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Subprime Fallout in the Mortgage Industry
Connecticut Subprime Lenders - Mortgage Industry Meltdown – Bridgeport, CT is in for a rough ride.
After 22 year in the mortgage and real estate businesses, we thought that we had seen it all. High and low Connecticut home mortgage interest rates, violent rate changes due to sudden changes in economic data or world news. The abuses of speculation on Connecticut lenders who took unnecessary chances and the demise of large firms that didn't keep up with the market demands.
None of the above is comparably as dangerous to urban middle class environments as is the current crisis in the Connecticut mortgage industry. Bridgeport CT is a typical middle class, small city with a significant population of people struggling to make ends meet. Many families are unable to save money because, what little income they do have is barely covering life's necessities - food, fuel, housing, utilities and health care.
Over the last six years the Connecticut real estate market has been very kind to Bridgeport CT. Rising Connecticut property values and the availability of low or even no down payment CT loans available for people with jobs and reasonable credit have been the engine of our growth. Because values were rising, the few people who overstretched their capability to make CT home mortgage loan payments on time were able to sell their homes, make a profit and avoid foreclosure.
Everything has changed. The Bridgeport CT real estate sales market has slowed appreciably since the fall of 2005 and average Bridgeport Connecticut home values started to drop to an estimated level of 10 percent of prior high market values. With the tightening of the availability of sub prime loans in Connecticut, the CT lenders who are currently making these loans are requiring their field review appraisers to do distressed value appraisals, which are lowering the market value another 10 percent. In other adjacent markets like Fairfield Connecticut with more income and credit stability than Bridgeport CT, the prices have fortunately just leveled off.
Bridgeport Connecticut is in trouble. Many of the people who bought their CT homes without having to make a down payment are now facing a negative home equity position. This means that the outstanding balance on their Connecticut home mortgage loan is larger that the value of the CT property. With any problem making a monthly Connecticut mortgage loan payment, the homeowner has lost their incentive to keep the home. They now have nothing to gain and a lot to lose if they sacrifice quality of life needs to make their monthly CT mortgage payments.
The easy way out is to walk away from the Connecticut mortgage obligation and turn the house over to the bank. This is technically called deeding the CT property to the bank in lieu of foreclosure. Foreclosures in Bridgeport Connecticut are soaring compared to last year's pace and, tragically, continue to climb. This is a dangerous trend as these foreclosures are always sold at distressed prices and negatively affect the home values on the block. This is not the American dream that the working class residents bought into when they were looking to build equity.
SECONDARY MARKET COLLAPSE
The mortgage business changed appreciably in the mid 1970s when the government formed Fanny Mae and Freddie Mac to save the banking industry from wild rate fluctuations. This was the result of the U.S. economy going off of the gold standard.
The concept and its execution were very simple and it worked. These huge mortgage buying entities would purchase mortgages from the banks and other mortgage lenders so that they didn't have to take a risk on holding low-interest loans. The risk was passed on to bond holders who bought the mortgage paper as collateralized securities.
The process is called securitization. They arranged with the large Wall Street firms to pool large amounts of these mortgage loans into bond issues that were called Mortgage Backed Securities. For three decades, the MBS market was comprised of mostly standard 30-year fixed-rate loans that also included government issued FHA and VA loans.
The long track record of MBS bonds with stable interest rates and almost negligible loan default rates gradually led to a loosening of the standards due to a desire by the bond market for riskier loans. This is when the bond market started to buy sub prime loans.
SUB PRIME LOANS
The designation "sub prime" is the description of Connecticut home mortgage loans that are made to borrowers who have issues that are not acceptable to regular A paper lenders. CT loans are rated as being A, B, C or D paper - A is the least risky and D the most risky based on underwriting valuations.
Sub prime lenders in Connecticut have been around for a long time but the real growth in this market occurred when the bond market started buying the sub prime paper. These Connecticut mortgage lenders service people with credit issues, employment irregularities, little or no savings and the self-employed.
The market for sub prime loans grew from hundreds of millions to hundreds of billions of dollars quickly and became a major source of income for the big Wall Street players. The sub prime lenders wrote the loans and the Wall Street firms bought and securitized them.
