) One came to me on April 19, 2007, showing that a borrower with a credit score of 620 (which is low) could qualify for a loan of $650,000 with a down payment of 10%. Checking back in my "Deleted Items" archive, I found a message from the same rep dated June 20, 2006. At that time, he was offering the borrower with a 620 score a loan of $1 million with nothing down.

The 2006 offer was insane, a product of the euphoria created by steadily rising real estate prices. The current rules are no longer based on the inevitability of rising prices.

The Prospects

If house prices begin to rise again this year, the problems of the subprime market will go away. In 1998-99, we had a similar episode in which as many as 20 subprime lenders failed. But in 2000, house prices took off, the problems disappeared, and few people today even remember the episode.

This time, however, the prospects for a quick revival of house-price appreciation are very poor; a further weakening is much more likely. Under these conditions, there is an ominous cloud on the horizon: Subprime borrowers who took 2/28 ARMs in 2005 and 2006 will have their interest rates and payments reset to much higher levels during the remainder of this year and next. A significant number will not be able to make the new payments and won't be able to refinance because the equity in their houses is not sufficient to meet the new underwriting requirements. They face foreclosure.

What, if anything, should be done about that is discussed next week.

Email this Page IM this Story Bookmark this Story Add to your Del.icio.us account Digg this Story Print this Story

Rate This story

Very Good (33 Ratings): 4/5

Sign-in to rate!

5 Comments

Showing comments 1-5 of 5

Donald - Friday, April 25, 2008, 1:50AM ET Report Abuse
- Overall: 3/5
Cry me another River!!!! While trying to sell my house at this time, which is in fact about 10 percent below what I could have sold it for 1-2 years ago, I find the most annoying part of this as being buyers who STILL don't have a clue. Granted I have a property worth around 200K and would be willing to take 185-190 for the fact that a first time home buyer would be looking at my property. However, first time buyers!, Get your Sh__ together and get your financing in order FIRST! Oh, you had it and the Lender backed out????? Sounds like big money stirring up trouble for those who aren't even the problem! I say lower the value of the bank! Can the over paid directors and CFO's. I don't se my home appreciating for a while like it did 5-7 years ago, but it will grow again at a more modest pace because the area is still superb for young families just starting out through High school age children. Parents are always looking for the best schools and park districts and thats what My home has to offer. I said I am sell or willing to take around 10% less than what it was appraised for a year ago. Guess why???? I am not a greedy cuss like most, and would like to see my home go to a nice young family who will appreciate it. Problem #1 Big Money sticking it to those just starting out and making sure they can help those who need the least, Directors and Quick change fast money hounds who thought they could FLIP properties and expect the poor middle class to cover the bill for their stupidity.
HCSKnight - Tuesday, June 26, 2007, 2:02PM ET Report Abuse
- Overall: 1/5
"The big losers are those borrowers who, as unwitting victims of hype and deception, took out mortgages that were unworkable if house prices stopped rising." You've got to be kidding me. This is nothing more than more of the Left's/Socialist "unfair" garbage. It CANT be that the person going for the loan SHOULD have been responsible & educated themselves? Or that they listened to the old addage "If it sounds too good to be true...." Writing essays with lots of technically correct "analysis" that disregards ALL the factors is NOT being HONEST. Only in economics, & Global Warming, can such total disregard for the MAJOR factors which give rise to an outcome be so willfully disregarded. Mr. Guttentag, & the whole bleeding heart/left/liberal/socialist agenda, are the ONLY things more sad than the ignorant & greedy/easy way folks who are now "paying the piper".
Yahoo! Finance User - Thursday, June 7, 2007, 12:08PM ET Report Abuse
- Overall: 3/5
Our solution to dealing with refinancing every 2 years for the last 6 years was doing our homework for answers and what really made a difference to us is by getting on the interest cancellation program for our mortgage through United First Financial. We just got on their program and we have all our credit card debts paid off and are now set to pay our 30 year mortgage off in half the time! This program is helping us save almost $200,000 off our mortgage & basically USE THE BANK'S MONEY INSTEAD OF THEM USING OUR MONEY!! We build up equity each month and we don't have any lifestyle changes- no extra payments out of our pocket or anything like that. It really works! We watched the video on this website www.u1stfinancial.net/johnfechik and filled out the financial analysis on the website to see if we fit the criteria- not everyone does- but our financial future looks great now & I can finally sleep at night NOT worrying about how we will ever get out of debt!! If the President made it a law for all homeowners to get on this program, we could have America on the road to recovery soon with all the debt we have burdening us!!
EJ - Tuesday, June 5, 2007, 8:33AM ET Report Abuse
- Overall: 4/5
Great series. As someone with a low credit score & looking at buying the last 2 years, it has been interesting to watch the meltdown. One factor you have not considered in the rebound scenario (maybe you have) is future buyers. Housing prices are too high and no rebound will occur until they correct for buyers like me. In the meantime, credit repair is a priority while the housing market corrects and shoddy new construction ends. It's wait and see time for the next generation of buyers- taking the hit on higher interest rates in the future seems like a gamble worth taking in this enviroment. Who would buy an overpriced, low quality product just because it's on sale?
davidanthonyporter - Monday, June 4, 2007, 1:09PM ET Report Abuse
- Overall: 3/5
Jack, I enjoyed your article. I wanted to let you know that your RSS feed is messed up. I subscribed to your feed and it is title "The Naked Economist". I am getting your feed but the title is wrong. I thought you might want to have someone check that out.

Meet the Experts

Charles Wheelan, Ph.D.The Naked Economist
Jeremy Siegel, Ph.D.The Future for Investors
Laura RowleyMoney & Happiness

Robert KiyosakiWhy the Rich Get Richer
Ben SteinHow Not to Ruin Your Life
Jack M. GuttentagThe Mortgage Professor

Anya KamenetzGeneration Debt
Mick WeinsteinThe Week's Best Stock Blogs

» View all experts

More from Jack M. Guttentag

The Mortgage Encyclopedia

An authoritative yet concise guide to the mysteries of mortgage finance, arranged alphabetically from "A-Credit" to "Zero Balance." Includes information that will help you decide whether to use a mortgage broker, learn if you can avoid mortgage insurance, and much more. Reach for this indispensable guide and get the fast, accurate information you need!

Order your copy now!

Find out more about The Mortgage Professor.