Most of the news reporting on the subprime meltdown has focused on the problems that borrowers face when their loans reset from low teaser rates to much higher fixed rates. While this is a big issue for millions of borrowers, resetting subprimes are just a single wave in an ocean of bad mortgage debt. This can be seen from the fact that many of the subprimes were seriously delinquent or in foreclosure long before the mortgages reset to higher rates. In an analysis done early this year, the FDIC found that 10 percent of the subprime adjustable rate mortgages issued in 2006 were seriously delinquent (missed three or more payments) or in foreclosure within 10 months of issuance. Since no mortgages had reset at the 10-month point, clearly there were other problems. Either borrowers could not afford even the low teaser rates or they were defaulting because they realized that their homes were worth less than their mortgages. The latter problem will only get worse as house prices continue to decline in response to the glut of housing on the market (the inventory of unsold new homes is 50 percent above the previous record and the number of vacant ownership units is almost twice the previous peak) and tightening credit conditions curtailing demand. Falling house prices will cause many homeowners to find that they owe more than the value of their mortgage. This provides a temptation to just walk away, which will get larger as the gap between the size of the mortgage debt and the price increases. Subprime borrowers, with poor credit histories, might not be very concerned about the prospect of another black mark on their credit history due to a foreclosure. For this reason, plus the fact that many really can’t afford their mortgages, it is not surprising that most of the defaults have been in the subprime segment so far. However, as more homeowners come to realize that they have a large amount of negative equity in their home, the default rate in the prime market is certain to rise. (Defaults to date have been concentrated in the ARM segment partly because of an adverse selection issue. Less well-situated borrowers are more likely to have taken out ARMs since the payments are typically lower than fixed rate mortgages. Therefore it's not surprising that ARMs holders would default at higher rates than holders of fixed rate mortgages.) When defaults begin to soar among prime mortgages, the big money boys better not say how surprised they are.
--Dean Baker
