Subprime debtors few, but expose growing risk

Given all the financial turmoil blamed on subprime mortgages this year, it's easy to forget that they are a small slice of the mortgage market.

For starters, about a third of the nation's 75 million homeowners have no mortgage.

Of the $9.8 trillion in outstanding residential mortgage debt at the end of March, 13 percent - or $1.27 trillion - was in the hands of subprime borrowers.

And of subprime borrowers, 13.3 percent were behind on their payments, according to the Mortgage Bankers Association.

If losses reach $113 billion this year and next, as Mark Zandi, chief economist at Moody's Economy.com in West Chester predicted, that would still be just 1 percent of the overall mortgage market.

Even so, "it's big enough to be a catalyst for investors to reevaluate the risks they've been taking," Zandi said. "The financial impact is bigger because investors overstepped so far in so many markets."

Investor appetite for risk enabled subprime and Alt-A - or minimally documented - mortgage lending to explode from $215 billion in 2001 to $1 trillion in 2005, according to Inside Mortgage Finance. That happened in a symbiotic relationship with soaring house prices, particularly in California, Florida, Nevada and Arizona.

"They are absolutely linked. Without subprime, there is no bubble," said Susan Wachter, a professor of real estate at the Wharton School of the University of Pennsylvania.

And now, it is going to take a long time to recover.

Zandi predicted that average house prices nationwide will fall 10 percent from their peak in late 2005 to their trough in the middle of next year.

So far, the Philadelphia region, where the real estate boom was small compared with other areas, has remained relatively stable.

Likewise, the delinquency rate here has not soared as much as it has in places like Modesto, Calif., and Miami.

It will take years to unwind the financial knot of mortgages wrapped into debt securities that are now buried deep inside hedge funds and foreign-investment vehicles.

On Wall Street, billions in stock market value have already been lost by companies connected to risky mortgage lending, as nervous institutional lenders pull back from the sector.

Locally, the market value of Radian Group Inc. has evaporated by $2.52 billion - or more than half - since the end of June because of a credit squeeze at a subprime-mortgage investor that the Philadelphia mortgage insurer co-owns.

Another Philadelphia company, RAIT Financial Trust, has lost more than 70 percent - or $1.25 billion - of its market value over the same period because of its exposure to mortgage companies and home builders.

Subprime lending did not start out as a monster that laid waste to the equity of homeowners and the market value of lenders.

It has been around for a long time in the form of equity-based lending - which means that loans are based on the value of property rather than the quality of a borrower's credit - said Guy Cecala, publisher of Inside Mortgage Finance in Bethesda, Md.

"Historically, the feeling was you couldn't use a credit score with a subprime borrower because they had no credit," Cecala said.

But using their experience with credit cards, lenders adapted the use of the credit score to subprime-mortgage lending. That gave them the confidence to put a price on the higher risk of subprime lending.

That contributed to an increase in the U.S. homeownership rate, from about 64 percent in 1995 - where it had been since the late 1960s - to a peak of 69.2 percent at the end of 2004, said Wachter, the Wharton professor.

In 2004, subprime-mortgage lending exploded from 8 percent of the mortgage market - where it had been for years - to 18 percent, Cecala said. It climbed to 20 percent in 2005.

"What happened is that mortgage lenders started digging a lot deeper" for potential borrowers to make loans that could be sold on Wall Street, Cecala said.

The game is over for now.

"We've entered a period of uncertainty," said Gordon B. Fowler, chief investment officer at Glenmede Trust Co., of Philadelphia. "How bad does it get for the consumer and how much will that take down growth? And the other piece of uncertainty is who is going to be left holding the bag? We're not going to know who is holding the bag for quite some time."