houseINhandsAs houses foreclose in many parts of the country faster than they are sold, many homeowners struggling to make their mortgage payments find that it is much easier to simply walk out of their homes. Since their property values are only going down, the option to refinance is not possible. So their resolution seems more logical than to continue to barely make payments in order to delay the inevitable.

Late, but eventually, many policy makers have realized that the cause of the deteriorating American economy is due in great part to subprime borrowing and predatory lending. And in order to avoid the looming recession, there have been many attempts to keep the troubled homeowners to stay in their homes.

Treasury Secretary Henry Paulson and banks representing half the U.S. mortgage market agreed to offer 30-day freezes on foreclosures, acknowledging the need for a stronger response to the worst housing slump in a generation. (Bloomberg)

The 30-day freeze program, dubbed Project Lifeline, is an effort to give the distressed borrowers additional time to modify their loans with their loan servicer to a more affordable monthly payment.

But the attempts proves to be futile. And the foreclosure rates continue to climb at record high levels.

During January, it was reported this week by RealtyTrac, there were 153,745 initial foreclosure notices sent out in the United States. That dwarfed the 43,000 total sales of newly built single-family homes and amounted to nearly half the total sales figure, which includes sales of existing homes and condominiums. (NYT)

But one of the latest proposals could very well be the light at the end of the tunnel. Office of Thrift Supervision Director John Reich proposes the most viable plan yet yesterday on Capitol Hill.

Under the OTS proposal, homeowners would be able to refinance their mortgages at the current market values, with the lenders getting “negative-equity certificates” to be redeemed once the home is sold.

Negative-equity certificates may help servicers limit their losses and avoid an “avalanche of borrowers who choose to walk away from the mortgage,” Scott Polakoff, the OTS senior deputy director, said yesterday. The Federal Housing Administration could help homeowners refinance, he said. (Bloomberg)

Essentially, the troubled borrower can refinance his or her house at current market value — which likely is lower than when the house was initially purchased — during which time the OTS will agree to cover the difference. The difference is what is here being referred to as “negative-equity certificates.”

When it eventually comes time to sell the home — ideally when the home value rises above the initially bought price — the negative-equity certificates will be redeemed by the OTS.

This plan seems to be the most viable of all laid out on a grand scale. It’s not a hand out, because it’s not asking the government to purchase the mortgage directly. It simply allows the homeowners to modify their loan while remaining in their homes with dignity.

The plan is at its infancy stage and only time will tell if it’ll come to fruition over the course of the next few weeks.

 

This is Part 3 of an on going series called, “The complete guide to subprime for dummies.” In Part 1, I explained how an individual with poor credit gets wrongfully approved for a home mortgage. And Part 2 covered the other side of the subprime mess — investors who purchased these subprime mortgage-backed securities.

In this section I will hope to explain what the “crisis” is in this so called “Subprime mortgage financial crisis” that we are going through. This will probably be one of the hardest for me to cover. Not because of the complexity of the situation. Rather, I don’t want to leave out anyone that is affected by Johnny (from our example in Part1) defaulting on his monthly mortgage obligations.

Subprime crisis

First layer: subprime borrower

This certainly is the most obvious victim. Johnny, from our example in Part 1, has probably barely been able to keep up with his two monthly mortgage payments. It’s very likely that once the rate on his ARM mortgage has risen, he would be obligated to default (stop making payments altogether).

So when Johnny’s house is foreclosed on, his plight isn’t simply that he is suddenly homeless, he must now worry, too, about being able to afford to live anywhere else. Since almost all of his paycheck was going towards the mortgage, Johnny might not have enough saved in his bank account to even afford advance payment to be able to rent.

Additionally, the foreclosure will ruin his credit score enough to never get approved for future loans again.

As if that wasn’t enough, If Johnny’s mortgage company is anything like those that specialize in these type of subprime loan, then they deceptively haven’t been paying his property taxes. Which despite foreclosure, is Johnny’s responsibility.

Second layer: subprime securities investor

“A sure thing,” is what these investors were essentially told. Since the credit rating agencies’ approval was the only indication of these securities’ worth all that one could go by, no one suspected enough to investigate further.

In retrospect, these certainly weren’t high grade securities, as they were declared, but the very opposite — junk bonds.

