Is This Just a "Sub-Prime" Mortgage Crisis?

The current home mortgage crisis is often referred to as a "subprime" crisis. That's useful shorthand, but it really isn't accurate and unfortunately obfuscates the scope of the problem. The mortgage problem isn't just limited to subprime. It extends beyond it in (at least) two ways.

First, as the Wall St. Journal has reported, many of the subprime loans were not made to subprime consumers. That is, the borrowers had FICO scores above 620. Not only does this indicate that something is seriously amiss in the mortgage market (yield spread premiums encouraging brokers to push consumers into costly loans, perhaps?). It also tells us that the problem isn't just subprime.

Second, it's worth remembering that only 14% of mortgages outstanding are subprime. Most mortgages aren't subprime. To be sure, a disaster in 14% of the market is a huge problem in and of itself. But this graph from Credit Suisse is the most sobering thing I've seen in a while. It shows that most of the interest rate resets ahead aren't subprime, but are instead Alt-A and option-ARMs. Alt-A is the category of loans made to consumers with FICO scores just above the subprime threshold. Option ARMs give borrowers several payment options, including making a minimum payment that does not even cover the interest that accrued in the last month. This means it's pretty easy for an option ARM to end up underwater, even in a market where prices are holding steady. If real estate prices are dropping, it is even more likely that an option ARM will end up upside down, which makes refinancing near impossible. The bulk of the Alt-A and option-ARM resets are coming in 2010-2011. A lot of things could change before then. But we might just be seeing the tip of the iceberg in the housing market.

Comments

[jm]

One frequently reads on the net that in California the initial mortgage to purchase a home is a "non-recourse" loan, but refinance mortgages are "recourse" loans, the significant of the distinction being that on the latter the lender can go after other assets to satisfy any deficiency in a foreclosure, and on foreclosure or short sale the amount of debt "forgiven" equates to income for the borrower, generating an income tax liability and requiring that they receive a 1099 for it.

I've been unable to Google up any information on whether the law in Illinois is the same.
What is the law in Illinois?
(Purely intellectual curiosity.)

[David Yen]

To answer the first questions, there is no such rule for residential mortgages in Illinois that I know of. Of course, someone could negotiate for a nonrecourse loan, but it is not the norm.

By the way, I find it odd that anyone who have intellectual curiosity about such a specific question about Illinois, but not any other state.

If you want the know the law in Illinois on mortgage foreclosures, you can start with 735 ILCS 5/15-1501 et seq, or you can consult an Illinois attorney.

[Mark]

Jim - whether a loan is recourse or non-recourse isn't really the issue. It's the choice of law that the creditor makes when foreclosing. I'm admitted to the bar in CA, WA, NY, NJ and DC, and have done some foreclosures, though admittedly not in all those jurisdictions. In CA and WA, a creditor has a choice of a judicial foreclosure or a non-judicial foreclosure.

The advantage to a non-judicial foreclosure is that the creditor can go from notice of default to sheriff's sale in about 120 days (assuming the creditor allows the minimum time between required periods before taking the next step). And, as implied in the name, there is no (or minimal) court involvement. However, in exchange for the fast-track, no-court option, the creditor waives the right to a deficiency judgment - the collateral is the creditor's only recovery.

If the creditor wants to recover a deficiency judgment, it must use the judicial foreclosure route. The problem with that route is that the creditor must go on the court calendar with the rest of the civil cases, and hope for a trial some time within the next three to five years. Plus, for the creditor going that route, it opens the action up to all available counterclaims by the debtor, including fraud, nondisclosure, et cetera, et cetera, all of which will involve the creditor in significant discovery delays and costs. And the creditor must also determine whether the debtor will be able to pay the deficiency judgment at the end of the case; a judgment that's dischargeable in bankruptcy anyway.

Small wonder that I've never in 17 years of practice seen a judicial foreclosure in a residential mortgage foreclosure. You might see them occasionally in a commercial foreclosure where there's a deep pocket around, but it's still rare.

Sorry I can't address Illinois, but most states, particularly in the Midwest and West modified their laws during the Depression to eliminate the deficiency option in non-judicial foreclosures.

[jm]

David and Mark, thanks for the info.

My reason for asking is that I suspect that many of the purchasers of NW suburban McMansions have used pay-option ARMs to buy them, and that when the loans recast to fully amortizing payments in a few years (and they find themselves hundreds of thousands of dollars upside down, not sitting on the huge profits they expected), they will default and would be at risk of receiving a 1099 for the amount of debt forgiven if not for the HR3648 "amnesty". Since the HR3648 provisions expire at the end of 2010, the effect might be to cause some McMansion owners having pay-option ARMs that recast in 2011 to default even before they recast.

[Dale]

This market correction is going to make it possible for my wife and I to reasonably afford a house without creative financing. Our current financial plan is to purchase in 2010-11 and the information above only solidifies my belief this is the right plan. Let the corrections keep coming!

[StuckOnSmart]

My wife and I played by the rules, saved for a rainy day, lived BELOW our means, and tried to avoid risks we did not understand or could not tolerate. Put simply -- risk averse, debt-free, fiscally prudent people.

YET, it now appears that stupidity and exploitation are rewarded, and thrift and fiscal responsibility are penalized.

Bernanke keeps reducing the yield which means our accumulated savings, (it did not fall out of the sky -- it is the result of hard work and thrift) yields VERY LITTLE.

Where do we stand?

[nrringlee]

Dale,

I share your frustration at the outset of this bailout, but once you take a look at this subprime rescue operation, you will realize that it is just a bone thrown to Wall Street, the Banks and the real estate industry by politicians who are simply seeking refuge from the political fall out.

What we have here are patterns of behavior, and yours:

"risk averse, debt-free, fiscally prudent people"

have resulted over decades in financial security, stability and the achievement of long-term goals.

The folks who might or might not get bailed out by the Fed's so-called rescue will stumble from this subprime trap right in to another. Just wait and see. There is no sense of security like knowing you own what you own, and no one can come after you on a whim or flux in the financial markets. Hang tough with you values.

[ohwilleke]

One suspects that many of the non-subprime customers with subprime loans are minorities who live in predominantly minority businesses, as historically, that is where most of that kind of lending has taken place.

Also, it is worth noting that in addition to Alt-A (which is simply subprime lite) and option-ARMs, another big indirect impact has been on the jumbo loan market, which is not government or government corporation subsidized or organized.

But, it is also worth noting that the conventional loan market has remained quite healthy, and that there has been accordingly less impact on home prices in neighborhoods where conventional loans are predominant.