WASHINGTON (MarketWatch) -- For the first time in the nation's history, a significant number of Americans are being threatened with the loss of their home even though they still have a steady, good-paying job.
It's not just an issue for people with poor credit, those with subprime loans. It also affects people with good enough credit to qualify for a prime loan. Known as Alt-A mortgages, these loans were written for 1 in 5 U.S. mortgages and could have a big impact on the economy and on credit markets -- bigger, perhaps, than the effects of the recent shockwaves buffeting the subprime-lender market, economists say.
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In coming months and years, the credit crunch that's now squeezing mainly the poor is likely to hit millions of middle-class homeowners who took out risky loans during the great housing boom earlier in the decade. More than 1 million families will lose their homes in the next few years, by one estimate. Another study predicts 2.2 million foreclosures.
This threat is new in American history. Its impact on the economy, and upon the American Dream, is uncertain.
In the past, homeowners have generally lost their home to foreclosure only when they suffered a major life-changing event, such as loss of their job, a major illness or death of a family member. A big jump in foreclosures was unheard of outside a recession that brought high unemployment.
But now, because of the recent popularity of loans geared to let people buy a more expensive home than they can truly afford, all it will take is the passage of time to trigger a default. At some point, all these loans are adjusted to switch from a low, subsidized monthly payment to the full amount required to pay off the loan.
In the not-too-distant future, millions of Americans may receive a letter advising them of their mortgage "reset" or "recast" with the same dread they now feel for a pink slip or for bad news from their oncologist. The only difference: They know (or should know, if they noticed what they were signing) exactly what's coming: An average monthly increase of $1,512 in their monthly mortgage payment.
Because this risk is so novel, experts don't have a clear grasp yet on how big of an impact the credit crunch might have on the economy. Most economists say the problems won't spread too far beyond the poor, and that the extent of the losses to families, mortgage underwriters and investors will be small in the context of a $13 trillion economy.
But others think the risks are widespread and that the economy could be hit hard by the failures in the credit market. It could take years to fully recover.
"This is different," said Mark Zandi, chief economist for Moody's Economy.com, who warns that the problems in the subprime mortgage market will spread. "It will mean the difference between an economy that will glide through the slowdown and an economy that sputters."
"The risks are all negative," Zandi said.
According to a Credit Suisse report, tighter lending standards, increased foreclosures, more supply on the market, lower prices, and less construction of new homes will affect all parts of the market.
"It's not just a subprime issue," Ivy Zelman, a housing analyst for the bank, wrote in the report.
Researchers are studying three major channels through which a mortgage meltdown's shockwaves could rattle the economy.
The most direct way would be through falling home prices.
Demand will continue to fall. Tougher mortgage underwriting standards will eliminate about 20% of the potential buyers, including 50% of the subprime buyers and 25% of the Alt-A buyers, according to estimates by Credit Suisse.
The supply of homes would also grow.
Foreclosures and homes dumped on the market by desperate sellers would further depress prices, which in turn would further depress voluntary home sales and home building in a vicious downward spiral, some analyst say. Housing would remain a drag on the economy and on employment for far longer.
Payment shock
In a weak market, some homeowners facing a large payment shock would find it difficult, if not impossible, to refinance their loan or sell their home for what they owe on it. About 13% of the owners who face a mortgage rate reset this year have less than 5% equity in their home, and therefore will not be able to refinance unless they have other assets.
If prices fall 5%, the percentage with no equity would grow to 23%, according to Christopher Cagan, director of research for First American CoreLogic, a mortgage research firm in Sacramento. And if prices fall 10%, it would jump to 35%.
And then there's the chilling effect of a slowdown on consumer spending. According to Federal Reserve data, consumers have taken about $3 trillion in equity out of their homes in the past five years, adding about 7% to disposable incomes every year. That boost kept the economy humming and has driven the personal savings rate below zero for the first time since the Great Depression.
If home prices fall or even flatten out, consumer's ability to fatten their wallets based on home equity would be curtailed.
If home prices fall or even flatten out, consumer's ability to fatten their wallets based on home equity would be curtailed.
