It's not the Borrowers; It's the Loans.

Denial runs deep in the financial markets. The vast majority of participants either want or need prices to steadily increase. Any facts or opinions that run counter to the idea of ever increasing prices must be quelled in order to prevent a catastrophic collapse of prices due to panic selling. One of the more glaring examples of this phenomenon has been the slow leak of information regarding the upcoming debacle in our housing market.

In February and March as the sub-prime lending implosion became front page news, market bulls were presented with a major public relations problem. It was imperative for the bulls to convince buyers the damage from subprime lending was “contained” and would not “spill over” into other borrower categories and ultimately into the overall economy. The supposition is that the widespread use of exotic loans is not the problem, it is the practice of giving these loans to those with low credit scores. In other words, it is not the loans, it is the borrowers. This is wrong. It is not the borrowers; it is the loans.

As a primer, I would like to illustrate the basic distinctions made with the type of borrower and the type of loan (for a better, more detailed analysis see Calculated Risk). There are 3 main categories of borrowers: Prime, Alt-A and Sub-Prime. Prime borrowers are those with high credit scores, and Sub-Prime borrowers are those with low credit scores. The Alt-A borrowers make up the gray matter in between. Alt-A tends to be closer to Prime as these are often borrowers with high credit scores which for one or more reasons do not meet the strict standards of Prime borrowers. In recent years one of the most common non-conformities of Alt-A loans has been the lack of verifiable income. In short, “liar loans” are generally Alt-A. As the number of deviations from Prime increases, the credit scores decline until finally you are left with Sub-Prime.




There are also 3 main categories of loans: Conventional, Interest-Only, and Negative Amortization. The distinction between these loans is how the amount of principal is impacted by monthly payments. A conventional mortgage includes some amount of principal in the payment in order to repay the original loan amount. The greater the amount of principal repaid, the quicker the loan is paid off. An interest-only loan does just what it describes; it only pays the interest. This loan doesn’t pay back any of the principal, but it at least “treads water” and does not fall behind. The Negative Amortization loan is one in which the full amount interest is not paid with each payment, and the unpaid interest gets added to the principal balance. Each month, the borrower is increasing the debt. One of the features of all interest-only or negative amortization loans is an interest rate reset. All these loans have provisions where the loan balance comes due either in the form of a balloon payment or an accelerated amortization schedule. Either way, the borrower must either refinance or face a major increase in their monthly loan payment. This increase in payment is what makes these loans such a problem, and this is why it isn’t the borrower, it is the loan.

Loan Matrix

As you can see from the table above, the category of loan and category of borrower are independent of each other. Starting in the lower left hand corner, we have the lowest risk loan for a lender to make, a Prime Conventional mortgage. As we move up or to the right, the risk increases. The riskiest loan a lender can make is the Negative Amortization loan to a Sub-Prime borrower.

The market apologists have admitted there is risk going up the side of the chart because sub-prime borrowers are beginning to default. These same spin-doctors are denying the risk of default will spill over into Alt-A and Prime. They making this argument because these two categories have historically had low default rates. They conveniently forget all the “liar loans” taken out by those with higher credit scores and payment resets for I/O and neg am loans which were also given to the Alt-A and Prime crowd. Historically, this group has not defaulted because they have not been widely exposed to these loan types. Basically, they are ignoring the risk moving along the bottom of the chart: the risk endemic with Interest-Only and Negative Amortization loans. This is a fatal flaw in their analysis.

So why will so many Alt-A and Prime borrowers go into default? To answer that question, we need to make a more detailed analysis of the exhibit: Adjustable Rate Mortgage Reset Schedule

Adjustable rate mortgage reset schedule

First, I would suggest you review Financially Conservative Home Financing. In that post I stated, “At the time of reset, if you are unable to make the new payment (your salary does not increase), or if you are unable refinance the loan (home declines in value), you will lose your home. It’s that simple.” It is my contention based on the information in the above chart, we can deduce the Alt-A and Prime borrowers will face one or both of the conditions which will cause them to lose their homes.

Look at the gray bars which make up the majority of the reset amounts due over the next 24 months (2007 and 2008). These are the Sub-Prime borrowers. They are already defaulting in large numbers, and we have all witnessed the tightening of credit (or elimination of credit) being offered to these borrowers. We also know many of these borrowers were put into the dreaded 2/28 loans and they cannot afford the reset. And, as if that isn’t enough, most of these borrowers were given 100% financing (if they could save up for a downpayment, they probably wouldn’t be Sub-Prime.) Therefore, it is probably safe to assume many if not most of these borrowers will default. Why wouldn’t they? Most haven’t put any money into the transaction, they have no equity as prices are declining, and they already have bad credit. What is the worst that could happen? They will just go back to renting, big deal. Think about what that means… a large number of defaults and foreclosures will occur over the next 3 years (the time span will be spread out due to differences in borrower holding power and the time spent in the foreclosure process).

Life Cycle of a Foreclosure

In addition to the tightening credit and worsening buyer psychology, if large numbers of sub-prime borrowers are defaulting over the next 3 years, prices will certainly fall. Therefore, it is also safe to assume that when the Alt-A and Prime borrowers who have taken out adjustable rate mortgages need to refinance starting in earnest 3 years from now (see the red and light gray bars in the Adjustable Rate Mortgage Reset Schedule), they may be underwater and unable to refinance.

Why do I think so many will be underwater? For one, prices will be significantly lower in 2010. In the forums, we have already documented price reductions by the builders of about 15%, and we also know it isn’t helping sales. More builder price reductions are on the way. It isn’t difficult to imagine prices being 30% or more below the peak by 2010. How many Alt-A and Prime borrowers with adjustable rate mortgages do you think have more than 30% equity in their properties?

Household Equity 2006

Nationally, approximately 40% of residential real estate is owned outright; therefore, if the total equity in real estate is 55%, the remaining 60% of homeowners have a total of 15% of home equity. This is admittedly a rough calculation, but it certainly does not appear as if a great many people with mortgages have more than 30% equity in their homes to ensure they are able to refinance. Many bulls have speculated that most Irvine homeowners are sitting on mountains of equity because home prices have increased so dramatically over the last 5 years. Sounds plausible, but it isn’t true. Where did this equity go?

