Fears are growing in the US that problems in the 'subprime' mortgage industry could spread throughout the housing market and the wider economy
Frances Darden, a disabled mother of three from Boston, long dreamt of owning her own home. Several banks turned her down for a mortgage because she did not earn enough. She was starting to give up hope.
But in September 2004, an advertisement in the local newspaper for a home buyers' seminar caught her eye. "It was so appealing," she recalls. "It said: 'You can afford your dream home. Let's make history'."
Ms Darden, who is in her late 40s, went along to the presentation with her best friend. Soon afterwards she was looking at houses, through an estate agent. She says the agent encouraged her to buy a multi-family property, where she could become not only homeowner but landlady as well.
At that time, her monthly income was made up of not much more than $1,800 (€1,360) in disability payments, a small amount of child support and a modest rent subsidy.
Much to her surprise, Ms Darden was "pre-approved" for a loan worth $894,000. "When they told me, I couldn't believe it. But they said: 'We're different from everyone else, we can help you.' "
Ms Darden put no money down. She says she was assured her monthly repayments would be $5,000 and that rental income would fully cover those costs - and put money in her pocket to boot.
As it turned out, the repayments were more than $7,500 a month. The annual interest rate was 11.7 per cent, nearly double the level a creditworthy borrower would be charged. By November the following year, she had fallen hopelessly behind on her mortgage. One flat in the two-unit house she had bought was foreclosed on and sold. The other is soon to go to auction.
Ms Darden's experience explains why the "subprime" mortgage industry in the US is facing such painful problems. The root of it all is simple enough: many home buyers with low credit scores nonetheless managed to land big home loans over the past couple of years.
Victoria Wagner, credit analyst at Standard & Poor's, the ratings agency, says some subprime mortgage lenders dramatically lowered their standards amid "the so-called democratisation of credit", granting loans that contained many levels of default risk. These included a lack of income documentation and no downpayment. Ms Wagner calls this kind of risky lending "unprecedented".
Now buyers such as Ms Darden are falling behind or defaulting, as interest rates that started relatively low go higher and home prices in some parts of the US stop rising. So far the problem has remained largely contained within the subprime sector. It may stay there but concern is growing that difficulties could spread throughout the housing market and then, perhaps, the wider US economy.
The first way the subprime decline could impact on the housing market is if a flood of foreclosed homes came up for sale and pushed down prices in areas where the supply of homes is already high because demand has dropped off.
Analysts at Lehman Brothers project that mortgage defaults could reach $225 billion during 2007 and 2008 and perhaps go as high as $300 billion. "The risk that they impact the broad housing market and begin to weigh upon prime borrowers is very real," they say.
Figures released this week by the Mortgage Bankers Association show that a final splurge of loans made recently is likely to be the poorest quality on record, with the proportion of mortgages in the initial stages of foreclosure at all-time highs and late payments and overall defaults reaching 5 per cent last quarter. Delinquency rates for subprime adjustable-rate mortgages, the riskiest kind, hit 14.4 per cent.
The numbers could get much worse because many who bought homes face "resets" in their mortgage payments; the low rates that tempted them in will revert to higher, market-determined rates. Lehman estimates that more than $900 billion of mortgages will hit a reset in the next two years.
Many people facing resets will have banked on being able to refinance their loans. But that might not be possible if lenders continue tightening their approval standards.
Still, it is far from certain that the subprime ailments will infect the broader housing market. Steven Wieting, economist at Citigroup, suggests that the problems are likely to affect financial institutions and their investors - as indeed they already have - more than consumer sentiment and the economy at large. But if the marginal buyer - someone able to buy a house only if conditions are right - is knocked back, that could at best slow a recovery in the housing market.
At worst, it could lead to recession. David Rosenberg, North American economist at Merrill Lynch and a perennial bear, says: "This housing downturn is far from over and the full impact across the economy has not been felt . . . As with most bubbles, this one started with loosening credit guidelines, excessive price appreciation, classic performance-chasing [ and] speculative fervour, and now ends in lawsuits."
Whatever the impact of the subprime fiasco on the wider economy, it is already deeply painful for many Americans. Ms Darden in Boston, for her part, recently filed for bankruptcy protection. An attorney from a legal aid clinic run by Harvard Law School is advising on how to start restoring her credit. That includes pursuing claims against those who arranged her purchase and the accompanying mortgage.
"I don't wish this on my worst enemy," she says. "I've spent many restless nights worrying about this. You work all your life, you save, you dream - and now it's all gone."
