In This Article
30-Second Summary
Headline: Stocks slip, Fed stays optimistic, and the forecast from '04
Background: Discount rate cut, New Century bankruptcy, and the Senate hearing
Reference Material: Interest-only mortgages, ARMs, and Countrywide Financial
Opinion: Regulation, the dot.com analogue, and fiscal irresponsibility
History: Lenders' stocks rocket, analysts skeptical
Related Links
Subscribe to Business UpdatesLenders and Home Buyers Long Deaf to Mortgage Warnings
August 24, 2007 11:21 AM
by
findingDulcinea Staff
As the sub-prime meltdown continues to hurt U.S. stock markets, the mortgage industry, politicians, and the public try to apportion blame for a crisis that was predicted years ago.
30-Second Summary
Sub-prime mortgages, designed for borrowers with poor credit ratings, are much more likely to end in foreclosure than conventional loans.
Since the end of the real estate boom, in 2005, lenders have increasingly found themselves unable to recover the full amount of the principal when sub-prime borrowers can’t make their payments.
As a consequence, a number of lenders dealing in these products, which are mostly adjustable rate mortgages (ARMs), have gone into bankruptcy, delivering a heavy blow to the U.S. economy.
Thus far, the situation is easy to understand. What is less clear is why these lending practices continued for so long. Back in 2004, British analyst Peter Schiff was not alone in defining the American economy as an “ARM time-bomb” when he discussed the prevalence of high-risk mortgages.
Neither buyers nor the mortgage industry heeded such warnings. Speaking at a Senate hearing in March, Sandy Samuels, the Executive Managing Director of Countrywide Financial Corporation, a major sub-prime lender, said that during the “cooling of the housing market” there was a “dramatic liberalization of underwriting guidelines” as “lenders vied to retain volumes and increase market share.”
In other words, according to Samuels, lenders made it easier for applicants to get a sub-prime loan as the risks of home ownership increased.
Such perilous behavior has prompted some pundits to accuse banks and brokers of “predatory lending.” Among them was Sen. Chris Dodd (D–CT) when he chaired the Senate hearing at which Samuels testified.
However, others have questioned how appropriate the term predatory is since both lenders and borrowers have followed a path to insolvency.
Schiff, writing in 2004, spread the blame for the crisis he foresaw among all participants: “Home buyers have been lured into this foolish choice [to invest in ARMs] by estate agents and mortgage brokers eager to earn commissions, their own avarice in pursuit of easy riches, and by central bankers desperate to keep the real estate bubble inflating.”
Since the end of the real estate boom, in 2005, lenders have increasingly found themselves unable to recover the full amount of the principal when sub-prime borrowers can’t make their payments.
As a consequence, a number of lenders dealing in these products, which are mostly adjustable rate mortgages (ARMs), have gone into bankruptcy, delivering a heavy blow to the U.S. economy.
Thus far, the situation is easy to understand. What is less clear is why these lending practices continued for so long. Back in 2004, British analyst Peter Schiff was not alone in defining the American economy as an “ARM time-bomb” when he discussed the prevalence of high-risk mortgages.
Neither buyers nor the mortgage industry heeded such warnings. Speaking at a Senate hearing in March, Sandy Samuels, the Executive Managing Director of Countrywide Financial Corporation, a major sub-prime lender, said that during the “cooling of the housing market” there was a “dramatic liberalization of underwriting guidelines” as “lenders vied to retain volumes and increase market share.”
In other words, according to Samuels, lenders made it easier for applicants to get a sub-prime loan as the risks of home ownership increased.
Such perilous behavior has prompted some pundits to accuse banks and brokers of “predatory lending.” Among them was Sen. Chris Dodd (D–CT) when he chaired the Senate hearing at which Samuels testified.
However, others have questioned how appropriate the term predatory is since both lenders and borrowers have followed a path to insolvency.
Schiff, writing in 2004, spread the blame for the crisis he foresaw among all participants: “Home buyers have been lured into this foolish choice [to invest in ARMs] by estate agents and mortgage brokers eager to earn commissions, their own avarice in pursuit of easy riches, and by central bankers desperate to keep the real estate bubble inflating.”
Headline: Stocks slip, Fed stays optimistic, and the forecast from '04
August 23, 2007––Stocks fell again after the initial optimism that followed Bank of America’s decision to invest in Countrywide Financial, a major source of sub-prime loans, gave way to suspicion. The bank’s move had conveyed confidence in the mortgage market, until worries began to spread that the investment was made to help out an ailing institution.
Source: The Wall Street Journal
August 22, 2007—The Wall Street Journal focused on apparent optimism at the Federal Reserve. Officials there pointed to a rise in large mortgages and stable stock prices as two key indicators that the economy is gradually recovering from the blow dealt to the sub-prime mortgage market.
Source: The Wall Street Journal
August 22, 2007—The market rallied in response to expectations of an interest rate cut and “takeover talks that suggested credit concerns had not completely killed off merger-and-acquisition activity,” wrote the Financial Times.
Source: The Financial Times
July 2004—Financial analyst Peter Schiff wrote that given the current interest rate environment, there were no circumstances in which it would be advisable to get an adjustable rate mortgage (ARM). “That such a high percentage of people in the United States and elsewhere are currently opting for adjustable rate mortgages reflects a level of real estate speculation unparalleled in history,” he argued.
Source: The Daily Reckoning
Background: Discount rate cut, New Century bankruptcy, and the Senate hearing
August 17, 2007—The Federal Reserve cut the discount rate charged to qualified lenders, mainly banks, on borrowing. The action was taken in hopes of limiting the damage caused by the sub-prime crisis, though CNN and others define the cut as largely “symbolic,” showing confidence in the market but offering no real aid to the companies in trouble.