Mortgage Equity Withdrawals

Has anyone else noticed all the conspicuous consumption in Irvine? Every house has two luxury cars in the driveway, the Spectrum is always full of shoppers, and every homeowner is busy competing with their neighbor to see who can look richer (see Southern California’s Cultural Pathology). If you want to know where all the equity went: they spent it.

To bring us back to where we started, a great many Alt-A and Prime borrowers will lose their homes because they will be hopelessly underwater when they need to refinance 3 to 5 years from now. If they had borrowed with conventional mortgages as they did in the past, they would not be facing this mortgage reset timebomb, and they would simply ride out the Sub-Prime debacle just as many homeowners made it through the declines of the early 90’s. However, it is different this time. This time, the loans they have taken out are going to ruin them. It’s not the borrowers, it’s the loans.

34 thoughts on “It's not the Borrowers; It's the Loans.

  1. zovall

    Excellent article IrvineRenter! Any idea on what the percentages are for the Borrower and Loan Type Matrix? I definitely concur that this problem is not limited to the subprime market.

  2. IrvineRenter


    I could not find a breakdown for each category. I did see a post on Calculated Risk where it was stated that Prime borrowers took out a great many option ARM and sub-prime loans, not because they couldn’t get better terms, but because it was a quick and easy way to extract mortgage equity. There will be some who quip that Orange County or Irvine is not exposed to sub-prime, but since that was the primary mechanism of mortgage equity withdrawal, which is epidemic in OC, we are particularly exposed. Plus, since nobody in OC can truly afford the houses they bought over the last few years, the profusion of Alt-A liar loans is another ticking time bomb.

    I predict the next national headlines concerning the housing market will focus on Alt-A liar loans.

  3. ripcord


    I presume your plot of Percentage Household Equity vs. Time is for the entire nation. I would be interested to see a similar plot for Orange County or SoCal. Our real estate doubled in the last five or six years, so I would be astounded if the percentage equity in SoCal didn’t also spike. I agree with you that the rate of equity extraction also increased, but I would be very surprised if Irvine homeowners were not sitting on more equity than they were in 1990. Do you have any data concerning this? If Irvine homeowners have less equity that in the 1990s, even given the absurd runup in home values, we really could be heading for a seriously hard landing.

    I cannot believe that the amount of home equity DECREASED in America over the last couple of years. Are people really that misguided?

  4. SoCalwatcher

    Great post! I have commented on this phenomenon with SoCal housing in a few other forums and keep getting the same typical SoCal FB response: I’m crazy, nothing is happening, prices are going up still and the market is fine.

    It’s amazing how educated professionals get themselves into suck terrible economic predicaments. How does one become educated to think critically and then get themselves wrapped up in these crazy unadvantages loans and then add insult to injury by spending this equity on depreciating consumables? It is amazing how keeping up with the Joneses to maintain self-esteem and image trumps any rational thought.

    These loan resets and home value crashes are a painful reminder that irrational narcissism can have some devastating prices.

  5. IrvineRenter


    The chart is for the nation as a whole. I cannot find any data specific to Irvine or OC; however, the anecdotal evidence is pretty strong. Speak to any loan officer or financial planner, and they will tell you people here have spent it as fast as their house made it. Not everyone, of course, but it does not take many to go into foreclosure to drive everyone’s home prices down.

    When I first saw that home equity declined during the period of rapidly increasing home prices coupled with the dramatic increase in mortgage equity withdrawal, it was a real eye opener for me. Believe it. It is real. The data proves it. People are that misguided/stupid, and it will be the cause of their destruction.

  6. GrewUpInIrvine

    With regards to the “Percentage Equity In Household Real Estate) – it doesn’t look right. Between the housing market boom over the last 10 years and the devaluation of debt with time (aka the positive inflationary impact upon debt) the chart seems off. The only plausible explanation would be a corresponding increase in 2nds and HELOC’s to discount or even negate the last 10 years of housing apprecation and inflationary devaluation. Any charts that demonstrate these two debt instruments over the last 15 years?

  7. Tom in Newport Beach

    I don’t think there will be any “destruction” in Newport Beach or the surrounding areas. So far I’m not seeing anything out of the ordinary. Mean home prices have tapered off, but I don’t see blood in the streets. Just more spending, more consumption, more pimped out SUVs with shiny new rims, and lots of plastic surgery, vacations, etc. Nope, it is business as usual around here in good ole’ affluent South O.C. I’ve witnessed 30% pull backs in real estate prices before (1989 – 1996), and I’m hoping I see it again. But for now, I feel the general public around here is oblivious to most of what I read here.

  8. crucialtaunt

    IrvinerRenter- excellent, talented, and nuanced writing – as always! You are a great asset to this blog. Now, you are making money from this aren’t you? If not, you really should be!

    I have been contemplating the “Irvine Wealth Conundrum” for a while. The following statement really got me thinking:

    “Has anyone else noticed all the conspicuous consumption in Irvine? Every house has two luxury cars in the driveway, the Spectrum is always full of shoppers, and every homeowner is busy competing with their neighbor to see who can look richer (see Southern California’s Cultural Pathology). If you want to know where all the equity went: they spent it.”

    It is quite conceivable that a dual income professional family in Irvine, making say $150-200k annually could “afford” two luxury cars on real wages alone.

    Is there a quantifiable method to determine how much of Irvine’s conspicuous consumption comes from “real wages” from work, vs. from cashing out home equity (“the live-in mistress”)? Anyone familiar with BLS data – if it gives details on sources of income?

  9. ocjohn

    Yes the American consumer is misguided. The national personal savings rate has turned negative since mid 2005. While the governement calculation excludes capital gains, certainly the main contributor, MEW, has more or less gone to zero now. So the negative savings rate has to reverse at some point, and consumer spending has to slowdown to correct the imbalance in household balance sheet. The economy could get pretty ugly for everybody and the ripple effect means evey more pain for the housing market.

