The State of the Market

By Jack Guttentag
The Washington Post
Saturday, June 2, 2007; F23

Over the past two weeks, I have explained that the immediate cause of turmoil in the subprime market has been the halt in house price appreciation and that the underlying cause has been a myopic tendency by lenders to make loans that worked only if prices continually rose. What's the state of the market now?

The pain is uneven. The dozens of subprime lenders that have failed have garnered little sympathy. Put simply, they gambled and lost. Some borrowers fall in that category as well because they were trying to profit from house price appreciation. Instead, they face foreclosure.
Investors in securities issued against pools of subprime mortgages have also felt pain as the market value of these securities has declined. Lehman Brothers estimates the decline at $19 billion. Most of it is concentrated among the riskiest securities, which promised the highest yields. (Few tears are being shed for those investors, either.) Securities rated AAA, which are first in line to be repaid and last in line to take losses, have been hurt very little.

Mortgage brokers have not been significantly affected. A few have lost access to subprime lenders, but most have been able to replace defunct lenders with other lenders.

The big losers are those borrowers who, as unwitting victims of hype and deception, took out mortgages that were unworkable if house prices stopped rising. Now, with values stagnant, many of these borrowers are waiting for the next shoe to drop. They have adjustable-rate mortgages on which the rate will reset to a much higher level.

The subprime market remains open. This is the good news, and it should not be taken for granted. When the international banking crisis erupted in the early 1980s, the market adjustment stretched over a decade, during which there was almost no new lending.

The subprime lenders who remain are the more cautious ones. They are also more likely to be affiliated with other firms with deep pockets, which will help them ride out future market disturbances.

Of course, the profit potential in subprime lending is not what it was. Investors require a higher yield than before, especially on the riskiest securities. This has caused tightening of underwriting requirements, which has effectively lopped off the riskiest segment of the market.

Underwriting requirements are more restrictive. Underwriting requirements are the conditions that borrowers must meet to be eligible for a loan. They are significantly more restrictive now than they were a year ago. One of the most important shifts is the near-disappearance of the 100 percent (no-down-payment) loan.

Periodically, I receive an advertisement from a subprime wholesale lender rep advertising what is available from his firm. (He thinks I am a mortgage broker.) One came to me on April 19, showing that a borrower with a credit score of 620 (which is low) could qualify for a loan of $650,000 with a down payment of 10 percent. In my records, I found a message from the same rep dated June 20, 2006. At that time, he was offering the borrower with a 620 score a loan of $1 million with nothing down.

The 2006 offer was insane, a product of the euphoria created by steadily rising real estate prices. The current rules are no longer based on the inevitability of rising prices.

The prospects for some are poor. If house prices begin to rise again this year, the problems of the subprime market will go away. In 1998 and 1999, we had a similar episode, in which as many as 20 subprime lenders failed. But in 2000, house prices took off, the problems disappeared and few people today even remember the episode.

This time, however, the prospects for a quick revival of house price appreciation are poor. A further weakening is much more likely. Under these conditions, there is an ominous cloud on the horizon: Subprime borrowers who took out 2/28 ARMs in 2005 and 2006 will have their interest rates and payments reset to much higher levels this year and next. A significant number will not be able to make the new payments and won't be able to refinance because the equity in their houses is not sufficient to meet the new underwriting requirements. They will face foreclosure.

Next Saturday, I will discuss what if anything should be done about that.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.


Copyright 2007, Jack Guttentag
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