Frances Darden, a disabled mother of three from Boston’s Dorchester neighbourhood, long dreamt of owning her own home. Several banks turned her down for a mortgage because she did not earn enough. She was starting to give up hope.
But in September 2004, an advertisement in the local newspaper for a home buyers’ seminar caught her eye. “It was so appealing,” she recalls. “It said: ‘You can afford your dream home. Let’s make history’.”
Ms Darden, who is in her late 40s, went along to the presentation with her best friend. Soon afterwards she was looking at houses, through an estate agent from Champagne and Associates Real Estate and a mortgage broker from New England Merchants Corporation which were involved in the seminar. She says the agent encouraged her to buy a multi-family property, where she could become not only homeowner but landlady as well.
At that time, her monthly income was made up of not much more than $1,800 (£930, €1,360) in disability payments, a small amount of child support and a modest rent subsidy. Much to her surprise, Ms Darden was “pre-approved” for a loan worth $894,000. “When they told me, I couldn’t believe it. But they said: ‘We’re different from everyone else, we can help you.’ ”
Ms Darden put no money down. She says she was assured that her monthly repayments would be $5,000 and that rental income would fully cover those costs – and put money in her pocket to boot. As it turned out, the repayments were more than $7,500 a month. The annual interest rate was 11.7 per cent, nearly double the level a creditworthy borrower would be charged. By November the following year she had fallen hopelessly behind on her mortgage. One flat in the two-unit house she had bought was foreclosed on and sold. The other is soon to go to auction.
Ms Darden’s experience explains why the “subprime” mortgage industry in the US is facing such painful problems. The root of it all is simple enough: many home buyers with low credit scores nonetheless managed to land big home loans over the past couple of years.
Victoria Wagner, credit analyst at Standard & Poor’s, the ratings agency, says some subprime mortgage lenders dramatically lowered their standards amid “the so-called democratisation of credit”, granting loans that contained many levels of default risk. These included a lack of income documentation and no downpayment. Ms Wagner calls this kind of risky lending “unprecedented”.
Now buyers such as Ms Darden are falling behind or defaulting, as interest rates that started relatively low go higher and home prices in some parts of the US stop rising. So far the problem has remained largely contained within the subprime sector. It may stay there but concern is growing that difficulties could spread throughout the housing market and then, perhaps, the wider US economy.
The first way the subprime decline could impact on the housing market is if a flood of foreclosed homes came up for sale and pushed down prices in areas where the supply of homes is already high because demand has dropped off. “The big question is, how quickly will housing prices adjust lower as delinquency rates rise?” says Richard Gilhooly, senior fixed income strategist at BNP Paribas.
Analysts at Lehman Brothers project that mortgage defaults could reach $225bn during 2007 and 2008 and perhaps go as high as $300bn. “The risk that they impact the broad housing market and begin to weigh upon prime borrowers is very real,” they say.
Figures released this week by the Mortgage Bankers Association show that a final splurge of loans made recently is likely to be the poorest quality on record, with the proportion of mortgages in the initial stages of foreclosure at all-time highs and late payments and overall defaults reaching 5 per cent last quarter. Delinquency rates for subprime adjustable-rate mortgages, the riskiest kind, hit 14.4 per cent.
The numbers could get much worse because many who bought homes face “resets” in their mortgage payments; the low rates that tempted them in will revert to higher, market-determined rates. Lehman estimates that more than $900bn of mortgages will hit a reset in the next two years.
Many people facing resets will have banked on being able to refinance their loans. But that might not be possible if lenders continue tightening their approval standards. “The main concern is that lenders could pull back from extending credit to the reset borrowers,” the Lehman fixed-income analysts say.
Still, it is far from certain that the subprime ailments will infect the broader housing market. Steven Wieting, economist at Citigroup, suggests that the problems are likely to affect financial institutions and their investors – as indeed they already have – more than consumer sentiment and the economy at large.
But if the marginal buyer – someone able to buy a house only if conditions are right – is knocked back, that could at best slow a recovery in the housing market.