    At this point, most homeowners don’t even know that prices have already declined by at least -10%. This isn’t the median price, but a price the same house tracked over time. Only the ones selling know now because they can’t sell at the price they thought they could get. Diligent blog readers who researched housing bubble sites also know.

    I think the Option ARM reset will hit earlier than expected. Most of these borrowers pay the minimum amount so the difference is added to the principal owned. Some loans automatically reset when a threshold as low as 110% LTV is hit. So the Option ARM crisis may be crashing upon us as the subprime reset wave recedes.

  10. smf

    I keep always asking this question and I still cannot find an answer for this.

    Why would anyone use a conventional loan to flip a house?

    In other words, who would put their own money at risk to flip a house, when you could get the gains w/o using a single cent of your money.

    These people are as much in trouble as actual ‘poor’ individuals, and I have seen plenty of them.

    BTW, I have a RE relative, and she says that the only people she sells to in Sacramento are investors.

  11. lendingmaestro

    It is the loans and the borrowers.

    Remember a prime credit score does not denote intellegence. It is the consumers job to be financially responsible. The advent of low-doc loans and neg am loans facilitated this bubble. I’ve posted numerous times about the prime borrowers I speak to on a daily basis who are in deep doo doo. Think of a pro body builder. At some point, natural supplements and lifting weights can only get you so big. You need a nice injection of steroids and BAM!!! You explode into a monster. Anyone know what happens next?? Either you conitnue the steroid use until your muscles explode and you look like Randy Macho Man Savage, or you quit and whither away into a shell of your former self. You can’t erase the damage. Anyone look at our wonderful governor lately?

    I often wonder when I go to the spectrum for a quick lunch at the corner bakery and see all the sheep walking around…….where do these people work!?

    Why work when you can just shop til you drop with those big credit cards? Then you can just pay those off with your new HELOC!! Then use the credit cards again and get a bigger HELOC! If you need more cash just redo the first into a new jumbo neg am loan. The best part is that your new payment is so low that you can afford another HELOC!!

    Eventually all debt needs to be paid. The whole concept of a loan was originally based on the fact that you’d pay it off. Somehow banks got wildly away from that and jumped into the futures and derivatives market.

  12. ripcord


    Thanks for the reply. I don’t have any contact with financial professionals, but I will take your word for it. My friends back in OC are either high-income renters or stable homeowners.

    You know how you always talk about being accused of being a “bitter renter”? Here is a new subspecies of housing bear: “bitter refugee”

    My wife as been telling me that I’m obsessed with OC real estate since I sold and got out, and the reason I’m obsessed is that I’m struggling with the fact that we left OC and I’m trying to convince myself I made the right move. So, I’m bitter that I had to leave OC for financial prudence, and I’m hoping for a crash so I can get back in on more sound footing.

    So, a “bitter refugee” is someone that loves SoCal, but had to leave from a financial standpoint, and welcomes a return to sanity so he or she can return and own with a 30 year fixed!

  13. OCMAN

    Thanks for the good post.

    Yesterday, I went to Columbus Grove, Lantana model house. I remember those plans going for well above 900s to close to 1.1 mil. I saw the price tag of 810k for the plan 1 and 885k for plan 3. Plan 2 were sold out currently but was around 860k. That is close to 15% drop from the peak in the previous phases.

    I asked the sales rep when would be the next phase because I saw some undeveloped areas. She murmured within a few weeks but added the fact that they (builder) have not decided how to divide the lot and whether it would be 1, 2, or 3 phases. The area is not that big may be for 25 homes at the most.

    My guess is they are not selling like hot cakes so the builder is testing the water and still waiting for the market turn around. The sales rep also said that they are definiately raising the price for the next phase, implying I need to pick one up now for “big” saving. William Lyon homes are not like Lennar EI(everything included) so the option could run up to 50k ~ 100k.

    My conclusion from the short conversation is that we still got some time to go for everyone including builder and sales rep to realize that price drop is necessary for the buyers to come out of the wood, well a few qualified and legitimate buyers.

    I can afford to get around 750k house using 30% of my AGI (including my wife’s income.. how sad), and it’s possible that I can stretch a little bit to pick up one of those but I they would make me a dumb buyer who would gnash teeth later…

    Just thought I would share that…

  14. Joe

    Good analysis. One conclusion that I disagree with – the foreclosures of prime borrowers who have had the value of their home decline.

    If the prime borrower bought in 2003 with a 5-year adjustable, it will adjust in 2008. If they put zero down, they may very well have negative equity by the time that loan adjusts. But….first of all, the adjustment (based on today’s interest rates) wouldn’t be too bad….if they had any income growth in those 5 years they should be fine. And second, if they are making their payments….the borrower will not foreclose. Just having negative equity won’t result in a foreclosure. If a prime borrower is making their payments on time and is having a loan adjust….the existing lender will work with them to put them on a similar new loan rather than foreclose.

    Now if that prime borrower was a mortgage broker……different story.

  15. IrvineRenter


    You are correct that negative equity is not necessarily the problem. The problem arises when the loan reset is not affordable and you can’t refinance. There will be a few who can afford the reset, and they will be OK. There will be many more who can’t and they will get foreclosed on. It doesn’t take many to bring down everyone’s property values.

  16. Hold Out

    After the sheeple (non-flippers) read and watch the news about the next two months of resets, they will pick up the phones and call every mortgage broker left on the planet to find a Refi.
    When they all flood the appraisers with requests for comps they will find out that the 10% drop has already come and gone and they have not much to look forward to. They will resign themselves to the fact that they have few choices.

    1) Run the clock down to their refi zero hour. Stop making payments and plan to move to a rental at zero hour plus 9 months.

    2) Play the greater fool lottery, list the home, wait and cut, rinse and repeat. Land a Greater Fool before Option 1 is more beneficial.

    If 99% of these folks choose option 1 the Real Estate Cheerleaders will point to the 07′ summer 3000% spike in appraisals and 1% jump in listings as a possitive sign and some greater fool will reward the 1% that listed.

    If any significant number are suicidal enough to pull the trigger on option 2, the chances of landing a Greater Fool will be worse than the Lottery. They will ALL be forced back into option 1 and line up like lemmings.

