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Wall St. Waits to See What Will Be Repaid
As the variations of adjustable-rate mortgages rise, so do the risks for
borrowers.
The financial services industry has made it possible for millions of
Americans to stop thinking, "I can't afford that."
Now, Wall Street is beginning to wonder how many people really couldn't
afford what they bought in recent years on incredibly cheap credit.
One-percent mortgage loans, zero-percent car loans, home-equity loans
for more than what your property is worth - all of this has been the cushy
financial reality for U.S. consumers in this decade. No house, car or
vacation has been out of reach, thanks to a network of eager lenders and the
global army of investors who've supplied them with capital at rock-bottom
rates.
In the midst of any wild party, however, some people do things they
later come to regret. And while talk of a housing bubble has been incessant
over the last year, only now are the money handlers on Wall Street beginning
to worry about payback - that is, how much of the credit extended in this
borrowing extravaganza won't be paid back.
If the only issue was whether real estate was overpriced, financial
market players could treat the housing boom like an entertaining TV reality
show: Isn't it funny what people will do?
Not when they're using someone else's money. Home mortgage and equity
line-of-credit debt has swelled from $4.8 trillion at the end of 2000 to
nearly $8 trillion now. And behind every borrower there's a lender.
Which raises the question: How fast will investors in financial company
stocks and in mortgage-backed bonds rush to sell, if they begin to sense that
a wave of loan defaults is inevitable?
Richard X. Bove, a veteran banking industry analyst at the firm of
Punk, Ziegel & Co. in New York, last week sent clients a research report with
a chilling title: "This Powder Keg is Going to Blow."
In it, Bove summarized the many ways fee-hungry lenders have fallen
over themselves competing to write mortgages for almost anyone who applies.
He notes that the number of variations of adjustable-rate mortgages with
low "teaser" rates has mushroomed over the last few years, leading up to the
newest twist: the so-called option ARM, in which the home buyer chooses among
several payment options, including making a minimum payment that is based on
an initial interest rate as low as 1%.
We're reliving the 1920s, Bove says. In those boom years, interest-only
loans were standard, and lenders usually had the right to demand full payment
on home loans after five years.
When the Great Depression arrived in the 1930s, and incomes and asset
values dived, home repossessions naturally soared. People couldn't afford
their loans and they couldn't sell their homes for more than they paid.
Bove believes the lending industry has taken a dangerous step backward
with option ARMs. "They are an outrage," he says. "The consumer simply does
not understand what this loan is" in terms of the risks it poses - not the
least of which is how the loan principal amount can rise, instead of
shrinking as it would under a full-payment loan.
Adjustable-rate loans in general accounted for about half of total
mortgage issuance last year, according to SMR Research Corp., a Hackettstown,
N.J.-based financial research firm. And the bigger the loan, the more likely
it was to be an ARM. Given sky-high home prices, the only way many buyers
could get into their dream homes was via a teaser-rate ARM.
The extent to which people have stretched to buy houses at ever-rising
prices also shows up in a survey SMR Research released last week. The firm
found that an increasing number of home buyers have been "piggybacking."
These buyers need two loans rather than one to complete their purchase - a
first mortgage typically for 80% of the home's value, and a home equity loan
to finance the rest.
SMR found that piggyback deals accounted for 19.9% of all home-purchase
mortgage dollars in 2001. That figure jumped to 41.7% in 2004 and to 48.2% in
the first half of this year, the firm said.
If those loans have adjustable rates, the payment burden on the buyers
is guaranteed to rise as the Federal Reserve continues to boost short-term
interest rates. Depending on how the loans are structured, the payments could
increase even after the Fed stops tightening credit.
And what if home prices finally stop rising, or even decline? That
could seal the fate of home buyers who figured that if their income couldn't
keep pace with their payment obligations they could simply sell their home at
a profit and pay off what they owe.
But don't most people make their house payment, no matter what?
Historically, they have. And the vast majority of homeowners almost certainly
will continue to make their payments.
Wall Street, however, is beginning to focus on how large the potential
danger zone is - the people who have drastically overreached with mortgage
debt and who may well end up in financial ruin in 2006 or 2007.
Overall mortgage delinquency rates still are low. The latest data
available show that the percentage of homeowners late on their payments stood
at 4.31% at the end of the first quarter, down from 4.46% a year earlier,
according to the Mortgage Bankers Assn. in Washington.
Even so, many economists believe delinquencies will rise as more people
face the first upward payment adjustments on their ARM loans next year. Any
slowdown in home prices would compound the problem.
For financial markets, just the scent of an upturn in delinquencies
could be enough to fuel heavy selling of securities tied to housing's
fortunes - builders, lenders and mortgage insurers, for example. Hedge funds
and other trigger-finger investors won't wait to find out how bad things
might get once the prevailing sentiment is that the tide has turned for the
real estate market.
Worth noting is that financial services stocks make up the biggest
single chunk of market value in the blue-chip Standard & Poor's 500 index, at
nearly 20%. (Technology is second, at 15.5%.)
Recent weeks have brought a taste of what might occur on a much larger
scale if housing worries mount. Shares of Downey Financial Corp., the parent
of a California S&L that does a big business in option ARM loans, have
plummeted 20% as some investors have grown anxious about the risks inherent
in those loans.
Another stock sector that has been hammered: real estate investment
trusts that buy mortgages and mortgage-backed securities. A Bloomberg News
index of 27 such stocks has fallen nearly 12% since July 20.
The biggest threat of upheaval is in the mortgage-backed securities
market itself.
That market, worth nearly $4 trillion, has provided much of the capital
for the housing boom. Instead of holding on to the loans they make, many
lenders package them and sell them to investors worldwide via mortgage-backed
bonds. The bond owners get the loan interest and principal passed through to
them.
The genius of the mortgage-backed securities market is how it has been
sliced and diced by investment bankers. There's a piece of a mortgage to
match every investor's need - long-term and short-term paper, high yield and
lower yield, insured and uninsured.
But the increasing complexity of the securities also raises the risk
that some investors will feel they can't be sure exactly what they're
holding, particularly in the case of bonds backed by the new wave of
adjustable-rate mortgage loans. If investors begin to worry that they won't
be repaid, their rush for the exits