Source: CNN
The Federal Reserve has been injecting money into the banking system, pumping out a total of $79 million in the first half of August. What that means is that the Fed offers cheap loans to banks—using the so-called discount rate—so that they can continue lending. The process is explained in this article from Slate.
Source: Slate
The sub-prime meltdown claimed its first major institutional casualty in April 2007, when New Century Financial Corp. filed for Chapter 11 bankruptcy. CNN reports that New Century had been the “poster child” for the sub-prime market, and that its financial troubles had been common knowledge since January. Its collapse had serious repercussions for the industry, as New Century was unable to pay more than $8 billion in loans to other financial institutions.
Source: CNN
Senate Hearing into Mortgage Market Turmoil
The hybrid adjustable-rate mortgages that are a significant factor in the so-called sub-prime meltdown are “made on the basis of the value of the property, not the ability of the borrower to repay,” said Sen. Chris Dodd (D–CT). “This is the fundamental definition of predatory lending.” Dodd made those statements in his opening statement as chairman of a congressional hearing into the “Mortgage Market Turmoil” held in March 2007.
Source: Senate Records
Five of the top sub-prime lenders were invited to testify at the Senate Hearing. A list of attendees and a link a video of proceedings are available at the Senate Web site.
Source: Senate Proceedings
Reference Material: Interest-only mortgages, ARMs, and Countrywide Financial
The Federal Reserve Board publishes a free leaflet online explaining the risks involved when taking out an interest-only or payment option ARM (adjustable-rate mortgage). There are two principal dangers to be aware of: “payment shock” occurs when payments double or triple as a result of an interest-only period ending or a rate adjustment; “negative amortization” is a the adding of unpaid interest to the balance of the loan, which means that the borrower owes more on the mortgage than originally borrowed.
Source: The Federal Reserve Board
Foreclosure is often a double-whammy of disappointments for defaulting homeowners, as they may still be taxed on the canceled debt. This will affect a great many families, as an estimated 20 percent of sub-prime loans, made to people with weak credit, will end in foreclosure.
Source: The New York Times
The sub-prime market incorporates unusual adjustable-rate loans, often called “exotic” mortgages, that offer a variety of ways to manage debt and repayment. Repayments can be “compressed,” so that monthly installments are deferred, and the borrower is faced with making multiple payments at some future date. Alternatively, the borrower might add additional loans onto the premium in order to make interest-only payments, gambling on an increase in income to make this expanding loan manageable. MSNBC reported in August 2006 on the growing disillusionment and foreclosures associated with exotic mortgages.
Source: MSNBC
According to The New York Times, former employees from Countrywide Financial, the nation's largest mortgage lender, have described lending practices that showed little concern about whether borrowers would be able to keep up payments. Among the questionable aspects of Countrywide’s business was a computer system in the sub-prime unit that took no account of cash reserves when calculating what mortgage to recommend borrowers. This meant that borrowers were steered towards sub-prime loans when they should have qualified for better interest rates.
Source: The New York Times
Up-to-the-minute information on the mortgage industry is available from the Mortgage Bankers Association.
Source: The Mortgage Bankers Association
The New York Times has a roundup of its stories on Countrywide Financial Corporation.
Source: The New York Times
Opinion: Regulation, the dot.com analogue, and fiscal irresponsibility
The chairman of the House Financial Services Committee, Democratic Congressman Barney Frank, argues that the unregulated sector of the industry is responsible for the high number of mortgage defaulters. Frank recommends greater regulation, contending that lenders have too much freedom to sell loans to a secondary market, releasing the banks from financial responsibility for those loans.
Source: The Financial Times
The bursting of the dot.com bubble should have alerted investors to the dangers inherent in the real estate boom, writes Adam Bryant of The New York Times. Bryant describes the property market as rocketing because it was perceived to be the “perfect antidote to dot-com stocks,” and writes that only now has the mistake behind that thinking become apparent.
Source: The New York Times
From Iran, reporter Hamid Varzi writes that America’s debt problems, which have been worsened by the mortgage crisis, have not only been felt around the world, but deepen the impression that America’s financial practices are greedy and immoral, especially in the Middle East. With $2.5 billion borrowed from abroad every day, “America needs to retain credibility with its overseas investors.”
Source: The International Herald Tribune
The Fed’s decision to lower the discount interest rate used on loans to banks is a largely symbolic move, according to Paul Krugman of The New York Times. The real problem is not with the banks, but with the “growing number of unregulated bank-like institutions [that] have become vulnerable to the 21st-century version of bank runs.” In a market dependent on confidence, however, “sometimes symbolic gestures are enough.”
Source: The New York Times
History: Lenders' stocks rocket, analysts skeptical
As far back as 2004, financial magazine Barron’s published an article titled “No Margin of Safety,” which took a skeptical view of the rocketing stock prices for sub-prime lenders. That report has been proved prescient by recent events.
Source: Barron's
Related Links
In the current financial climate, the roots of the word “mortgage” may send a shiver down the spine of many nervous homeowners. Mortgage derives from two Latin terms: mortuus, which means “death,” and gage, meaning “grip.” So explains financial advisor Seymore Hennigan in this short introduction to the financial death-grip.
Source: ArticleDevil.com
Reputedly, Home Depot dropped the price of its commercial supply business by nearly $2 billion dollars on 26 August, 2007. Sources involved in the sale negotiations said that this occurred in response to the sub-prime crisis, which has raised the cost of borrowing.
Source: The New York Times
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