For months doomsayers have been predicting that the slowing housing market, along with rising interest rates, would lead to mortgage foreclosures and bank losses. That hasn't happened yet, but delinquency rates have started to rise. What's worse, instead of cutting back on the exotic mortgages they've leaned on throughout the boom, many lenders are charging ahead on such high-risk loans full tilt. "Mortgage lending standards show little sign of tightening," says Frederick Cannon, bank analyst with New York's Keefe Bruyette & Woods Inc. investment bank. "[Lenders] should have dialed back the aggressive loans by now."
Cutthroat competition, say banks, leaves them no choice. Even after then-Federal Reserve Chairman Alan Greenspan admonished lenders a year ago for enticing borrowers to take on more debt, many still require little or no documentation, ask for low minimum payments, offer loans that are high as a percentage of home valuations, and permit borrowers to carry more overall debt than in the past. Few lenders have passed much of the rise in rates on to borrowers either. "Both the banks and consumers are stretching," says Peter J. Winter, an analyst with Harris Nesbitt Corp., a unit of BMO Financial Group (BMO).
The much-feared troubles may finally be arriving. Delinquency rates jumped more than 7%, to 4.7% in the fourth quarter of 2005, from the year before, according to the Mortgage Bankers Assn. Home buyers are becoming over-extended. In California, where seven of the 10 most expensive U.S. cities are located, one in five buyers already spends more than half of pretax household income on housing -- much more than the 30% recommended by the Housing & Urban Development Dept.
Worries center around the subprime lenders, which make loans to borrowers with less than stellar credit. Last year they issued a record $650 billion of mortgages. Such lenders now have a 23% market share of new loans, vs. less than 5% in 1994, says Brenda B. White, managing director at Deloitte & Touche Corporate Finance LLC. Periods of big profits are often followed by "serious indigestion in the market," she warns.
Many large subprime lenders sell their loans to Wall Street to repackage for investors to buy. By doing so, they argue, they move risk from their balance sheets to the broader market. Scott R. Coren, a Bear, Stearns & Co. (BSC) analyst covering mortgage finance, disagrees. He uses the sales at 14 such lenders to judge their appetites for risk, and to determine the quality of the loans they likely keep on the books. "They keep some skin in the game," he says.
Coren highlights several potential red flags. ECC Capital Corp. (ECR) and New Century Financial Corp. (NEW) do big business in California, where the median house price jumped 16% last year, to reach a record $548,430. Long Beach Mortgage Corp. (a unit of Washington Mutual) and NovaStar Financial Inc. (NFI) require only limited documentation and therefore may invite fraud, according to Coren's research. Fieldstone Investment Corp. (FICC) and First Franklin Financial Corp. write lots of loans called interest-only or option adjustable-rate mortgages, which allow borrowers to postpone making repayments of principal and even add unpaid interest to the debt. ECC and Long Beach declined to comment ahead of their earnings announcements. New Century says its California borrowers have solid credit and that it steers clear of loans with risky terms. First Franklin Financial says it sells off all its loans. A NovaStar spokesman says: "One variable doesn't explain the risk/return profile of an entire pool of loans." Fieldstone did not return calls.
Despite the lenders' precautions, some borrowers will receive a rude shock starting this year. Repayment terms on about $1.3 trillion of adjustable-rate loans will increase in 2006 and 2007, forcing some borrowers to pay up to 150% more per month. "In the hands of an unsophisticated borrower, [these loans are] dangerous," says Robert W. Visini, vice-president for marketing at San Francisco mortgage tracker LoanPerformance (FAF).
About 10% of U.S. households now face a great risk of running into credit problems, according to research done by Meredith Whitney, senior financial institutions analyst for CIBC World Markets Inc. (BCM). If borrowers start to default on their loans, their lenders could themselves face mounting problems.
It has happened before. In the mid-'90s some banks were so desperate to issue mortgages that they were lending as much as 125% of a home's appraised value. When the economy weakened, several filed for Chapter 11 bankruptcy, including United Companies Financial, which was later liquidated. Caution to those lenders who are pushing the envelope today.
By Mara Der Hovanesian