'Liar loans': Mortgage woes beyond subprime

Loans where borrowers gave little proof of income could be the next threat to the troubled real estate market - and the economy.

By Chris Isidore, CNNMoney.com senior writer

NEW YORK (CNNMoney.com) -- Subprime mortgages have been generating a lot of attention, and worry, among investors, economists and regulators, but those loans may be only part of the threat posed to the housing market by risky lending.

Some experts in the field are now concerned about the so-called Alt. A mortgage loan market, which has grown even faster than the market for subprime mortgage loans to borrowers with less than top credit.

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Alt. A refers to people with better credit scores (A-rated) who borrow with little or no verification of income, or so-called alternative documentation.

But some people in the industry call them "stated income" loans, or worse, "liar loans." And they were an important part of the record real estate boom of 2004 and 2005 that has recently shown signs of turning into a bust.

Standard & Poor's estimates that the Alt. A market has gone from less than $20 billion in loans in the fourth quarter of 2003 to more than $100 billion in each of the last three quarters. Overall, new Alt. A loans totaled $386 billion in 2006, according S&P's estimates - up 28 percent from 2005.

By comparison, subprime loans reached $640 billion in 2006, according to trade publication Inside Mortgage Finance, though that was down about 4 percent from the record level reached in 2005.

"Much of the growth of the last few years has come from reaching out beyond where the lenders should have reached out," said Guy Cecala, publisher of the trade publication. "It wasn't normal business that walked through their door. All was based on the idea that home price appreciation would cover over a lot of the problems that occurred. But that hasn't happened."

But just as the Alt. A market has grown even faster than subprime, some believe it could shrink even faster amid growing concerns in the marketplace. That means another pool of money that has supported home sales and housing prices being yanked just as home sales and prices are already in decline.

The loans were very popular with buyers seeking investment property rather than a home to live in. And while default and delinquency rates for Alt. A are just a fraction of the rates for subprime, the widespread use of the loans by investor-buyers is a concern. That's because there's a glut of investor-owned homes and condos already up for sale - with prices tumbling in many markets.

"There's a reason they ask on the application do you intend to live in the property," said David Berson, chief economist for mortgage financing firm Fannie Mae (Charts). "People who live in a property are less likely to default than investors."

Still, Berson said that while default rates are likely to rise for many Alt. A loans, he doesn't think it will reach the levels seen in the subprime sector. He said only 1.5 percent of Alt. A loans are now 60 days or more delinquent, while in subprime it is 7.5 percent. Absent a major recession, he doubts that Alt. A loans will reach the same kind of delinquency or default rates causing worries and lender bankruptcies in subprime.

But many in the field say that there is a real squeeze on Alt. A loans as lenders tighten up on underwriting standards. Mitch Ohlbaum, president of mortgage broker Legend Mortgage whose business was about 55 percent Alt. A, said he's seen a dramatic change in the business the last few years, and its now swinging back away from the loans.

"Stated income borrowers were typically self-employed people who write off a lot of income, so their tax returns really don't reflect what they're earning," said Ohlbaum. But he said the loans have grown in popularity for folks who had no money to put down on a home, or could only pay interest on a loan, especially by real estate investors.

"All that nutty stuff is going to disappear," said Ohlbaum. "Everyone today is shying away from the 100 percent of value loan. But anytime there's a big change in the market like there is now, everyone will overcompensate for a while. I think this will last for 12 to 14 months before things are back to normal, and I think you'll see more foreclosures, more people in trouble in the meantime."

And he said some types of Alt. A loans that had become popular, such as the no-money-down loans, are almost impossible to arrange today. And the definition of what is considered an A-quality borrower has tightened up.

Inside Mortgage Finance's Cecala said he believes underwriting of the loans had grown too loose by the end of last year, and that even some subprime borrowers were getting so-called low-doc or no-doc loans. He believes as much as a quarter of Alt. A loans were going to subprime borrowers. "In some ways it's the worst possible combination," he said.

Now with the market correcting, even some borrowers with good credit are having Alt. A loan applications rejected, Ohlbaum said. That will cut off another source of financing for the battered real estate market.

The biggest Alt. A lender is Pasadena, Calif-based IndyMac Bancorp. (Charts) Trade publication Inside Mortgage Finance estimates it did $70.2 billion of the loans in 2006, up 48 percent from a year earlier. As the sector grew, its shares shot up nearly 50 percent in a year and hit a record high in April 2006. But with rising concern about the mortgage sector, its shares have plunged 36 percent since the start of 2007.

But it's not just the smaller lenders like IndyMac in the sector. Like subprime, some of the nation's largest finance firms are major players. Countrywide Financial (Charts), one of the nation's largest mortgage lenders, is the No. 2 Alt. A lender with $68 billion in loans, according Inside Mortgage Finance.

GMAC, the finance unit of General Motors (Charts) that is now 51 percent owned by Cerberus Capital, is No. 3 on the list at $44 billion, and a unit of General Electric (Charts) is No. 4 at $28.3 billion, just ahead of Washington Mutual (Charts), the nation's largest thrift with $25 billion in the loans.

What is not known is which Wall Street firms, banks and hedge funds have bought hundreds of billions of dollars worth of mortgage-backed securities comprised of Alt. A loans, or have lines of credit out to the smaller Alt. A lenders.

"If they get spooked, you'll see the same things that are happening in subprime - repurchase requests, funding sources drying up," said Cecala.

But Fannie Mae's Berson said he doesn't foresee the problems getting as bad as subprime, even if the problems in the sector do get worse. He said the changes taking place are needed, though they will raise the cost of credit.

"I would suspect that investors will view credit risk with a better eye going forward," he said. "Loans that have potentially more risk will end up with higher [rate] spreads. Maybe they'll just widen to where they should be."

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