Anatomy of Mortgage Market Meltdown

In 2003, the Alt-A share of the mortgage market was just 2 percent and the subprime share was only 9 percent, according to the report from the Government Accountability Office prepared for the House of Representatives’ Committee on Financial Services. Findings from the report were originally presented to the committee on Oct. 10.

But by 2006, Alt-A loans represented 16 percent of the market, while subprime encompassed 24 percent, GAO said. Prime mortgages accounted for 58 percent and government-insured loans made up 3 percent. Subprime growth was concentrated in lower income areas — the same areas where FHA share dropped most sharply.

Investor loans reportedly rose from an 8 percent share in 1990 to a 16.5 percent share in 2006.

By June 2007, over 1 million mortgages were in default, up 50 percent from June 2005. The figure indicated more than 1 in every 100 mortgages was in default — a 28-year high.

Subprime loans accounted for at least two-thirds of the increase, while adjustable-rate mortgages performed much worse than fixed-rate loans. Loans originated in 2005 and 2006 accounted for around three-quarters of subprime mortgages in foreclosure as of September 2007.

“Subprime loans accounted for less than 15 percent of the loans serviced but about two-thirds of the overall increase in the number of mortgages in default and foreclosure from the second quarter of 2005 through the second quarter of 2007,” GAO said.

A rapid decline in home appreciation beginning in 2005, leaving borrowers with less opportunity to refinance, as well as relaxed underwriting and lower cash down payments were cited among the factors to hamper loan performance. Other factors included slowed employment growth, losses by investors on rental properties and increased use of residential mortgage-backed securities that have shifted risk from lenders to investors.

“A number of other factors — including incentives that potentially emphasized loan volume over loan quality and growth in the incidence of mortgage fraud — may have contributed to recent default and foreclosure trends,” the report stated. “Some industry participants and observers have linked the declining credit quality of loans in recent years to market changes that have reduced incentives and accountability for prudent underwriting.”

GAO said relaxed underwriting included limited-documentation and no-documentation programs, higher debt ratios and slowly-amortizing or negatively amortizing products. In addition, multiple risky factors combined to create risk layering.

Government sponsored enterprises Fannie Mae and Freddie Mac securitize conforming mortgages while Ginnie Mae securitizes government-insured loans, the report explained. All other nonconforming loans, including subprime and Alt-A, are packaged into private label RMBS by investment banks.

The agency noted the private label RMBS market had more lenient standards than Ginnie Mae or the GSE’s, while many originating lenders lacked adequate capital to honor representations and warranties and were not subject to the stringent oversight of bank regulators. Among the top 25 nonprime lenders in 2006, 21 were nonbank lenders that accounted for 81 percent of the dollar volume that year.

“In prior work, we have raised concerns about nonbanklenders, noting that some have been targets of some of the most notable federal and state enforcement actions involving abusive lending,” GAO said.

The report also cited mortgage broker share, which had grown to 60 percent by 2005, and rising interest rates as possible factors. Mortgage fraud, especially on subprime loans with limited or no documentation, was also a contributing factor.

Sunbelt states, including Arizona, California, Florida and Nevada, saw the biggest increase in delinquency. Midwest states with industrial economies saw more moderate increase. States with little or no growth in defaults included New Mexico, Oregon and Utah.

Projections call for a continued rise in delinquency through 2008 as hybrid ARMs continue to reset. The agency cited data that suggested around 13 percent of ARMs originated between 2004 and 2006 would foreclose over a six- to seven-year period.

GAO explained that the massive downgrades recently to RMBS have been limited to around 1 percent of the value of recently issued first-lien, subprime, RMBS rated by the agencies and primarily occurred within lower rated securities. But downgrades occurred on about 60 percent of RMBS backed by second liens.