When things are looking grim, people always bring up the argument that it "never happened before." What they fail to say is that the world isnt like it was "before" and that the system involved today is very different than it was in the past. This is as true for global warming as it is for housing prices.
When in doubt, follow the money. The lending industry has changed dramatically in the past decade so there is some real question about the rewards, risks, and motivations of the current system. Does our current system really protect itself from bad loans? If not, who is going to pay for those loans when people cant pay them anymore?
This is the first article I have seen that asked this critical question. Although the numbers are small now, this is a big issue and it may take years to find the answer.
Bad Loans Draw Bad Blood
October 9, 2006
As the housing sector cools, the mortgage market faces an awkward question: Who takes the hit when loans go bad?
A generation ago, nobody asked. Banks made loans and suffered the consequences when borrowers didn't pay. Today, a complex Wall Street machine buys and sells mortgages and packages the loans into securities that are diced and sliced and sold again to investors world-wide.
Under contracts that govern the exchange of mortgages, lenders often must take back loans that default very early in their lives or that come with underwriting mistakes, such as flawed property appraisals. As the housing boom fizzles, cases of bad underwriting are popping up and more mortgages are defaulting early. That has investment banks and other mortgage buyers invoking these contract provisions and pressing lenders to repurchase mortgages that get sold to third parties, creating big losses for some lenders."In a rising market, even a bad loan is a good loan," said Nate Redleaf, a research analyst with Imperial Capital LLC, a Beverly Hills, Calif., investment bank. "You could be sloppy and it didn't matter. Now people really have to do their jobs. They have to be more vigilant."
Mortgage repurchases aren't always reported, so it is unclear how many loans are being sent back to their lenders, or their total value. A study by Credit Suisse Group found evidence of a jump in the subprime market. It examined 208 bond deals involving pools of subprime mortgages totaling $234 billion. The study found nearly half of these mortgage pools had some loans repurchased in the first quarter of 2006, up from less than a third that faced repurchases in 2005. The dollar value of repurchased mortgages has been small -- well under 1% of the total value of mortgages in the pools with at least one repurchase -- but it also climbed, the study found.
It is unclear whether the recent round of mortgage hot potato represents a fine-tuning of the system that helped create the largest mortgage boom in history or the beginning of a more serious shakeout.
While "not serious" at this point, the buybacks are the first real test of the modern mortgage market, said Christopher Mayer, director of the Paul Milstein Center for Real Estate at Columbia Business School. "This will continue to be an issue even in the case of a soft landing" in real estate, he said.
Of the $3.1 trillion in mortgages originated last year, 68% were packaged into securities, Bear Stearns said. In the past, most mortgages rolled into securities were standard loans packaged by government-chartered loan clearinghouses Fannie Mae and Freddie Mac. Investment banks increasingly have gotten in on the action, and they have helped fuel the growth of atypical mortgages, including risky ones that don't require down payments or income documentation.
"You had a well-oiled machine," said Thomas Lawler, a former Fannie Mae economist and now a consultant. As loan volume declined in 2005, lenders got "a little more creative" and loan quality declined.
Credit Suisse estimates early defaults more than doubled on subprime loans that didn't require income documentation between the first quarter of 2004 and the first quarter of 2006.
...
Impac Mortgage Holdings Inc., a Newport Beach, Calif., real-estate investment trust that earned $270 million last year, saw repurchases triple between the first and second quarters of this year, rising to about $100 million. Impac said its repurchases peaked in the second quarter.
When loans go bad, both the original lender and the current owner have an incentive to resolve the issue quietly: Lenders need to be able to sell their loans, and investment banks need loans to bundle together and sell as securities. In some cases, however, disputes are winding up in court.
