Most of the discussion of the subprime crisis has focused on the inability of moderate income homeowners to meet the higher payments after adjustable rate mortgages reset to higher rates. While this is an important issue, the more fundamental problem is simply that house prices are falling. This point is illustrated beautifully by a chart accompanying an article in today's NYT showing default rates for subprime adjustable rate mortgages (ARMs) issued in 2005, 2006, and 2007. The default rate for each year rises dramatically for the same number of months after issuance. The default rate for subprime ARMs issued at the start of this year is already 8 percent. The default rate for subprime ARMs issued in 2005 is 16 percent, 32 months after issuance. This numbers are so striking since the vast majority of these mortgages have not reset yet. Even most 2005 mortgages have not reset, since the most common period is 36 months. In other words, the reset is not the problem with these defaults, people simply cannot afford their homes or realize that they owe more than the current value of their house, so they opt to walk away from it. The problem of falling house prices of course affects all homeowners, not just the subprime market. This is why we should expect much higher default rates in the future. Look for the Fed to be surprised.
--Dean Baker
