Credit Crunch: Tighter Loan Standards?

A: Resetting into higher interest rate loans could create a credit crunch down the road that could extend the leg of the housing correction; especially for much of the country outside of New York City. NYC real estate is 75% co-op and as such, is comprised mostly of buildings who have financial guidelines and policies for prospective purchasers to pass before allowing the deal to go through. This somewhat protects NYC when discussing topics like this as most buyers of co-ops are financially able to afford their home; even if their loan does reset. Not so for the rest of the country. So, we may have a domino effect on our local real estate market should this type of scenario play out in the future; with Manhattan real estate being affected more psychologically and at a lag.



Sub-Prime Lending -Sub-prime lending can be defined as lending to borrowers who have less than ideal credit. Such borrowers will pay a higher interest rate due to their increased risk of not repaying loans, based on credit history, low income, or other criteria used by lenders. During economic booms, sub-prime borrowers often can borrow more easily than they can at other times, as lenders chase higher yields in search of higher profit margins. When the boom is over, these loans tend to default at much higher rates than prime loans, and lenders again become wary of lending to sub-prime borrowers.

It's hard to argue that Sub-prime lenders have been reporting a surge in the # of foreclosures recently, and that federal regulation is a very real possibility. I wrote about this a few days ago in my post titled, "Existing Home Sales & Foreclosures", where the number of homes foreclosed by lenders rose by 42% in 2006 from a year earlier. Anyone not keeping an eye on this stuff is either blind or in denial. It's a serious data point and something to watch. If this continues, how healthy could the future fundamentals of investing in the housing market really be? Contrarian buyers shoud be getting very interested in jumping in if things do get a bit uglier.

This data is what will lead to a credit crunch. Here's how it will work:

HOUSING MARKET SLOWS AS LENDING RATES RISE --> LOANS RESET AT A HIGHER RATE --> HOUSING BECOMES LESS AFFORDABLE --> FORECLOSURES SPIKE --> LENDERS TIGHTEN 'LENDING STANDARDS' --> HIGHER RATES & RESTRICTING PURCHASE POWER SLOWS SALES --> INVENTORY BUILDS UNTIL FUNDAMENTALS CHANGE

The NY Times published an article on Friday titled, "Tremors at the Door", discussing just this type of scenario:

The once booming market for home loans to people with weak credit — known as subprime mortgages and made largely to minorities, the poor and first-time buyers stretching to afford a home — is coming under greater pressure. The evidence can be seen in rising default rates, increasingly strained finances at mortgage lenders and growing doubts among investors.

Wait it gets better...

Several mortgage lenders have recently collapsed. While the failures so far are small in number, some industry officials are concerned that they could be the first in a wave. The subprime sector, which produced loans worth more than $500 billion in the first nine months of last year, could shrink significantly.

And finally, what that could all result in...

A sharp contraction in subprime mortgages would have ripple effects, reducing consumers’ access to credit and affecting investors like foreign central banks, pensions and mutual funds that have been big buyers of mortgage-backed securities.

Ahhh, there it is: REDUCTION IN PURCHASING POWER (a.k.a. 'reducing consumers access to credit')

Bill over at Calculated Risk goes into detail often at the trouble many sub-prime lenders are experiencing. Here are some articles about local subprime lenders facing difficulty that he discusses:

OC Register discusses Orange County - Many of Orange County's boldest lenders are struggling to stay in the black - and in some cases to stay in business - as their customers miss mortgage payments in record numbers. These lenders, experts say, exercised poor judgment in a bid to maintain loan volume last year. They lent money to borrowers with spotty credit, known as the subprime market, without proper regard to their ability to repay, experts say.

Bradenton Herald discusses troubled developer's affect on Coast Bank - The management of Coast Financial Holdings Inc., parent company of Bradenton-based Coast Bank, announced Friday that it was anticipating problems with loans to 482 borrowers after a local development company said it may not have sufficient funds to complete construction on the homes.

Arizona Republic discusses cash-back scams putting local lenders at risk - The fraud involves obtaining a mortgage for more than a home is worth and pocketing the extra money in cash. Neighbors may then discover home values in the area are exaggerated. Homeowners stuck with overpriced mortgages may never recover the difference. And lenders end up with bad loans that, in the long run, could hurt the Arizona real estate market, the largest segment of the state economy.

UrbanDigs Says: This is something that for the most part is happening outside of New York City right now, but could lead to regulation or tighter lending standards down the road which could eventually affect us. It's an end result of the booming housing market and something to keep an eye on going forward to see if purchasing power is restricted due to rising loan standards. While many banks may have already started to tighten their grip, money is still relatively easy to borrow if you have decent credit and a job. So for now, we are ok; the future, well that's a story yet to be written.