[Hat tip to John, our resident Mr. Universe for locating this- I had a terrible time finding this paper!]

Earlier this week the Chicago Fed released a letter entitled, "Comparing the prime and subprime mortgage markets," by Sumit Agarwal and Calvin Ho.  The thesis of this paper was:

We believe that the subprime mortgage problems are not likely to spill over to the rest of the mortgage market or the broader economy.

That’s a line we’ve been hearing a lot, from a number of sources, so I was curious to see how they would substantiate it.  It did not appear to me that they did.

Let’s start with one statement that is true and easy to document:

The expansion of the subprime mortgage market has helped make homeownership possible for households that may not have qualified in the past. While the gains in homeownership are broad based, they are especially large for the minority and low-income communities. However, weaker financial conditions and lower credit scores of the subprime borrowers have led to a higher cost of borrowing; this, combined with declining or flat house prices and rising interest rates, has put upward pressure on the delinquency rates for subprime ARM borrowers.

No argument from me there. Agarwal and Ho go on to compare delinquency rates between prime and subprime:

Data provided by the Mortgage Bankers Association indicate that the overall mortgage delinquency rate has been hovering around 4% since the early 1990s. Although the rate has edged up to about 4.9% in the past 12 months, it remains near historical lows (see figure 1). This is largely because prime loans, which make up 80% of the mortgage market, have stable delinquency rates. Both fixed-rate and adjustable rate prime mortgage delinquency rates are approximately 2% and 4%, respectively— just around their corresponding historical averages.

Subprime mortgages, on the other hand, have exhibited significant increases in delinquency rates. In December 2006, over 13% of subprime loans were delinquent in the U.S., up from about 10% during the housing boom a few years earlier. More than 14% of subprime ARMs were delinquent in December2006, up from about 10% two years earlier, and over the same period, there were twice as many foreclosures on homes (i.e., loan defaults leading to seizures of homes by lenders).

OK- admittedly, while prime mortgages are also seeing an increase in foreclosures, they have proven to be far more stable than subprime. Here’s where they lose me though:

The subprime mortgage market constitutes about 15% of the overall mortgage market, and about 50% of subprime mortgages are ARMs. While there has been a 40% increase in subprime ARM delinquencies over the past two years, the rest of the mortgage market, especially the fixed-rate subprime mortgage market, has not experienced a similar hike in delinquency rates. This suggests that about 7.5% of the overall mortgage market has experienced a significant increase in delinquencies, reducing the likelihood of any spillover effects on the rest of the mortgage market.

So subprime makes up a minority of loans out there…why would that "reduce the likelihood of spillover"?  What their figures indicate is that whatever negative economic events might affect the market, it would be expected that subprime would be the most negatively impacted.  This does not indicate that prime is "bullet-proof."  They also indicated that the trend for all mortgages is up nearly one percent in the past year over historical norms, but fail to demonstrate why that trend will not continue. While prime foreclosures have been relatively stable in the recent past, you can’t ignore the little caveat thrown in on a typical investment prospectus, "Past performance is no indication of future returns."  This kind of logic can have you thinking, "I haven’t died yet-  Hallelujah, I’m immortal!" [Or home prices always go up!]

In the June 19, 2006 Arizona Republic it stated:

While delinquency rates fell for most types of loans from the fourth quarter of 2005 because of a stronger economy, delinquencies for both prime and subprime ARM loans increased year-over-year in the first quarter, according to the MBA.

The hardest hit states so far are those that have experienced the roughest times economically. Michigan, Texas and Georgia lead the pack, specifically around Detroit, Dallas and Atlanta, whose major employers have run into strikes, bankruptcies and industry downturns.

But as the housing market slows, experts expect foreclosures to skyrocket in those areas that have experienced the highest appreciation rate - like California, Florida, Virginia and Washington, D.C.

"There is a direct correlation between foreclosure sales and market activity," said Dr. James Gaines, a research economist at The Real Estate Center at Texas A&M University. "If the rate of appreciation is not there, then there is an increase in foreclosure sales."

As Gaines indicates- when appreciation is gone, foreclosures increase.  Declining property values will adversely affect all borrowers in a community- prime and subprime alike.  While in general a prime borrower may have more equity, better income, and more resources to deal with declining home values, prime foreclosures also rise in times of economic distress.

Agarwal and Ho ended on a positive note:

In response to the rising level of delinquencies, lending institutions have tightened credit and underwriting standards. Credit spreads on new subprime securitizations have increased, and subprime securities originations have slowed.

These measures, together with better disclosure by lenders, efforts to prevent lending fraud and abuse, and financial counseling for potential and existing borrowers, could go a long way toward helping households keep their financial obligations more manageable and reducing delinquency rates.

I must respectfully disagree.  While these measures will reduce the risk of future borrowers defaulting going forward, in the short term tightened lending is reducing the pool of available borrowers, reducing market activity, and thereby increasing foreclosures.

When you look at the ABX historical index- it’s clear that the market doesn’t buy  "What happens in subprime, stays in subprime," and I don’t either.  The difficulty in a declining market is that more people can’t sell a property for what they owe, increasing the likelihood of foreclosure  That may happen on a higher percentage basis to subprime borrowers, but Agarwal and Ho have failed to demonstrate that it won’t happen in significant numbers to anyone else.

Related Posts

1. Arizona and Nevada Tops for Subprime Mortgages (March 18, 2007)
   Tagged Housing Bubble, Market Trends in Las Vegas Market
   
   
2. Subprime Lending and ARMs Could Be Creating the Perfect Foreclosure Storm (June 23, 2006)
   Tagged Housing Bubble
   
3. Subprime Spillover Discussion – and a Bit of Business (April 7, 2007)
   Tagged Housing Bubble, Market Trends, Mortgage Banking in Fraud
   
   
4. Things Are Looking Shaky for Subprime Lenders (August 31, 2006)
   Tagged Housing Bubble, Market Trends in Federal Reserve
   
   
5. What's Behind the Subprime Meltdown? (January 30, 2007)
   Tagged Housing Bubble, Market Trends