At worst, it could lead to recession. David Rosenberg, North American economist at Merrill Lynch and a perennial bear, says: “This housing downturn is far from over and the full impact across the economy has not been felt…As with most bubbles, this one started with loosening credit guidelines, excessive price appreciation, classic performance-chasing [and] speculative fervour, and now ends in lawsuits.”
Whatever the impact of the subprime fiasco on the wider economy, it is already deeply painful for many Americans. Ms Darden in Boston, for her part, recently filed for bankruptcy protection. An attorney from a legal aid clinic run by Harvard Law School is advising on how to start restoring her credit. That includes pursuing claims against those who arranged her purchase and the accompanying mortgage.
New England Merchants says the mortgage broker she used was an independent contractor with the company, an arrangement that has since been terminated. Calls to Champagne and Associates were not returned.
Ms Darden faces having to move soon from the home that two years ago she thought was hers for life. “I don’t wish this on my worst enemy,” she says. “I’ve spent many restless nights worrying about this. You work all your life, you save, you dream – and now it’s all gone.”
Chain reaction is a dread
One way the subprime shake-out could lead to systemic problems across the capital markets is if investors who had little idea they might own such mortgages suddenly discovered that they did. These holdings would probably be through complex structures called collateralised debt obligations – packages of asset-backed bonds.
Investors in CDOs – say, pension funds in Europe or Japan – may be inclined to act more quickly when they detect subprime exposure than would a group that was already well aware of the risks in their CDOs.
One problem is a lack of information. CDOs are rarely traded and difficult to value. As a result, buyers are often reliant on credit ratings to know when to sell. However, credit ratings regularly lag market prices, meaning that losses can be greater than necessary when the credit rating downgrade finally comes.
Josh Rosner, managing director at Graham Fisher & Co, an investment research firm, says: “Because many buyers of CDOs can only hold investment-grade assets, they may continue to hold deteriorating and increasingly illiquid assets as long as credit ratings have not been downgraded.”
This means that when these investors eventually sell, they may also be forced to accept large losses in a fast-moving market. The heavier the losses, the less likely investors are to want to return, a classic case of “risk aversion”.
Such risk aversion is already clear among the commercial and investment banks that had provided funding to subprime mortgage lenders. Those banks cut off credit lines to New Century Financial and Accredit Home Lenders, pushing both close to bankruptcy filings.
With equity investors in subprime (and even prime) mortgage lenders offloading their shares – “then asking questions later”, according to David Hendler, an analyst at CreditSights – some industry executives say the selling appears irrational and panic-driven, another signal of growing risk aversion.
Angelo Mozilo, chief executive of Countrywide Financial, a leading mortgage lender, said on television this week that investors were dumping shares of home loan groups with little regard for a lender’s actual fiscal health. “This is now becoming a liquidity crisis,” he declared, adding: “It’s going to get uglier.”
The ugliness could spread if lending standards to companies, hedge funds, private equity groups and others come under review.A broad tightening of credit requirements by lenders could have ramifications throughout the markets.
For many, such a rethink is overdue. The returns demanded by investors on risky assets such as junk bonds and emerging market debt are not far from all-time lows. The pace of company defaults is also at a record low, perhaps diminishing the risk in the eyes of investors.
As well as affecting US mortgage borrowers, a credit crunch could make hedge funds that use large amounts of borrowed money cut their debt, perhaps selling assets en masse in order to do so. If that led prices to fall, the effect could feed on itself as others scrambled to limit losses.
Companies, particularly weak ones, could find it hard to refinance existing debt – potentially leading to a sharply higher incidence of failure, which would further rock credit markets.
The worry is that such a wave of “deleveraging” could swell, with few investors both willing and able to start buying and halt the decline in asset prices. “There is an elevated risk of a financial market crisis during the next two months,” says T.J. Marta, fixed-income strategist at RBC Capital Markets. “There is a concern that as liquidity tightens, the wheels could fall off.”
Signs exist that investors have adjusted leverage levels in recent weeks. The yen is tending to strengthen whenever other markets show weakness, an indication that “carry trade” investors – who borrow in yen at low interest rates to finance purchases elsewhere – are at best nervous about their exposure.
