Mortgage Market: Correction or Crisis?

THE RECENT U.S. housing market downturn affects credit union balance sheets and earnings. Some market analysts warn further erosion of mortgage quality could trigger a global financial crisis. Here are the facts.

During the past two years, U.S. lenders wrote a record $3.2 trillion in mortgages, with about 20% considered subprime. This mortgage origination increase-due partly to low interest rates and buyers' high expectations of property appreciation-was greater than long-term mortgage demand levels. Hence, it led to the current housing demand dearth.

Decreasing demand and increasing inventory have put the residential construction industry into a recession. Housing starts fell 13% in 2006-the largest decline in 15 years, according to the Commerce Department. New-home sales plunged 11%, and existing-home sales fell 8% in 2006-the largest decline since 1989, according to the National Association of Realtors® (NAR), Chicago.

The effects on the overall economy: The new-home construction decline shaved 1% from gross domestic product growth in fourth-quarter 2006 and is expected to do the same for first-half 2007. Economic growth could slow to 2% in coming quarters, down from 3.4% in 2006.

The effects on home prices: The national median existing home price was $219,300 in fourth-quarter 2006, down 2.7% from one year earlier, according to NAR.

Expect these price corrections to continue. Nominal home prices may fall another 2% in 2007, and it may take many years for prices to reach inflation-adjusted highs.

The large number of nontraditional mortgage holders will intensify the housing market slowdown. The Mortgage Bankers Association, Washington, D.C., forecasts $1.5 trillion worth of adjustable-rate mortgages (ARMs) will reset in 2007. Some will default, as borrowers find they can't afford higher payments and can't refinance because they owe more than their homes are worth.

The Center for Responsible Lending, Durham, N.C., predicts about 20% of the subprime loans made in the past two years will end in foreclosure. Overall mortgage delinquency rates are expected to peak at more than 5% during the next few years.

Because of these factors, expect mortgage credit quality to deteriorate in the short term. In January 2007, new mortgage foreclosure filings increased 19% from the previous month and 25% from January 2006, according to RealtyTrac, Irvine, Calif. The current national foreclosure rate is one new foreclosure filing for every 886 U.S. households. WaU Street investment firms and big banks are putting pressure on subprime mortgage firms to buy back bad loans, forcing many of the firms out of business.

Lenders have responded with stricter underwriting. More banks tightened mortgage lending standards in fourth-quarter 2006 than in any other quarter since the early 1990s, according to a Federal Reserve poll. Tighter credit standards make it harder for potential home buyers to buy homes, further depressing home prices.

The effects on credit unions: In 2006, credit unions originated $55.1 billion in mortgages, down 10% from 2005 and the slowest origination pace since 2001. Credit unions then sold 30.4% of their mortgage originations into the secondary market, the lowest percentage since 2000.

The good news is credit union mortgage delinquency rates increased only slightly from their record low levels. From June 2006 to December 2006, fixed-rate, first-mortgage delinquency rates rose to 0.28% from 0.22%, and ARM delinquency rates rose to 0.67% from 0.53%.

The risks from the current housing market slowdown on credit unions include potential spillover effects into credit card portfolios, as members with subprime or adjustable-rate loans come under financial stress and may become delinquent. Other risks include mortgage collateral value declines and a general slowing of economic activity-leading to lower credit demand.

If the subprime market worsens and affects the prime market, investors' supplies of funds into the housing market could dry up quickly, increasing mortgage interest rates and devastating the housing market.

Currently, however, a housing market crisis looks unlikely if job and income growth remain robust.