Risky Mortgages Hurt Borrowers, Investors

San Diego — 'Ultimately, putting people in a home they cannot stay in is not a business we should be in." Daniel H. Mudd, head of Fannie Mae, the big government-sponsored buyer of home mortgages, made this utterance recently at a Mortgage Bankers Association convention. Mudd shocked the attendees; the industry had been congratulating itself for making so many sub-prime loans, or high-interest mortgages, to people who cannot get credit from conventional sources. But lenders may have become too giddy in the real estate boom, suggested Mudd, whose name instantly became...er, uh, mud...among his peers.

The stock and bond markets are agreeing with Mudd, as a San Diego-based maker of sub-prime loans, Accredited Home Lenders Holding Company, has found out. Its stock has been more than cut in half this year, while the overall market has moved up sharply. Investors fear that a wave of mortgage delinquencies, defaults, and foreclosures among noncreditworthy people may whack companies like Accredited, whose earnings have plunged of late.

Fears are justified. The Mortgage Bankers Association reported in mid-December that in the third quarter (July to September), the percentage of mortgage payments at least 30 days late jumped to 4.67 percent from 4.39 percent in the April to June period. But it was much worse for sub-prime borrowers. The delinquency rate was 12.56 percent in the third quarter, highest in more than three years. For sub-prime borrowers holding adjustable-rate mortgages, the rate was 13.22 percent, also a three-plus-year nadir. And the sub-prime foreclosure rate is climbing. Last week, the Center for Responsible Lending predicted that 20 percent of sub-prime loans made in the last two years will wind up in foreclosure; more than a million people nationwide will lose their homes.

According to the New York Times, only 2.4 percent of all mortgages were sub-prime in 2000; now it's 13.4 percent, and more than half are adjustable-rate.

When housing was booming, everything was wonderful. Home prices were soaring. The sub-prime lenders dreamed up ever more creative loan terms for those with weak credit. The interest rates on the loans were scheduled to rise in a few years, but so what? If borrowers had trouble paying the higher rate, they could refinance the mortgage, using their quickly appreciating houses as collateral.

But now housing prices, particularly in formerly hot markets, are going south.

Financial implications for homeowners and their financiers are daunting. First, the people who have these high-risk mortgages, often members of minority groups, pay interest rates about three percentage points higher than those who get conventional mortgages. Adjustable-rate mortgages present risks if interest rates rise. Many sub-prime loans have wrinkles such as balloon payments. As the statistics show, people with such loans are much more susceptible to delinquencies, defaults, and foreclosures.

The economy is slowing. Inflationary pressures still exist; interest rates may rise more than they already have. Some metro areas such as San Diego are experiencing sharp declines in their previously overheated residential real estate markets. The bubble is bursting; as always, the wee folks will be left holding the balloon's tattered remains.

But it's not just the wee folks getting walloped. The institutions that issue mortgages -- prime or sub-prime -- sell the loans, often to Fannie Mae or other large financial institutions. Those institutions in turn bundle up the mortgages into high-yielding, lower-rated bonds that are sold to mutual funds, pension funds, and the like. If defaults on the underlying mortgages pile up, those bonds will go down in value -- something they have been doing this year.

Unfortunately, companies that generate and sell these mortgages are obligated to buy back those in which there is a default. That's one reason that potential acquirers of sub-prime lending companies are wary: they might get stuck having to buy back loans. Tax preparer H&R Block wants to dump its sub-prime unit. Orange-based ACC Capital Holdings wants to sell its Ameriquest operation.

There are worse signs. Agoura-based Ownit Mortgage Solutions, partly owned by Wall Street's Merrill Lynch, closed its doors early this month. It was the 11th-largest sub-prime lender. Its lending volume during the first half of this year had been up 44 percent. But as loans went sour and it had to buy them back, it ran out of money. Texas-based Sebring Capital Partners also shut its doors recently, as did Washington State-based Merit Financial.

As such news swirls around the capital markets, Accredited feels the sting. The company was founded in San Diego in 1990 with the mission of providing loans to people who can't qualify for standard mortgages because of high consumer debt, past credit difficulties, absence of income documentation, and similar woes. The company went public in February 2003, and in the three-year real estate boom, the stock soared from under $7 to over $60 early this year. But Accredited shares began losing altitude this year as loan originations fell and investors began shunning mortgage-backed bonds. In early November, the company revealed that third-quarter earnings per share were 83 cents, down from $1.87 a year earlier. Recently, the stock has been selling around $27.

In its filings with the Securities and Exchange Commission, Accredited has warned investors of the sub-prime lending risks. Higher delinquencies, defaults, and foreclosures "would reduce our ability to originate loans and increase our losses on loans," it said in the statement accompanying its third-quarter earnings. "Loans we originate during an economic slowdown may not be as valuable to us because potential purchasers of our loans might reduce the premiums they pay for the loans." A big percentage of its loans have been made in two once-zooming, now-crumbling states: California, 16 percent, and Florida, 12 percent.

In its annual report to the securities agency last year, Accredited warned, "Existing borrowers with adjustable-rate mortgages or higher-risk loan products may incur higher monthly payments as interest rates increase, or experience higher delinquencies and default rates."

But when the market is giddy, it ignores such caveats. It overshoots to the upside. On the other hand, when the news turns gloomy, it often overshoots to the downside. Today, some analysts believe that the housing downturn is already ending. Those who believe that would be wise to invest in Accredited, which sells below its book value, or the worth of the company if it were liquidated immediately. Very few stocks sell below book value these days.

TV's frenetic Jim Cramer, cofounder of TheStreet.com and one who enjoys being labeled the "Mad Man of Wall Street," likes Accredited stock. Cramer believes that concerns about sub-prime lending are overblown and notes that Accredited is seeing an increase in mortgage applications. "They'll have a tough time for many months," says Cramer, but "they have a good [business] model."

However, the view that the housing downturn is ending requires a large pair of rose-colored glasses. As an investment, Accredited scores lower than 76 percent of stocks that rating agency Standard & Poor's follows. "I would be very cautious jumping into the sub-prime lenders until we see the extent of the shakeout," says Bud Leedom, publisher of CaliforniaStocks.com. "There is fear of what is in these underlying portfolios. A lot of investors feel that sub-prime lenders will be going out of business. The ticking-time-bomb scenario is alive and well."