According to the Mortgage Bankers Association, foreclosures in the first quarter of 2006 fell slightly from 2005- except for subprime loans. That looks like it might be a piece of bright news among a lot of bad- but it hints of potential difficulties to come. The risk of mounting foreclosures for subprime borrows remains high.
According to a June 20 story carried by Reuters, (see article) "’A lot of these (home equity) ABS deals are backed by subprime loans, weaker borrowers. If there’s an economic slowdown, then those are the folks that are most likely to have a problem,’ said Dan Castro, managing director and chief credit officer in structured products at GSC Partners in New York.
What is especially dangerous for subprime borrowers are those who financed their homes with ARMs. Some borrowers used ARMs and other exotic mortgages to purchase homes that were barely within their means to pay. "ARMs are a ticking time bomb," said Brad Geisen, president and chief executive of property tracker Foreclosure.com. "Through 2006 and 2007, I’m pretty sure we’ll see a high volume of foreclosures."
The FDIC in a report from March of this year (see report) summarized the problem as follows:
"Changes in the structure of mortgage lending could pose new risks to housing. These changes are most evident in the rising popularity of interest-only and payment-option mortgages, which allow borrowers to afford more expensive homes relative to their income, but which also increase variability in borrower payments and loan balances. To the extent that some borrowers with these innovative mortgages may not fully understand the potential variability in their payments over time, the credit risk associated with these instruments could be difficult to evaluate. In addition, the degree of effective leverage in home-purchase loans has risen in recent years with the advent of so-called "piggy-back" mortgage structures that substitute a second-lien mortgage for some or all of the traditional down payment."
What does this mean for subprime lenders? The FDIC report goes on to say "Approximately 10 percent of U.S. households may be at heightened risk of credit problems in the current environment. This group mainly includes households that gained access to mortgage credit for the first time during the recent expansion of subprime and innovative mortgage loan programs. Not only do many borrowers in this group have pre-existing credit problems, they may also be more vulnerable than other groups to rising interest rates because of their reliance on interest-only and payment-option mortgages. These types of mortgages have the potential for significant payment shock that occurs when low introductory interest rates expire, when index rates rise, or when these loans eventually begin to require regular amortization of principal including any deferred interest that has accrued."
Also from the Reuter’s article-""There is a direct correlation between foreclosure sales and market activity," said Dr. James Gaines, a research economist at The Real Estate Center at Texas A&M University. "If the rate of appreciation is not there, then there is an increase in foreclosure sales."
Appreciation has slowed or disappeared across the country. If Dr. Gaines is right, we can expect an increase in foreclosure sales. While this will most effect the subprime market, it can be expected to adversely affect the rest of the market as well. Loose lending practices, higher interest rates and declining home values could well combine to create the perfect foreclosure storm- and that would be bad for all of us.