Economists Brace for Worsening Subprime Crisis

Jose Pomales and his son in front of their house i i

Jose Pomales and his 7-year-old son, Jordan, stand outside of their home in Hyde Park, a Boston neighborhood. They have lived there for 8 years, but two years after refinancing, Pomales is in danger of foreclosure. Chris Arnold, NPR hide caption

itoggle caption Chris Arnold, NPR
Jose Pomales and his son in front of their house

Jose Pomales and his 7-year-old son, Jordan, stand outside of their home in Hyde Park, a Boston neighborhood. They have lived there for 8 years, but two years after refinancing, Pomales is in danger of foreclosure.

Chris Arnold, NPR

The Mortgage Market

The Credit Crunch

Federal Reserve policymakers met Tuesday and decided to leave a key interest rate untouched for the ninth straight time. In a statement, the Fed said inflation remains its top priority. But by acknowledging an increase in the "downside risk to growth," the Fed made clear it's concerned about how a still-developing credit squeeze will affect the economy.

 

That squeeze started out in the subprime mortgage market, but it's now grown to a point where it has undermined the market for private-equity deals.

Jose Pomales stands on his back porch with his 7-year-old son, Jordan, and looks out over his big backyard.

Eight years ago, he moved into his modest ranch house in Boston's Hyde Park neighborhood and has since spent time and energy on landscaping and fixing it up.

Pomales has a solid job with a local housing authority, and he and his wife's combined income is around $65,000 a year. He says he has always paid his mortgage, but two years ago, Pomales refinanced and got a loan from New Century, a lender that has since gone under after writing too many loans that customers didn't or couldn't pay back.

The monthly payment on Pomales' $300,000 loan started at about $2,100. Then, the payment increased by more than $300 a month, and will soon be adjusted to about $2800 per month. In another six months, his mortgage payments will be increased even more.

Pomales says he had no idea how much his monthly payments would go up and is now unable to afford his home. His only option, he says, will be to either try to sell the house or just let the bank take it. Recently, he received a foreclosure letter in the mail.

"This is my home, and I don't want to let somebody just take what we've worked hard and sweated for. I mean it's not the biggest house. It's maybe not the most glamorous house. But it's my home," he says.

Many More in the Same Boat

Most subprime loans are fixed for two years, adjustable for 28, and even if overall interest rates stay flat, these loans still adjust up much higher than their initial rates when they hit their "reset date."

Analysts say that in September 2005, the subprime lending boom started hitting its peak. Now a bigger wave of rate resets could mean a flood of foreclosures.

Susanne Mistretta, a managing director with credit rating agency Fitch Ratings, says that the borrowers who have loans adjusting now are much more exposed to the rate reset than the borrowers who had loans adjust prior to this point. She says falling house prices and stricter credit standards are making it harder to refinance out of these loans, which were written during a time when lending standards in the mortgage industry were getting out of control. Many lenders were processing loans without documenting borrowers' incomes, and some loans were made for more than the houses are now worth.

Just last week, Fitch changed its default forecast for one subset of subprime loans, saying 50 percent more loans will default than they previously predicted.

A Historic Number of Foreclosures

More economists are predicting that a historic number of people will lose their homes.

"I foresee several million. I think that we could easily see 2 to 3 million people lose their homes and go back to renting, basically," says Bill Wheaton, who runs MIT's Center for Real Estate.

He says that some of those affected will be people who paid too much or borrowed too much against their homes. If their payments are rising and the houses are worth less than they owe, they'll just walk away, Wheaton predicts.

Many others facing possible foreclosure are longtime homeowners, like Jose Pomales, who say they just didn't understand what kind of loan they were getting into when they refinanced and who are now stuck.

Running Out of Options

Jose Pomales has tried unsuccessfully to refinance his mortgage, which is now managed by Chase Home Finance. He says he has been asking Chase to work with him and give him a more affordable interest rate but says they have refused.

Chase won't discuss individual customers, but a spokesperson offered this statement:

"Chase works with customers individually and uses a number of strategies to help borrowers facing financial difficulties, including refinancing and considering all options available to modify loans."

Other lenders are making similar pledges to modify or refinance customers who are stuck in loans with rapidly rising rates they can't afford, but housing advocates say that, so far, they are not doing it very often.

Pomales worries that without refinancing, he will soon be forced to leave his longtime home.

"We're just regular middle-class, hard-working individuals, and you hate to see things taken away when you're working hard for it," he says.

The Mortgage Market: What Happened?

Foreclosure sign

Nationwide, foreclosures surged by 47 percent in March compared with a year ago, according to RealTrac, which follows mortgage foreclosures. Joe Raedle/Getty Images hide caption

itoggle caption Joe Raedle/Getty Images

The Fraud Factor

Instances of outright mortgage fraud are also coming to light. Reports of suspected fraud from federally regulated institutions more than doubled between 2003 and 2006. Federal officials estimate mortgage fraud totaled from $1 billion to $6 billion in 2005 alone.

One strategy involved organized groups that sold several homes in a neighborhood based on inflated appraisals. An individual would buy a property, then sell it to a real or straw buyer at an inflated price and pocket the difference. Often, a ring of appraisers, mortgage brokers, real estate agents and closing attorneys colluded with the seller to push through the deal.

Such schemes temporarily drove up prices in neighborhoods, hurting other, earnest buyers who paid for homes that quickly lost their value.

Quicker processing times to accommodate the growth in mortgage volume made the system "abuser friendly," says Robert Russell, counsel to the Office of Thrift Supervision, which regulates some lending institutions. Rewarding brokers for sale volume, rather than for loan repayment, also contributed.

