Shocks and Lies

Foreclosures are ramping up across the country, but you don't hear much talk about the "four Ds" this time. Downsizing, divorce, death and disease are not the big culprits in the current industry shakeout. Instead, falling home values, overextended consumers and loan fraud appear to be driving forces behind the increase in subprime mortgage defaults.

Payment shock and shoddy underwriting seem to be to blame. Too many borrowers took out adjustable-rate mortgages with risky payment reset characteristics to buy homes they probably couldn't afford under more conservative underwriting. And low-documentation loans allowed some borrowers to, shall we say, exaggerate their repayment capabilities. These products have been nicknamed "liar's loans" for a reason.

Too often, these transgressions occurred with the tacit support of real estate agents and loan originators.

Not surprisingly, it's the loan servicing end of the mortgage business that will be challenged with managing this mess.

Some of the data are looking grim. A study by First American CoreLogic predicts that 13% of subprime ARMs originated between 2004 and 2006 will end up in foreclosure over the next six to seven years. And some data suggest that nontraditional loans such as interest-only payment-option products, even when made to higher credit score borrowers, are performing just as bad. It's not just trade publications like this one that have picked up the story. Hardly a day goes by without a headline ("Crisis Looms in Mortgages," The New York Times exclaimed on its front page last month) that conjures up fears of an industry meltdown.

At a recent industry forum, executives from Digital Risk said that the chief causes of rising foreclosure activity today are payment resets that stretch overleveraged homeowners, falling home values that limit their options and increasing incidence of outright fraud. All of those issues pose significant new challenges for default management and loss mitigation executives. Add to the mix the large number of loans made to real estate "investors" in recent years and you begin to see how the risk profile of outstanding loans has changed, and not for the better.

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