June, 2007

Predator’s Ball

How sub-prime lenders undermined the housing boom. 

By Greg Brooks

If you missed the May issue of Money magazine, you missed the best explanation yet of why your sales are down 30%. One article explained the sub-prime mortgage industry in terms even a homebuyer could understand. It’s the best scam since the S&L scandal. Here’s how it works:

You can get a mortgage from a bank or through a mortgage broker, but chances are they don’t keep it. They sell it to investment firms that bundle mortgages into bonds and resell them. In theory, it’s a good deal: Investors get a safe investment and banks get their money back so they can make more loans.

The problem is that safe investments also bring low returns, especially when interest rates are low. The solution was to bundle risky loans—those that justify a higher payback—with other investments so they don’t look risky, and then to sell them on the basis that early buyers get the right to be paid back first, while the rest get higher yields in exchange for greater risk.

They’re basically “junk bonds,” but five years ago, the same investors who guzzled dot-com Kool-Aid in the ‘90s had themselves convinced that the housing boom would never end. Demand for mortgage-backed securities fueled demand for mortgages, which encouraged brokers to tap the “sub-prime” market—i.e., borrowers with less-than-stellar credit ratings.

Sub-prime mortgages come in a variety of flavors, but they all have one thing in common: low teaser rates that at some point reset to higher-than-market rates. That’s not inherently bad, but it created a Catch-22 situation for homebuyers.

Rising home prices made sub-prime loans attractive because you could save money in the short term and refinance when the loan reset. According to Inside Mortgage Finance magazine, 8.4% of all mortgages issued in 2003 were sub-prime. From 2004 through 2006, sub-prime loans accounted for 18.9%, 21.3%, and 20.1% of the total respectively.

But sub-prime loans also fueled rising home prices by enabling buyers to purchase homes they couldn’t afford. According to Census Bureau data, the median price of an existing single-family home ranged from 3.0 to 3.5 times median household income from 1975 to 2000. Today, the median home costs 4.7 times median income, a 40% increase in five years.

In 2005, the Harvard Joint Center for Housing Studies conducted an analysis of past housing downturns and found two controlling factors: severe overbuilding, plus severe job losses. When one but not the other exists, the chances of a downturn are about 1 in 3. When both are present, they all but guarantee a crash.

Here’s where we stand: In March, unemployment was 4.4% and existing home inventories stood at 7.3 months. That’s higher than in January (6.6 months) but no higher than the peak in 2006, and most of the increase can be explained by bad weather.

The bad news is that median new and existing home prices rose 17% and 36.2% respectively from 2000 to 2005, while median income fell 2.1%. We don’t have severe job losses, but income erosion could have the same effect. Likewise, the surge in sub-prime loans will lead to a surge of resets starting in the second half of 2007, according to the Harvard Joint Center. If the result is a surge in foreclosures, overlending would have the same impact as overbuilding.

So is there a silver lining in this cloud? Absolutely—if you’re a bond trader making billions dealing in sub-prime mortgages. As one of them told Money magazine, “The consumer has to be an idiot to take on those loans, but it has been one of our best-performing investments.”