As Homeowners Face Strains Market Bets on Loan Defaults

Bryan Whalen and Ike Spirou have never met. But through the world of modern mortgage finance, their fates are inextricably linked.

Mr. Whalen, who manages a multibillion-dollar mortgage-bond portfolio at Los Angeles-based Metropolitan West Asset Management, stands to gain if Mr. Spirou, a financially stretched homeowner in New York City, reneges on his mortgage loan. That's because Mr. Spirou's $360,000 loan was packaged with thousands of others into a bond, and Mr. Whalen has entered a newfangled derivative contract -- similar to an insurance policy -- that will pay off if enough loans in the bond go bad.

"The sophistication is remarkable right now," says Mr. Whalen. "You can profit in any scenario."

Even as More Loans Go Sour Mr. Whalen represents a new breed of investor: people who are using financial instruments to bet against the homeowners they consider most likely to suffer in a housing downturn. Many such investors, including Mr. Whalen, don't expect the current slide in house prices to lead to widespread economic malaise. Rather, they're betting on trouble for folks like Mr. Spirou -- so-called "subprime" borrowers who have become homeowners thanks to the increasing availability of easy credit.

Whatever happens with Mr. Whalen's wager, there's a lot more at stake than his fund's performance or the roof over Mr. Spirou's head. Subprime lending has put as many as two million families into homes over the past decade, helping push the U.S. homeownership rate up to 69% from 65% -- a major shift toward an "ownership society" that politicians of all stripes have touted as one of the nation's economic successes. As the bets play out, they will show how much of that success is permanent, and how much a temporary phenomenon fueled by overly aggressive lending.

So far, the subprime market has held up relatively well. But it's beginning to show some cracks -- most evident in the nascent derivatives trade, which provides a useful window into investor sentiment. Since August, when house prices logged their first year-on-year decline in more than a decade, the cost of insurance against defaults on bonds backed by subprime loans has risen as much as 16%, suggesting investors are concerned that more homeowners will start to renege.

"You've got a lot of borrowers who didn't have credit before, and a lot of them don't know how to manage that credit," says Dan Castro, managing director at GSC Group, a New York asset-management firm that focuses on the mortgage market. "The place where you're really going to see fallout is in the subprime."

The advent of the subprime market reflects a sea change in the way banks make home loans. As recently as the mid-1990s, potential homeowners had to get over high hurdles to borrow money. Background checks could take weeks or months. Lenders typically required down payments of at least 20% of a home's value. People with dented credit, or young folks without adequate credit histories, had few if any options.

Over the past decade, though, a convergence of factors has emboldened banks to lend where they wouldn't before. For one, the development of the Internet and advances in computing technology have made it much easier and cheaper to process and package new loans. Electronic databases on borrowers have made it easier for banks to assess the risk of lending to people with shakier credit, while new insurance-like derivatives have helped them mitigate that risk. And robust demand from investors -- both in the U.S. and abroad -- has given banks a big incentive to lend, because they can easily turn around and resell the loans in the form of bonds, reaping a tidy profit.

As a result, both the volume and variety of subprime loans have boomed. Since the beginning of 2002, banks and specialized lenders such as ACC Capital Holdings Corp.'s Ameriquest Mortgage Co., New Century Financial Corp., and H&R Block Inc.'s Option One Mortgage Corp. have made some $2.2 trillion in loans. That is more than five times the amount in the preceding five-year period, and includes a growing share of "affordability" products such as "piggyback," "interest-only" and "no-doc" loans. These products, respectively, allow borrowers to avoid a down payment, make extra-low payments in a loan's early years, and state their income without supporting documentation. Subprime loans' actual interest rates are typically much higher than those on more traditional "prime" loans.

Big Role

Foreign investors have played a big role in making money available. Analyst Mike Youngblood at investment bank Friedman, Billings, Ramsey & Co. estimates foreigners snapped up about a third of the $2 trillion in subprime-backed bonds issued since the beginning of 2002, often through investment vehicles known as collateralized debt obligations, or CDOs. These divvy up pools of bonds into slices with different levels of risk and return.

