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Relaxed credit standards behind home foreclosures
Bryan Pope - Texas A&M University
Jan 28, 2007

Based on results from its recent mortgage study, the Center for Responsible Lending (CRL) predicts that one out of five subprime loans issued during 2005 and 2006 will fail, resulting in foreclosure for millions of American homeowners.

CRL's study, the first nationwide review of subprime mortgages issued between 1998 and third quarter 2006, revealed that the subprime market has experienced high foreclosure rates despite low interest rates and a favorable economic environment during recent years.

Dr. Mark Dotzour, chief economist with the Real Estate Center at Texas A&M University, says the overall residential real estate market is on fairly strong footing. The real vulnerability in the residential housing market is in the entry-level housing category in regions where a large percentage of buyers have purchased with little or no down payment.

The CRL study cites a number of factors behind the foreclosures, including adjustable rate mortgages with steep rate and payment increases, prepayment penalties, limited income documentation and no escrow for taxes and insurance. But Dotzour said another factor is also at play.

"In recent years, investor thirst for the higher yields of mortgage-backed bonds has allowed mortgage lenders to relax credit standards and issue loans that have a much higher risk of foreclosure," Dotzour said. "Many people who have bought homes in the past five years would never have been able to buy a home at any other time in our country's history. It stands to reason that when you make riskier loans, you are going to have more foreclosures."

So who will lose when the expected tsunami of foreclosures washes through the system? Dotzour said it will not be the mortgage companies, who originate the loans, collect a fee and then sell the loans, and he doubts it will be mortgage bond holders, who have ways of hedging both interest rate risk and credit risk.

Instead, hedge funds, pension funds and endowment associations that have been chasing yield by accepting more risk, or large commercial banks offering complex derivatives to allow traders to hedge their risk in mortgage bonds are likely to feel the pinch.

"It's safe to say that nobody knows exactly where the ultimate risk really lies in the financial markets," Dotzour said. "Look at how long it is taking Fannie Mae to get their accounting straightened out to the point that even a financial genius could understand it. There is no way a layperson will ever be able to understand the risk they take when they buy stocks in large financial institutions."

One thing is for certain, though. Those who will be hit the hardest will be families that lose their homes to foreclosure.

"Many of these people are first-time homebuyers," Dotzour said. "How long will it take for them to come back to try homeownership again? Will their families and friends who observe this difficulty step back and pass on homeownership?"

Dotzour said price pressures on foreclosure sales could retard equity growth for other neighborhood homeowners, many of whom have bought homes with a small down payment. With negative equity, these homeowners may not be able to sell their homes if they need to.

"We have seen the good parts of the social experiment in expanding the credit risk of mortgage borrowers," he said. "We may be getting ready to see the consequences."

The Real Estate Center has been providing solutions through research for 35 years. Funded primarily by Texas real estate licensee fees, the Center was created by the state legislature to meet the needs of many audiences, including the real estate industry, instructors, researchers and the general public.



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