Even consumers who didn't take out any equity increased their spending during housing's big heyday, and they'll probably slow their spending as prices flatten out. Homeowners experiencing rising equity felt richer and didn't feel the need to save as much. Economists say consumers spend about 5 cents of every extra dollar in housing wealth.
In addition, households faced with much steeper mortgage payments would cut back on discretionary spending to avoid defaulting on their mortgage.
The third transmission channel is financial.
In dollar terms, the scale of the potential losses from resets of adjustable-rate mortgages is insignificant when compared with the size of the capital markets. Cagan estimates losses of just $112 billion out of a $9 trillion mortgage market, leading him to conclude that mortgage resets won't break the economy or the financial system.
The deeper question is what will happen to investor sentiment. "This has the potential to undermine global investor confidence," said Zandi of Economy.com. The result could be a general drying up of credit, even to the most qualified and untainted borrowers.
And once investors turn cautious, it's difficult to predict how it will play out. After all, in the Asian financial crisis of 1997-98, even countries with sound policies were punished by investors rushing to get their money out of Asian markets. There's not much reliable information about who owns the riskiest mortgages.
Investors who eagerly bought these risky mortgages on the secondary market are having second thoughts, not just about subprime mortgages, but also all the other bits of paper in their portfolio that they didn't pay much attention to. They are finding out that there's not as much collateral in the collateralized debt obligations, known as CDOs, as they were led to believe.
In a paper issued last month, Joseph Mason, a finance professor at Drexel University and visiting scholar at the Federal Deposit Insurance Corp., and Joshua Rosner, managing partner of Graham Fisher & Co., concluded that the market hasn't accurately priced in the risk of default on non-traditional loans, or of the even-more complex mortgage-backed derivatives they are spun into.
The quality of the underlying asset is opaque to the investor as well as to regulators.
"Even investment-grade CDOs will experience significant losses if home prices depreciate," Mason and Rosner wrote. And decreased funding for mortgages from big investors "could set off a downward spiral in credit availability that can deprive individuals of home ownership and substantially hurt the U.S. economy."
In the worst-case scenario involving a credit crunch, "a vicious cycle of lower spending, weaker hiring and income gains, tighter credit and still lower spending could result, pushing the economy into recession," according to a recent report by Goldman Sachs.
Lemming loans
So far, defaults and foreclosures in the subprime market have received all the attention. The latest data show that more than 14% of subprime adjustable-rate loans were delinquent at the end of 2006, compared with 2.3% for prime fixed-rate loans.
However, Goldman Sachs economists have concluded that delinquency rates are rising nearly as fast for the riskiest prime ARMs, the loans some are calling "toxic loans," or "exploding mortgages."
It might be more accurate to call them "lemming loans," however, because that metaphor best describes the mass insanity and suicidal financial consequences of such loans.
Subprime generally refers to borrowers with a poor credit history. It was a market that accounted for about one-fourth of the mortgages written in the past three years, up from less than 10% five years ago.
America's housing bubble wasn't fed by subprime borrowing alone. Especially on the coasts where home prices were soaring, many buyers with excellent credit, high incomes and good jobs took out more debt than they can repay. Nationally, these Alt-A loans accounted for about 20% of mortgages last year, and more than half of the loans in the states with the frothiest housing markets, according to Credit Suisse. In 2003, Alt-A loans were about 5% of the market.
It used to be that the mortgage industry refused to lend more money than borrowers could repay. There were strict standards requiring a hefty down payment and limiting the size of a loan. These standards helped create the largest secondary mortgage market in the world, which gave big investors the confidence that they'd get their money back with a nice return if they funneled trillions of dollars into the U.S. housing market.
But that was before lenders realized they could make more loans and earn higher profits if they bent the standards, right under the noses of the investors who bought those mortgages.
The result was an explosion of exotic mortgages, all designed to maximize the amount of the loan: adjustable-rate loans with little or no money down, loans with no documentation of income or assets, loans with a simultaneous second mortgage, mortgages with low initial "teaser" rates, and even mortgages with monthly payments so low they don't even pay all the interest due.
If it hadn't been for the extra leverage created by lemming loans, the housing bubble would have never gotten off the ground. It's how ordinary bungalows began to be priced like mansions -- suddenly families with ordinary incomes were getting approved for almost unlimited credit.