    FYI: I am pretty sure this time around all those appraisers and loan agents will ask for cash up front from the REFI applicants for the privalege of being told that they are underwater. The cheerleaders will spin this spike in Earnings and Applications as another reason to BUY BUY BUY. You will also see Agents (of Doom) offering to list for an up front fee instead of commisions for those foolish enough to try and sell. The Cheerleaders will spin them as big hearted saints for helping homeowners through this dip. That 6% might help a few but not enough to make a difference in the outcome, only delay the inevitable.

    The day you stop seeing adds for no fee loans will mark the start of the march to the cliff.

  17. bought_high

    PRIME borrowers should have the ability to pay-off their loan – they will need less trips to the mall or put the wife back to work. But in the end, they will struggle to try to hold onto their house and should not worsen the flood of REO homes on the market. Also, as Joe said – lenders will work with qualified borrowers to keep them making payments instead of losing more money thru foreclosure.

    If ALT-A is mostly ‘liar loans’ then that could be big trouble – as the money won’t appear out of nowhere. As for sub-prime, we are already seeing the effects and foreclosure is the only way out.

    The question becomes how big of a drop and how quickly… If enough people are waiting on the sidelines (bitter refugee and OCMAN) then the drop in prices could take a while…

  18. mike

    Great post. While I’m a firm believer in the bubble, I’ve yet to see any tangible information on the Alt-A numbers. Can anyone think of a way to find out some of these figures?

    1. Alt-A percentages for 2/28 3/27 reset teaser loans.
    2. Alt-A percentages “liar loans” ( I realize this may not be available to the general public)


  19. lendingmaestro

    Clarification of Prime ARM resets.

    A prime borrower that got a 5/1 IO @ 4.75% in 2002 will se the first adjustment period in 2007. Their rate however will then be calculated by adding the index plus the margin. The index could be LIBOR, MTA, COFI, COSI, CODI, etc…The margin is fixed and was disclosed at the time of the original note signing. Most banks have first adjustment caps of 2%-5%.

    For instance our 5/1 LIBOR has a first interest change cap of 3%. That means their rate would adjust from 4.75% to LIBOR plus the margin. LIBOR is currently over 5%, so they’ll be looking at a rate of over 8%. Now most prime borrowers will refi before this happens, but they will need equity and they will still need to have strong ficos. The 5/1 rate is going for close to 6% now so either way, they are looking at a rate hike.

    The neg am loan is a completely different story. We have customers that are already at a rate near 9%. On a 500k mortgage that equates to an IO payment of 3750 a month, but they’re minimum payment is only 1750 a month. They’re loan balance is increasing by 2k a month and what they don’t realize is their loan will recast once it reaches 110% of the original balance, or 550k. At the current rate they’ll recast with 24 months. That means they will be forced to make the full payment every month.

    Back breaker. Now the borrower has a mortgage late and can only refi into a sub prime loan which they can’t afford

  20. Tom

    To “Hold Out”

    “The day you stop seeing adds for no fee loans will mark the start of the march to the cliff.”


  21. IrvineRenter

    Hold Out,

    “I am pretty sure this time around all those appraisers and loan agents will ask for cash up front from the REFI applicants for the privalege of being told that they are underwater.” I hadn’t thought of that. Funny!


    “If ALT-A is mostly ‘liar loans’ then that could be big trouble – as the money won’t appear out of nowhere. ” That is a succinct statement of the real problem with Alt-A. In markets like ours where prices are very high, the percentage of Alt-A loans is also very high.


    I have not found an authoritative source for the % of Alt-A liar loans. It is probably safe to assume the majority of those issued since 2004 are of this type. “Going Stated” was the only way anyone could qualify for the sums loaned.


    Thank you for the added clarification.

    I had also read that these I/O loans get amortized over what remains on a 30 year schedule. For instance, a 5 year I/O would be amortized over 25 years at time of reset. Can you confirm this? The payment shock would be huge if there is an accelerated principal repayment schedule. I think most assume they pick up with a 30 year schedule once the I/O period ends.

  22. ripcord


    I had a 5/1 I/O at 4.875% loan originated in 2003. When it hit 2008 it was scheduled to be reamortized over 25 years. Also, the margin was not 3%. Mine was 1.5%, with a 5% jump ever year and a cap of 9.9%. So, I wouldn’t have been hosed, but it would have been painful had I not jumped ship.

    The real killer would have been the need to pay principle. I took the loan because I had the income but not the down payment for my house in Turtle Rock (I was less than one year out of grad school). And no, I wasn’t fooling myself, I actually calculated that even if I were not to get any raises in 5 years I could still afford the increased payment. I chose the I/O loan because the rate was much lower than a jumbo 30-year fixed at the time. It turned out to be a winner for me… but I think I was just lucky.

  23. IrvineRenter


    Does sound like you were a lucky one, but you were smart about what you were doing as well. These are risky loans, but it sounds as if you understood the risks and took on only what you knew you could handle. That makes you an anomaly 🙂

    I came across this article about the widespread use of Option ARMS. It wasn’t just sub-prime borrowers. The article is a bit dated, but the content still rings true.

  24. lendingmaestro

    All of our IO products. 5yr, 7yr, and 10yr have an interest only option for 10 years. This helps with the payment shock, but the rate is still considerably high. After the 10 year interest only period the loan must amortize in 240 months (20 years). You’ll be making the 20 year payment

    Regardless of the payment term the loan will need to pay itself off at the end of the amortization term.

  25. SoCalwatcher

    Irvinerenter- go check out Business Week – April 11, 2005 issue about the housing bubble. It is painfully accurate, even two years ago!!

  26. wbcmbg

    What do you guys think about selling Housing Futures on the CME? I believe they are predicting something like 5% drop in home prices in the next 9 months.

    Some problems I see are: how they calculate the home price, the liquidity of the housing futures market, and having a time factor to worry about.

    I believe the median price is calculated by the resell of the same home. It seems like there’s going to be problems with how they determine the price. For example, if it’s the same house, does that mean it will included remodeled homes which will naturally increase the value of the home?

