Mortgages: How Long Till Daylight?

A long time -- certainly not before the end of 2008. And borrowers shouldn't expect easier mortgage terms until 2009.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

November 19, 2007

The subprime mortgage crisis is going to take most of 2008 to clear up. Hardly a day goes by without a major lender announcing a multibillion-dollar write-down on the value of mortgages and mortgage-backed securities in its possession. The cascade of bad news spells big trouble for banks' earnings in coming quarters as well as a continuing drag on the stock market and the economy in general.

In the meantime, a huge chunk of the mortgage market -- namely, subprime and other higher-risk loans -- will be frozen, sapping demand for housing and imposing continued downward pressure on the pace of construction and sales. The risky loan category rose from only 7% of outstanding mortgage debt in 2000 to almost 25% this year.

Up to one in five risky mortgages may well go into foreclosure, meaning that these loan defaults would total about 5% of the entire mortgage market. That may not seem like a huge proportion, but it's enough to give investors and banks the jitters. Note that the total value of these defaults would be $450 billion. Investors in mortgage-backed securities stand to lose a whopping $225 billion or so, since they'd make back some cash by selling foreclosed properties.

Odds are that mortgage lenders won't start loosening up loan terms until 2009. They've got plenty to deal with until then. Banks are holding, not dumping, their mortgage-backed debt. Diane Swonk, chief economist with Mesirow Financial, says, "Some of the asset-backed securities are good, but no one knows which ones."

Given that unknown, there's no fire sale going on now. However, banks are substantially marking down the value that they expect to derive from such mortgages in the future. Some financial vultures are circling, offering the lenders 50¢ or even less on the dollar for the mortgages. But the lenders think they can get more for their assets once the subprime dust settles. After all, most of the loans considered untouchable now will actually continue to generate income. Banks figure that market hysteria will pass in a year or so, allowing sellers of mortgage-backed securities to extract more value from their sale.

In fact, most risky mortgages aren't held by the banks that originated them. The loans were securitized and sold in bundles to Wall Street investment firms, which in turn resold them to investors such as pension funds in the U.S. and foreign banks around the world. The now-infamous structured investment vehicles set up by Citigroup and others did much of the dealmaking in mortgage securities.

There are still mortgages being made and sold as securities, but their volume can't fill the void caused by the drying up of subprime loans. There are mortgages for customers with solid credit histories. Standards have been tightened, though, which further reduces the pool of buyers. Note, however, that loan requirements are tightening up from extremely lax levels during the boom years. As housing consultant Thomas Lawler says, "Lending levels were ludicrous from 2003 through 2006."

Now it's more typical for banks to require at least a 10% down payment and to not offer home buyers the option of a piggyback home equity loan to finance part of the purchase. Given the combination of fewer subprime loans and tighter standards for creditworthy customers, the tally of unsold homes in the U.S. is about 1 million, double the amount at the end of 2005.

Interest rate cuts by the Federal Reserve will provide some help. The cuts will lower rates on adjustable rate mortgages (ARMs) by three-fourths of one percentage point, easing the blow of higher interest rate resets for some homeowners. All told, about $1 trillion worth of ARMs will reset during 2008. How many of those homeowners choose to walk away from their houses or go into default will affect the price of securities held by Wall Street firms and other investors. Meanwhile, the supply of unsold new and existing homes will continue to rise.

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