Alt-A Home Loan Time Bomb
By Kent Anderson, Oregon Bankruptcy Attorney on May 12, 2008 in Foreclosure News, Interest and Fees
The sub prime loan crisis has caused a rapid decline in home values across the country. This has depressed the middle class consumer and caused a cutback in many industries related to residential construction. When consumers feel that they have less equity in their homes, they slow their discretionary purchases. This slow down in consumer purchasing, coupled with rising fuel prices, has created a downward spiral for the economy. Unfortunately, more economic trouble may be on the horizon.
The twin fiscal crises of declining home values and tightened credit continue to worsen, threatening the fiscal stability of Fannie Mae and Freddie Mac, the twin giants of the federally-chartered secondary home mortgage market. Responding to an announcement by Standard and Poors warning of signs that the Federal Government might be forced to bail out Fannie Mae, CNN Money issued a dire warning: Trillion Dollar Mortgage Time Bomb Threatens.
Eli Broad, a philanthropist and co-founder of KB Home, the fifth-largest U.S. homebuilder by revenue, voiced the general opinion of knowledgeable economists when he said in an April 27 interview that he expects home prices to drop another 20 percent. “I don’t think we’re anywhere near a bottom in housing” Broad told Bloomberg TV in an interview at the Milken Institute Conference in Beverly Hills, California. “We’re going to have a big inventory of unsold, unoccupied homes that’s going to take three or four years to clear out.”
The continued drop in home values inevitably leads to escalating numbers of homes that are under water with respect to their mortages. Until recently considered to be a problem mainly of sub prime mortgages issued to borrowers with poor credit, generally without adequate income documentation and with terms predictably leading to default down the road, foreclosure on under water mortgages is now working its way into what has been called the “Alt-A” market.
Alt-A home loans are issued to borrowers with good credit ratings who often lack adequate income documentation to satisfy the requirements for a conventional prime loan. As of April 2008, an estimated 16.3% of the Alt-A loans issued in 2006 and 2007 were under water in that debt exceeds the value of the property, and the number of under water loans is expected to grow. These loans are at high risk of default and foreclosure even in the face of some lender’s willingness to reduce interest rates or otherwise modify terms. Fourteen months after origination, 4.21 percent of Alt-A loans made in 2006 face 90-plus-day delinquencies. The 90 day default rate was 1.59 percent for 2005 Alt-A loans and 0.91 percent for 2004 originations after 14 months of existence. The figures exclude exotic loans such as pay-option adjustable rate loans (POARMs) which allow borrowers, within certain specified parameters, to choose a payment amount each month. The large proportion of Alt-A loans used to finance second homes and investment properties further increases the risk that borrowers will default and allow the property to be foreclosed.
In areas where housing prices have declined the most, even FHA-backed prime loans are vulnerable to foreclosure if the homeowner experiences a drop in income and the falling market has eliminated an equity cushion that could allow sale or refinance as an opiton. Currently Fannie Mae’s portfolio includes 2.8 trillion in mortgage debt, about 23% of all residential home loans in the US. This includes 314 billion in Alt-A loans. In contrast, the company’s net worth stands at 45.4 billion, including 21 billion in tax credits which can only be used to offset future tax liability (the company operated at a loss in 2007). This figure is significantly below the operating capital required of most other federal financial institutions. Fannie Mae has looser restrictions placed on its activities than normal financial institutions. For example, it is allowed to sell mortgage-backed securities with half as much capital backing them up as would be required of other financial institutions.
Between them, Fannie Mae and Freddie Mac financed or guaranteed 82% of home loans initiated in January, 2008, up 46% in the second quarter of 2007. They have recently tightened their underwriting standards and raised the dollar amount they will finance, but it remains to be seen whether either of these changes will persuade investors to continue to buy their mortgage-backed securities. If investors get cold feet, the home loan market is in big trouble.
The CNN Money article predicts that the Federal government would bail out Fannie Mae in that eventuality. Although Fannie Mae has no explicit claim to Federal rescue, some companies (the argument goes) are too big and too central to the economy to be allowed to fail. The article also warns that the size of the bailout could destroy the Federal Governments own credit rating.
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