Third layer: you, your community, United States

When a house forecloses, all properties lose value within a given mile-radius, depending on the region. Which presents two problem.

First, in your community,

lower property values translate into less revenue to fund schools, hospitals and other government-funded programs. (SFBizJournal)

Secondly, Americans have the habit of spending money taken from the equity in their homes. The equity changes proportionately to the property value. So the housing slump is bound to have a negative effect on this trend. Note: 2/3 of the country’s economy is generated by consumer spending.

Conclusion

I could add a fifth and six layer too — how the banks are suffering, and how the whole world lost its faith in the face of always shiny American economy. Or I could’ve explained other aspects in further detail– why exactly the dollar lost its value or how hedge funds leveraged to buy these securities (essentially buying borrowed money with borrowed money). But all above stated, I believe, conveys the message: “There must be immediate actions taken to address the crisis.”

We must take that action with extreme caution, too, though. Because although there is enough blame to go around — home buyers, loan officers, mortgage banks, credit rating agencies, investors, Alan Greenspan — implementing constraint regulations onto them could cause undesired results beyond the current.

This is Part 2 of an on going series called, “The complete guide to subprime for dummies.” In the first part, I explained how an individual with poor credit gets wrongfully approved for a home mortgage.

But “wrongfully” is a subjective remark, and is currently up for debate. Many argue that subprime mortgage allowed homeownership to minority families that otherwise would not have had the privilege. But let’s save that discussion for later.

The other side of subprime: mortgage-backed securities

When Johnny, from our example in Part 1, purchases a house for $350,000 with a loan and added interest, he is actually agreeing to pay that loan multiple times over for a period of 30 years. Depending on the specifics of the contract, Johnny could potentially end up paying up to $800,000 over 30-year period. This is where banks make the bulk of their money — in the long-term.

But sometime banks do not want to wait 30 years for a contract to mature. So they seek investors who would buy these contracts and collect dividends as time progresses.

These contracts are not sold in its entirety to just one individual investor. It is divided into pieces and sold to multiple investors. These pieces are what is referred to as securities — in this case, mortgage-backed securities.

Most of the time, investors buying these securities have no idea who Johnny is and what house he is purchasing. There is not any transparency between the investors and the home buyer.

The investors can only go by the word of a credit rating agency that determine the quality of these securities.

Many of these subprime mortgage-backed securities were rated top quality by the credit rating agencies. Which consequently mislead investors into buying these securities they would otherwise think twice before purchasing.

You notice how when you type the word “subprime” on MS Word, a squiggly red line shows up below it indicating a misspelled word? That’s because its a recent word. But it’s been gaining popularity in the news pretty quickly.

As is appropriate. Since this issue concerns all of us. Which is why I am going to try my best to give a comprehensive explanation of this crisis in simple terms for everyone to understand. I am going to do so in parts, since although the complete picture must be understood, their are many aspects to the story.

Hopefully this explanation in some way influences avoiding the trend to occur again.

What is subprime?

Properly referred to as “B-paper,” “near-prime,” or “second chance lending,” subprime in laymen terms refers to “giving out big loans to those with poor credit.”

e.g.

Johnny wants to purchases a home worth $350,000. He must put down $80,000. And take out a loan for $270,000.

At his $32,000 a year job, a below average credit score of 600, and nothing to show for in his savings account, no banks in their right mind will give out a loan to Johnny, or others like him. Normally, the story should stop here since Johnny can’t even afford the down payment ($80,000). But the subprime story has only begun.

Since Johnny’s loan officer, Mindy, stands to make a little percentage from this transaction (getting Johnny the loan), she ‘modifies’ his information to get Johnny approved. She also gets Johnny a second loan for the money down.

The credit score can’t be altered. But in the loan application papers, Johnny is shown to make a yearly salary of $45,000, he has $10,000 in his savings account, and has no other major debts or monthly obligations.

Bank 1 gives Johnny a fixed mortgage rate for the money down ($80,000) at 9.75% . His monthly payments for the small loan is $700.

Bank 2 gives Johnny a 2/1 Adjustable Rate Mortgage (ARM) for the $270,000 at 7.25% — with the understanding that this rate will rise in two years. His monthly payment for the big loan (at the moment) is $1500.

Click here to view a New York Times interactive graphic showing where such subprime mortgages were most prevalent.