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Subprime Sequel

August 11, 2008 11:47 AM

ABC News' Charles Herman reports:  It was just over a year ago that the nation’s economy began to falter and start flirting with falling into an outright recession.  The source of the trouble was clear:  the collapse of the housing market. 

In particular, one word was used over and over to explain why homeowners were defaulting on their loans and banks were reporting a record number of foreclosures. 

Subprime. 

Ap_foreclosure_080811_blog Few people outside of bankers, brokers and economists had ever heard of the word, least of all, the homebuyers who actually received subprime loans.  As a result, journalists would add some explanatory sentence next to the word such as "loans to people with poor credit."

Now that word has become old hat, and a year later, a new word is entering the lexicon that could be the source of the continued economic slowdown.

Alt-A.

Like subprime, alt-A describes a type of loan.  These are one step up from subprime, but still not as good as prime loans  --  loans provided to people with good credit (see, I did it right there, explaining a prime loan). 

Fred Cannon, banking analyst with Keefe Bruyette and Woods, described it this way:  "They are loans written to a borrower with better credit scores but with a lot less underwriting."  In other words, a borrower could have great credit but did not provide any documentation proving his or her income to guarantee the loan. 

What’s troublesome is that these borrowers are missing their payments at an alarming rate.  In the past year alone, the number of homeowners more than 60 days late has quadrupled to 13   percent, according to LoanPerformance.  And homeowners who received these loans in 2007 are defaulting at much quicker when compared with borrowers in previous years.   

You don’t need to tell that to banks like IndyMac, First National Bank of Nevada and First Priority Bank of Florida.  These three banks, especially IndyMac, were involved in issuing alt-A loans, and all three were taken over by the FDIC last month.

When IndyMac failed, one analyst said he thought it would be the first in a slew of future bank closings, especially on the West Coast.  Another banking analyst pointed out that the difference between IndyMac failing and other mortgage lending institutions that have gone bankrupt since the housing market collapsed is that IndyMac is federally insured. 

"Now the insured lenders are crashing for the same reasons" was how Cannon reacted to the news of IndyMac’s collapse, those reasons being loans defaulting at higher rates.  And it’s not just subprime loans; it’s now alt-A.

So what is an alt-A loan? 

First, the name.  In the mortgage world, "A" loans are prime loans while loans that have a greater risk of default are classified as "B" or "C."  So alt-A loans are loans that aren’t prime.

It can also be the type of loan, especially the option-ARM (or adjustable rate mortgage).  With these loans, a borrower can choose one of usually four mortgage payment options each month that range from the full interest and principal due to a lower interest rate and no principle. 

Another banking analyst walked me through an example of an option-ARM that illustrates how scary the problem can be for many homeowners.

Say you have a 30-year option-ARM for $100,000  in which  your "accrue" rate  --  the actual interest rate for the loan  --  is  6 percent  and the "pay rate"  --  the minimum rate you can pay each month  --  is 2  percent.

Monthly payments at 6 percent equal $599.55 a month in order to pay off the loan in 30 years. 

Monthly payments at 2 percent are only $369.62, nearly $230 less than the actual rate you should be paying.  Each month that difference --  $230 -- is added to your loan amount.  If you pay 2 percent for an entire year, you will add $2,760 to your loan.

If you do this for an extended period of time, at some point, you will hit the "cap" allowed on the loan:  This is the maximum amount that can be added, usually around 15 percent to 20 percent  of the original mortgage.  When this happens, you can’t pay the minimum anymore, the terms of your mortgage change and so will your payments. 

In the above example, if by the fifth year you now owe $120,000 and you hit your cap (20 percent above the original loan), your monthly payments adjust to the 6 percent rate and your loan now has to be paid off in 25 years (instead of 30 years). 

Bigger loan, bigger interest rate, less time.  Your monthly payments now come to $773.16!  That’s $403.54 more than what you had been paying or more than double.

Why in the world would anyone take a loan like this?  Probably to keep monthly payment as low as possible, or perhaps this loan allowed you to buy a more expensive home.  Maybe you worked freelance and when you did get paid, you were paid well.  Or maybe even you got a year-end bonus that could be applied to the loan all at one time to make up for what you hadn’t paid over the year.

For many borrowers, however, good credit and good salaries were not enough to finance a home in markets like San Diego, where housing prices soared.  An option-ARM gave borrowers that extra lift they needed to be able to purchase a home. 

And since everyone said how home prices always go up and never decline, if you ever approached the cap, you could just refinance or even sell your home if necessary. 

At least, that’s what everyone said

Instead, home prices have now dropped 16  percent  as measured by the S&P/Case Shiller index,  and many analysts expect another 10  percent  drop before the real estate market stabilizes.  Already, more than 9 million of 52 million homeowners with first mortgages owe more than their home is worth, according to Mark Zandi, chief economist with Moody’s Economy.com.