    Throughout the years I realized that being right in this type of situation is great, but everyone else thinks your being pessimistic. I’ve given up on trying to educate people that want to live in a dreamworld. I might as well profit from my knowledge. So are you guys going to try to profit from this?

  27. graphrix

    Irvinerenter – Another great post and to me it looks like you are right that the cancer is spreading to ALT-A. Ironically I was taking a look today at the MBS pools and the increase in deliquencies today. ALT-A has begun to suffer an increase with some lenders being worse than others. Some are even worse than some of the subprime pools. Even A paper is seeing an increase but not to the point of worry yet but again some lenders are seeing more of an increase than others. What is amazing is the increase within the option arm pools that are barely six months old that are seeing increases that justify the significant changes in underwriting guidelines. I would expect more changes with this loan or even some lenders no longer offering it.

  28. Eurominds

    From Bloomberg

    Subprime Bondholders May Lose $75 Billion From Slump (Update1)

    By Mark Pittman

    April 24 (Bloomberg) — Bond investors who financed the U.S. housing boom are starting to pay the price for slumping home values and record delinquencies in subprime loans.

    They will lose as much as $75 billion on securities made up of millions of mortgages to people with poor credit, says Pacific Investment Management Co., manager of the world’s biggest bond fund. Some of the $450 billion in subprime mortgage-backed debt sold last year has lost 37 percent, according to Merrill Lynch & Co.

    BlackRock Inc., AllianceBernstein Holding LP and Franklin Templeton Investments are vulnerable because investors have replaced banks and thrifts as the primary source of money for U.S. mortgages. More than $6 trillion of mortgage bonds are outstanding, dwarfing the amount of U.S. government debt by about 50 percent.

    “Bond investors will be the ones who will take the losses,” not the banks, said Scott Simon, who oversees $250 billion in asset-backed securities at Newport Beach, California- based Pimco, a unit of insurer Allianz SE in Munich.

    Investors are losing money because of places like Riverside County, California, where foreclosures almost tripled last quarter to 6,103 from a year earlier, the biggest increase in the U.S., according to

    Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, used Riverside loans as collateral for $1.5 billion of bonds sold in January 2006. Some of the lowest-rated portions of the securities trade at 63 cents on the dollar, down from more than 100 cents in October, according to data compiled by Merrill Lynch.

    BlackRock, Franklin Templeton

    Investors in the Lehman bonds include New York-based BlackRock, which oversees $1 trillion of assets and AllianceBernstein, which manages $726 billion, according to filings with the Securities and Exchange Commission. Franklin Templeton, a San Mateo, California-based firm that oversees $565 billion, also bought the bonds, data compiled by Bloomberg show.

    Bond investors paid for the decade-long real estate expansion that led to a record 69 percent of Americans owning their own houses.

    Home buyers were able to get loans from banks, thrifts and mortgage companies who would then typically sell them to underwriters, freeing up cash for more lending. New York-based Lehman; Bear Stearns Cos., the biggest underwriter of mortgage bonds; Morgan Stanley, Wall Street’s biggest real estate investor, and other securities firms packaged loans into bonds and then sold them.

    `More Lenient’

    About two-thirds of mortgages get turned into bonds, up from 40 percent in 1990, when the market was $1.08 trillion and the country suffered its last real estate slump, according to data from the Federal Reserve and Fannie Mae in Washington.

    Mortgage companies increased the amount of loans they provided when the economy was accelerating by accepting home buyers who previously couldn’t obtain credit. These subprime mortgages totaled almost 20 percent of all new home loans last year, according to the Mortgage Bankers Association, a Washington-based trade group.

    When U.S. growth slowed and home prices stopped rising last year, delinquencies mounted. About 13 percent of subprime mortgages made in 2006 were delinquent after 12 months, with 6.65 percent considered “seriously delinquent,” or more than 90 days late, Standard & Poor’s estimates.

    “Underwriter standards have gotten progressively more lenient,” said Mark Tecotzky, chief investment officer at Greenwich, Connecticut-based Ellington Management Group LLC, a $4 billion hedge fund that invests in mortgage bonds.

    `Feet to the Fire’

    Bondholders are as much to blame as lenders, Federal Deposit Insurance Corp. Chairwoman Sheila Bair in Washington says.

    “We should hold the servicers’ and the investors’ feet to the fire on this,” Bair said in testimony to the House Financial Services Committee last week. “We did not have good market discipline with investors buying all these mortgages.”

    Barney Frank, a Democrat from Massachusetts and chairman of the House Financial Services Committee, and Spencer Bachus of Alabama, the top Republican on the committee, said earlier this month that they favor legislation making bond investors liable for loans that end up in default.

    `Attractive Yield’

    Investors say more regulation may dry up financing for homes, causing more delinquencies and damaging the economy. The National Association of Realtors in Washington said today that sales of previously owned U.S. homes declined 8.4 percent in March to an annual rate of 6.12 million, the lowest level in almost four years.

    The bond market has reduced “the cost of mortgage credit by linking investors and home-buying families through mortgage securitization,” said George Miller, executive director for American Securitization Forum, an industry trade group for investors and underwriters in New York. Miller made the comments last week in testimony to the House Financial Services Committee.

    Roger Bayston, director of fixed income at Franklin Templeton, which bought $800,000 of the Lehman bonds, said his firm hasn’t lost money because it purchased the highest-rated portions of the securities. He would buy them again, he said.

    BlackRock bought the portion of the SAIL 2006-1 bonds rated AAA and due in six months because “it offered an attractive yield relative to similar securities,” said Aaron Read, fixed- income portfolio manager at the firm.

    The AAA rated part pays 8 basis points more than the London interbank offered rate in yield while securities based on credit- card payments and with the same ratings pay about 2 basis points or 3 basis points less than Libor, Read said. A basis point is 0.01 percentage point.


    AllianceBernstein spokeswoman Stephanie Giaramita didn’t return calls seeking comment. Pimco’s Simon said his firm is also only buying the highest-rated parts of mortgage bonds.

