Investors and Homeowners suffer at the Hands of Lenders

When it came to soaring home prices, Wall Street gambled and now homeowners and investors in the subprime housing market are paying the price of lenders’ arrogance. What goes up must come down!

Amid rapidly rising home prices in 2005, irresponsible lenders took advantage of Americans eager to live the dream. With such come-ons as No credit? No problem! and No down payment required, lenders had no shortage of eager borrowers, especially when they didn’t require proof of income or even ask how long a potential borrower had held a job. A shocking number of subprime and Alt-A loans even financed 100% of the home’s purchase price.

Low teaser rates and interest-only payments made the deals irresistible, and if hesitant applicants dared to wonder aloud how they’d afford higher payments in the future, their lenders gave a breezy answer: With home prices soaring into the foreseeable future, their equity would rise more quickly than their debt.

Don’t worry; be happy! With news stories daily about defaulting homeowners unable to sell, we know just how unhappy many of these homeowners are and, by extension, those who invested in these mortgages, often unwittingly. What if Wall Street had been right and home prices had continued upward? Were these loans and investments guaranteed to fail no matter what?

Default in less than a year

Yes. A bad loan is a bad loan. Industry analysts are predicting record mortgage defaults and foreclosures this year, when teaser rates, interest-only payments and other introductory options expire. But the problem is not that homeowners won’t be able to afford the higher loan payments then. The problem is that homeowners haven’t been able to afford their loans since the moment they signed the application. A review of the collateralized debt obligations (CDOs) and other subprime securities sold to investors in 2006 and 2007 estimated at $362 billion reveal that borrowers have been in default for some time, and investors would have lost millions even if home prices had lived up to Wall Street’s wishful thinking.

How do we know? On subprime mortgages issued in 2007, the November delinquency rate exceeded 11% — while the teaser rate was still in effect. This means 300,000 homeowners defaulted on loans they had for less than a year. Some homeowners defaulted within just a few months. Some failed to make even the first payment.

Investors fed lenders’ enthusiasm

Experts took notice in 2006 and 2007 when a reported 60% of subprime and Alt-A borrowers got loans without proving they could repay them. In light of a waning housing market in 2006, these experts urged lenders to tighten their underwriting practices.

Instead, lenders made more, not fewer, of these dubious loans. They made so many exceptions to their already lax rules that although they made up no more than 5% of subprime loans before 2006, they represented the majority of these loans issued in 2006 and 2007, said analyst Michael Youngblood in a CNNMoney.com article by Les Christie.

Lenders continued to make these loans because investors continued to buy them, according to Doug Duncan, chief economist of the Mortgage Bankers Association (CNNMoney.com). Merrill Lynch, Citigroup, UBS, Morgan Stanley, Bank of America and others eagerly bought the subprime loans, packaged them with other assets into mortgage-backed securities and collateralized debt obligations (CDOs) and earned huge profits from investors lured by the promise of high yields and AA or AAA ratings.

Investors who believed they purchased low-risk mutual funds but actually invested in CDOs and other securities backed by subprime mortgages will be shocked by significant losses resulting from a dramatic rise in already-high default rates. Investors can expect the worst as the bulk of these loans move to their higher interest rates and new repayment terms during 2008.