It all feels like some sort of scary movie, but with real world implications.  First, it was those horrid subprime loans.  And just when it looked like that might be getting that beast under control, we have the sequel, "Alt-A:  Son of Subprime."  Let’s hope this one is short-lived. 

August 11, 2008 | Permalink | User Comments (4)

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Thank you for your article. I hope most Lenders will read it, because how you described the scenarios behind these type of loans are exactly what had happened and still happening. Most Lenders knew at one time or another that this housing crisis will happen as it happened already before - in the early nineties. What the Lenders did not expect was the magnitude and how
the crisis escalated. Because these
loans were available to almost every
buyer you can think of, the R E developers were the ones who took
advantage of these loan being available. These developers pocketed
huge, obscene profits on overpriced
homes. Please do not forget that most of these developers do have in-house
loan processing branches who actually
pre-qualified (?) their buyers, and approved blindly these sub-prime and Alt-A buyers. Here in No. California, you will see communities which are only 25 -30% developed, and even the homes which are completed had been vacant for months, some over a year.

But the reason I am writing you today
is not to remind you of what you already know. I just one to give another outlook - the Prime
Borrowers - those who bought their homes
with full documentation, 10 - 20% down-
payment, were able to document their income and where their downpayments came from. These homeowners who without the fault of their own became
victims of this plunging house market.
They are not defaulting yet, despite of the knowledge that their homes already lost 40 -50% of their purchase value.

What do you think will happen to these homeowners? Yes, there are still homeowners who can afford to pay their mortgage, maintain their homes, but are
strongly contemplating leaving their homes because their neighborhood is no longer safe, surrounded with these
foreclosures and short sales. How long
do you think this Homeowners will have
the motivation to stay in their homes
knowing that they are paying twice as much as the next door neighbor who bought their home 40 -60% lower than
how much they bought theirs? Or how long do you think will they stay in their homes, knowing that their neighborhood are turning rapidly into a ghost town? Most of these homeowners will eventually default too, not because
they want to, but because they have to
for the safety of their family and to
economic sense.

To make matters worse, all these Lenders/loan servicing companies are
not hearing their plea. Most of these
Lenders are ignoring the homeowner who is still in good standing, they have no available program addressing their concerns.

So be alarmed....this is not going to be an all out sequel to "Alt-A: son of Subprime", but it will be an entirely new episode already in the making "Prime-time to Disaster"

But all these can be prevented....the
next feature presentation must be "Bail-out", thru headliners Freddie and Fannie. If the Feds are all out in their support for a bail-out of these mega stars, what kind of bail-out can they offer these unfortunate homeowners?

Foreclosures and short sales is not the answer - because these actually caused the collapsed of the housing industry.
The housing market is overwhelmingly saturated with homes being offered at half the price because they were "bank-owned", the regular seller didn't have a
chance to sell unless it is a "short-sale".

These banks are willing to loss 30 - 60%
of their loan balances thru foreclosure
than offering the defaulting homeowner
a chance for a fresh start. In California where an average loan balance at the same time last year was around $480,000 not including the additional cash infusion for foreclosure fees and unpaid property
taxes, are departing their REOs at an
average of $238,000 today. This is the main reason why banks and mortgage lenders lost the value of their portfolios. Any loan which received
"short pay-off" against the actual loan
balance were carried as a "loss". I do not understand how Freddie and Fannie
are willing to accept losses through
"short pay-offs" instead of just accepting lower monthly payments from these defaulting homeowners? Would it be better to have "lower income" than
report huge "losses" in their books?

I am a simple person with simple logic.
It does not take a rocket scientist to
know why these banks and mortgage lenders were in trouble.....

If you happen to read my comments, I want to share a simple solution to these
housing problem, coming from a simple person with simple logic. E-mail me.

Posted by: Lina45 | Aug 11, 2008 11:00:03 PM

Love to hear that JP Morgan lost 1.5 billion. Their employees have no idea what is going on. They closed on a new construction loan for me without a certificate of occupancy and was locked out of the house for 5 months. Then I recinded the loan with the 3 day right of recession. They are holding to the loan a lawsuite has been filed in Broward county Florida. You go Jp Morgan Chase.

Posted by: allan cohara | Aug 12, 2008 7:40:04 AM

I worked for Jp Morgan and in the Tampa office. This file was pushed through by the underwiter who well new their was no ceritifcate of occupancy. Just wanted those end of month numbers work. That is what happened. James Diamond should know what his employees are up to his own employees deceiving homeowners

Posted by: ann kohl | Sep 3, 2008 11:54:22 AM

I was making 7.5% mortgage payments on time for 3 years on my $450K house, when the rates adjusted upwards and went all the way to 11%. I took the loan out in 2005 to put some money into my business. I can still afford 7.5%, but not the higher rates. I know the bank will loose money on a foreclosure. My question is "If I continue to pay at 7.5% is that good for everyone or will a lot of folks get hurt?". This sub-prime crisis is puzzling to me.

Posted by: JTom | Sep 18, 2008 1:30:55 PM

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