Going for broke

April 2, 2007 9:35 AM

Why are subprime mortgage lenders in trouble?

If a borrower fails to make payments on a mortgage, the lender can foreclose and recover the amount loaned by selling the property. I understand that subprime lenders deal in riskier loans, but as long as they can take the property, why are the lenders going broke?

posted by Joe Invisible to work & money (19 comments total)

Two partial reasons, there are likely others: If property prices fall, the property may no longer be worth the amount of the loan. Also, sub-prime lenders are very often offering second mortgages, and the holder of the first mortgage gets first crack at the proceeds of the sale.
posted by jacquilynne at 9:43 AM on April 2, 2007

NPR had a thing about this on Friday. Apparently The Big Banks have been lending money hand over fist to the subprimes but now that the market is soft they are taking it back.
posted by DU at 9:45 AM on April 2, 2007

I'm not a specialist, but I think the number of repossessed houses on sale creates a glut on the market, thereby reducing their value. So the lenders cannot recoup the whole value of the original loan. Another problem is that of cash flow. The lenders are probably borrowers themselves (they actually lend money they don't have) and cannot face their own obligations, because no money is coming in. Could be completely wrong on all this...
posted by bluefrog at 9:46 AM on April 2, 2007

The sub-prime lenders rely on selling the mortgages on. They are risky but high yield. As the threat of foreclosures rose, the risk became too great, and they couldn't find any buyers for new loans. So they ended up with too much debt and are in troubly/bankruptcy.

Their biggest problem is the new mortgages they gave out, and they can't foreclose on them because they aren't late in paying or anything.
posted by smackfu at 9:47 AM on April 2, 2007

If a borrower fails to make payments on a mortgage, the lender can foreclose and recover the amount loaned by selling the property

Only if they can find a buyer. Look at Casy Serin, When this house was foreclosed on, no one bid and the lender didn't get any money. Same with this house and this one. That's three houses that the lenders are now not making a penny off of. And that was after months of non-payment.

So if a mortgage lender lends money, then housing prices drop, they have no way to recover the money if the buyer can't make payments. They may recover some of the money, but not all of it.
posted by delmoi at 9:48 AM on April 2, 2007

Also, the people that underwrote the gigantic loans to these subprime lenders (morgan stanley, UBS, etc etc) have a strict repayment schedule in order to cover their asses and make their profits. If a sub prime lender has many foreclosures, their income is unsteady and unreliable and quickly dwindling (you can't just decide on day x you need to sell 25 houses to meet your obligation to UBS on day x+1) and then they cannot pay back their loans. Not only that, the stock price of these subprime lenders starts to tank as they obviously aren't as valuable anymore.
posted by spicynuts at 9:49 AM on April 2, 2007

the lender can foreclose and recover the amount loaned by selling the property

The lender can foreclose, and recover whatever is left after a 6 to 10 month foreclosure process, paying for repairs and cleaning up the property, and loss of interest payments for that time. This can leave the lender in the red even if prices are stable. If prices decline enough, borrowers find themselves with a house that more is owed on than it is worth, which tends to make it less likely that they will continue making payments. The lender ends up with more houses to sell, that are worth less money than they lent.
posted by yohko at 10:19 AM on April 2, 2007

"Negative equity" plus illiquidity of assets.
posted by holgate at 10:29 AM on April 2, 2007

The subprime lenders are caught in a cash-flow crunch as the rate of foreclosure goes up. The lender's bank (where the subprimes got *their* loans) calls in their chits as this foreclosure rate (and risk) goes up, and if the subprime isn't moving their debts to other companies fast enough or their houses aren't getting resold fast enough due to the softening housing market, the subprime will run out of money.
posted by rhizome at 10:41 AM on April 2, 2007

"but as long as they can take the property, why are the lenders going broke?"

A really simple answer banks are not in the business of foreclosing on properties, then reselling them; they're banks!

A little more complicated answer would involve lenders acquiring overpriced (in relative terms) assets in a declining market. Hardly a recipe for success. One might be inclined to think if the repossessed houses were held for long enough the lenders show a profit, but see above - their business plans aren't structured that way.

Getting more complicated: the money supply has been expanded recklessly since 2001. So much so that The Fed has stopped reporting M3 (a proxy for measuring how much money has been sloshing about). At the same time, lending standards across the board were sharply reduced. Not good either. Finally, a lot of the subprime market isn't serviced directly by banks or other firms that will make the bulk of their money by holding the mortgage to maturity. There is a entire industry that's grown up predicated on the business of floating loans, repackaging and selling them on. So the people making loans only cared the borrowers could make the first few payments, long enough for them to pass the problem on. Even worse, some of these structured products allow the purchaser to sell them back to the lender under certain circumstances. See selling overpriced assets into a declining market; the purchaser will only sell the product back if they believe the future price will be less than today's price.

