Origins of the Subprime 'Tsunami'

As hard as it might be to believe, you haven't seen anything yet. What is happening with the whole subprime mess is just the tip of the iceburg.

Still, there will be some winners in all this. There are still sleazy lenders making questionable loans to risky borrowers. But here is a recap of how we got to the situation that has the new media in an uproar (i.e. -- the latest catastrophe). I also have some thoughts on why this is an advantage for multifamily investors.

The subprime issue was the 9,000 pound elephant in the room that no one wanted to talk about. I always knew it was going to come back and bite the industry and the economy in the collective rumps. Subprime loans, and these interest only vehicles, unveiled with great fanfare three to four years ago, are all coming crashing down. I took some heat a few months ago when I first stated this, but I'll say it again. One person's downfall is another's gain. As more subprime lenders fail, and subprime borrowers either lose their homes or cannot get a loan, there will be increased pressure on multifamily properties. Which means multifamily investors will benefit.

But the revealing side of the subprime mess, which few people want to talk about, was discussed in January at a seminar for investors. The event, which was also webcast, featured Jack McCleary, head of asset-backed security training for UBS Investment Bank. Here is the number one most important snippet from his insider's view, as reported by Inman News:

-- At first, subprime mortgage lenders "basically (took) a page out of the credit card model, which was, 'We're going to risk-base price the consumer debt. You show us the consumer, we can put a high enough coupon on there that we'll be able to provide credit where it didn't exist.' In other words, subprime lenders calculated that if they just charged high enough rates, it didn't matter if some people weren't able to repay their debt."

-- By 2002 to 2004, with interest rates hitting historic lows, subprime lenders began targeting homeowners with credit card and other debts for refinance and home equity loans. "It became a debt consolidation model," McCleary said. "There was some HPA (home-price appreciation), so people had equity in their homes. Ameriquest was very good at this -- most of their production for this period of time was cash-out refis." The thinking at the time? "Take the equity out of the borrower's home, use that to pay down consumer debt, and transfer it into mortgage debt that's tax deductible. We're providing a service, we're helping borrowers make efficient and good financial choices."

-- The mortgage refinance business proved lucrative -- if you could generate loans at a high volume. With the emergence of a market for private-label mortgage-backed securities, the money was there to loan. It was just a matter of convincing people to borrow. Subprime lenders expanded their operations and advertising so they could make more loans.

-- When the refinancing boom petered out in 2004 -- in part because interest rates were headed back up, but also because many who wanted to refinance had already done so -- lenders were left wondering how to keep squeezing profits from their large operations. The parties that be could have sought out how to solve the problems of borrowers. But in 2005, the industry decided it had originator problems to solve. "How do we generate more volume? Loan prices aren't high enough, because the spread between the WAC (weighted average coupon, or interest rates paid by borrowers on the mortgages in a pool) and LIBOR (the London Interbank Offered Rate, or the basis of the lenders' cost of credit), isn't large enough."

-- Intense competition brought profit margins down. There also was an affordability problem with the borrower because prices had increased so much in some markets that fewer families could afford to buy homes.

-- "The answer that solves everybody's problems was 80-20s," or piggyback loans, McCleary said. "The borrower obviously can afford to buy the home now, if he doesn't have to put any money down, and by adding seconds into the portfolio, the WACs increased. Generally the WAC on seconds is, for subprime, call it 10.5 to 11 percent. Adding 5 to 10 percent of that to any pool has a significant impact on the WAC."

The industry did it to itself. Everyone saw it coming and no one said a word. But multifamily, my favorite real estate investment vehicle, will benefit.