Subprime crisis spreads into other kinds of mortgages

Aug 11, 2007

Subprime crisis spreads into other kinds of mortgages
Homowners who want to refinance may be casualties

The crisis in the subprime mortgage market has burst into other kinds of mortgages. Businesses and individuals with poor credit are now finding it much harder to borrow, if they can at all.

It appears that many homeowners who want to refinance their mortgages — often because their old mortgages are about to require sharply higher monthly payments — will be unable to do so. That may lead to more home foreclosures and put further pressure on the housing market.

At the heart of the problem is the combination of complexity and leverage. The securities that financed the expansion of mortgage lending were hard to understand, and some of the investors who owned them had borrowed so much that a small drop in value put pressure on them to raise cash.

"You find surprising linkages that you never would have expected," said Richard Bookstaber, author of a new book, A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation.

"What matters is who owns what, who is under pressure to sell, and what else do they own," he said. People with mortgage securities found they could not sell them, and so they sold other things. "If you can't sell what you want to sell," he said, "you sell what you can sell."

It appears that securities backed by subprime mortgages were owned by people who also owned securities backed by leveraged corporate loans. With the market for mortgage paper drying up, and a need to raise cash, they sold the corporate securities, and that market began to suffer.

Cushion of fixed rates

In past years, most borrowers had fixed-rate mortgages. If they kept their jobs, they could meet the monthly payments even if the value of their home had declined so much that they could not get a new mortgage.

Now, however, many mortgages call for sharply rising monthly payments after a few years, and borrowers were given loans without regard to their ability to meet the higher payments. Lenders assumed the mortgage could be refinanced, and that rising home prices would assure repayment of the loan.

Investors erroneously assumed that housing prices would keep rising, said Dwight Jaffee, a real estate finance professor at the University of California, Berkeley. "I can't believe these sophisticated guys made this mistake. But I would remind you that lots of investors bought dot-com stocks. When you are an investor, and everybody else is doing the same thing and making money, you often forget to ask the hard question."

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