By Faryal Virk
In almost every country, home ownership is something most people desire. It is no different in the United States, where an established mortgage industry has made credit available to millions, making it easier for them to own their own home. Depressed economic conditions in the 1970s and 1980s subdued the mortgage market, but with the boom of the 1990s, mortgage volume experienced dramatic growth, and from 2000 onwards, there was an unprecedented increase in credit available to home buyers at attractive interest rates. One of the factors that facilitated this expansion was the securitization of mortgage portfolios. Banks packaged their mortgages into different types of securities and sold them to investors. The price of the securities depended on what the investors were willing to pay for the type of asset and its risk profile. This process freed up the banks’ capital, allowing them to generate more mortgages and to use cash for investment in securities that included mortgage obligations.
With the increased capacity to lend, banks competed vigorously to generate mortgages and create a cycle of securitization and lending. Different types of mortgages were aggressively marketed to prospective home buyers and credit standards were relaxed, with some banks lending up to 100 percent of appraised value. ‘Ninja’ (no income no job and assets) and ‘stated income/stated assets’ (as stated by borrower without independent verification) loans became commonplace. Adjustable rate mortgages (ARMs) that re-priced in 3-, 5- or 7-years became popular because of their low introductory rates compared with conventional fixed rate mortgages. These products were particularly attractive to subprime borrowers who were previously excluded from home ownership. By 2005 sub-primes made up almost 13 percent of mortgages compared with less than 5 percent ten years before.
With so many more borrowers in the market, demand for homes increased and prices kept rising. In their efforts to cross-sell products, banks also marketed Home Equity Lines of Credit (HELOCS), which targeted the unfunded part of home purchase prices. These were used by consumers to spend on home improvement and other expenses (such as cars and appliances). But all good things must come to an end. By 2006, the first round of ARM re-pricing began in a rising interest rate environment, causing the interest component of monthly mortgage payments to increase, which impacted borrowers’ ability to repay. Banks began to experience an increase in mortgage delinquencies and defaults, and started tightening up their credit standards. This initiated a vicious cycle where people trying to sell their homes in order to avoid foreclosure found fewer buyers. At the same time, the economy began to falter, causing job losses and consequent mortgage defaults. Loan to value ratios became inverted, especially on sub-prime loans. Many borrowers decided it was not worth their while to pay back loans that exceeded the value of their homes, and simply began mailing their keys to lenders after vacating their homes.
As financial institutions struggled to come to grips with their asset portfolios that consisted of both mortgages and mortgage backed securities, they endured losses and the prospect of capital inadequacy. New funding for mortgages declined, while existing mortgage defaults increased. The first round of defaults involved sub-prime loans, but given current economic forecasts the wider market may soon be impacted. All these events have adversely impacted the financial sector and the real estate market. Builders have new home inventories that are being sold at deep discounts compared with pricing that was possible a few years ago. Existing homes are coming on the market, many due to foreclosure, which is also lowering prices. However, with the credit crunch, there are few buyers for these properties, and in the short term it seems that the mortgage crisis will deepen.
Faryal, who lives in Texas, has an interest in banking and finance. (Pun intended)
This article was originally published in the print edition of Valuemag, issue 2, June 2008.