Subprime Mortgage Market News

Daniel Gross, reading the Wall Street Journal (no link available), pulls out two interesting factoids that suggest that things are not quite hunky dory in consumer land despite the good headline numbers that we are seeing.

The 2005 data through September reveal that these mortgages are faring worse than in comparable periods in each of the three previous years. This year, 6.23% of the loans are delinquent, on average, in their first nine months, a rate not surpassed until the 20th month for 2004 mortgages. By September 2004, that year’s mortgages had a delinquency rate of only 3.72……. (previous from WSJ)

now words from Dan Gross: More than 20 percent of the adjustable-rate suprime loans made in both 2002 and 2003 are delinquent? Who is holding the bag on all this?

Consumers who are going into subprime, low or no doc mortgages with declared or stated income programs tend today to be very marginal borrowers. Given that the savings rate is negative and as General Glut this is all that is keeping the headline numbers up combined with real wage declines, credit is the only to keep on spending and ignoring problems.

Dan Gross’s post points out that even in an environment of very low interest rates (lower than today), the marginal mortgage buyer is having very significant problems paying their monthly mortgage bills even with the teaser and lock-in rates still in effect. The most marginal buyers with the most expensive houses, are in worse shape than identical virtual people who were able to buy a couple of years previously. Now this is a problem because there are only a few ways to work around this problem of not paying off your mortgage.

The first is to find more income. For the overwhelming majority of Americans, that means either cutting back on expenditures and shifting those resources to the mortages, or picking up more work or better paying work. The first is a net negative effect on short term economic performance. Finding a new job or better pay is a damn difficult thing to do right now, so it is an unlikely choice. But if you want to protect your credit, you are probably cutting some consumption off.

The second option is to refinance. You can do this in a couple of different ways — extending the term, providing better documentation to lower your rates, going for a more exotic loan, or doing it on the cheap and making partial payments to ruin your credit scores while stretching out the option space while praying for a miracle, massive home appreciation burst, or a new source of income.

The problem with this is that it is looking very likely the yield curve will invert, which as Prof. Hamilton explains is a good predictor of a slowdown or significant recession. Kash at Angry Bear has a very good post and graph with the narrowing curves. We are not at an inverted curve yet, but as David Altig at MacroBlog notes, the most likely implied probability of short term rates will be at 4.75% in March. If long rates behave like they have been behaving, that is a good inversion point.

Now why is this bad for subprime borrowers looking to refinance to avoid deliquncey? Simply for two reasons. The obvious reason is that an inverted yield curve signals a recession or a slowdown, which tends to lead to less economic activity which tends to lead to fewer jobs and far fewer raises, which pushes the probability of a miracle further away. The slightly more subtle reason is that short term rates strongly influence the interest rates available on ARMs while long term rates have more influence on fixed rate products. If the curve inverts, there will be little to no difference on Day 1 interest rates between fixed and traditional floating rate mortgages, and even the teaser rates for the more exotic options are going to be more expensive than they would have been earlier this year. Refinancing means accepting higher interest rates and much lower amortization and equity construction if the marginal borrower qualifies for more traditional products. However, since the borrower in this situation is looking to refinance is most likely already a marginal borrower using risky or exotic forms of leverage, it is less probable that they’ll qualify fully for a full doc 80/20 loan with a good rate. Instead they’ll have to refi into something even crazier than what they have now. So hello OPTION ARM or anything else like that.

The third option is to go to the bank, and hand them the keys and walk out and laugh as the bank is on the hook for a house that may be upside down. This risk has been shifted to a broader cirle of risk holders over the past generation, including the derivatives market. No one has any freaking clue how this scenario could play out if any of the major and semi-major derivative players have errors and uncovered and unknown risks somewhere in their mortgage backed security related portfolios.

Right now we are living in interesting times with economic growth being supported by a massive expansion of debt despite interest rates that are bouncing off the bottom that they hit earlier this year. Over the past couple of years, the marginal American home buyer has taken on a massive amount of risk carried only by these low interest rates and shielded by short term teasers. At the same time, the traditional tools of getting away from short term, payment shock of good economic AND wage growth have not come through for the American consumer. The scenario that I am sketching is dark, and not the highest probability event, but it is something that is plausible in occuring.

Leave a Reply

Your email address will not be published. Required fields are marked *

Connect with Facebook