Lesson Learned

By Lawrence Yun
NAR Senior Economist

First the Greed
From hedge funds and pension funds to the Chinese government and institutional gamblers, money poured into the U.S. housing market. The clarion call went out: Lend, and reap the rewards (yields). Defaults? Don't worry about them. Even if that happens, just sell the foreclosed home and recover the loan.

That all worked fine as long as the value of the collateral was greater than the loan amount. From 2001 to 2005, the typical U.S. home price rose by 6.6, 7.8, 8.4, 9.3 and 12.4 percent successively in each of those years. Price gains were triple or more in such places like San Diego, Las Vegas, and Miami. Lending at higher interest rates provided pure and easy high rates of return in such times and in such places. No one in his or her proper mind would ever believe such price increases would be sustainable. Yet, Wall Street believed. Moreover, investors were promised new, innovative returns from collateralized debt obligations and tranche slicing and mortgage derivatives. In other words, put all those risky loans into a bowl, mix well, and out comes non-risky products. Of course, it really didn't turn out that way.

Now the Fear
Troubled loans are piling up. A default is a genuine default if collateral value doesn't rise sufficiently to cover the debt obligation. Those promises of innovative and high returns are turning empty. Investors have stopped providing funds to reckless mortgage brokers. Many subprime lenders are quickly going belly up. Other lenders - apparently not distinguishing from the bad with the good - have also tightened standards for other mortgage loans. Rates on jumbo loans have been rising. The spread between U.S. government bonds -- the safest assets -- and mortgage rates across board has widened as a result.

Soon the Rational
Smart players will soon realize that there are big differences in loan products and not all carry similar risks. The default rates on the subprime adjustable rate mortgages have been rising steeply -- from 3.3 percent just two years ago to 6.5 percent in the first quarter of 2007. The defaults on prime, fixed-rate mortgages were unchanged at 0.5 percent, over the same time period. Subprime loans account for 9 percent of all home mortgages. Yet, subprime loans accounted for 53 percent of all foreclosed properties.

There are alternative loans to subprimes that will help keep the housing market intact. FHA loans, traditionally the product of choice among low-andmoderate income households, have higher default rates than prime loans. But FHA loan performance has been far superior to that of the subprimes. After drastically losing market share (from 14 percent in 2001 to only 3 percent in 2006), FHA will surely regain popularity in the aftermath of the subprime fallout.

Consider the comparisons between FHA and subprime adjustable loans. The default rate on subprime adjustable-rate mortgages are about three times higher than that for FHA loans. More strikingly, the loss mitigation appears not important for subprimes. The ratio of foreclosure rate to delinquency rate (i.e., the likelihood of a foreclosure once a borrower is delinquent in payments) is much higher for subprime loans. The loss mitigation is very saddening in places like Indiana, a state that has had one of the highest foreclosure rates in recent years arising from slow job growth in the state. A delinquency nearly assures a foreclosure on a subprime loan.

Lesson Learned
Rising delinquency and foreclosure rates are big concerns. The foreclosure rate on subprime loans with adjustable re-setting rates has been particularly troubling. But problems revealed can be lessons learned. Lenders are already adopting sounder credit- lending standards. Fooled once - shame on Wall Street. Fooled twice - shame on Capitalism. Where money is involved, mistakes do not get repeated.