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Investors Fear 'Shock' from Subprime Meltdown.
Loan Defaults, Delinquencies Spreading New Fears Through Residential Markets
Improving supply-demand fundamentals in most U.S. markets and the absence of any slowdown in activity among investors has most commercial real estate observers cautiously optimistic over prospects for another banner year.
However, given the extreme cap rate compression that has resulted in razor-thin LTV coverage ratios among many commercial assets that traded hands in recent months, borrowers are also leery of any unexpected shock to the economy that could impact market conditions.
Some have viewed the burgeoning subprime mortgage market as just such a ticking timebomb that could provide that shock. Many more are focusing on the risk, especially following this week's plunge in worldwide stock prices that was viewed by some as a wake-up call for re-evaluating investment risk.
In recent years, a number of residential lenders engaged in making higher-risk, higher-cost "subprime" home loans have flooded the market with high-risk hybrid mortgages, often approved without considering whether the borrower could afford the loan. This year, the aggressiveness is all coming back to bite them.
Foreclosures and losses are mounting in the subprime market. At best the trend is causing a huge shakeup among lenders. At worst, it could deliver another battering to America's residential housing sector.
This week, Freddie Mac, a U.S. government chartered corporation that supports homeownership and rental housing by purchasing residential mortgages and mortgage-related securities, became the first major investor to ban subprime loans from its portfolio. The company said it will no longer buy common types of subprime mortgages and will only accept subprime adjustable rate mortgages that qualify borrowers at the "fully-indexed and fully-amortizing rate."
The move is designed to discourage lenders from approving loans at start rates that can rise sharply when scheduled rate increases become effective within two or three years.
Subprime home loans-designed for borrowers with weaker credit-have been an attractive investment in recent years. Subprime lending, the riskiest category of aggressive loans, soared from $150 billion in 2000 to $650 billion in 2005. However, they have become increasingly risky for homeowners.
The subprime lending industry was doing fine until the Federal Reserve started its string of 17 hikes in the short-term interest rate in the summer of 2005, taking the rate from 1% to 5.25%. Four out of five subprime loans carry floating interest rates that, after the first year or two, change every 12 months as short-term interest rates fluctuate. Because of the Fed hikes, homeowners who received these loans in 2005 are now finding their monthly payments rising by 30% to 50%, leading many to fall behind in payments.
About 70% of subprime loans also have prepayment penalties that can make it too expensive for homeowners to refinance to conventional fixed-rate loans with lower interest rates. Because home prices are flat or falling in many of the poorer neighborhoods where subprime loans are most common, even those owners who can handle the prepayment penalties may find it impossible to get new loans large enough to cover their balances on the old ones.
The result: increasing numbers of defaults and delinquencies. At the end of 2003, about 7% of subprime loans were in foreclosure or serious delinquency -- with payments at least 90 days overdue, according to Morgan Stanley. By late 2006, the figure had soared to 12.6%. For all mortgages, the figure is 1.4%.
It has also become apparent this year that many subprime loan investors did not fully anticipate their own risks.
S&P Ratings downgraded 400 residential mortgage backed securities classes in 2006, which broke the record of 292 set in 1990. Subprime mortgage collateral accounted for 229 (56%) of those downgrades, jumping from only 56 (37%) in 2005.
However, lenders with significant subprime mortgage exposure are getting bit the hardest.
This month, New Century Financial Corp. of Irvine, CA, has seen its common stock drop about $20/share (about 75% of its value) after the company reported accounting errors that caused it to fail to track accurately how some of its mortgage loans are going down in value.
At last count, the company had been hit with 10 class action lawsuits over its accounting/stock price issues.
Another stock that suffered was that of HSBC Holdings PLC, the biggest bank in Europe and the largest subprime lender in the U.S.
Stock analysts said that the company needs to put away 20% more money to cover loans that may become uncollectible. The company itself believes that it may need close to $10.6 billion to cover these troubled loans.
HSBC has seen its stock drop by $10/share in the past two weeks. Also, Bobby Mehta stepped down as CEO of HSBC North America Holdings Inc. and chairman and CEO of HSBC Finance Corp. (formerly Household International Inc.), and resigned as a group managing director, and from the boards of HSBC Bank USA.
Stung by repurchase requests for loans with early payment defaults, the mortgage industry wholesale mortgage lenders -- which derive their business from loan brokers, have been swallowed up, exited the business or closed shop altogether.
* Metropolitan Savings Bank of Pittsburgh ended the longest stretch of time without a U.S. bank failure since the Federal Deposit Insurance Corp. started keeping track of such things in 1934. It had been 952 days since the previous bank failure.
* Ownit Mortgage Solutions, Mortgage Lenders Network USA and ResMAE Mortgage Corp. all filed petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code.
* Central Pacific Mortgage agreed to sell six wholesale branch offices.
* Lenders Direct Capital Corp. stopped taking applications from mortgage brokers.
* Accredited Home Lenders said it would no longer make stated-income loans to borrowers with credit scores less tab 640 and would curtail first-time homebuyer programs and programs that include piggy-back seconds, which will significantly cut its second mortgage originations.
* Fremont General Corp. notified its brokers it would no longer make second lien loans. And
* New York Mortgage Trust Inc. agreed to sell substantially all the assets of its New York Mortgage Co.'s wholesale lending arm.
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