WASHINGTON — Approximately 1.1 million foreclosures are expected in the next six to seven years due to aggressive lending practices, fluctuating home prices, and the rise of the securitization model that allowed lenders to significantly lower underwriting standards, according to a Government Accountability Office report expected soon.
House Financial Services Committee Chairman Barney Frank, D-Mass., and Rep. Spencer Bachus of Alabama, the panel's top Republican, requested the nonpartisan study in April to shed light on the scope, cause, and possible solutions for the surge in defaults and foreclosures.
Details of the report were revealed in a briefing from the GAO to the House Financial Services Committee last week. A copy of the briefing, dated Oct. 10, was obtained by American Banker and is available
Though the GAO's briefing did not offer policy recommendations, and some of its conclusions have been offered previously, its findings alone could play a critical role in shaping legislation to overhaul mortgage standards. The agency often is seen as a provider of independent analysis that can persuade lawmakers on both sides of the aisle.
In particular, the emphasis on the role of securitization in fostering the rise of defaults also could have a significant impact. Rep. Frank is close to introducing a bill that is expected to include some limited assignee liability — a concept the banking industry opposes.
The GAO was careful not to single out a specific reason for the growth in defaults and foreclosures, but it did put a strong emphasis on the symbiotic relationship between the growth of the securitization model and the easing of underwriting standards.
"Originators had financial incentives to increase loan volume, potentially at the expense of loan quality," the GAO said. "As lenders sold loans on the secondary market, the risks were passed on to investors."
Before the 1990s "lenders held most loans on their balance sheets, so the same entity that originated the loan and created the risk bore the risk," according to the briefing.
Investors and originators also underestimated the dangers of new products, including no-documentation and low-documentation loans, the GAO said. "Officials from investment banks and credit rating agencies … acknowledged that they were surprised by the speed and severity of [home price appreciation] declines and underestimated the risk of certain loan features such as low and no documentation and high … [loan-to-value] loans."
Mortgage fraud was also a factor, according to the briefing. Fraud on subprime and alternative-A loans often was linked to a prevalence of no- and low-documentation loans, the GAO said. It cited a report by the Mortgage Asset Research Institute which found that cases of mortgage fraud grew to 28,000 last year, from 3,500 in 2000.
The GAO found that other conditions, such as regional economic conditions and rising interest rates, also had a marginal impact on rising defaults and foreclosures. But the agency cited analysis that found the increase in interest rates helps explain only roughly 6% of the change in delinquency rates on all mortgages originated between the fourth quarter of 2005 and the first quarter of 2007.
Also, the GAO said that it had not sufficiently analyzed the differences in performance on loans originated by bank and nonbank lenders. However, its previous work "raised concerns about nonbank lenders noting that some have been targets of some of the most notable federal and state enforcement actions involving abusive lending."
The agency also found that the role of brokers has increased in recent years and cited an estimate that brokerage firms jumped from 30,000 in 2000 to 53,000 in 2004. It also noted that brokers originated about 60% of subprime loans in 2005, compared with only 25% of the prime market.
Last year the top 25 originators of subprime and alt-A loans accounted for more than 90% of the dollar volume of all such originations, according to the briefing. Those top originators included 21 nonbanks, including 14 independent lenders, and seven nonbank subsidiaries of banks, thrifts, or holding companies.
Between the second quarter of 2005 and the second of this year, subprime loans accounted for less than 15% of loans serviced but represented about two-thirds of the overall increase in the number of mortgages in default and foreclosures, the GAO said.
The GAO also faulted lenders for aggressive practices. "Aggressive lending practices reduced the likelihood that some borrowers would be able to meet their mortgage obligations," the briefing said.
From the second quarter of 2005 to the second quarter of this year, the number of defaults grew 43%, to 473,000. The number of houses that started — but had not exited — the foreclosure process increased 55%, to 619,000, according to the briefing.
But the problem is liable to get worse, the GAO said. It cited a study this year that found 13% of adjustable-rate mortgages originated from 2004 to 2006, or about 1.1 million homes, would enter foreclosure over a 6 to 7 year period as a result of interest rate resets.
"The extent to which current default and foreclosure trends continue depends on a number of factors, including lenders' willingness to modify loan terms, the amount of liquidity available for refinancing ... and general economic conditions," the GAO said.
