The next ‘catastrophe’
The media tends to get caught up on buzz phrases. One of my favorite phrases from the election, which has carried over to the current economic situation, is “Main Street.” Politicians were trying to separate “Wall Street” from the rest of the population that owns businesses. Buzz phrases can be effective in delivering a quick meaning, but sometimes they oversimplify problems.
I was talking to a colleague about loan defaults and asked her what she thought was going to transpire in terms of foreclosure rates.
She said they were going to go up, and mentioned one of the reasons why. She brought up a good point, which has been mentioned in the media recently and is getting “buzz phrase” worthiness: “Alt A loans are the next type of loans to go bad.”
Before I define Alt A loans, let me give a synopsis of subprime loans, since understanding subprime loans and the subsequent subprime debacle will clarify what the media believes is the ensuing Alt A catastrophe.
Subprime loans were for borrowers who had lower credit scores, usually in the 600-650 range.
Some subprime loans were given to borrowers with credit scores below 580. Subprime borrowers usually “stated” financials, with no documentation needed to prove liquidity or income.
To mitigate these riskier loans, lenders charged a premium in terms of interest rates. However, to make the loans competitive and attractive, many subprime loans were offered with “teaser rates.”
A common teaser rate program started the loan at a low rate, which was fixed for two to three years.
After the fixed period, the payment adjusted to a market level, which usually caused an increase, often skyrocketing to twice the fixed payment.
Since many individuals who took subprime loans were barely able to afford the low fixed payment, they ended up falling behind on payments and eventually lost homes when the payments adjusted.
Currently, the majority of the subprime loan adjustments have been made. However, according to CBS’ “60 Minutes,” we have not even begun to feel the pain of the housing mess that will be caused by Alt A loan adjustments.
An Alt A loan is a loan that essentially falls between prime and subprime loans. Alt A loans were not considered risky because of the borrower’s credit worthiness, but rather because of the structure of the loan itself.
Alt A loans were larger loans that did not meet the Fannie Mae or Freddie Mac guidelines. Moreover, Alt A loans usually had high loan-to-value (LTV) and high debt-to-income ratios. The problem with high LTV loans is when the real estate market corrects itself and recedes, the loan to value ratio elevates, placing more risk in the lender’s hands.
For example, if a property is worth $500,000 and the value drops by 10 percent or $50,000, the value of the property drops to $450,000. If a lender placed a 95 percent LTV loan on the property at the original value, the lender would have a $475,000 loan against the property.
Once the value drops, the borrower has a loan that is higher than the property’s value, causing the borrower to be upside down on the property.
This is problematic to the lender because if the owner decides to walk away from the property, the lender is left with a minimum $25,000 loss, which is the difference between the loan amount and decreased value. High LTVs are partially why Alt A loans were considered risky.
Another reason Alt A loans are risky is because of high debt-to-income ratios — DTI. A debt-to-income ratio is used during the underwriting process. The debt-to-income ratio is usually expressed as two numeric numbers.
The first number represents a borrower’s front-end ratio, which is expressed as a percent of housing costs to income, while the second number — known as the backend ratio — represents the borrower’s debts including the mortgage as a percentage of their gross income.
For example, if a borrower had an annual income of $120,000 or $12,000 a month, and the required ratio was 25/35, the max principal and interest mortgage payment plus taxes and insurance would be $3,000 ($12,000/mo x .25) which would represent the front-end DTI ratio.
While the max backend ratio, which includes the mortgage payment along with all recurring debts, is $4,200 ($12,000/mo x .35).
Alt A loans were considered risky because DTI ratios exceeded conforming limits. Over time, the marketplace became saturated with Alt A loans that had aggressive DTI ratios.
The one major difference between Alt A loans and subprime loans was the fixed period. Alt A loans were fixed for between five and seven years, with some fixed for 10 years.
The issue now is all of the Alt A loans that have not adjusted, will do so beginning in the fourth quarter of 2009. People say that Alt A loan adjustments will be catastrophic to California, even more so than subprime because more than 50 percent of the Alt A loans were originated in this state.
I do not know if Alt A loan adjustments will be “catastrophic” to California. Yes, the unemployment rate is escalating and values continue to correct in a downward direction, but many borrowers who took Alt A loans were credit worthy and would not want a short sale or foreclosure on their credit report.
The wildcard is where the indices are at the time of adjustment. If an Alt A loan is tied to the six month LIBOR (London Interbank Offered Rate) and adjusts while the index is low, the payment may be lower than the borrower is paying on the fixed rate. Of course, the inverse is possible, which could elevate a payment substantially each month.
People’s memories are short, but history will remember the unsustainable housing appreciation, aggressive loan terms and the ensuing financial hangover. I am hopeful that lessons will have been learned and history will not repeat itself.
Mike Heayn is a Commercial Loan Consultant, specializing in Multi-Family Lending. He can be reached at (310) 428-1342, or e-mailed at maheayn@yahoo.com.
