Lender Bender

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The ongoing trainwreck that is the residential mortgage lending business continued to unfold on Friday:

New Century Financial, one of the largest subprime lenders, announced that it was the target of an SEC criminal investigation regarding New Century's financial accounting and stock trading.

Fremont General Corp., almost as big a subprime player as New Century, was issued a "cease and desist" order from the FDIC and has since announced that it is shutting down its subprime lending operation entirely.

Two more lenders, Impac Mortgage Holdings and San Diego's own Accredited Home Lenders, joined the earnings restatement parade, presumably because they too vastly underestimated the number of exotic loan borrowers who would end up in default once the home price appreciation perpetual motion machine ground to a halt.

Notably, it appears that the surprise default problem has spread from the subprime arena to that of so-called "Alt-A" loans. The nomenclature seems a bit fuzzy, but as near as I can tell, the term "subprime" is really reserved for borrowers with low credit scores.

Alt-A loans are mortgages that are granted to borrowers with higher credit scores, but which allow non-traditional features such as low down payments, limited income documentation, or initially low "teaser" rates.

It doesn't seem that unpredictable that Alt-A mortgages should experience a high rate of default. Having a history of paying your credit card on time is all well and good, but it isn't much help if your mortgage payment suddenly adjusts to a level that you simply can't afford to pay (based on your real income, that is ... not the income that you stated on the loan application).

That said, the issuers of these loans sure do seem surprised at the number of defaulting borrowers.

The potential significance of the ongoing meltdown in the mortgage industry can hardly be overstated. As I have described before, the virtuous cycle of higher home prices begetting laxer lending begetting even higher home prices, and so on, was absolutely crucial to allowing real estate prices to achieve their current absurd levels. Prices simply couldn't have reached these heights without the lenders' attempts to throw money at anyone who would have it.

Now, those same lenders are scrambling to compensate for their prior excesses, and the virtuous cycle has turned vicious. The increase in defaults has led to tighter lending policies. As borrowers with resetting teaser-rate loans find that they can't refinance into loans anywhere as sweet as they originally had, more of them default, which leads to even further tightening by mortgage lenders. The process is every bit as self-reinforcing as the one it replaced, though not nearly as much fun. And it could have a big impact on home prices in the months ahead.