Much to do about nothing: Foreclosures and sub-prime

Roger Schlesinger
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Posted: Apr 30, 2007 9:44 AM

Headlines are blaring, foreclosures are sky rocketing and sub-prime problems are creeping into the prime lending area. So what! If you get past the headlines you realize that foreclosures are probably still below the historical average and the prime lending market is vibrant except for lenders who made deliberate moves to emphasize the option arm market.

These loans which are easy to sell, bad for the borrower and very profitable for the lenders, at least in the early years have a way to turn on the borrower and lender in the later years. Why, because you have to make two bets: interest rates need to stay low and real estate prices need to continue rising. Not easy to win two bets on one transaction.

Let's start with foreclosures. A recent report stated that U.S. foreclosures were up 42% from 2005. You ask, why did the rate jump so high in 2006? Wrong question. The right question would be why was the foreclosure rate so low in 2005? The number of foreclosures increased from 885,000 in 2005 to 1,259,118 in 2006. The report goes on to say while that is a substantial increase it is still within the scope of normal historical averages. So, what happened in 2005? Just one of the best real estate markets of all times with prices increasing in double digits across the nation. Nevertheless there were still 885,000 foreclosures out of probably 125 million homes in this country.

The three states with the highest foreclosure rates are Colorado, Georgia and Nevada.

Colorado still has a " hang over " from the telecommunications debacle around the beginning of the century, Nevada had 21,000 in 2006 which was up from about 7,000 which is so low that it was off the charts. Georgia had 2.5% of the households go into foreclosure which is still historically in line.

The total percentage of households in foreclosure in the United States in 2006 was 1.1%.

This tells you one important fact: read the story not the headlines.

Now the sub-prime blame game. I truly believe that most people who write the stories haven't the slightest idea what type of loan is a sub-prime loan. I think their opinion is anything that isn't a fixed rate is a sub-prime loan. I know they believe any 100% loan is a sub-prime loan. Many years ago I did a 100% purchase for a doctor who wanted to buy a million dollar home and didn't want to disturb his stock portfolio. One of the biggest banks in the world gave him the loan without batting an eye.

On the other hand several years ago I got a loan for a client for $3.2 million on a house appraised at over $6 million. The loan included $1.7 million cash out for the client to buy a construction yard for his company. This was a sub-prime loan because it was way out of the parameters of the major prime loan lenders. Both loans have performed perfectly.

To rehash an old column the sub-prime debacle included a number of firms who thought that they could defy common sense to make money they saw laying on the playing field and untouched by others. They went to stated wage earner loans, 100% financing, at low credit scores, in the 500 range and low and behold the borrowers couldn't make the payments.

Ray Charles could have seen that coming. Add in a couple of other crazy loans and you have the makings of a debacle. It is for the most part over. Many hedge funds are now buying up the remaining sub-prime lenders as they are very profitable and well run companies.

The problem that remains is in the prime field with several very large, household name lenders, up to their eye brows in option arm loans. As I said in the beginning of the article on an option arm you need to win two bets: rising housing prices and falling interest rates.

Currently they are losing on both. Real estate prices are flat to slightly lower and interest rates have risen over the last two years, although not extremely high. In the option arm loan most borrowers pay the teaser rate that leads to negative amortization (the increasing of the balance of the loan, not the decreasing as in standard loans.) Without an increase in the price of the house the equity starts shrinking and at some point the lender will no longer allow the teaser rate to be paid. The fully amortized payment is as much as two to three times more than the teaser rate. With shrinking equity it becomes harder to refinance and payments are missed. It was an accident waiting to happen.

The morale is to understand all facets of the loan you take, not just the good parts. It would be a hard loan to sell to borrowers if the borrowers were interested in finding out everything they should know about the loan. For the most part they just want the high lights.

Misunderstandings come from lack of understanding. Lack of understanding comes from failure to familiarize yourself with the facts. It's that simple! .