As the nationwide real-estate boom of recent years goes bust, economists and regulators are questioning the role that mortgage lenders played in helping to create an overheated housing environment. Here, an overview of what happened:

A Rush of New Buyers

In the early 2000s, the economy was healthy, interest rates were low and consumers felt a bit flush – all of which helped push real-estate values up across the country. With values escalating, lenders felt more confident about making mortgages to customers whose poor credit histories had prevented them from buying homes in the past. (When values are rising, borrowers are less likely to default, because they can take money out of their homes if they run into trouble.)

That put more potential homebuyers in the market, helping to raise home-ownership rates to a record 69 percent in 2004 – which pushed housing prices up more. Skyrocketing prices (double-digit growth year over year was common in some areas) lured real-estate speculators, creating even more demand — and driving the cycle further.

Risky Loans Proliferated

To attract this growing pool of borrowers, lenders repurposed "creative financing" products that had previously been marketed to high-income borrowers seeking flexibility with their money. Among the most popular were variations on the adjustable-rate mortgage, or ARM.

ARMs are loans whose interest rates adjust up or down periodically. The initial rate is typically fixed for a period of two or three years. The benefit is that the starter rates are lower for ARMs than for traditional, fixed-rate mortgages. That means lower monthly payments, making homeownership more affordable and allowing borrowers to qualify for a bigger loan.

Some of the creative ARM products that flourished of late included interest-only and payment-option loans. With the former, a borrower only pays the interest on the loan — not the principal balance — during the introductory period. With payment-option ARMs, borrowers get to choose how much they pay each month: enough to cover the interest plus the principal, the interest only... or less than the interest. In that last scenario, the unpaid interest is tacked on to the principal, leaving borrowers owing more than the amount of the original loan.

How prevalent were these loans? Nearly 23 percent of all mortgages taken out in 2005 were interest-only ARMs, and more than 8 percent were payment-option ARMs, according to First American LoanPerformance. In certain once-sizzling markets, the numbers were much higher: For example, 34 percent of all new mortgages in California in 2005 were interest-only.

These products made sense to borrowers who thought they'd live in their homes for a few years, then sell at a profit or refinance. But now that housing sales have stalled and prices are softening, borrowers can't do either very easily.

And many borrowers are facing painful payment hikes: According to a First American CoreLogic study, one-third of ARMs taken out between 2004 and 2006 began with "teaser" rates below 4 percent. Payments on these loans will double on average – if they haven't already done so, says study author Dr. Christopher Cagan.

Growth in Subprime Lending

And then there were the loans to borrowers with poor credit. Subprime loans expanded to 20 percent of the mortgage market in 2006, from 9 percent a decade earlier. These loans carry higher interest rates to compensate for the risk posed by borrowers. They can be traditional fixed-rate loans, but most are ARMs, according to Susan Wachter of the University of Pennsylvania's Wharton School.

Recent subprime loans were rife with risky terms — interest-only payment options, penalties for paying off the loan early (which makes it costly to refinance into a better loan), and low documentation requirements, meaning borrowers needed little paperwork to verify that they could, in fact, afford the loans. (These so-called "liar loans" accounted for about 58 percent of all loans in 2006, according to First American LoanPerformance).

Kathleen Keest of the Center for Responsible Lending says the pairing of these new loan types and new pool of borrowers was dangerous.

"They took the riskiest of products and sold them to the weakest borrowers to compound risk," Keest says.

Unethical Practices

In the old days, most homeowners obtained mortgages from their local bank or credit union, which adhered to strict lending rules. Nowadays, the lion's share of homebuyers' business (70 percent) goes to independent mortgage brokers — some of whom get bonuses for steering borrowers to higher-interest loans.

Experts say many recent borrowers were put into ARMs that are likely to cost far more over the life of the loan than if they'd chosen a fixed-rate option. Often, consumers could have locked in fixed-rate loans at low interest rates, but lenders downplayed the advantages of these loans.

Experts also cite numerous cases where borrowers say they didn't understand the loan structure — and the escalating payments; in many cases, they couldn't really afford them. Jennie Haliburton, a 77-year-old widow in Philadelphia, told NPR she refinanced into a subprime ARM that now costs her $300 more than the $800 she was originally told she'd pay. Her loan resets in May 2008. If the current interest rate holds, the monthly payments will grow to $1,218; depending on rates, they could eventually reach almost $1,700 — 95 percent of her Social Security income.

Loose Oversight

New loan products allowed more Americans to own their own homes than ever before. But regulators exercised little oversight over the booming mortgage market. The Federal Reserve and four other federal regulators did not issue guidance for nontraditional mortgages until last year. They recommended that lending institutions consider the borrowers' ability to make payments over the life of the loan before underwriting, and that they improve disclosure to consumers.

Yet many, including Federal Reserve executive Roger T. Cole, say it was too little, too late. "Given what we know now, yes, we could have done more, sooner," Cole told Congress in March.

But the loans are already out there; all that's left is to wait for the fallout. According to First American CoreLogic, this year and next, about $260 billion in prime ARMs and $376 billion in subprime ARMs will begin to reset.

So What Now?

Several lenders are taking steps to curtail the rising tide of foreclosures. Washington Mutual plans to refinance up to $2 billion in subprime loans at below-market rates. Citigroup and Bank of America are working with an advocacy group to similarly target $1 billion in subprime mortgages, focusing on cities with high foreclosure rates. Freddie Mac is fueling the market with a commitment to buy up to $20 billion in subprime loans, and Ohio is floating a $100 million bond issue to help troubled homeowners.

The new environment may also drive new solutions. Lenders now face falling home prices, large loan portfolios with no money down, and a home-foreclosure process that may cost them tens of thousands of dollars. Renegotiating loans -– lowering the interest rate or extending the payment period –- may be more attractive than foreclosing.

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