    The losses in mortgage bonds haven’t spread to other markets, even though more than 50 lenders have halted operations, gone bankrupt or sought buyers since the start of 2006, according to Bloomberg data. Defaults on subprime mortgages tracked by the Mortgage Bankers Association surged to a four-year high in the fourth quarter.

    “The economic risk, the macro risk — I don’t see it posing a serious problem,” U.S. Treasury Secretary Henry Paulson said after a speech in New York on April 20 in response to questions on the collapse of the subprime mortgage market.

    Brown Grass

    Driving around Riverside County’s Lake Elsinore, realtor Abdul Syed counts about 40 lots with brown grass in the 1,200- home Tuscany Hills subdivision. Owners stop watering their lawns when they are about to lose their homes, he said.

    “All of these people are probably in default and probably going to face foreclosure really soon,” said Syed, who in 2002 moved to the town of 38,000 about 60 miles from San Diego.

    The owner of 16 Ponte Russo paid $650,000 for the Mission- style house in November 2005 and got financing for 100 percent of the price from BNC Mortgage Inc. in Irvine, California, according to country records. BNC is a subprime lender owned by Lehman.

    The owner never made mortgage payments. Now, the house is on sale for $496,000 following a foreclosure. Attempts to reach the owner weren’t successful.

    That house is “a real nice one because it backs up into a canyon and you have endless views of hills,” Syed said. “That’s a great deal. The banks must be getting kind of desperate.”

    More than 43 percent of the bonds sold by Lehman, called SAIL 2006-1, are based on property in California. Foreclosures in the state have quadrupled since September to $2 billion, according to Foreclosure Radar in Sacramento. SAIL stands for Structured Asset Investment Loan Trust.

    Rates Reset

    The SAIL bonds were backed by 7,600 mortgages when they were issued. Almost $50 million of the loans are in foreclosure, some $25 million are 90 days delinquent and banks have seized property backing $30 million more, according to data compiled by Bloomberg. The bonds are one of only six to ever be downgraded before their first anniversary, and the biggest of that group, S&P said.

    Rates on almost half of the loans in the Lehman bonds are scheduled to increase to an average 10.3 percent in December from about 7 percent now, according to the prospectus for the securities.

    David Sherr, the managing director in charge of global securitized products at Lehman, and Steven Skolnik, chief executive officer of BNC, declined to comment.

    Packaging mortgages into bonds has been the fastest-growing part of the debt market since 1995, providing investors with securities and a default rate below 1 percent.


    Fees from securitizing assets like mortgages and student loans almost tripled in the past five years to $5.6 billion, Bank of America Corp. analyst Michael Hecht in New York estimated. Like Lehman, underwriters including Bear Stearns, Merrill Lynch and Morgan Stanley bought lenders to gain access to a steady supply of loans.

    Much of the demand for the mortgage bonds came from Europe and Asia, where investors borrowed in their currencies and used the proceeds to buy higher-yielding assets in America. The Fed holds $675 billion of mortgage bonds and debt sold by Fannie Mae and Freddie Mac — the two biggest financiers of home loans –on behalf of foreign central banks and international accounts, an eightfold increase this decade.

    Demand Jumps

    Demand for high-yielding mortgage bonds jumped after the Fed in 2003 cut its target interest rate for overnight loans between banks to a 45-year low of 1 percent. Subprime mortgages typically have rates at least 2 percentage points or 3 percentage points above safer prime loans.

    Subprime mortgage bond sales grew to $450 billion last year from $95 billion in 2001, according to the Securities Industry Financial Markets Association, a New York-based industry trade group. The amount of mortgage bonds outstanding increased 82 percent over that period.

    “More money was being lent than should have been lent,” Congressman Frank said in an interview. Mortgage bond investors “provided liquidity without responsibility,” he said.

    Subprime mortgage-backed securities from 2006 may be the worst ever, with delinquencies on the underlying debt “consistently higher” than in the prior five years, according to S&P. Losses on loans backing bonds will be between 5.25 percent and 7.75 percent, S&P said.

    Losing Homes

    As many as 2.4 million Americans may lose their homes, the Center for Responsible Lending in Durham, North Carolina said in testimony to Congress last month. The National Association of Realtors this month said the median price for an existing home likely will fall 0.7 percent to $220,300 this year, the first annual drop since the trade group began keeping records in 1968 and probably the first decline since the Great Depression.

    Foreclosures in California will rise to 70,000 in 2008 from 3,000 in 2005, said Bruce Norris, a resident of Riverside, California, who buys houses in foreclosure.

    “There is no way this is going to play out without pain,” Norris said. “It’s already not OK. It just hasn’t hit the courthouse steps.”

    To contact the reporter on this story: Mark Pittman in New York at .

    Last Updated: April 24, 2007 11:16 EDT

  29. Morgan


    Good post, although I have to say I believe it is the borrowers AND the loans. The borrowers chose those risky loan types trying to buy more than they could under standard underwriting guidelines.

    The distinction between prime, alt-a and subprime is a red herring. As I’ve said “Your FICO score can not make your mortgage payment.”

    In the PIMCO report “I’m Still Renting” Mark Kiesel states “Clearly, this is not just a subprime issue, but rather an ARM reset issue as both subprime and prime borrowers potentially are forced to put homes back on the market with almost $1 trillion of ARMs resetting over the next two years.”


  30. IrvineRenter

    Subprime `Liar Loans’ Fuel Housing Bust With $1 Billion Fraud

    By Bob Ivry

    April 25 (Bloomberg) — Cheating on mortgage applications is so widespread and so seldom punished that it’s fueling an increase in foreclosures that will prolong the housing slump, said Robert W. Russell, counsel to the director of the Office of Thrift Supervision, which oversees savings and loans.

    Borrowers and brokers commit fraud when they exaggerate the applicant’s income, qualifying the borrower for a home he otherwise couldn’t afford. Such fraud robbed lenders of an estimated $1 billion last year, according to data collected by the Washington-based Mortgage Bankers Association and the Federal Bureau of Investigation.

    “Misstatements about employment and income are being made every day,” Russell said. “The brokers are just putting down on paper what the underwriters would require. There are borrowers providing false information as well.”

