Lenders see spike in subprime defaults

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Defaults on subprime mortgages have jumped to recessionary levels and triggered in the last month what could be the beginning of a shock to the financial system, with the failure of several lenders and major losses at a Hong Kong investment bank, top finance analysts said yesterday.

Higher interest rates and less access to cheap mortgages lie ahead, particularly for young people and minorities with shaky credit who are seeking to buy their first homes -- and the nation could face a serious credit crunch in housing that spills over to the rest of the economy, said Joseph P. Mason, a Drexel University finance professor.

"This situation can unravel in a lot of different ways," he said, as major investors such as Hong Kong's HSBC Bank -- which announced Feb. 8 that it experienced unexpected losses as a result of defaults in mortgage portfolios it traded -- withdraw funding from the mortgage market and force banks and mortgage brokers to tighten the loose lending standards that enabled many people to buy homes in the past three years.

Like a slow-motion train wreck, the credit crunch is likely to unfold in stages as banks that have not been stung by losses step in and fill the void left by failed lenders, he said.

"The hiccup could be economically costly in the housing market. It will hurt the subprime borrowers we are trying to help," he said. Mr. Mason is co-author of a study warning of potentially serious problems in the mortgage-backed securities market if rising defaults collide with declining house prices to put both borrowers and lenders in a monumental squeeze.

Part of that scenario already is unfolding, as house prices last year declined in 73 cities -- many of which saw an unusually rapid appreciation from 2000 to 2005, the National Association of Realtors reported yesterday. The Washington area was among the losers, with an average home price drop of 2.6 percent in the past year. Many Florida and Midwestern cities experienced double-digit losses.

As homeowners face the double whammy of declining prices and rising mortgage payments built into loans that provided discounted interest rates and lenient repayment schedules in initial months, some are choosing to bail out. Defaults are at unprecedented levels among subprime borrowers who took out loans at the beginning of last year before the housing market imploded.

"The impact of slowing house price growth is being reflected in accelerated delinquency," HSBC said in announcing its losses, noting that "the absence of equity appreciation is reducing refinancing options." The company added that it anticipates further losses and delinquencies as the payments on about $2 trillion in mortgages adjust upward in the next few years.

Besides HSBC, New Century Mortgage, a top California lender to home buyers with tarnished credit ratings, announced last week that it had miscalculated the early default rate on loans it sold to investors and would have to restate its earnings. Several smaller lenders suffered such large losses by the end of last year that they went into bankruptcy.

The chain of losses is likely to mount. A report by Merrill Lynch yesterday found that giant Wells Fargo & Co. and National City Corp. are the banks most exposed to losses from defaults by subprime borrowers.

Fears that HSBC's experience could spread to other banks and lenders caused a nose dive in stocks and bonds last Friday and drove up the interest rates on loans to subprime borrowers.

"Investors are becoming more risk-averse," said Joshua Rosner, managing director at Graham Fisher & Co. and co-author of the study on dangers posed by the explosion since 2003 of unregulated mortgage-backed securities known as "collateralized debt obligations."

The debt instruments, unlike traditional mortgage securities, are not subject to even minimal disclosure requirements and usually are broken up into multiple pieces including portfolios with high concentrations of loans considered most likely to default. Many of those "toxic" loans have been bought by hedge funds, mutual funds and foreign investors seeking high yields in recent years.

The proliferation of unregulated debt obligations is what enabled lenders to offer borrowers extremely low initial interest rates and other lenient terms such as no down payments. But the loans are not guaranteed by the government, and whether they continue to be available will depend on whether investors continue to want to make such loans.

"My biggest worry is that performance problems with some loans could cause investors to shun these [debt] products, and we'll lose an entire market," Mr. Rosner said.

He cited evidence that the official rates of default and foreclosure -- as high as they are -- are vastly understated because lenders have been working with delinquent borrowers to stave off foreclosures in an effort to avoid even deeper losses.

He said the credit crunch could be worsened, ironically, by new rules from banking regulators requiring banks to tighten lending standards. The crackdown is likely to make it more difficult for hard-pressed borrowers to refinance, while further pinching home sales to first-time buyers, he said.

Michael Fratantoni, researcher at the Mortgage Bankers Association, said the markets are overreacting. "We're seeing some subprime failure. There'll be some repositioning, but the market will level out."