Industry News

As Defaults Rise, Washington Worries

By VIKAS BAJAJ

During the summer’s credit crisis, investors concluded that the default rates on subprime mortgages made last year would probably prove to be the highest in the industry’s history.

But there now appears to be another contender for that dubious honor: loans made in the first half of this year.

Borrowers who took out loans in the first six months of 2007 are falling behind on payments faster than homeowners who took out loans last year, according to a report by Friedman, Billings, Ramsey, an investment bank based in Arlington, Va. The data suggested that more Americans could lose their homes and that the housing market’s troubles might persist longer than many analysts have been predicting.

The report’s author, Michael D. Youngblood, a portfolio manager and analyst at Friedman, Billings, Ramsey, said that most mortgage companies and banks had not tightened lending standards for borrowers with weak, or subprime, credit until July or August, even though early this year regulators, analysts and mortgage investors knew that the easy lending policies of 2005 and 2006 were producing high default rates.

“There are $10.6 trillion of mortgage loans outstanding in the U.S., and even if the brakes had been slammed, it was going to take a long time to slow this locomotive down,” said Mr. Youngblood, who has researched home lending for more than 20 years. “And I don’t see that the brakes were slammed on or that the engineer had a new track to follow. That track only now seems to be appearing.”

He noted that Countrywide Financial, the nation’s largest lender whose practices are often emulated by smaller companies, did not significantly tighten standards until August. And it was only in mid-July that Moody’s Investors Service and Standard & Poor’s, the large ratings agencies, said they would make major changes in the assumptions that they use to evaluate pools of home loans sold to investors.

As of August, default rates on adjustable-rate subprime mortgages written in 2007 had reached 8.05 percent, up from 5.77 percent in July, according to Mr. Youngblood’s analysis of pools of home loans put together by Wall Street banks and sold to investors. By comparison, only 5.36 percent of such loans made last year had defaulted by August 2006. Default rates on fixed-rate subprime mortgages were lower, but were rising at a similar pace.

Data analyzed by Moody’s confirms the trend Mr. Youngblood has identified. Executives at Moody’s say they are monitoring the performance of recent loans, but were not yet ready to discuss their conclusions.

It is unclear whether loans made in the last couple of months are stronger, because lenders were making and securitizing far fewer of them and investors have grown wary of bonds backed by subprime mortgages.

“You may not hear that much about that stuff, because it’s not seeing the light of day,” said Evan Mitnick, a managing director at Westwood Capital, a boutique investment bank in New York.

In the first six months of the year, Wall Street securitized $215 billion in subprime loans, down 23 percent from the comparable period a year earlier, according to Friedman, Billings, Ramsey. By the end of August, the total had dropped by 33 percent from the comparable eight months of 2006.

The recent weakness in job growth and falling home prices in many parts of the country have probably contributed to the higher default rates on loans from early this year, specialists say.

Job losses in the housing industry have put pressure on the economies of formerly fast-growing states like Arizona and Florida. And declining home prices have made it harder for borrowers to refinance loans, especially in cases where the buyers could afford the homes only with the help of the low introductory rates on adjustable mortgages.

Those borrowers are expected to encounter further strain in the months and years ahead as their loans are reset to higher variable rates. When they try to refinance their mortgages, many of them will face stricter lending standards. Many lenders are now requiring borrowers to provide documentation of their incomes, and they will not lend more than 80 to 90 percent of a house’s value.

A survey of 500 borrowers with adjustable-rate loans released yesterday in Cleveland showed that the resetting of rates will put a significant strain on homeowners.

Among borrowers whose rates have already been reset, 41 percent said they were worried about their ability to make payments, compared with 18 percent of borrowers whose rates had not been reset yet. Nearly three-quarters of families with incomes less than $50,000 a year said that an increase in their rates would hurt them, compared with 40 percent with incomes above $50,000.

Financing homes with adjustable mortgages was popular during the housing boom because the borrowers could enjoy lower rates in the first two or three years and then refinance. That worked when house prices were rising fast, but now that prices are flat or falling, it is proving unsustainable, said Keith Ernst, a senior policy counsel at the Center for Responsible Lending.

“Subprime lending had problems with underwriting for a while, and it was evident in weak housing markets — just ask the people in Cleveland,” Mr. Ernst said. “Now that the weakness is widespread, it has pulled the covers on all subprime loans.”