Steven Wieting, economist at Citigroup, points out that banks have tightened lending standards, at least for mortgages, according to the latest quarterly survey by the Federal Reserve. But he notes that the shift followed a period of easy loan availability, which continued even after mortgage delinquencies began to rise.
There seem few signs of investors leaving the debt markets. The huge quantities of capital looking for a home, which have powered the ability of private equity to announce ever larger leveraged buy-outs, have not dried up. Still, analysts worry that the subprime meltdown could be the catalyst that brings the era of easy access to cheap debt to a close.
A rout could turn vicious
One area where the impact of the subprime mortgage shake-out is already clear is the equity market. Each day on Wall Street seems to bring fresh news of specialist lenders collapsing and fears about possible problems elsewhere, such as at the investment banks that have big subprime holdings. The result is dizzying volatility.
Financial stocks have been down since worries over the subprime sector began in earnest in mid-February. The big equity sell-off of February 27, though in part the result of concerns about a possible economic slowdown in China, also demonstrated subprime anxieties in the US. The financial sector took among the biggest tumbles that day, with some banks down by as much as 8 per cent.
The power of fear has remained visible this week. Goldman Sachs shares failed to budge even after the bank reported another quarter of stunning earnings on Tuesday – and Goldman does not even have much of a subprime business. Lehman Brothers, which does, saw its shares initially plunge 5 per cent when it reported record results on Wednesday but suggested that it was seeing some impact from problems in the subprime market.
Lehman’s shares reversed course later that morning when executives took the very rare step of publicly spelling out exactly how much of its revenue (an average of 3 per cent over the past six quarters) came from its business of originating and buying subprime loans in order to package and sell them as mortgage-backed securities to investors.
“The current battle involving Wall Street firms’ subprime exposure and investor perception of contagion risk rages on without any end in sight,” says Michael Hecht, a Bank of America analyst. “This is occurring in spite of positive commentary from both Lehman and Goldman Sachs that the sky is not falling.”
One fear surrounding the investment banks is that while subprime might not be that big a problem on its own, a flight from risk could mean that other profitable Wall Street businesses – such as the packaging of prime mortgages, credit card loans, student loans and other liabilities into securities – would dry up.
David Viniar, Goldman’s chief financial officer, says such securitisations have been a key part of Wall Street’s profit growth. But he adds that he does not think the current subprime problems will derail that growth.
“The concept of securitisation, which I think of as the ability to [divide] up credit risk so you can put it in the hands of people who want it as opposed to people taking parts of risk they don’t want, has been an important development over the last several years,” he says.
“It has been good for all of the capital markets – and I still think it will be an important financial tool that will be used, although I think the subprime market will be smaller.”
The wild ride played out in the larger market as well on Wednesday, as the two main schools of thought (subprime is a disaster versus subprime is no big deal) fought it out, leading to big swings in the main indices.
One of the biggest fears among market watchers now is that the worriers will win, whether based on fact or fear, and push stock prices beneath levels that have held even in the face of recent heavy selling pressure. For the Dow Jones industrial average the recent bottom being watched by the market is 12,050, which was hit on March 5. If that level is breached, the theory goes, the rout could quickly turn vicious, with selling begetting more selling and reason going by the wayside.
One common counter-argument is that there is plenty of cash on the sidelines waiting to rush in to buy stocks on the cheap after a few days of big losses. While it is true that there is a lot of liquidity looking for a place to go, it does not follow that this money will naturally flow back into the stock market.
“Liquidity isn’t about money on the sidelines per se, but rather about the risk appetite of those on the sidelines,” says Paul McCulley of Pimco, the investment group. “When risk appetite turns, no amount of liquidity on the sidelines matters, particularly when a crowd gathers there.”
Alan Ruskin, strategist at RBS Greenwich Capital, says the subprime story could continue to impact on markets through the rest of 2007. That would not necessarily lead to repeated big sell-offs but it could prevent any significant gains. “The persistent uncertainty does restrain buying and the return of risk appetite,” Mr Ruskin adds. “The market is plainly more fearful about what it does not know than what it does know.”
By Ben White in New York, Rebecca Knight in Boston, Eoin Callan in Washington, Richard Beales, Saskia Scholtes and Michael MacKenzie in New York
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