Sub-Prime Market Stirs Turmoil

August 26, 2007
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GRAND RAPIDS — The sharp rise in foreclosures in the sub-prime mortgage market that began in 2006 is now approaching something akin to a financial crisis in the United States. But the sub-prime market meltdown has spread beyond this country’s borders and is shaking up global financial markets, too.

A number of factors combined to spin the sub-prime market out of control.

At the time the Federal Reserve started its credit expansion six years ago, a lot of Americans were already overextended on credit. The economy was in a funk, and the unemployment rate was on the rise. As interest rates dropped to historical lows, many borrowers took advantage of the rates to buy larger or second homes and entered into loan agreements that they really couldn’t meet. Many borrowers also snapped up home equity lines to take cash out of their houses.

When interest rates stopped falling, new mortgage applications slowed, but mortgage lenders weren’t ready for the party to end, said Kerby Wallick, CFA, senior investment manager at Legacy Trust. So they cast a wider net for prospective customers by lowering lending standards and introducing new loan products so more people could qualify for loans. It’s painfully obvious now, Wallick pointed out, that many mortgages were granted to borrowers based on lower interest rates, lax credit standards and higher home values at the time.

“Unfortunately, a sub-prime loan was a very easy loan for a lot of people in this industry to make,” said Pava Leyrer, president of Heritage National Mortgage Corp. and current president of the Michigan Mortgage Brokers Association. “It was a quick and simple loan, and a lot of people who got the loan may or may not have deserved it.”

After interest rates were reset higher, many people with two- or three-year adjustable rate mortgages found themselves unable to afford their new monthly payments, Leyrer  noted. Eventually, the housing market bubble burst, home prices depreciated and foreclosure activity took off.

“You saw a domino effect, a layering affect of risk,” Leyrer said “It was the perfect storm.”

RealtyTrac’s July 2007 U.S. Foreclosure Market Report showed 179,599 foreclosure filings in July, up 9 percent from the previous month and up 93 percent from July 2006. Nevada, Georgia and Michigan posted the top foreclosure rates among all states. Michigan had the dubious distinction of being ranked third highest, with one foreclosure filing for every 320 households, according to RealtyTrac. Detroit, in fact, ranked No. 1 among the nation’s 229 metropolitan areas for foreclosure rates. Detroit’s foreclosure rate in July was 70 percent higher than in June, with one foreclosure filing for every 97 households, or more than seven times the national average.

Outwardly, the sub-prime mortgage market and the stock market don’t appear to have much connection, but the two have become linked in a way that is having some impact, Wallick said. The sub-prime market meltdown has caused several multi-billion-dollar hedge funds to collapse — worthless, has driven several mortgage lending institutions into bankruptcy, and has led to major declines in stock markets around the world. Too, large losses in the sub-prime market can spill over into the broader economy and cut into GDP, and that’s beginning to happen, he acknowledged.

When lenders started lending to less and less qualified borrowers, they did some fancy financial engineering and had investment banks package up a lot of the mortgages and slice up the mortgage pool according to risk, into what is called “tranches,” Wallick explained. In an effort to secure some yield, investment banks sold the tranches off as CDOs — Collateralized Debt Obligations — to hedge funds, pension plans, insurance companies and large institutional investors. A lot of foreign investors bought into the sub-prime market CDOs, as well, which got global financial markets involved.

“A lot of folks, mostly hedge funds, that bought the CDOs tried to protect their risk by doing another financial derivative called a ‘credit default swap,’ where they tried to sell off the risk of default to somebody else,” Wallick recalled. “That made their position a little more stable, but it also cut down their potential return, because they essentially had to buy insurance on these things. What they did then was use a bunch of leverage; they went back to the investment banks and borrowed on their pool of mortgages.” 

One of the now-depleted hedge funds, the Bear Stearns fund, for instance, had about $700 million worth of actual principal that went to investment banks such as Merrill Lynch, and the hedge fund borrowed about $15 billion on that $700 million collateral. Everything was great, Wallick said, as long as interest rates were stable and house prices were going up. He said the only problem was that no one knew how the synthetic bonds and hedges would perform under stress and who would hold the ultimate risk if they broke apart.

The sub-prime market became tied to the stock market when some of the investment banks and insurance companies began to realize the CDOs weren’t worth nearly as much nor were they as protected as they thought.

“They realized they should have been pricing them differently based on the actual risk in them,” he noted. “The investment banks have so much borrowing against the CDOs that they’re having to sell ‘good stuff’ to come up with the cash to pay off their debt.”

The big investment money-center bank stocks — such as Goldman Sachs, Merrill Lynch, Lyman Brothers and Morgan Stanley — were the first to take a hit. Wallick said the original problem was more of a Wall Street problem as opposed to a Main Street problem, because Wall Street investors backed sub-prime mortgage securities without verifying the strength of the portfolios. The situation is affecting mortgage lenders such as Countrywide Home Loans, which can’t get funding to meet the mortgages it has already approved because nobody is lending money on anything that looks risky right now, Wallick said.

Unfortunately, people facing delinquency or foreclosure won’t have any breathing space until the economy improves or credit loosens, Leyrer said. She believes credit will loosen; it’s just a matter of when and whether it will be soon enough. Leyrer advises people who are in that situation or headed that way to seek the advice of a trusted mortgage professional because there are options. She said any member of the Michigan Mortgage Brokers Association will give a consumer a free consultation to help them figure out where they are financially and what they can do to keep their home. There are foreclosure tip sheets for consumers available on the MMBA Web site. Leyrer also encourages consumers to register complaints, and report fraudulent lending activities and unfair lending practices. 

Both Leyrer and Wallick agree that the situation will probably get worse before it gets better. So far, in an effort to turn things around, the Federal Reserve has cut the interest rate at which banks can borrow from the Fed, so banks could have the liquidity to meet loan obligations and funding needs, Wallick observed. The push is on, too, for government-sponsored enterprises — the Fannie Maes and Freddie Macs — to come in and buy more mortgages and provide that liquidity to the secondary market that the hedge funds had been providing. 

“I think what the Fed is probably going to have to do is let some of these hedge funds blow up,” he remarked. “The Fed isn’t here to save them; it’s here to keep the financial system sound and liquid and functioning.”     

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