    Loans that require little or no documentation of income soared to $276 billion, or 46 percent, of all subprime mortgages last year from $30 billion in 2001, according to estimates from New York-based analysts at Credit Suisse Group. Homebuyers with those loans defaulted at a 12.6 percent rate in February, compared with 1.5 percent of fully documented prime mortgages, said San Francisco-based First American LoanPerformance, a mortgage consulting group.

    A 2006 study cited by the Mortgage Asset Research Institute showed that almost 60 percent of stated income loans were exaggerated by at least 50 percent.

    `Liar Loans’

    “Everyone calls these loans `liar loans’ because we know these people were lying,” said Jim Croft, a spokesman at the Reston, Virginia-based Mortgage Asset Research Institute.

    Nancy Olland’s application for a mortgage said she made $6,900 a month. She needed that much income to qualify for her loan. The 48-year-old mental health therapist from Cleveland Heights, Ohio, actually makes $3,286, based on her pay stub.

    She said she wasn’t asked to document her income. She signed the application without reviewing it and discovered the discrepancy months later.

    “I don’t know where the information came from,” Olland said. “I didn’t give it to my mortgage broker. Was it literally fabricated out of thin air?”

    New Century Financial Corp., the second-largest U.S. subprime lender last year, was Olland’s lender.

    Laura Oberhelman, a spokeswoman at Irvine, California-based New Century, said in an e-mail that the company only approves loan applications “that evidence a borrower’s ability to repay the loan.” To stem fraud, she said New Century used electronic and manual systems “designed to detect red flags like inflated appraisal values, unusual multiple borrower activity or rapid loan turnover.”

    New Century filed for bankruptcy on April 2.

    Red Flags

    As part of a pending class-action lawsuit in State of Minnesota District Court alleging Ameriquest Mortgage Corp. charged borrowers extra fees, former account executive Mark Bomchill, who worked in the Plymouth, Minnesota, branch office, said it was “a common and open practice at Ameriquest for account executives to forge or alter borrower information or loan documents.”

    “I saw account executives openly engage in conduct such as altering borrowers’ W-2 forms or pay stubs, photocopying borrower signatures and copying them onto other, unsigned documents and similar conduct,” Bomchill said in a sworn statement.

    “It wasn’t really done behind closed doors,” Bomchill said in an interview.

    Ameriquest spokesman Chris Orlando said the Irvine, California-based company, which once was the biggest subprime lender, has “zero tolerance for fraud” and works hard to find it and prevent it.

    Fraud Complaints

    “When we discover an employee involved in fraudulent activity, we take decisive action up to terminating employment and pursuing criminal action,” Orlando said.

    Mortgage fraud complaints more than doubled in the U.S. from 2003 to 2006, according to the Financial Crimes Enforcement Network, a division of the U.S. Treasury Department. Suspicious activity reports pertaining to mortgage fraud increased 14-fold from 1997 to 2005, according to the organization.

    There is a pattern of “exaggerated or fabricated income information associated with subprime loans,” the Vienna, Virginia-based enforcement network said in a report in November.

    The difficulty in calculating mortgage fraud is only one- third of lenders are required to report suspicious behavior, said Mortgage Bankers Association spokesman John Mechem.

    The FBI targets what it calls “fraud for profit,” which is related to conspirators who lie to get multiple mortgages and have no intention of repaying them, said Special Agent Stephen Kodak in Washington.

    Lying About Income

    Individuals lying about their income to buy a house they intend to live in, or “fraud for housing,” occurs more often but accounts for less money lost, Kodak said. The FBI generally does not go after “fraud for housing,” he said.

    Yet many “fraud for housing” schemes end up as “fraud for profit” conspiracies, said David McLaughlin, head prosecutor for the Georgia attorney general.

    “Even the most benign-looking fraud can have far-reaching consequences,” McLaughlin said. “Those properties will fall into foreclosure and there’s a risk when you have a fraud scenario and the person is in so far over their heads, those are the prime targets for fraud-for-profit criminals to prey on.”

    McLaughlin said his priority is “fraud for profit” cases, though he would like to prosecute homebuyers who lie on their mortgage applications.

    Low documentation loans were established in the 1980s mainly for the self-employed and non-U.S. citizens whose pay was difficult to verify. They can be processed quicker than standard loans and typically cost the borrower an extra quarter point on his mortgage. They were made possible by relaxed lending guidelines, or what Bear Stearns Cos. analyst Gyan Sinha calls “Hail Mary underwriting.”

    `Anyone With a Pulse’

    “The loans were available to anyone with a pulse,” said Greg Bass, a former account executive in Austin, Texas, for subprime lender Long Beach Mortgage Co.

    When interest rates started to climb from the lows of June 2003, subprime lenders eased their standards so more people could afford homes, said Sandor Samuels, executive managing director of Calabasas, California-based Countrywide Financial Corp., the biggest U.S. mortgage lender.

    Homeowners flooded lenders with requests to refinance mortgages during the U.S. housing boom from 2001 to 2006 when median home prices increased 56 percent, according to the Washington-based National Association of Realtors.

    Prices Peak

    “When everyone was eating up the subprime market, it was great to be in the business,” said Josh Tullis, sales director for A. Anderson Scott Mortgage Group in Falls Church, Virginia. “In the heyday, I knew guys who went from making $2,000 a month working 60 hours a week at McDonald’s and they’d come over here and work 15 hours on a loan and make $4,000.”

    The riskier mortgages generally command higher broker commissions. Tullis said one subprime mortgage, which typically costs 2 to 3 percentage points more than a standard loan because it goes to borrowers with bad or limited credit, pays him the same as five mortgages for borrowers with good credit.

    The number of subprime mortgages has grown 10-fold in the past seven years to 5.97 million, according to the Mortgage Bankers Association.

    As many as 2.4 million U.S. homes are in danger of foreclosure, according to the Durham, North Carolina-based Center for Responsible Lending. Foreclosure filings rose 47 percent last month from a year ago, said RealtyTrac Inc. of Irvine, California.

    Borrowers with low-documentation subprime mortgages were almost 10 times more likely to suffer foreclosure than homeowners with fully documented prime loans, the company said.

