Are Foreclosures Only A Subprime Problem?

Most of the recent foreclosure news has concerned subprime loans, but could the same problems impact other parts of the mortgage marketplace?

“If late payments and foreclosures are rising for well-qualified borrowers, then you can expect interest rates to climb and mortgage standards to harden for everyone,” says James J. Saccacio, chief executive officer of, the leading online marketplace for foreclosure properties. “In effect, the marketplace will say there are fewer well-qualified borrowers and therefore rates for all borrowers should go up.”

Residential financing can generally be divided into three layers. At the top are prime loans, financing with the lowest rates for the best-qualified borrowers. At the bottom are subprime loans, high-cost mortgages for those with weak credit. In the middle we have “Alt-A” financing, loans for those who may not have the credit needed for prime mortgages or who want riskier loans.

In a typical year mortgages worth about $3 trillion dollars are originated nationwide. Of this total, according to a recent Credit Suisse study entitled Mortgage Liquidity du Jour: Underestimated No More, about 57 percent ($1.71 trillion) are prime loans, 20 percent ($600 billion) are subprime, 3 percent ($90 billion) are government financing such as FHA and VA loans while another 20 percent ($600 billion) are “Alt-A” financing.

We know that subprime and FHA foreclosure levels now top 13 percent. In comparison, 1.19 percent of all loans are currently in the process of foreclosure, according to the Mortgage Bankers Association. Many — if not most — of those borrowers in the “process” of foreclosure will not lose their homes because they will be able to bring their loans current, refinance, sell or work out a loan modification with the lender.

As to Alt-A financing, Credit Suisse says “delinquency rates are trending well above historic levels throughout the Alt-A market, and even on 2006 vintage prime ARM products.”

Credit Suisse adds that when compared with loans originated in 2003 and 2004, delinquencies and foreclosure rates for recent Alt-A adjustable loans are “3 to 4 times” higher.

The latest MarketPulse report finds that “delinquency rates on subprime and Alt-A mortgages have roughly doubled within the past year and show no signs of moderation.” In particular, the report found that Alt-A interest-only loan delinquencies were up four times when compared with similar mortgages from 2003 and 2004.

What Credit Suisse and MarketPulse found pretty much describes basic real estate thinking:

When home values rise and interest levels fall there are fewer foreclosures because monthly costs are affordable, loans can be easily refinanced and the option to bail-out by selling properties is readily available. In such markets the “foreclosure discount” is small and sometimes nonexistent.

If local markets slow and interest rates rise, then foreclosure levels will increase because borrowers no longer have easy options. If borrowers refinance they face steeper monthly costs because rates have increased while recent buyers often cannot sell at a profit. In such markets the “foreclosure discount” can be significant, meaning that many homes can only be sold at substantially reduced prices.

The news that delinquency and default rates for Alt-A loans are increasing has now begun to change marketplace dynamics. The first responders will be mortgage investors who equate higher default rates with greater risk and thus seek higher interest levels as a result. According to the Securities Industries and Financial Markets Association, individuals and institutions bought mortgage-related securities worth nearly $2 trillion in 2006.

You can already see changes in the marketplace. As one example, M&T Bank — a multi-state bank with assets of more than $56 billion — says that it’s cutting back on Alt-A loan originations. Why? Because “at a recent auction of such loans fewer bids than normal were received and the pricing of those bids was lower than expected.”

“Investors who buy mortgage securities are taking a new and tougher look at the marketplace,” says RealtyTrac’s Saccacio. “The result is that it’s increasingly difficult for mortgage lenders to re-sell non-traditional loan products, whether or not they’re subprime mortgages. For many borrowers, the shift in marketplace preferences means that the era of easy qualification standards for financing and refinancing is largely passing.”

Peter G. Miller is the author of The Common-Sense Mortgage and is a syndicated columnist in more than 110 newspapers.

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