From feast to famine: Farewell, easy credit

Coming soon to a theatre near you: Revenge of the Ninja.

HCL Finance Inc., a San Jose, Calif.-based subprime mortgage lender, made a name for itself at the height of the California real estate boom with a signature loan it called the NINJA -- No Income, No Job, No Assets.

Distressingly, HCL wasn't alone in offering these and other exotic mortgages to millions of Americans least able to take on debt.

How lenders such as HCL got so deeply into the low-brow business of lending to the riskiest home buyers helps explain the spectacular meltdown of the U.S. subprime mortgage market.

And if experts are right, worries about the $10-trillion (U.S.) in mortgages out there could soon infect other areas of consumer credit, helping to drag the planet's largest economy closer to recession, along with dependent countries.

"This is spreading beyond the subprime market," warns economist Joseph Mason, a former federal bank regular who now teaches finance at Drexel University's LeBow School of Business. "There's starting to be spillover into prime loans."

This isn't about failing financial institutions or even foreclosures -- though that is happening. Most experts agree a rationalization of mortgage lenders would probably be a good thing in the long run. The broader concern is that problems in the mortgage market could unleash a classic credit crunch, rippling through the rest of the economy and eventually to Canada. This would dry up the free and easy credit that has fuelled purchases of everything from homes to cars, couches and big-screen TVs.

Disturbingly, bankers, investors and regulators have seen this movie before. The boom-bust scenario now playing out the market for subprimes -- loans to the riskiest borrowers -- is remarkably similar to other recent episodes when the basic principles of sound lending were ignored or forgotten, until it was too late. There was the technology bubble of the late 1990s, as well as the trust and savings-and-loan crises of the 1980s.

Then, as now, financial institutions dramatically reined in credit after getting burned on bad loans. Indeed, the flight of lenders from the tech bubble of the late 1990s drove many of them toward the perceived stability of consumer credit -- including home equity loans and mortgages.

How the industry got in this mess, again, is a disturbing tale of lending excess.

The simple explanation for why HCL and other lenders made seemingly uneconomic loans is because they could. A thriving aftermarket quickly turns subprime mortgages into bonds, flipping the revenue stream to investors around the world. Most banks no longer keep the loans in-house, so they don't care if homeowners can't keep up with payments. Instead, they make money on lucrative fees and push the risk up the line to an investment dealer such as Merrill Lynch & Co. Inc. or Goldman Sachs Group Inc., which then passes it on to hedge fund and pension fund investors.

The dirty little secret of the mortgaged-backed securities market is in the packaging. Investment dealers bundle the loans into collateralized debt obligations, or CDOs, which are then sliced into tranches, based on risk.

Investors who take the low-risk loans get a relatively low interest rate, but are first in line to get paid in the event of a foreclosure. The high-risk tranches offer much higher returns, making them attractive to hedge funds, mutual funds and other investors. But if there are foreclosures on the underlying mortgages, they are last to get their money out.

The catch is that U.S. pension rules require the riskiest tranches of any CDO be sold first in order for the bonds to be eligible for pension funds and mutual funds. This, critics argue, has given many of these bonds an aura of safety and stability they don't deserve.

It was similar during the heyday of dot.coms, when investors and bankers piled in simply because their peers were already on board, without asking tough questions about the viability of underlying businesses. Likewise, in the go-go mentality of the mid-1980s, lenders and borrower alike believed they were recession-proof, even as interest rates soared.

The same psychology infected the post-millennium housing market. While the housing market was soaring, demand for high-yield mortgage bonds was insatiable, pushing lenders to find ever-riskier loans to sell. And home buyers, desperate to get in on the real estate boom, were far too eager to take on debt, ignoring fine print about escalating interest rates and other catches. As long as house prices were rising, the owner could extract equity to pay off the loan. Likewise, the lender felt secure because it was always possible to foreclose and sell the property for more money.

It was a match of buyer and seller that was too good to be true. Home ownership shot up to a record of nearly 70 per cent. In the past four years alone, mortgage debt has risen by $9.5-trillion.

There is no end to the exotic offerings from banks and mortgage companies, including "balloon mortgages" in which homeowners pay only interest for up to a decade, no-down-payment loans, or low teaser rates that ratchet up in subsequent years. Then, of course, there's the NINJA, where the lender essentially turns a blind eye to borrowers' obvious red flags for risk.

The result of all this no-questions-asked money has been, well, entirely predictable. In Mississippi and Alabama, one in 10 homeowners is no longer making payments on his or her mortgage. The rate is only slightly better in other key states, including the auto industry heartland of Ohio, Michigan and Indiana.

Over all, the percentage of U.S. mortgages in foreclosure hit a seasonably adjusted rate of 0.54 per cent at the end of 2006 -- the highest reading in nearly four decades of record-keeping, according to figures released this week by the U.S. Mortgage Bankers Association.

The impact is already starting to blight entire neighbourhoods.

"We have found neighbourhoods with abandoned homes, 200 at a shot," Louise Gissendaner, senior vice-president and director of community development in Cleveland at Fifth Third Bancorp, reported recently to the Federal Reserve Board's consumer advisory council. Abandoned homes, she lamented, have "devastated our city to a great degree."

