Will the Subprime Turmoil Spread Upwards

While the recent rise in defaults on subprime mortgages has become front page news, the most common viewpoint is that this will not have a significant impact on the economy since prime and Alt-A mortgages represent 45% and 20%, respectively of all mortgages outstanding and we are yet to see significant defaults in theses loans.

The source of the problem is that about 80% of subprime mortgages today — many of which were taken in the last few years — are adjustable-rate mortgages (ARMs) that have been nicknamed “exploding ARMs” because they have low fixed-interest payments in their first few years but then usually adjust to higher interest payments. Many of the sub-prime mortgages which were taken during the last few years have recently reset at higher rates leading to a rise in bad loans.

As many as 30% of the prime and 60% of the Alt-A mortgages taken out in the last few years were also ARMs. However, they have longer reset periods — 2 years or more — than subprime, which means we have yet to see the impact of higher payments on this segment of borrowers.

Already we are seeing seeing higher delinquency rates among prime borrowers, although not yet at alarming rates. 2.57% of all prime mortgages are now delinquent compared to 13.3% for subprime, according to the Mortgage Banking Association. Since almost half of all mortgage originations are prime, only a small rise in default rates is required to cause severe financial loss.

The reason many subprime borrowers are defaulting is the lax lending standards which allowed people to get mortgages who never should have. The lenders did not mind because there was a huge demand for mortgage-backed-securities (MBS) from investors. Common sense suggests that this insatiable hunger for MBS surely would have caused lenders to be similarly liberal when it came to originating prime and Alt-A mortgages.

That is, the current Alt-A borrowers probably would have been classified as subprime, and prime borrowers as Alt-A in the past. Thus, there is a substantial risk that the default rates for these mortgages could rise to significantly high levels, similar to what we are now seeing in the subprime group.

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