Self-improvement programs normally start this way: Recognize that you have a problem. Clearly, the home building industry is facing the fact that during the past three years, credit got too easy. Sub-prime excesses are now a daily headline staple.
But realizing you have a problem is only the first step in dealing with it. Builders have a great deal at stake in managing loan failures in their communities. Homes that come back onto the market as a result of blowouts are distressed sales that add to inventory.
But, credit remains the lifeblood of housing demand. Builders need to find ways to keep it flowing and meet customer demand without provoking the ire of regulators.
Fasten Your Seat Belts
Higher sub-prime default rates are expected, but what is occurring now is without precedent for at least two reasons. First, the sub-prime share of all mortgage loans has never been this high. In fact, five years ago, sub-prime loans were no more than a few percentage points of the market. Today, by Credit Suisse's estimates, sub-prime mortgages account for 11 percent of all mortgage debt outstanding. Add to that, the so called Alt-A market, where credit scores of borrowers are higher but the loans are riskier for other reasons (such as no verification of income or assets, payment option, or interest-only loans) and the combined total approaches one-fifth of all mortgage debt. Predictably high default rates now apply to a hefty chunk of the overall market.
Second, risk has been heaped on risk in the sub-prime market. By 2004, adjustable rate mortgages with deeply discounted initial fixed-rate periods of two years (so-called 2/28 loans) began to take the sub-prime market by storm. Interest-only loans as well as "don't ask, don't tell" no income-no asset loans spread to the sub-prime market.
In an environment of rising home prices and two-or-more year delays on adjustable mortgage payment resets, problems festering in the sub-prime market were masked. Now, as a wave of sub-prime loans heads for two-year resets, and 2007 shapes up as a period of weak home price growth in most markets and price declines in many, the excesses of the past are coming home to roost.
True, sub-prime loans are heavily concentrated in low-income, especially minority, urban neighborhoods with little new housing. However, in states where builders are most active–Georgia, Texas, and Nevada–the sub-prime loan share is high overall, while in others, such as California and Florida, the use of interest-only loans and payment options is high in both new- and existing-home sales. The Alt-A market is only now starting to see eroding performance as resets proliferate. Before long, Alt-A lenders will feel pressure to tighten standards.
Taking the Next Step
Deal with problem loans now before they become foreclosures. When the builder is the lender, it makes sense to try to take a haircut on a loan by offering workouts rather than incur a resale of yet another unit in inventory. When troubled loans are outside of a builder's control, identifying which loans maybe in trouble is difficult.
It may pay to turn to a third-party counseling agency.
Any solution that spares a borrower from facing a payment shock for several years is better than ignoring the problem or putting them into a product that will demand further modifications to avert another short-term payment crisis.
Now is the time to move from recognizing the problem to dealing with it. Builders have a compelling interest in not letting too many homes in communities they are still building out come back on the market with discounted sticker prices. Tough times demand tough choices and decisive action. BB
Eric Belsky is executive director at the Joint Center for Housing Studies at Harvard University.