Can the subprime shakeup bring down the market?

From Bloomberg:

Housing Threatened by Defaults in Sub-Prime Mortgage Market

“As the Fed tries to tighten credit standards, some borrowers who planned to roll over a mortgage into a better product are going to get caught in the corridor and may end up in default,” said Joseph Stiglitz, the 2001 Nobel laureate in economics who teaches at Columbia University in New York.

Sub-prime mortgages, home loans with rates at least 2 or 3 percentage points above the safest, so-called prime loans, are given to people with poor or limited credit histories, or high debt burdens relative to their incomes. Such loans made up about a fifth of all new mortgages last year, according to the Mortgage Bankers Association in Washington.

The pool of money available to borrowers like Jones who don’t have the highest, or prime, credit ratings is shrinking as investors in mortgage-backed securities shy away from riskier sub-prime loans. More restrictive lending standards makes it more difficult for people to purchase houses, said Angelo Mozilo, chairman and chief executive officer of Calabasas, California- based Countrywide Financial Corp., the U.S.’s largest mortgage lender.
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“If you get too restrictive on that, it could have a material effect not only on people’s lives, but it’s a chain reaction,” Mozilo said in a Dec. 5 interview. “If people can’t buy the used home, then the people who are in that home can’t buy a new one.”

U.S. foreclosures begun on sub-prime adjustable-rate mortgages, or ARMs, rose to a four-year high of 2.19 percent in the third quarter as borrowers struggled to pay mortgage bills while interest rates increased, the Mortgage Bankers Association reported. During the five-year boom in housing prices, homeowners who fell behind on mortgage payments could sell their homes and pay off their loans or get better refinancing terms based on the higher value of their property.

The U.S. housing slump that began in 2006 probably will reach bottom in the third quarter of this year as sales of previously owned homes fall to an annualized rate of 5.9 million before rising to 6 million in the fourth quarter, according to a Jan. 17 forecast by David Berson, chief economist of Fannie Mae, the world’s largest mortgage buyer.
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More regulation may eliminate the ability of homeowners with adjustable-rate mortgages, like Jones, to refinance with new loans, leaving them vulnerable to higher payments. Some mortgage bond investors say that may hurt both current loans and the overall housing market, according to Dale Westhoff, a senior managing director at New York-based Bear Stearns Cos., the largest underwriter of mortgage bonds.

Lenders such as General Electric Co.’s WMC Mortgage, Accredited Home Lenders Holding Co., New Century Financial Corp., and Fremont General Corp. have raised their criteria for sub- prime loans.
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Underwriting standards for sub-prime loans have been too low for at least a year, resulting in loans being issued to borrowers who have little chance of paying them back, Shaughnessy said. That will hurt the insurance companies, pension funds and asset- management firms that are holding some of the U.S.’s $6 trillion of mortgage-backed securities in their portfolios, he said.

“There’s a monster beneath the surface of the financial markets,” Shaughnessy said. “No one knows when or where the credit crisis is going to rear its ugly head.”

Typical sub-prime loans have rates that are below the levels they will adjust to even if the Fed doesn’t raise rates. The ability of the so-called teaser rate to rise quickly causes some consumer protection groups to call the loans “exploding ARMs.”

“Some borrowers aren’t aware that with an exploding ARM, their rate can double in a two-year period,” said Sharon Reuss, a spokeswoman for the Center for Responsible Lending in Durham, North Carolina. “There’s too much smoke and mirrors.”
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Investors are demanding an average 1.6 percentage points more than benchmark rates to buy BBB-rated bonds backed by sub- prime mortgages, up from about 1 percentage point in August, data compiled by Barclays Capital show. Investors seek “significantly” higher yields to own the securities whose underlying borrowers struggled to meet their obligations within a year of taking the loan, according to the securities unit of London-based Barclays Plc, the third-biggest U.K. bank.

“A lot of people cut corners in a bid to keep monthly payments low by taking out riskier adjustable loans at a time when fixed rates were near historic lows,” said Greg McBride, a senior financial analyst at Bankrate Inc., a research firm in North Palm Beach, Florida. “With the increase in short-term interest, that risk has come home to roost.”