Yep its a mess. I don't think it's the end of the world, but I do believe this will be socially divisive, as mortgages are called, homes lost, familes driven apart.

All due to irresponsible lending.
posted by Mutant at 10:46 AM on April 2, 2007

A little peripheral but related to the question, here is a comment I made to one of the US business magazines about a year ago. They ended up using less than one paragraph, so I don't think there is a problem reproducing it here and I certainly wasn't paid - they asked, I answered.

And yes, you're correct - I do have strong feels about this mess.

-------

I'm a Banker and consider offering mortgage products such as ARMs irresponsible lending.

The majority of individuals these products are being marketed to are subprime obligors; typically living paycheck to paycheck, these folks almost always have little in the way of liquid financial assets. Perhaps carrying excessive credit card debt, most even lack six months emergency savings to tide them over should they lose their income.

Regardless of personal circumstance, when purchasing homes to live in people should be steered towards long-term, fixed-rate debt, financed off a 20% down payment; this is prudent finance, this is how our parents and grandparents bought their homes and they had solid reasons for doing it this way.

I'm American who has lived in London for the past decade. I work in Investment Banking, have fifteen years of international banking experience, hold an MSc in Quantitative Finance, an MBA, and teach finance part time at a University in London. I wouldn't consider purchasing an ARM mortgage but I'm in a position to fully understand all the risks. Unfortunately, most who are offered ARMs or other such exotic financial products don't have a clue of the downside and this ignorance is what lenders first prey upon then profit from.

In 1992 George Soros, via his Quantum Hedge Fund, famously led speculative attacks on the British Pound. On what is now known as "Black Wednesday", September 16th 1992, The Bank of England was forced to hike interest rates to 16% in order to defend the value of Pound Sterling.

ARM payments immediately skyrocketed and previously manageable mortgage payments increased, sometimes in excess of 300%. The supply of houses for sale increased by several orders of magnitude. As supply surged and demand crashed house prices cratered.

Over the next twelve months hundreds of thousands lost their homes. Most, if not all, of these homes were repossessed by the same banks that offered floating rate financing to begin with. Even now some people in England are still paying down mortgages on homes they lost over a decade ago.

Lest you believe this crash was solely a creation of The Bank of England, a uniquely British phenomenon, Australia is currently experiencing a housing crash with prices in some cities down almost 50% over the past two years.

It won't be much different in the US. Over the past three years hundreds of thousands have acquired overpriced homes, financed by ARMs. The US Housing Market is already sharply slowing in response to a wave of interest rate hikes. As demand for houses plummets and the economy slows, perhaps entering recession, these marginal owners will be forced to dump overpriced assets into a declining market; as the British and Australian experiences show us, the outcome will not be pretty. But responsible lenders don't measure all markets in terms of dollars and cents gained or lost.

The social fallout will be severe and pronounced as families lose homes, marriages are ruined and families torn apart.

All driven by these irresponsible lending practices.

There is a reason why our parents and grandparents eschewed floating rate debt in favour of long term, fixed rate mortgages. Having lived through The Great Depression, they knew the cost of uncertainty. This is a lesson millions of Americans will be forced to relearn in the months and years ahead.

An expensive - and totally avoidable - lesson.
posted by Mutant at 10:58 AM on April 2, 2007 [8 favorites]

There's also the hype angle -- everyone who has an interest in the subprime market plays up the problems and the repercussions to increase the chances of a government bailout.
posted by backupjesus at 12:03 PM on April 2, 2007

backupjesus: "There's also the hype angle -- everyone who has an interest in the subprime market plays up the problems and the repercussions to increase the chances of a government bailout."

yes, but where there's smoke, there's fire.
posted by Mr. Gunn at 12:56 PM on April 2, 2007

Oh, absolutely, Mr. Gunn, but it's pretty clear that the basic PR message out of the mortgage industry has gone from "Everything's great! Buy a house or two!" to "You and all of your friends and family will be foreclosed on next Tuesday!" in just the last few weeks.
posted by backupjesus at 1:15 PM on April 2, 2007

"everyone who has an interest in the subprime market plays up the problems and the repercussions to increase the chances of a government bailout."

Well, let's look at this a little more closely.