RATING THE MORTGAGE PAPER
The traditional way of setting Connecticut interest rates for sub prime loans has been a computer evaluation that is based on an underwriters evaluation of the risk level of each loan. The higher the risk, the higher the interest rate will be set to anticipate a higher default rate. In a normal economy, these rate projections have worked well.
So what upset the apple cart? A doubling of the mortgage default rate. The problem that upset the process has been the fact that the default rate has grown to double the size of the usual default rate when the market was stable. Traditionally, mortgage default rates hovered around 3 percent with sub prime defaults getting up to about 6 percent.
The current default rate as stated in The Wall Street Journal, on nonperforming loans is running 12.4 percent and climbing. This has caused the yields on the sub prime loans sold to bond holders to drop significantly and is threatening to lower the bond ratings. Wall Street firms that have made these loans are now in a credit crunch and they have reacted by stopping their purchase of sub prime paper. Since the sub prime market has grown to such a large part of the MBS market, the impact of withdrawing this liquidity from potential mortgage borrowers will have a negative effect on the U.S. economy, especially the credit industry.
SUB PRIME MARKET WITHDRAWAL
There isn't a sub prime lender in the country including the biggest firms that haven't been adversely affected by this turn of events. When the big Wall Street firms recently cut off the purchase of the lower quality mortgage paper, they effectively put all of these sub prime lenders out of the market for risky loans.
Firms that did a majority of their business in high risk mortgage programs had to shut down operations as their cash flow dried up. For firms that did a smaller percentage of their overall business in this product range, they simply shut down the marketing programs for low down payment loans to focus on other, less risky products.
The net effect is that in the last three months, 62 mortgage firms, each writing billions of dollars in sub prime loans, have withdrawn the only workable mortgage products from the most sensitive and needy segment of the home buying market, the average wage earner who wants to buy a home.
THE EFFECT ON THE COUNTRY
Real estate sales nationally are estimated to be off by at least 20 percent since last summer. The withdrawal of the affordable housing financing by the sub prime market will further set back sales of homes in the months to come. Each market will be different depending on the economic makeup of their residents with higher income areas not being adversely affected as much as lower income areas.
The slowdown in sales and loss of a significant mortgage lending capacity will create a failure of many firms both in the mortgage and real, estate businesses. This will definitely have a negative effect on our national economy. It may even put the economy into a recession as has been recently predicted by Alan Greenspan. A scary thought.
THE EFFECT ON BRIDGEPORT CONNECTICUT
Bridgeport is extremely vulnerable because such a large percentage of its population is comprised of middle class wage earners. It is estimated that one half of real estate sales over the last few years has been to our local residents who have moved from renting to owning. With the mortgage programs that made this move to home ownership removed from the marketplace, both the continued sales of homes and the stability of our home values are at risk.
An examination of the Superior Court calendar in Bridgeport on Monday, March 26, 2007, shows that there were 113 foreclosures on the calendar, most of them in Bridgeport. There have been days recently when this foreclosure number was over 150 properties. It will get worse.
Equity in a home is based on the current appraised value less the total mortgage amount owed, not on what it was worth one year ago. Seniors who want to retire may have to delay their plans if
the market conditions have reduced their home value enough to prevent them from meeting their capital needs to cover their projected retirement living expenses.
At a time when Bridgeport needs to increase the city's grand list value, we are faced with a potential decline in property values that will place additional tax pressure on the city's homeowners. With one of the highest tax rates in the state companied by escalating energy costs, Bidgeporters are faced with out of control cost of living increases that will definitely boost the rate of foreclosures.
THE GOVERNMENT HAS TO REACT
Recent U.S. Senate hearings chaired by Connecticut Senator Christopher J. Dodd, who is chairman of the Banking Committee, are investigating the sub prime problems and the senators are looking for solutions.
From our viewpoint, they don't understand the depth of the problem or the huge potential this loss of financing for housing will have on the country. We are looking at a liquidity crisis where money that would ordinarily be plentiful for home financing is totally absent from the market place.
Because this problem is a national emergency, our government has to find a solution that will restore the availability of mortgage financing to this important segment of the market. Knowing how slowly the federal government works, the potential solution could take two years or more to be implemented. This will be unacceptable to the people affected. Are we going to have to be entering a recession before our government officials will wake up and deal with the problem? We hope not.
