New Century Financial Corp., one of the nation’s largest subprime mortgage lenders, declared bankruptcy on April 2, joining a growing list of subprime lenders struggling to survive amid a rising tide of foreclosures across the nation.
The subprime mortgage industry is a sizeable chunk of the entire industry. Consumer groups, economists, mortgage bankers, politicians and the Federal Reserve Chairman have given their view on what many are calling the crisis of rising foreclosures associated with subprime mortgage lending. And those views vary as to the effect on the housing industry and the economy as a whole.
What is subprime mortgage lending?
Individuals with a poor credit history have a hard time qualifying for a favorable home loan such as one that a local bank might underwrite. Subprime mortgage lending, then, is the practice of making home loans to these individuals. This form of mortgage lending grew in the 1990s. Subprime borrowers might have a credit history stained by numerous late fees, writeoffs or bankrupties, or they might have a very short credit history. Borrowers who have a high debt-to-income ratio are also likely to be grouped into this category.
Subprime mortgage loans are made for both first-time home buyers and homeowners who want to refinance. These loans include adjustable rate mortgages, no-money-down mortgages and interest-only mortgages. In interest-only mortages, payments begin low and then skyrocket at a later date.
To lenders, subprime borrowers pose a higher level of credit risk than individuals with good credit; that is, there is a greater chance they will not pay back the loan. To make up for the increased rate of default, subprime lenders impose higher interest rates and fees.
According to the Federal Reserve Bank of San Francisco, an increase in access to the capital markets through loan securitization also contributed to growth in subprime lending in the 1990s. Securitization is the repackaging, pooling and reselling of loans to investors as securities.
Critics of subprime mortgage lending argue that lenders trick borrowers into taking out home loans they cannot possibly pay back. Proponents maintain the loans open the door to homeownership to individuals who normally would be unable to buy a home.
Over 2 million people with subprime mortgages are in danger of losing their homes this year, according to the Center for Responsible Lending, a nonpartisan research and policy group. The center also predicts that 1 out of 5 subprime mortgages granted between 2005 and 2006 will fail. These foreclosures are expected to cost Americans about $164 billion in lost equity from 1998 through 2006.
The Mortgage Banker’s Association, a Washington-based group that represents the real estate financing industry, takes issue with the center’s assessment. A recent MBA report states that the CRL’s "pessimistic" account ignores the fact that 85 to 90 percent of subprime borrowers do not default on their loans.
John Robbins, chairman of the MBA, testified March 27 before the U.S. House of Representatives’ Financial Services Committee Subcommittee on Financial Institutions and Consumer Credit. He said the subprime market should be stabilized, consumers facing foreclosure should receive assistance, and steps should be taken to avoid a recurrence of this phenomenon. Robbins added that responsible lenders extend credit only to borrowers who are willing and able to make mortgage payments, and do not trick borrowers. He acknowledges, however, that "bad loans were made."
Congress recently entered the fray. In late March, Sen. Charles E. Schumer, chairman of the Joint Economic Committee, said he intends to introduce a bill to crack down on predatory lending and create a federal system to regulate lenders.
Fed Chairman Ben Bernanke has said that lenders failed to calculate the ability of many subprime borrowers to repay their mortgages, particularly for ARMs where payments rise with interest rates. He also said it is worth looking into a federal anti-predatory lending law.
But some analysts think it is an exaggeration to call the current problems in the subprime mortgage industry a crisis, and warn against overreacting.
In a recent article, Austan Goolsbee, professor of economics at the University of Chicago Graduate School of Business, quotes a mortgage analyst who warned in 1981 about the risk of subprime mortgages. He argues that Congress should be mindful of the potential downside of too much tightening of lending regulations, and that subprime lending has led to increased homeownership. He cites a study, conducted by two economists at the Federal Reserve Bank of Boston, that shows a growth in new kinds of home loans from 1970 to 2000. These new types of mortgages have allowed borrowers to make their own decisions about housing, and they generally made good decisions. Goolsbee added that the rise of subprime loans has also opened the door of homeownership to African-Americans and Hispanics.
The Center for Responsible Lending reports that a majority of home loans made to African-Americans were subprime loans; the corresponding figure for Hispanics is 40 percent.
It is for just this reason that a coalition of advocacy groups, including the National Council of La Raza, the largest Latino civil rights group in the nation, is telling lenders to stop foreclosures on subprime mortgage loans. They argue that lenders, real estate agents and investors who bought subprime loans share the blame.
The high subprime delinquency rate and rise in foreclosures has led to a sharp fall in recent weeks in the purchase of bonds backed by subprime mortgages.
This week the chairman of the Federal Reserve Bank of Dallas said the subprime mortgage crisis has been largely contained. He said the financial system and economy is strong enough to weather the storm, and argued that regulatory agencies are striving to avoid radically changing credit standards, which could additional slowdown in the U.S. housing industry and economy.
But there is also evidence that the problems in the subprime mortgage market are spreading to loans called Alt-A mortgages, which, roughly speaking, fall between a prime and subprime market. M&T Bank Corp, a Buffalo, N.Y.,-based regional bank, reports that a recent auction shows investors don’t want to buy its Alt-A loans. Bank officials feel the subprime home loan mess is inching up the mortgage ladder and hurting the rest of the market. They expected more bidders, but ended up selling Alt-A loans for lower prices than expected.
A recent report from the Federal Reserve indicates that 15 percent of U.S. banks began tightening their credit standards in 2006 in subprime and Alt-A markets, making it tougher for borrowers to obtain home loans. One thing’s for sure, politicians, economists and consumer groups will continue to wrangle on the decaying subprime lending industry for a long time to come. Time will tell what the long-term effects will be on the nation’s housing market and the economy.