Who would benefit most from a bailout, if one were to occur? Certainly not the lower tier mortgage originators who originated and largely drove the irresponsible lending. The entire industry would be opened to Federal scrutiny. The harsh light of day. No, that's nothing all the shady, very, very slippery operators who have pervaded every nook and cranny of this business over the past few years wants. Some of these business practices have barely been legal. In fact, people are starting to go to jail over the crap that's been going on the past five or so years. So they will not welcome The Feds being given any excuses whatsoever to root about in their backyard.

How about the obligors, those who took out loans, many holding what in the industry are called "liar loans"? These mortgages, issued without documentation of any kind other than legal identification, form a significant part of the industry's outstanding debt, by some estimates perhaps as much as one third: would these individuals welcome tighter lending practices, perhaps a reevaluation of existing loans against ability to service debt? Would they risk having their mortgages called? No a chance.

Government officials, hoping to rescue folks before they go under, to be seen as heroes? Possibly, but then again we've got questions about the money supply, about M3, why did The Fed stop reporting it? And why wasn't The Fed more closely monitoring the explosive growth in the nations money supply? How could this have happened, to the most vulnerable and financially unsophisticated amoung us?

Again we see encounter more questions that one group or another would find troublesome.

So while claims of hypesters hoping for government bailout are superficially appealing, once we take closer look its difficult to find a single group that would welcome such inquiries.

No, I'm afraid this is modern travesty. Hundreds of thousands of lower income folks who are guilty of nothing more than wanting what most other Americans have, were sold financial products they neither understand nor could afford, they effectively were fleeced of their cash, and then left to their own devices as interest rates started to rise. Without recourse as their ARMs reset previously affordable payments skyrocketed. Sadly, foreclosure and forfeiture of any equity they might have built up will be the only way out for large numbers.

Many of us in the banking industry believe this not be hype, but a tragedy. As I mentioned before, a totally avoidable disaster.
posted by Mutant at 1:41 PM on April 2, 2007 [1 favorite]

If you want the wide-angle, hardcore, massively informative viewpoint, I suggest you take a look at NYU Finance professor Nouriel Roubini's blog, especially his scathing essay-long post entitled "Who is to Blame for the Mortgage Carnage and Coming Financial Disaster?". It's not the easiest read, but it is well worth the effort. If you really want to grok the situation, Bill Cara has hosted the now-infamous Credit Suisse Report (PDF) explaining every aspect of this oncoming financial disaster. This is going to make the S&Ls look like a tiny economic blip...
posted by LimePi at 1:50 PM on April 2, 2007 [3 favorites]

My sister works in this field and she JUST sent me an email about it.

From a big picture, they're collapsing because of shoddy lending standards; I've talked at length about this elsewhere and I won't get into it now. But over the short term, Fannie Mae and Freddie Mac retroactively changed their lending standards and refused to buy loans that they had previously agreed to fund. So they gave back many billions in loans, instantly destroying multiple subprime lenders.

Had they not changed their position retroactively, it would have been much less destructive. But the ultimate fallout would have been the same; the economy is going to go into the most profound tailspin we have ever experienced.
posted by Malor at 1:55 PM on April 2, 2007

Mutant, I see your point, but the same arguments could be made about the S&L crisis of the '80s, and the government still ended up footing the bill for that, for a variety of reasons. And there are lots of parallels to the current situation.

I will be angry as hell if it happens, but there's going to be tremendous pressure on politicians to do something about this fiasco, and it has "S&L bailout" written all over it.
posted by Gamblor at 2:00 PM on April 2, 2007

The simple reason that subprime lenders are going broke (despite the fact that the loan is secured by the land) is due to: FRAUD.

Here's how it works: Joe buys a house for $150k. Then he sells the house to his "friend" for $250k. Then the friend sells it back to Joe for $350k. Then Joe sells it to his friend again for $450k. And let's say they did all that in a year or two years. Did the house really appreciate $300k in that time? No. In fact, nobody would pay $450k for this house unless they were participating in a fraud.

Low and behold neither Joe nor his friend ever make a single mortgage payment. So the bank forecloses and tries to sell the property. But nobody will buy it at that price so the bank takes a loss.

How did Joe and his friend get away with this? They used stated income subprime loans (because neither of them has any credit, they are criminals after all) and the appraiser was in on the fraud. And honestly, the lender could've discovered the fraud pretty easily but they just kept making the loans while the getting was good.

So, to answer your question, if you are buying in a highly desirable neighborhood you will probably be fine. But if you are buying in a transitional neighborhood or an average neighborhood that saw tremendous price increases in the last few years, you will probably have grave difficulty selling the home yourself because you will be competing with a flood of foreclosure sales. Of course, if you don't think you'll sell, and you stay in the home for five or ten years, you'll probably be just fine.
posted by GIRLesq at 11:49 AM on April 4, 2007