Subprime SOS Tom Musil, D.P.A. April 15, 2008 The media are replete with articles and data about how subprime mortgages are hurting homeowners, lenders, investors and the U.S. and international economies. The media reports involve wide-ranging and complex issues. The problems run the gamut from individual homeowners losing their homes through mortgage fraud, to the plight of international investment funds that have made loans to hedge funds that have used collateralized pools of dubious subprime mortgages as security.Surprisingly, despite the media reports and regulatory and congressional investigations, the true nature and extent of how subprime and other forms of subprime-related securities were transformed into other forms of debt, remains to be seen.Subprime mortgages were targeted at inexperienced borrowers who could not (or believed that they could not) qualify for prime mortgages. Subprime mortgages have fees and interest rates that are substantially higher than those of prime mortgages.Because of these high interest rates and fees, the return for subprime mortgage investors was substantial. Given the strong housing market, investors in the subprime funds believed that they were facing little or no risk. Unfortunately for them, soaring mortgage delinquency and foreclosure rates have proven them wrong.A heightened competitive spirit in the lending community accompanied the rapid growth in subprime mortgages, as buyers and refinancing homeowners were offered a wider-ranging variety of mortgage financing gimmicks to entice them into new mortgages. The gimmick mortgages included zero down payments; low adjustable interest rates that would reset after a few years; mortgage qualification without employment, credit checks or income verification; and the ability to defer payments or pay only the mortgage interest. And mortgage fees were built into the loan amount making the financing or refinancing that much easier.It is fairly easy to trace the steps that brought the housing and credit markets to their current positions. From 2001-2006 home prices increased 50 percent nationally. In the 13-county Twin Cities area, the median home price increased from $124,900 in 1998 to $225,000 at the beginning of 2008. In 2000, the amount of subprime mortgage financing nationally was about $150 billion. By 2005, U.S. subprime mortgage originations grew to more than $650 billion annually. The estimated amount of U.S. subprime mortgages range from $1.5 trillion to $2 trillion. About 50 percent of the subprime mortgages are securitized, in effect spreading the risk to banks and investors.Securitization fueled the rapid growth in subprime mortgages. Wall Street firms purchased subprime mortgages from the originating lenders and repackaged the mortgages as Asset Backed Securities sold to banks, conduits and investors.The subprime ABS were often combined with other debt instruments and took on the form of Collateralized Debt Obligations (CDO). Because of the unjustified high grade (AAA) which was typically given to CDO bonds, the bondholders could use the bonds as collateral for short-term financing and commercial paper. The rating agencies concurred that the subprime mortgages were safe, and, because the securities were comprised of large diversified pools of low- and high-risk debt, ratings were unjustifiably high.The rating agencies have since lowered their expectations on the value of the subprime mortgage funds, although they were too late. The investors holding ABS and CDOs needed the subprime mortgage payments to meet their own respective principal and interest payments. When subprime mortgage defaults increased, the cash flow chain was broken and ignited investor panic. Commercial paper investors ran from the structured debt market, creating the current liquidity crisis.When the problems with defaults on subprime loans first surfaced last summer, the European Central Bank stated that the crisis could potentially be as devastating as conditions during the Depression. This strong comment received little media attention. Since then, the European Central Bank and the Federal Reserve Bank have made available vast sums of money to maintain the flow of credit and prevent a worldwide recession. So far this has worked, but the underlying problems of the subprime mortgage defaults and the resetting of adjustable rate mortgages will continue to present challenges to banking systems and investors for the next few years.The subprime mortgage default problem is international in scope. A good illustration of this is Cleveland, a city hurt by subprime lending and in which one out of every 10 homes is in foreclosure. Deutsche Bank Trust, acting for bondholders, is the largest residential property owner in the city.The subprime mortgage default problem and its ramifications for investors are similar to events of the late 1920s when investment trusts, using the new vogue term “high leverage,” created huge paper profits. One 1920s investment trust, United Founders Corporation, built a company worth more than $686 million on a $500 investment. Another trust had assets of more than $1 billion – but its major holding was an electrical company that was valued at $6 million in 1921.Providing credit for subprime mortgages without sound mortgage underwriting, like the almost pure speculation of the late 1920s, works in reverse once a market breaks.Where do we go from here? Over the next few years we will continue to see a correction in housing prices. The decline in home prices will vary substantially throughout the country. Markets that had steep increases in prices, saw high levels of investor speculation or face regional economic problems will adjust by the greatest degree. Homeowners who purchased their properties at the high point of the market will be hurt the most.Gimmick mortgages will continue to contribute to the housing bubble. This will be most common in subprime and prime adjustable rate mortgages that will reset over the next two years from their initial low interest teaser rates to a current market rate. If a property cannot be sold and the owners cannot qualify for refinancing, the property will likely go into foreclosure, contributing to a downward trend in home prices.While several federal and private sector programs will soon be underway, the two issues that will present themselves are the immense cost to correct the problem and the ability of troubled housing consumers to qualify for mortgage financing under any terms. The high foreclosure rates in states like Michigan and Ohio are, in large part, a reflection of employment and economic issues. The role and effectiveness of the government sponsored Fannie Mae and Freddie Mac also remain to be seen. Both agencies reported losses in 2007 and have small combined capital reserves totaling $65 billion that support more than $3 trillion in mortgages.The housing bubble has had a direct impact on new home construction, and we can expect to see employment- and construction-related manufacturing impacts. The housing bubble will have an effect on durable goods purchases but also may creep into retail spending where consumers, aware of their loss of wealth reflected in property and investment values, cut back on discretionary purchases.What is unknown is how financial derivative contracts, the value of which is derived from underlying assets (stocks, bonds or securities), will be affected by mortgage foreclosures. Derivatives have increased from about $6 trillion in 1990 to about $380 trillion in 2006, and have a substantial presence in subprime and other home mortgages. In a financial environment that allows the securitization of just about anything from home mortgages and car loans to the recording royalties of the Rolling Stones, expect the unexpected. In 2002, Warren Buffett described speculative derivatives as “financial weapons of mass destruction.”Tom Musil is the director of the Shenehon Center for Real Estate and the Master of Science in Real Estate program at the Opus College of Business.