Banks Feels Brunt of Defaulted Mortgage Loans

The nation’s banks are just beginning to feel the pain of defaults on risky mortgages they made at low introductory rates when housing prices were soaring, U.S. Federal Reserve Governor Susan Bies said.

Bies, who has been the Fed’s top banking policy official in her tenure at the U.S. central bank, said last week banks are likely to see more missed payments and foreclosures as consumers with weak credit histories begin to face higher monthly mortgage payments.

“What’s happening is the front end of this wave of teaser- rate loans that are coming into full pricing,” Bies said at a risk-management forum in Charlotte, North Carolina. “So what we’re seeing in this narrow segment is the beginning of the wave. This is not the end, this is the beginning.”

Bies’s comments reflect growing attention among bank regulators to the turmoil in the so-called subprime mortgage market and its impact on consumers and U.S. lenders. Many subprime borrowers face large prepayment penalties they can’t afford, nor can they go through with mortgage refinancing or sell their homes, she said.

Bies, 59, said regulators are concerned about “payment shock” in mortgage loans made to borrowers with weak credit histories whose payments surge after a low introductory period. These subprime adjustable-rate mortgages represent 7 percent of mortgages made in the last few years.

U.S. bank regulators have been watching rising numbers of cases of missed payments and defaults in the subprime market since last spring, Bies said.

Tougher Guidelines
The Fed and four other bank regulators released proposed guidelines last week instructing banks to strengthen their underwriting standards and offer clear disclosures on loan terms to subprime borrowers.

The central bank also said last week that the delinquency rate on banks’ residential home loans reached a four-year high last quarter. Bies said the problems in the mortgage market are well- contained.

“We’re seeing this in a very narrow segment,” Bies said. “We’re watching for contagion, we haven’t seen it.”

Bankruptcies, Sales
More than two dozen mortgage companies have gone bankrupt, closed operations or sought buyers since the start of 2006, according to data compiled by Bloomberg.

Irvine, California-based New Century Financial Corp., the second-largest U.S. home loan lender to subprime borrowers, stopped making new loans. Analysts speculate the company may soon file for bankruptcy protection.

Fremont General Corp., a Santa Monica, California-based mortgage lender, said on March 2 that it would sell its subprime mortgage lending operations three days after the Federal Deposit Insurance Corp. notified the company of objections to its subprime lending practices.

“In the housing markets and bubbles that occurred in some areas, to afford housing, people pushed their limit to afford a house,” Bies said. “And in doing so, lenders tried to create products to meet those demands.”

Fed Meeting
Bies and other Fed governors yesterday attended a meeting of the Fed’s Consumer Advisory Council in Washington where they were warned that rising mortgage foreclosures are likely to get worse.

The Fed officials heard stories about Cleveland, Philadelphia, Denver and New York, where neighborhoods are falling apart as homeowners struggle to pay loans or abandon their homes in foreclosure. Consumer advocates said loose underwriting standards in the subprime market caused the growing foreclosure rates.

Higher mortgage interest rates should have compensated investors for risk if markets were functioning correctly, said Massachusetts Institute of Technology professor Robert Solow, winner of the 1987 Nobel Prize in economics. Standards may have fallen below appropriate levels in the “euphoria” of borrowing and lending, Solow said in an interview with Bloomberg Radio today.

SOURCE: Bloomberg News