    Increase in Foreclosures

    The number of subprime borrowers who are late on their mortgage payments is at a four-year high, according to the Washington-based Mortgage Bankers Association. The median U.S. new home price peaked at $257,000 in April 2006 and slipped to $250,000 in February, according to the U.S. Census Bureau.

    “A lender funding the transaction doesn’t have an incentive to make a fraudulent loan,” said Chuck Cross, a director at the Conference of State Bank Supervisors in Washington. “But the originator does not have the same economic incentive not to. He makes the fee regardless of whether the loan is good or not.”

    With prices falling, it’s no longer as easy for homeowners to wring cash out of their properties by refinancing. New home sales slowed to a seven-year low in February.

    Nancy Olland said the loan she took out last year is too expensive and she can’t make her monthly payments. She tried to contact the broker who wrote her mortgage, but she said she can’t find him.

    The broker’s boss, William Gregg of Tanager Mortgage Group Inc. in Cleveland, said Olland’s broker was fired for not following the firm’s “strict guidelines.”

    Olland said she is considering bankruptcy.

    “Probably the most difficult thing for me in all of this is I’m well-educated,” Olland said. “I have a master’s degree. I’m not stupid, but I handled this situation stupidly.”

  31. Hold Out

    I stumbled upon another thing I did not think of and I haven’t seen mentioned around here.

    I’ve been going down to the Civic Center in Santa Ana often these days. I am a contractor in SoCal. I build all those things under the street that mess up your commute and add to your MeloRoos and utility bills (more on that later). Anyway I went there to turn in a bid for a couple of public works projects, and I picked up a pamphlet to keep busy while I waited.

    It was a Guideline to the Orange County Assesors Appeal Process.

    Then it hit me. If I own a home in OC and the mortgage was fixed. When prices fall below what I paid for it, I could walk in to the assesors office and appeal for a reduced assesment. How can they say no. I have lots of evidence. Just print up this blog and turn it in with the appeal. I get to stay in my house and save some money. I would be an idiot not to try.

    So after the market gets kicked down by all of these future failed adjustables coming down the pike, the market will get pushed down and held down by all of these folks who held on and want to save on taxes. How are the comps going to get back into a rising trend if all these folks make a mad dash to 10 Civic Center Plaza. In a down market the comps depend just as much on the assesor as they do on the tiny pool of purchases. What is a house worth in the future if only 4 neighbors managed to sell last month but 15 or 20 managed to get a reduced assesment? How lopsided can that equation get?

    The recourse to lower taxes has no financial risk to the applicant. They can literally SHORT the housing market and not pay for that risk. Howard Jarvis has made reading the bottom of the market impossible.

    This can have the effect of pushing prices down even further. If the county says no, big deal, it cost the applicatn some postage, and a little time, the county even gives you the forms to write on! (NOTE TO COUNTY: Start charging for Assesor Forms).
    If the county says “yes”, they open the floodgates and thanks to my observation and blogs like this everyone will know about it. (NOTE TO SELF:Buy a parking lot next to the Civic Plaza, gonna be a busy place)

    If you combine the 6 years of resets with 6 years worth of homeowners with the constitutional right to appeal for a lower assesment. What then?

    (NOTE TO SELF: Parking attendant next to Civic Center might be the only job worth having in 6 years. I wonder if they take applications at the exit booth.)

    I know what your all gonna say. “But if you do this, you risk making the market worse”. I will damage demand, which in turn will damage the economy. If the County looses revenue they will be forced to cut back on services or raise taxes. Either choice will further weaken home values and the economy. This will lower prices even further. Maybe down to where a majority of homeowners will be below the value of their Prop 13 assesment. The worsening economy will eventually threaten my ability to pay my mortgage if I loose my job. In the long run I am better off if I continue paying at the rates I am at now. In the long run prices will come back up and I will once again soon be in a house worth more than I paid for it. In the long run, if everyone is responsible this wont happen.

    Your right, your right, it would be wrong of me to think of only myself before others.


    I am sure all those rightcheous, law abiding folks that appraised, financed, commisioned and brokered our way into this mess will stand by me.

    WHO IS WITH ME!!!!!!!!!!!!!!!!!!!!! Anyone, Anyone?

    (for the love of God, will someone make sure Ben Stein reads my post.)

  32. IrvineRenter

    Hold out,

    I know there is a process for reducing your assessed rates, but I imagine they don’t make it easy. Also, I don’t know if declining value gives you an appeal. After all, they can’t raise your rates more than 1% a year, so once you get it lowered due to “declining value” shouldn’t they get to raise it back up due to “increasing value?” Property taxes will definitely decline over the next several years. It will force cutbacks at municipal levels, but California has been through this before. Hell, all they have to do is go back to the spending level of 3 or 4 years ago. The unions won’t like it, but too bad.

  33. Hold Out

    I’ve read through the pamphlet and it spelled out clearly that if you feel the assesment of value is to high you can appeal, from July through September every year.
    A google of the county board found this site:

    QUOTES from the site:

    Who can file an Assessment Appeals application?
    Any property owner who disagrees with the assessed value of his/her property may file an appeal. Although not required, a property owner may have an attorney, family member or professional tax agent file on his/her behalf.

    Do I have to file an application every year?
    Possibly. If you disagree with the assessed value of your property, can support it with evidence, and are not satisfied with the outcome of an informal review with the Assessor, you may wish to file an application.

    Does it cost anything to file an application?
    No. The County does not charge fees for filing or processing assessment appeal applications.

    What information do I include on my application?
    ALL QUESTIONS ON THE APPLICATION MUST BE ANSWERED. Specific instructions are included on the reverse of the application to assist you.

    Where do I file my application?
    Mail the completed and signed application to the Post Office Box listed on the back of the application.

    The State Board has a report on their review of the OC’s Appeals Board.

    Out of 14,000 applications in 03-04 they resolved 7000 and pushed the rest to next year. Of the 7000 resolved 1100 got reductions. But be carefull 28 managed to get an increase.

    To hasten the end days click here:

  34. nirvinerealtor

    Use recent past sales history of the same housing tract to support your requested value. I tried it and I got instant approval.

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