Last year, there were roughly 1.2 million foreclosures across the United States. Experts predict another 1.5 million families could lose their homes this year as lenders foreclose.

As defaults and foreclosures mount, the appetite is waning for high-risk mortgage bonds, undermining the entire mortgaged-backed securities market. Many subprime lenders are simply closing up shop and exiting the business as investors put the squeeze on mortgage companies.

"I am seeing fear and panic in the faces of everyone here from the CEO on down," an unidentified account executive at a major subprime lender wrote on a real estate blog this week. "Wall Street is breaking our balls hard over early defaults and forcing us to buy back bad paper."

And the worst, the executive warned, may be yet to come as automatic rate-resetting clauses for many borrowers are "due to explode and [they]will be unable to refinance due to diminished home values."

In recent weeks, the spreads between the triple-A-rated tranches and lower grades has ballooned -- another sign that dealers are having a tough time structuring deals as investors get spooked.

Interestingly, the way mortgages are converted into bonds is virtually identical to the mechanism by which all other forms of consumer debt are securitized, including home equity lines of credit, student loans, car loans and credit cards. As a result, these markets too may be caught up in the subprime downdraft, according to Mr. Mason of Drexel University.

"This technology of funding is not in any way isolated to mortgages," he explained. "The funding crunch that we see is not just going to affect subprimes, especially if consumers start turning down in their spending. We're going to see fewer loans of all kinds being made."

He pointed out that lenders have been pushing consumers into home equity lines of credit as they max out other forms of debt, such as credit cards.

"There's no firewall between the subprime market and the rest of the mortgage market," insisted Nicolas Retsinas, director of the Joint Center for Housing at Harvard University.

Mr. Retsinas, a former savings-and-loan regulator, said some of the lending practices that people associate with subprime lending have clearly "leaked" to the prime market, including aggressive marketing of exotic mortgages.

And it is the interconnectedness of credit markets that should concern Canadians.

Canadian mortgage lenders are quick to point out that they're largely immune to the U.S. problem because subprime loans represent a tiny share of the mortgage market (5 per cent compared with more than 20 per cent in the United States). The housing market is so far holding up well, and Canadian lenders have been a lot less aggressive in chasing customers, who unlike Americans, can't deduct mortgage interest charges from their taxes. But Canada would get walloped anyway if credit conditions tighten significantly, triggering a U.S. recession.

It wasn't supposed to play out this way.

From Wall Street and Bay Street to the White House and the Fed, the reassurances about subprime lending have been remarkably similar for months now: Don't worry. The problem is marginal, manageable and contained. U.S. Treasury Secretary Henry Paulson repeated those assurances this week, noting that the fallout in subprime mortgages is "going to be painful to some lenders, but it is largely contained."

And yet every week brings new evidence that the crisis is spreading.

New Century Financial, the No. 2 U.S. subprime lender, is hurtling toward apparent bankruptcy. Stock in Accredited Home Lenders of San Diego, another major subprime lender, has plunged and the company says it's looking for new capital to stay in business. Two dozen other subprime lenders have already gone bankrupt or simply stopped making new loans.

There is also evidence bankers are starting to get more cautious. The latest survey of loan officers by the Federal Reserve showed the percentage of banks that have tightened their lending standards in the three months ended in January was the highest since mid-1991.

So how close are we to recession? If house values continue to fall sharply and the Fed doesn't come through with interest rate relief soon, the probability of a recession later this year "is very close to 100 per cent," economist David Rosenberg of Merrill Lynch warned.

What happens when subprime loans go bad

AN EAGER BUYER

A home buyer in San Jose, Calif., with few assets and a spotty credit history gets a subprime mortgage in 2005 from HCL Finance Inc., 'home of the No-Doc Loan.'

SHIFTING RISK

The risky loan and its income stream are quickly flipped to a major investment bank, which packages it with other mortgages and sells them as high-yield bonds to hedge fund and mutual fund investors.

DOWNWARD SPIRAL

The mortgage rate ratchets up in 2007 and the home buyer quickly falls behind on payments. The house has lost $100,000 in value, leaving the buyer with negative equity and making a sale impossible. Foreclosure looms.

FALLOUT

Investment banks shun HCL and other subprime lenders.

WHAT IT MEANS

As the mortgaged=back securities market shrinks, nervous banks tighten their lending standards, denying all sorts of consumer credit, including car loans, student loans and home equity lines of credit.

Who's swept up

Twelve publicly traded stocks short-sellers and others are targeting in the subprime market.

Red flags

Signs the subprime meltdown situation is continuing to spiral:

* A sharp fall in new mortgages, combined with continuing spike in defaults and foreclosures.

* House prices tumble

* Banks tighten lending standards for homes, cars and other forms of consumer credit

* Widening spreads in the mortgage bond market.

* Flat or falling retail sales

* Jobless rate heads higher

SOURCE: JIM CRAMER/REALMONEY.COM

BARRIE MCKENNA/THE GLOBE AND MAIL