Easy credit fueled the bidding wars.
Falling prices
During the big housing bubble, all these loans performed well. With rising prices giving homeowners additional equity, they could always roll one lemming loan over into another, and they could usually take thousands of dollars of equity out as cash. The credit rating agencies gave their seal of approval to these loans.
Now, however, home prices are no longer rising, and that could make many of these loans go sour in a hurry.
According to the S&P/Case-Shiller index, U.S. home prices were up just 0.4% in December 2006 compared with December 2005, and prices were falling in most metro areas at the end of the year. Even in the San Francisco Bay Area, prices fell at a 5.5% annual rate in the last half of 2006, and 9.2% in San Diego.
The best predictor of whether a loan will go bad isn't the credit score of the borrower, but whether the loan is a fixed-rate loan or an adjustable-rate loan with an extra layer of risk, said Cagan of First American CoreLogic. He predicts about 1.1 million families will lose their homes in the next few years because of mortgage rate resets.
Last year, 55% of the Alt-A loans came with simultaneous second mortgages. The average loan-to-value ratio was 88%. More than 80% of Alt-A borrowers chose to provide no documentation of their income, and 62% took an interest-only or option ARM that reduced payments at the beginning with the promise of higher payments later. More than one quarter of the Alt-A loans were one-year adjustable loans, not the five-year adjustable that has been the standard for prime borrowers.
"Cumulative foreclosures on 'teaser-rate' mortgages -- which are classified as jumbo or Alt-A rather than subprime -- could significantly exceed those on subprime mortgages," Jan Hatzius, chief economist of Goldman Sachs, wrote in a research note.
The danger of the lemming loans is that as more of them go bad, more homes will come on to the market. That will drive down prices even more, taking away what little equity the remaining homeowners have and eliminating any chance for them to refinance their loan or sell the house for what they owe. And even more homeowners will go off the cliff.
Cagan figures that every percentage point drop in home prices will mean another 70,000 foreclosures.
According to Cagan's research, about 8.4 million households have adjustable-rate mortgages that are expected reset to a higher rate in the next few years. About 1.3 million have mortgages with initial teaser rates below 2% that will reset to a much higher payment when the introductory period elapses. On average, they'll face an increase of $1,512 in their monthly payment.
About one-third of those families will lose their homes, Cagan estimates.
Someone with a $500,000 mortgage (not uncommon in the Bay Area where such loans are popular) with a 2% teaser rate could find her $1,850 monthly payment rising to $3,500 or more. That would represent a mortgage payment of more than 50% of the median household income ($86,300) in San Francisco.
In the past, homeowners were expected to keep all their debt service to less than 38% of their gross income.
Negative amortization
For homeowners already stretched to the breaking point, the mortgage reset will be catastrophic. But there's something even worse: negative amortization.
Regular amortizing loans pay off part of the principal each month, and eventually the borrower owns the home free and clear. But negative amortizing loans add to the principal each month. The loan balance literally gets larger each month.
Large percentages of recent buyers ranging from California and Florida to Washington and Virginia will face an additional shock because they took out a negative-amortization loan. Nationally, about 10% of the loans taken out in the past two years had negative amortization, including about 24% of the loans in California and 29% in the Bay Area.
These loans allow buyers to make minimum payments that don't cover all the interest due each month. The interest that isn't paid is added to the principal. The shocker comes when the principal grows to a pre-determined level (perhaps 110%, or 115% of the original loan) and the loan is "recast" immediately as a fully amortizing loan, in some cases resulting in a doubling of the monthly payment.
This comes on top of any scheduled reset of the mortgage rate.
Negative-amortization loans were most popular in the areas with the fastest-growing prices during the real-estate bubble. Now most of those same areas have experienced falling prices, meaning the house may be worth less than what the owner owes the bank.
Even among those who believe the credit problems in the mortgage market will have a big economic impact, only a few economists are calling for a full-fledged recession this year. But they all think the risks are rising. 
By Rex Nutting,
Rex Nutting is Washington bureau chief of MarketWatch.By Rex Nutting,
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