The risk in subprime

During the boom, lenders gave homeowners loans they couldn't afford. Now they're feeling the consequences.

By Ellen Florian Kratz, Fortune writer

NEW YORK (Fortune) -- When a certain $126,000 subprime loan on a $696,000 house on the West Coast failed to produce a single mortgage payment, alarm bells went off at Clayton Holdings, a company that monitors credit risk.

Closer scrutiny revealed other red flags. The borrower's previous rent payment had been $1,000, compared to the $4,482 she was supposed to be shelling out for both the primary loan and the $126,000 piggyback. And her stated income was $84,000 even though she was an hourly worker at Target.

"We do an autopsy to find out what caused the loss of blood," says Keith Johnson, Clayton's COO. "It's a CSI subprime."

In the past few weeks, the bodies have been piling up fast and furiously. Fallout from subprime mortgages - that is, home loans to borrowers with a blemished credit history - gone bad has wreaked havoc on the industry.

Big names Washington Mutual (Charts) and HSBC have reported hits tied to their subprime business and there has been a nonstop barrage of bad news for major subprime lenders, including New Century Financial (Charts) and NovaStar Financial (Charts).

Now the worry is what happens to the economy if enough homeowners go into default and to the financial markets if enough investors take a bath on mortgage-related securities.

The market may want to brace itself for more surprises. "To one degree or another, all of these lenders are facing the same kind of difficulty," says Mark Zandi, chief economist with Moody's Economy.com.

Last year, 13.5 percent of mortgages originated in the U.S. were subprime, according to the Mortgage Bankers Association, compared to 2.6 percent in 2000. Overall, the subprime market was $600 billion in 2006, 20 percent of the $3 trillion mortgage market, according to Inside Mortgage Finance. In 2001, subprime loans made ups just 5.6 percent of mortgage dollars.

By the end of 2006, subprime delinquencies more than 60 days late jumped to almost 13 percent, compared to 8 percent a year earlier, according to LoanPerformance.

As for foreclosures, they're currently running 25 percent higher than they were this time last year, according to RealtyTrac. "We don't have high unemployment, high interest rates or a slowing economy, but we're seeing the number of foreclosure filings pushed above historic averages," says Rick Sharga, a marketing exec for RealtyTrac. "You can't underestimate the effect of higher risk loans."

Adding to the problem are jittery lenders who have suddenly begun to tighten their standards. "You're seeing credit score requirements being increased. You're seeing documentation firming up," says Bob Walters, chief economist with Quicken Loans. "Fewer people will get loans and maybe rightly so."

The higher hurdles, while perhaps healthy for the long term, will cause a short- term credit crunch. Translation: delinquencies and foreclosures should rise, which will create more credit problems in a vicious cycle that will probably weigh on housing for the rest of the year.

None of this is good news to investors in U.S. residential mortgage-backed securities, which now account for some 20 percent of the global fixed income market, the largest component.

And plenty of investors have been drawn into the riskier subprime pieces of these mortgage-backed securities that yield higher payoffs, instead of sticking with highly rated mortgage securities.

Particularly troubling for investors is the rapidly deteriorating quality of subprime vintages originated in 2005 and 2006, years when lenders were downright promiscuous about who they loaned money to.

Serious delinquencies - defined as loans at least 60 days late or in foreclosure or bankruptcy - for a 5-month old loan originated in 2006 is running at almost 4 percent, according to Moody's, compared to 2.2 percent for a similar loan originated in 2004.

The scariest part of that statistic is the fact that 2006 borrowers are still in their fixed-rate period. "What will they do when their payment starts to rise?" says Glenn Costello of Fitch Ratings.

The worry then is that somebody, somewhere has been overly aggressive in their subprime investments and goes belly up, spooking investors and sparking a world financial crisis.

That, of course, is just the nightmare scenario and not everybody is convinced the fallout will be so widespread. "I think [the risk] is containable," says Lewis Ranieri, Chairman of private equity firm Hyperion, who developed the idea of mortgage-backed securities in the 1970s when he worked at Salomon Brothers. "I don't think this is going to be a cataclysm."

Many point to last fall's implosion of hedge fund Amaranth as a sign that markets can handle these kinds of setbacks.

But not everyone finds that argument soothing. "If there is a fault line in the global financial system, it runs through the U.S. mortgage market," says Zandi. "Everyone throws up Amaranth, but that involved a small market with little implication for any other asset class. If some hedge fund blows up on a residential mortgage-backed securities investment, that has very different kinds of implications because it is the biggest chunk of the global fixed income market. So the ripples will be more like waves, and it could turn into a tsunami."

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