The problem becomes a solution if the higher risk on these loans is offset by a higher interest rate. There is always a price at which an investor in MBS bonds will make a purchase if they are comfortable that the collateral is stable and the interest rate is sufficient to offset high rate of default. Even if the default rate of sub prime loans goes to 15 percent, that also means that 85 percent of the
loans are still in good shape and are performing properly.
A practical and immediate step that cam be taken would require the big Wall Street firms to get the approval of the Federal Reserve to cross the line and increase interest rates on sub prime loan programs. This will raise the threat of “predatory lending," which has been a favorite political consumer issue over the last few years. The big question is; are there any other alternatives that would achieve the desired cure to the problem besides resorting to raising interest rates?
Lloyds of London never has a problem insuring any type of risk because they know that they will set the return at a level that will satisfy their investors. The buying of higher risk mortgage paper should require the same kind of evaluation. The difference is that rating insurance risk doesn't involve consumer issues, as it is mostly business oriented. When our consumers are involved, politicians have to satisfying the voters that they are protecting consumers rights. Politically correct action should insure there isn't any high rate abuse occurring.
The possibility of government rate subsidies for targeted consumers could be the answer. In reality, it will never fly because of the huge potential for this type of program-becoming a drain on the treasury and an entitlement at a time when the country is under significant financial pressures.
THE ALTERNATIVE SOLUTIONS
There was a time before the mid 1970s when savings banks were the prime source of mortgage financing. They held the paper as "portfolio loans" and always required at least a 20 percent down payment before they would even look at the loan opportunity.
ARMs, or adjustable rate mortgage programs, may be an answer for local banks to make low down payment loans and hold the paper to season it for a year or two. This would require the government to back them up with an insurance guarantee if the loans defaulted and there was a shortfall in recovering the full value of their loan. This insurance is called PMI (private mortgage insurance) in the private sector and MIP (mortgage insurance premium) for FHA loans.
With an exposure of about 15 percent of the sub prime loans to protect, PMI insurance which traditionally covered the first 20 percent of the loan amount can be charged to all borrowers in this classification. This will spread the risk and protect the purchasers of the MBS bonds. The goal is to restore the availability of mortgage financing for our middle class citizens without disrupting the rest of the economy. The PMI solution will accomplish this objective as long as it is implemented quickly.
City and state government officials could also step forward with an increased down payment assistance program that would help people who have decent credit and a steady job. HUD has traditionally financed this market segment but has been underfunded in recent years. Our federal government could increase the funding to HUD and expand this progran1. Their ability to move quickly enough to avoid the coming effects of the melt down is unfortunately questionable.
CONCLUSION
When we are in a market where we have declining property values, this makes it fiscally prohibitive for lenders to do 100 percent mortgage financing except for the strongest borrowers. The risk the lenders or the Wall Street firms don't want to take is that they make a loan and the value of the property continues to drop after the closing. Their exposure for a loss is undetermined and significant. Something they won't voluntarily accept.
The engine driving the local economy has been the real estate arena. This boom is coming to a halt. Up until the spring of 2006, people have been able to take equity out of their homes to upgrade their properties. Now this trend is turning around and heading the wrong way. Add to this the fact that the handful of sub prime mortgage lenders who are still in business have made significant underwriting¬
restrictive changes that will further reduce the availability of mortgage financing for wage earners.
That this will adversely affect the country in the months to come is a given. While our federally elected officials debate issues, the snow ball that is moving down the mountain that is a serious weakening of the real estate and mortgage markets will continue to grow in size and complexity.
What we need quickly is informed leadership and the execution of plans to correct this potentially devastating situation. Are there national or local leaders who will step forward to take a position on addressing this issue? This is a serious concern we put to our elected officials.
The biggest question to be asked is, what has our elected officials planned to do to anticipate the potential loss of tax revenue to Bridgeport? How are they going to offset the serious long-term
effects this potential cash flow problem will have on the running of our city? Do they have any proposal or solution for these anticipated issues?
We hope so or we are in for a rougher ride economically that anyone seems to be aware of or is prepared to face.
Barry J. Piesner and Charles Coviello lead Citizens For A Better Bridgeport.
Connecticut Post Sunday April 29th, 2007.
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