The WSJ reports that delinquencies on subprime mortgages have been increasing at a troubling rate recently.
Based on current performance, 2006 is on track to be one of the worst ever for subprime loans, according to UBS AG. “We are a bit surprised by how fast this has unraveled,” says Thomas Zimmerman, head of asset-backed securities research at UBS. Roughly 80,000 subprime borrowers who took out mortgages packaged into securities this year are behind on their payments, the bank says.
The fact that borrowers with bad credit histories are now having a tough time making loan payments shouldn’t come as a complete surprise if we consider how the boom began:
The subprime industry’s current troubles can be traced back to 2003 and 2004, when defaults were unusually low. Investors who purchased these loans did well and were eager to buy more. That encouraged lenders to lower their standards, making loans to more people with low credit ratings. Lenders also grew less inclined to demand full documentation of income and assets and more willing to offer “piggyback” loans that allowed borrowers to finance 90% or 100% of the purchase price without being required to buy private mortgage insurance.
Many lenders kept introductory “teaser” rates low even after short-term interest rates began rising in June 2005, while increasing the amount the rate could rise on the first adjustment. That meant borrowers would face sharply higher costs when their monthly payments were reset.
The environment has changed over the past year with interest payments increasing for borrowers. And if they aren’t able to make their payments, they can’t sell their houses as quickly and for as much value as before.
The borrowers aren’t the only ones feeling the pinch in the subprime mortgage market:
If delinquencies continue to grow, the pain could also be felt by investors who have flooded into the market for subprime securities. Because of the way mortgage-backed securities are structured, investors who buy investment-grade securities aren’t likely to be hurt if losses are close to expectations. But if losses on the underlying mortgages substantially exceed expectations, some investors who buy the riskiest slices of subprime securities are likely to rack up losses. These include hedge funds and investors who buy collateralized debt obligations, pools of debt instruments that are often snapped up by foreign buyers.
There has been a bubble in subprime mortgage securities which was fueled by foreign governments wishing to invest their dollar reserves in debt instruments and by hedge funds who were engaged in the carry-trade. As delinquencies continue to soar it is reasonable to expect foreigners and hedge funds to pull out of the mortgage-backed securities market. This will force lenders to tighten their lending standards and cause a substantial decline in the volume of subprime mortgages. A fall off in mortgage activity will further hurt the housing market and, of course, the economy
