A Housing Collapse Could Wound the Banks

Spreading the risk won't save lenders if the price bubble bursts

It has been a tough year for banks, what with profits being hit by corporate loan defaults, junk-bond losses, and restructuring charges. The next knock may come from the one area of the economy that has long seemed like a safe haven: housing. Thanks to a hyperefficient home loan industry, the amount of outstanding home mortgage debt has skyrocketed more than 40% in the past five years, to $5.28 trillion, according to the Federal Reserve. Not only is homeownership at record levels, but consumers have also opted to refinance into larger and larger loans.

There is no sign that banks are putting on the brakes either, despite signs of a crumbling economy. The four biggest lenders nearly tripled mortgage originations in the first six months of 2001. In fact, profits from home loans have helped banks offset weak commercial and investment bank business.

Some now say the home loan factory has worked too well by creating overvalued home prices. Critics worry that, just as in the savings and loan crisis of the early 1990s, financial institutions will be hit hard if real estate values fall and loan delinquencies or defaults pile up. A decade ago, thrifts got themselves into trouble because they made residential and commercial real estate loans for inflated amounts to borrowers who could not pay. A government bailout of the failing thrift industry ended up costing taxpayers $200 billion.

At first glance, banks seem to have wised up since then. In the early 1990s, they held on to most of their real estate loans and suffered accordingly when the defaults piled up. Today, most lending institutions either sell off their loans to government-sponsored Fannie Mae (FNM ) and Freddie Mac (FRE ) or package them as mortgage-backed securities. These securities are then actively traded on Wall Street between corporations, foreign investors, and insurance funds. In 2000, there were more than $3 trillion in mortgage-backed securities outstanding.

But all that doesn't get the banks totally off the hook. They are still required to hold on to some or all of the risk for loans sold to Fannie Mae and Freddie Mac. In 2000, banks were responsible for losses of about 20% of the $2.5 trillion loan portfolio held by Fannie and Freddie.

In addition, bankers say privately that Fannie Mae and Freddie Mac sometimes force them to take back poorly performing loans, even when they have sold them outright. Michael Quinn, a Fannie Mae senior vice-president, acknowledges that "when loans go bad, we look at why they went bad." He says Fannie Mae does occasionally charge them back to the lender, but such instances are rare.

That could change. A deeper downturn and a concurrent rise in mortgage delinquencies and defaults could be disastrous for banks that sell loans to Fannie and Freddie should those organizations require banks to eat their losses. "Lenders are scared to death," says Christine Clifford, partner at Wholesale Access, a risk assessment firm. "Every loan there is a loss on, Fannie and Freddie are going to ask them to buy it back."

"RAW DEAL." The consolidation of banks and investment banks in recent years may also have raised their exposure if the housing market goes bust. Many of the largest home lenders--including Chase Manhattan Mortgage Corp. and Citigroup Mortgage--are now subsidiaries of bank holding companies. Rather than selling loans outright to investment banks, these lenders just transfer the loans--and the risk--to another part of their holding company. "As these loan pools go bad and securities start underperforming, investors are going to go back to the investment banks that sold them and say: `You sold me a raw deal, and I want you to take it back,"' predicts Charles Peabody, partner at Ventana Capital.

Some housing experts say there's no question home prices are greatly inflated. "The hard part is figuring out when the bubble is going to burst," says Sean Ryan of Fulcrum Global Partners, based in New York. "When all the Internet stocks were going up 40 points a day in 1999, it was clear it was a bubble, but if you went out and shorted them you would've lost your shirt." Mortgage lenders can only pray the air goes out of this bubble a lot more slowly.

By Heather Timmons in New York

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