Whatever the drivers, the subprime market's growth has brought significant political benefits by boosting the home-ownership rate -- an achievement that the administrations of President Bush and President Clinton have been quick to claim as their own. A recent study by two researchers at the Federal Reserve Bank of Chicago, Jonas Fisher and Saad Quayyum, suggests that subprime lending alone could account for close to half of the four-percentage-point rise in the ownership rate since 1995, almost as much as demographic changes, low interest rates and government programs combined. What's more, they surmise that the change could be long-lasting, because the technological innovations that enabled subprime lending are here to stay.

"It's quite remarkable," says Mr. Quayyum of subprime's contribution to homeownership. "This could be a permanent boost."

That means the market for derivatives on subprime debt could be here to stay, too, along with all the other infrastructure that allows investors to parcel and trade the risk of lending to U.S. home buyers. Some believe this will make the economy more resilient to the current housing downturn by keeping the credit lines open. "You have given people better tools to manage the risks, and this gives you hope that the pendulum's not going to swing as far back as it has in the past," says Martin Mühleisen, an economist at the International Monetary Fund who has studied the mortgage market. "But this new financial world has yet to be tested."

Back in 2002, Mr. Spirou entered the new world of mortgage finance in more ways than one: He launched a career as a self-described "kick-ass mortgage broker," and he set his sights on a two-story Colonial-style house right next to his parents' place in Queens, a middle-class borough of New York.

At the age of 23, with only a few years of credit history, he might have had a hard time getting a traditional home loan. But he found an eager lender in Option One, which lent him $266,000 toward the $300,000 purchase price. The loan required an initial monthly payment of $2,200, which after two years would start floating with short-term interest rates. Option One says it has guidelines in place to make sure its borrowers are able to pay.

At the time, Mr. Spirou could easily afford the loan. He had seen his monthly income jump to more than $10,000 in the midst of the housing boom. Still, he says, he lived beyond his means, taking friends out to dinner at Ruth's Chris Steak House and buying new clothes for the brokers who worked under him. He also took on loans to buy two new cars -- a Pontiac Grand Prix for himself and a Pontiac Grand Am for his mother.

"I was young, naive," he says. "I had to look like a big shot."

In late 2003, with some $64,000 in auto and credit-card debts, Mr. Spirou again tapped the subprime market. The rising value of his house allowed him to take out a $360,000 loan from Long Beach Mortgage, a unit of Washington Mutual Inc., despite the fact that his growing debts had dinged his credit rating. After paying off the old loan and some $12,000 in credit-card bills, Mr. Spirou says, the new loan left him with about $65,000 in the bank. "I started using the ATM card like it was going out of style," he says.

A Washington Mutual spokesman declined to comment.

Warning Signals

The ease with which folks such as Mr. Spirou were borrowing against their homes sent warning signals to some investors. The concern: that in their rush to attract customers amid the housing boom, mortgage lenders were lowering their standards. In 2005, for example, the share of interest-only loans grew to about 18% of all subprime loans, from next to nothing in 2001, according to data provider First American Loan Performance. Over the same period, the share of subprime loans that required little or no documentation of the borrower's income grew to more than 16% from about 10%.

"We looked at this and thought we're going to see lenders who are misusing these tools," says Mr. Whalen. "We're going to see the performance of their bonds deteriorate."

At about the same time, in early 2005, Wall Street bankers were developing a new kind of derivative contract that would allow investors such as Mr. Whalen to make bets based on their misgivings. Called a credit-default swap, it had previously been applied mainly to corporate and sovereign bonds. Like an insurance contract, it pays off if a subprime-backed bond suffers a certain amount of losses to defaults. The holder, known as a protection buyer, makes regular payments to a bank or other counterparty for the insurance, and also has the right to resell the contract. If defaults prove higher than expected and the bond starts to look riskier, the value of the contract rises, and the holder can resell it at a profit.

