The boom in risky and subprime mortgages is finally catching up to neighborhoods like this one in Denver, where delinquencies, defaults and foreclosures are spiking.
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This local malaise, repeated in city after city, has ballooned into trillions of dollars in losses around the world, thanks to the magic of Wall Street's financial engineers. Blame it on one of the Street's recent innovations, the collateralized debt obligation, or CDO. The recipe: buy home loans, blend them, then slice up the result into different securities (reflecting different levels of risk) to sell to investors. Many such securities carry AAA or "investment grade" ratings despite subprime mortgages being in the mix. From there, things get really complex--CDOs created from other CDOs, synthetic CDOs crafted from credit-default swaps, none of which had experienced a down market. "The problem is that CDOs were untested. There was not much history to suggest CDOs would behave the same way as AAA corporate bonds," says Richard Bookstaber, a hedge-fund manager and author of A Demon of Our Own Design, who views market palpitations as a predictable by-product of complex financial products like CDOs. (For the author's take on the subprime disaster, go to time.com/bookstaber.
Now that the foundation is shaking, there are scant buyers for the lower-grade issues built on top of the pooled mortgages, and the values of those CDOs have plummeted. Losses in the subprime market drove Bear Stearns to declare two of its hedge funds, once topping $1.5 billion, all but worthless, and banks as far afield as Germany and France have frozen funds or received bailouts because of exposure to U.S. mortgages.
The Looming Disaster
FOR REAL ESTATE, NEXT YEAR COULD BE EVEN worse if interest rates don't fall. In 2008, some $680 billion worth of adjustable-rate mortgages are due to reset, according to Bank of America. That's $165 billion more than this year, and of those loans that are likely to carry higher rates, nearly three-quarters are subprime. Since many adjustable mortgages change rates after two or three years, the loans due for reset would have been written in 2005 and 2006, the years underwriting standards were bent the most. "It's clear that the performance of loans will be worse," says Mark Adelson, recently departed head of structured finance research at Nomura Securities, "but it's not yet clear how much worse."
One way to think about it is to consider how much more homeowners will have to pay to keep their mortgages current. According to an analysis by First American CoreLogic, a firm that tracks real estate and home loans, a typical subprime first mortgage that was originated in 2004 to 2006 will face a monthly increase of $407, and a typical teaser-rate loan, the type often sold to people based on their ability to pay the introductory rate and not the reset, will see monthly payments jump by $1,512.
Back in Colorado, people are reacting. This summer, three laws went into effect that, among other things, require anyone selling a home loan to make a reasonable inquiry into the buyer's ability to repay it. In recent years, as a growing percentage of loans have been generated by brokers rather than the banks that ultimately owned the mortgages, best interests have been at odds: brokers can make more money with higher-rate loans, even if buyers qualify for a better deal. And that doesn't even touch the lending arms of home builders, which come with their own special conflicts of interest once you consider pressure from shareholders to get people into houses and book those profits. Establishing a fiduciary duty for mortgage sellers, which Congress is considering as well, is meant to realign interests. In the meantime, many banks are working with homeowners to renegotiate loan terms to avoid foreclosure. Still, the EZ Credit addiction is tough to cure. Drive through Green Valley Ranch, and you still see signs for 0 DOWN PAYMENT, 100% FINANCING.
In early August, American Home Mortgage, a mortgage lender with little subprime exposure, declared bankruptcy, stoking speculation that troubles are bound to spread to securities backed by higher-quality mortgages. It didn't help when lenders Countrywide and Washington Mutual subsequently issued dire warnings about losing liquidity because so few people want to buy mortgages on the secondary market right now. "One of the most interesting things is, we don't know who's going to suffer," says Karl Case, a housing economist at Wellesley College. "Obviously, the people who get foreclosed against suffer. That goes without saying. But who bears the losses ultimately is really complex." We can start with the stock markets around the world, which have surrendered $3 trillion in value over the past month, thanks in large part to the mortgage monster beginning to come undone.
But houses don't trade like stocks, so when it comes to correcting the system when it gets out of whack, we're talking years, not weeks. "Real estate," says housing economist Thomas Lawler, "is a slow, tedious process." In July, after the two Bear Stearns hedge funds first ran into trouble, bond guru Bill Gross of Pimco wrote a foreboding investment outlook, pointing out that hedge funds tied up in trading are the top layer of the problem, not the root. That can be demonstrated in the Mile High City and, as Gross wrote, "in the Summerlin suburbs of Las Vegas, Nevada, and in the extended city limits of Chicago headed west towards Rockford, and yes, the naked (and empty) rows of multistoried condos in Miami, Florida." It's a big problem. How big, we're still waiting to find out.
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A MORTGAGE'S PATH FROM MAIN STREET TO WALL STREET The Housing Frenzy
For generations, U.S. house price appreciation largely tracked inflation. But around 1995, home prices began rising at an unprecedented pace. The boom created wealth throughout the economy, but also created risks that spread far beyond the housing market. Here's how:
• Real House Price Index
• Change in housing prices, adjusted for inflation
• Source: Center for Economic and Policy Research Everyone Into The Risk Pool
To bring in more home buyers, lenders began offering mortgages with only a cursory scrutiny of the borrow's qualifications. Many of these loans - including subprime mortgages going to people with weak credit - had low starting interest rates that would rise over time. • Subprime mortgages as a percentage of all mortgage originations
• Source: Inside Mortgage Finance
The Trouble With Bubbles
As long as home values rise and interest rates stay low, everyone's happy. But once prices flatten or fall and interest rates creep up, those once-manageable house payments can jump quickly. Subprime borrowers are most vulnerable. Many can't sell or refinance because they owe more than their home is now worth.
• Median sales prices, existing homes
• Source: National Association of Realtors