In January 2005, for example, Mr. Whalen bought an insurance contract on the Long Beach Mortgage Loan Trust 2004-2, the bond into which Mr. Spirou's loan had been packaged. He agreed to pay the counterparty, Citigroup Inc., $20,300 a year for a contract that would pay up to $1 million if more than 3.35% of the loans originally in the bond went bad. So far, the wager hasn't made money: He says he could sell the insurance for close to what he paid.

Mr. Whalen sees the new derivatives mainly as a hedge against the riskiest part of the subprime market. He looks to bet against bonds with high concentrations of loans to people who have low credit scores, who did "no-doc" loans, or whose homes aren't worth much more than they owe on their mortgages.

"These are the marginal guys," he says. "It doesn't mean the mortgage market is a bad market to invest in. It means you have to make sure you stay away from certain borrowers." For the most part, Mr. Whalen is still bullish: His fund owns some $300 million in subprime-backed bonds, mostly higher-rated issues.

Lately, though, more investors have started worrying about what will happen to subprime borrowers as house prices plateau and start to fall. Rising home values rescued many borrowers who didn't have enough income to make their payments, because they were able to take the needed cash out of their homes. Now, if homeowners run into income problems and can't sell their houses for enough to pay off their loans, they will be left with no option but to let the bank take the house.

"While prices are appreciating or steady, people try harder to make those mortgage payments," says Stuart Feldstein, president of SMR Research Corp. in Hackettstown, N.J., which has done studies of house prices and foreclosures during previous downturns in California, Texas and other states. "But when their investments become worth less than what they owe, they tend to just walk away."

What's more, many will face an added shock as the monthly payments on their loans -- most of which are fixed for only two years -- reset to reflect higher interest rates. Christopher Cagan, director of research at First American Real Estate Solutions in Santa Ana, Calif., estimates that about $640 billion in subprime loans made in 2004 and 2005 will reset to higher rates over the next five years -- a trend that he expects will lead to some 450,000 added defaults.

"And that's just resets," he says. "That's not including things like job loss, divorce, death in the family or serious illness."

Falling Standards

Meanwhile, data on loan delinquencies suggest that lending standards have indeed fallen. As of August, about 3% of borrowers who took out subprime loans in 2006 were more than 60 days behind on their payments -- about three times the level two years earlier and more than four times the level for all types of borrowers. Kenneth Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at the University of California, Berkeley, predicts that by 2008 as many as one in five of all subprime borrowers will be in arrears, and that foreclosures will help send the homeownership rate back down by about a percentage point.

"While 80% of this is a good thing, the 20% that's bad is going to come home to haunt us," he says. "That's just the way it happens: Bad practices get exposed in the downturns."

That worry is reflected in the derivatives market. The annual cost of $1 million in insurance against moderately risky subprime-backed bonds has gone from a low of about $21,500 in early August to $25,000 Friday, and has spiked as high as $27,800. Market participants say big hedge funds increasingly are using the derivatives to make outright bets against U.S. homeowners. This summer, for example, New York hedge-fund manager Paulson & Co. launched a fund that has aimed specifically at profiting on subprime defaults.

"People are more nervous," says Greg Miller, a portfolio manager at Saye Capital, a Los Angeles-based hedge fund active in the subprime market. "It could get ugly. If there is a significant pickup in defaults there are going to be a lot of bad bonds out there, and CDOs could be in trouble."

Mr. Spirou's situation offers a glimpse into the difficulties many homeowners face. As the housing boom has faded, his income from the mortgage brokerage business has fallen to about $6,000 a month. As a result, he's gone into arrears on his own mortgage. To catch up, he must now make payments of about $3,200 a month, up from $2,600 when he took out the loan. His other payments on credit cards and auto loans add up to about $2,500. Meanwhile, he says, the interest rate on his loan is scheduled to reset in December.

"It's going to be a fight," he says. "I'm just waiting to see how these next couple months of business are going to be -- if I can get myself back on my feet." He says he's been considering selling his house, but so far hasn't found a buyer willing to pay the right price. He's also looking into ways to get another loan.

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